Almost Daily Grant's
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Tuesday, June 18, 2019
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.”
Recap June 18
So much winning
“The cultural level of a nation is mirrored by its rate of interest: the higher a people’s intelligence and moral strength, the lower the rate of interest.” Thus declared economist Eugen von Böhm Bawerk, according to Richard Sylla and Sidney Homer’s classic tome A History of Interest Rates. By that logic, Europe is the domain of superhumans, as the overnight deposit rate has resided below zero since June 2014 and at negative 40 basis points since March 2016.
The M.D. overseeing Europe’s monetary affairs has his own version of the Hippocratic Oath. Speaking at the ECB’s annual forum at the resort town of Sintra, Portugal today, ECB president Mario Draghi made waves by suggesting the central bank will impose still lower interest rates:
Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools. . . Negative rates have proven to be a very important tool in the euro area.
In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.
The implications are clear. Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, told Bloomberg: “Draghi is going to finish his tenure [set to end on Oct. 31] with a cut. The door is now open and I don’t see how they can not walk through it.” Mike Riddell, fund manager at Allianz Global Investors, noted: “The ECB has just handed the bond bulls an ammunition dump.”
Five years and counting into the negative rate era, the ECB’s increasingly radical policies designed to hot up inflation simply haven’t worked. Eurozone CPI rose just 1.2% year-over-year in May, the lowest figure in over a year. Likewise, the “five year, five year inflation swap rate,” Draghi’s preferred metric for the future inflation expectations that the central bank is so eager to manipulate, fell to a record low 1.14% on Friday, since rebounding to 1.23% but still well below the five-year average of 1.48%, let alone the ECB’s now-symmetrical, “close to 2%” bogey.
While inflation stubbornly refuses to follow the playbook, the bond market has been more easily cowed. Following Draghi’s remarks today, the French 10-year yield temporarily broke below zero for the first time ever, while Sweden (which resides outside of the eurozone currency bloc but is an E.U. member state) also saw its 10-year borrowing costs make their first ever foray into negative territory.
More broadly, the worldwide sum of negative-yielding debt instruments rose to $11.8 trillion as of yesterday, up from less than $6 trillion as recently as last fall and within range of the record $12.2 trillion seen in July 2016 (when the 10-year Treasury yielded less than 1.4%, compared to 2.06% today). Never in the 4,000 years of human history, per Sylla, were negative rates seen in substantial size prior to this cycle. The upside-down policy rate extends to the less-creditworthy members of the E.U., as Baa3/triple-B-rated Italy and B1/double-B-minus-rated Greece saw their 10-year yields fall to 2.12% and 2.51%, respectively, not far above the split-rated (triple-A at Moody’s, double-A-plus at S&P) United States.
Bloomberg’s global negative rate index by market capitalization since January 2010
The peculiar state of affairs has not seemed to help the Old Continent’s frail banking system, which lags far behind global peers in terms of profitability and valuation (Almost Daily Grant’s, May 28). As the banks list, one of the shakiest institutions continues to search for answers. Bloomberg reports today that Deutsche Bank A.G. (which has seen shares fall 84% in the last nine years to less than 21% of its year-end 2018 book value) CEO Christian Sewing is set to “purge” a number of top executives and is also “zeroing in on another round of deep trading cuts that may result in the shuttering of the U.S. equities” division.
Others take a different tack. Speaking on a conference panel this morning, Cornelius Riese, co-CEO of Frankfurt-based DZ Bank A.G. (Germany’s second-largest by assets), observed that negative rates indeed “have a huge impact on banks.” Riese ventured to offer some gentle criticism of Draghi & Co.’s grand policy experiment: “Maybe at the end of the story, in three to five years, we will notice it was a historical mistake.”
Not everyone was so circumspect. This morning, Donald Trump took to Twitter to complain:
Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA. They have been getting away with this for years, along with China and others.
Sad!
Recap June 18
News that Trump will meet with China’s Xi Jinping at the G-20 meeting next week helped spur another bull move, as the S&P 500 jumped 1% to close within 100 basis points of its April 30 highs. Energy prices ripped with WTI crude closing above $54 for the first time since late May, while gold moved to a new 52-week high above $1,346 an ounce. Treasurys rallied with strength in the long end pushing the curve flatter, and the VIX finished just above 15.
- Philip Grant
Monday, June 17, 2019
That was then
How the turntables have turned.
How the turntables have turned.
Everyone's a critic
A shocker this morning:
A shocker this morning:
Recap June 17
That was then
How the turntables have turned. Over the weekend, the New York Post reported that Goldman Sachs Group, Inc. CEO David Solomon has been invited to perform at European house music festival Tomorrowland later this summer, a gig which “will take DJ D-Sol’s career to a new level, according to insiders.” Solomon/DJ D-Sol already saw a recent single reach as high as number four on the Billboard Dance music charts earlier this year.
It’s a new era for Goldman, long a Wall Street investment partnership led by co-chairman John Whitehead, a Navy veteran who saw action at the invasions of Normandy and Iwo Jima before joining the firm in 1947. A 2015 Financial Times obituary of Whitehead cited a telling exchange early in his Wall Street career:
As Whitehead relates in Money and Power, How Goldman Sachs Came to Rule the World, that did not mean the partners tolerated any compromise in formality. Arriving at the office in a seersucker suit in a humid New York summer, he was accosted by Walter Sachs, scion of the firm’s co-founder and asked: “Young man, do you work at Goldman Sachs?” He confirmed that he did, only for Sachs to reply: “In that case, I would suggest that you go home right now and change out of your pajamas.”
As for the musically-inclined who don’t care for techno, alternatives abound. As noted by Jim Bianco this morning on Twitter, Fed governor Richard Clarida released an album in 2016 on Apple Music. Relevant track titles include “Gone too far,” “Take too long,” “Just can’t wait” and others.
Everyone's a critic
A shocker this morning: Patrick Drahi, founder and president of the board of telecom giant Altice N.V. as well as chairman of Altice U.S.A, Inc., announced he will acquire Sotheby’s, Inc. (BID on the NYSE) for $3.7 billion in cash. Drahi, worth some $9.3 billion according to Forbes, will take 275-year old Sotheby’s private through his appropriately named BidFair USA, LLC entity, ending the company’s 31-year run on the New York Stock Exchange.
The $57 per share deal price represents a 61% premium to Friday’s close and is 56.3% above Sotheby’s volume weighted average price over the past 30 days. BID shares had not exactly been a hot commodity of late, falling 25% from the Grant’s bearish analysis on September 7, 2018 to Friday, compared to a 10% loss from the Russell 2000 Index. Following today’s announcement, BID shares now sit higher by 19% over the past nine months and change.
For already junk-rated (Ba2 at Moody’s and double-B-minus at S&P) Sotheby’s, today’s news is seemingly a best-case outcome for management and shareholders, if not the short interest. Wendy Battleson and Giulia Costantini, co-founders of Art Strategy Partners and themselves former outspoken bears (Grant’s, April 19), have this comment:
Taking Sotheby's private was the only smart move for the company. Sotheby's requirements for complete transparency as a public company and quarterly disclosures of guarantee risk and the sizing of their art finance book were cumbersome when compared to their main competitor Christie's. Auction houses like confidentiality even within their own operations and being public simply doesn't allow that.
Sotheby’s, Inc. one-year price chart. Source: The Bloomberg
For Drahi, a self-described “longtime client and lifetime admirer of the company,” BID’s cachet looms large, as he describes Sotheby’s in the press release as “one of the most elegant and aspirational brands in the world.” Consistent with Altice’s highly leveraged business model (net debt stands at 6.8 times consensus 2019 adjusted EBITDA), Drahi will fund the deal through financing from BNP Paribas S.A., as well as by selling a portion of his stake in Altice U.S.A., Inc.
Is that move a sign of the times? A number of corporate bellwethers have recently opted to monetize existing stakes instead of raising fresh capital. On May 30, the Financial Times reported that SoftBank Group Corp.’s Vision Fund will take out $4 billion in loans, collateralized by its stakes in Uber Technologies, Inc., Guardant Health, Inc. and Slack Technologies, Inc., after encountering difficulty in raising money for a Vision Fund sequel.
The FT notes that “by borrowing against the value of publicly traded shares, SoftBank can return capital to investors in the fund while bypassing ‘lock-up’ periods that can prevent shareholders from selling stakes in newly-listed businesses.” That follows an $8 billion margin loan in April 2018 taken out by SoftBank collateralized by its stake in Alibaba Group Holding Ltd. (BABA on the NYSE). Last Thursday, The Wall Street Journal reported that Alibaba filed confidential paperwork with the Hong Kong Stock Exchange ahead of a second listing, a move which could raise upwards of an additional $20 billion per media reports.
Alternatively, some companies pursue highly dilutive offerings to scrounge cash. On Thursday, single-B-plus-rated Hertz Global Holdings, Inc. announced a rights offering of up to $750 million, a move which will help the company meet $1.5 billion in debt maturities set for 2020 and 2021 but would dilute existing shareholders by 69% if the entire allotment were exercised.
Recap June 17
Stocks gave back early gains as the S&P 500 finished just above unchanged, up 15% year-to-date and 2% below its April 30 high-water mark. WTI crude and gold both ticked lower, finishing at $52 a barrel and $1,339 an ounce, respectively, and rates mostly ticked higher. The Fed commences its two-day policy meeting tomorrow, with interest rate futures currently implying 17% odds of a rate cut on Wednesday.
- Philip Grant
Thursday, June 13, 2019
Liquidity shortage
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s
Yesterday, the U.S. Treasury reported that Uncle Sam’s
QT Progress report
Recap June 13
Liquidity shortage
From Bloomberg:
The London Metal Exchange is toughening its stance on alcohol consumption with new rules that will prohibit floor traders from drinking during the workday, according to people familiar with the matter.
Maybe they could take the party to a WeWork office?
Recovery room
Yesterday, the U.S. Treasury reported that Uncle Sam’s May deficit totaled a record $208 billion, bringing the 2019 year-to-date (the fiscal year begins on Oct. 1) shortfall to $739 billion. For context, full-year 2018 and 2017 saw gaps of $779 billion and $666 billion, respectively.
The explosion in government deficits during this extended epoch of economic growth is unusual. Typically, the government ledger improves during expansions, as revenues increase and the need for emergency spending diminishes. Thanks in large part to the Trump administration’s 2017 Tax Cuts and Jobs Act, that playbook is out the window. Instead, the White House’s own Office of Management and Budget pegs this year’s deficit at 5.1% of GDP.
The flowing red ink is set to continue, if estimates from the Congressional Budget Office are on the beam. The CBO pencils in deficits averaging 4.3% of GDP each year through 2029. That compares to a 50 year average deficit of 2.9% and 2.4% as recently as 2015.
Those persistent deficits will accelerate the pileup of Treasurys, as the CBO estimates that debt held by the public will jump an additional $12.7 trillion to $28.5 trillion by year-end 2029, equal to 92% of projected GDP from 78% currently and 66% in 2011.
There’s more where that came from. The Wall Street Journal reports today that “political support for taming deficits has melted away.” The electorate is increasingly comfortable with persistent shortfalls, as a January survey from Pew Research found that 48% of respondents favored prioritizing deficit reduction, down from 72% in 2013. Then, too, former IMF economist Olivier Blanchard argued at the American Economic Association in January that as government borrowing costs have generally lagged nominal GDP in the past 75 years, debt can essentially pay for itself as long as the economy keeps growing.
Indeed, as the post-crisis economic expansion rolls into its 120th consecutive month, tying the March 1991 to March 2001 period for the longest on record, The Journal concludes that the U.S. “is on course to test just how much it can borrow.”
That complacency is understandable, considering the bond market’s forgiving stance. Since 2002, federal debt held by the public has more than quadrupled, to $16.2 trillion. Yet, as the government’s books deteriorate, interest rates march lower, with the 10-year yield now at 2.13%, compared to 4.9% 17 years ago.
An interruption of the now decade long economic expansion would accelerate those fiscal shortfalls. Over the past 50 years, recessions have spurred deficit growth equating to 4% of GDP, on average. As widely noted, the yield curve suggests that something nasty may be in the offing (Almost Daily Grant’s, June 6).
Other indicators are likewise concerning. On Monday, The Dodge Momentum Index, a leading indicator for nonresidential construction, fell 9.2% year-over-year in May, with the commercial component down 16% from a year ago. Similarly, the Architecture Billings Index, which leads nonresidential construction activity by nine to 12 months, slipped into contraction in March for the first time since 2017. After a modest rebound in April (the most recent reading), American Institute of Architects chief economist Kermit Baker commented: “In contrast to 2018, conditions throughout the construction sector recently have become more unsettled.”
As the prospect of recession hovers and investors pile into the obligations of an ever-more spendthrift government, might an inflection point be approaching? The Feb. 9, 2018 edition of Grant’s Interest Rate Observer detailed the psychological shift between current conditions (underscored by the famous line reputedly offered by Dick Cheney: “Reagan proved that deficits don’t matter”) and the fallout of the 1946 to 1981 bond bear market, in which the 30-year Treasury was quoted at 14% in 1984, offering an inconceivable inflation-adjusted yield of nine percentage points:
In a bear market, new supply is perceived to be bearish, or at least not bullish (another tautology freighted with trading wisdom). Supply is thought to be bearish not, perhaps, because the supply of bonds is greater than the demand for bonds at prevailing yields and prices (though that is certainly true), but because the very thought of fixed-income securities has become repellent.
That attitude, and its opposite, are years in gestation.“The bond crop never fails” was how disgusted fixed-income investors expressed the free-floating hatred (or love-hatred, as the opportunities for reinvestment of coupon income were forever improving) of an asset class that had disappointed so many for so long.
From which it would follow that the Cheney/Reagan deficit doctrine is due for cyclical revision.
QT Progress report
No change this week, as the Fed’s portfolio of securities held outright remained at $3.668 trillion, down $9.2 billion from the trailing four-week average. Since the fall 2017 commencement of QT, total balance sheet assets are down by 13.7%, an 8.3% simple annualized pace.
Recap June 13
Stocks finished little changed, leaving the S&P 500 marginally higher so far this week, while resources caught a bid with WTI crude bouncing over $52 a barrel and gold reclaiming a 52-week high at $1,341 an ounce. Another strong day for Treasurys saw the curve steepen as the short end outperformed, and the VIX remained stuck, finishing near 16 for a seventh straight session.
- Philip Grant
Tuesday, June 11, 2019
Inspector Gadget
Will the taxpayer say no más? Last week, four Democrats on the House Committee on Oversight and Reform wrote a letter to the Department of Defense Inspector General asking for a broader investigation into TransDigm Group, Inc. (TDG on the NYSE). TransDigm, which provides aerospace equipment to public and private entities including the DoD, has long been under scrutiny for its aggressive pricing. Only recently has the extent of these practices been laid bare.
A preliminary Inspector General examination from 2015 to 2017 of government contracts for 47 spare parts found that TransDigm earned “excess profits” on all but one, totaling $16.1 million of the $26.2 million total audited value. Markups ranged as high as 4,451% on some equipment. The four Democrats write:
Because you identified so many overcharges in just the small sample of contracts you examined, we believe it is highly likely that TransDigm is receiving additional excess profits that have not yet been identified.
The interest is bipartisan. On May 15, Senate Committee on Finance Chairman Chuck Grassley (R., Iowa) wrote a letter to Secretary of Defense Patrick Shanahan featuring some withering criticism of TransDigm’s business practices:
The pattern of price-gouging by TransDigm and its subsidiaries has gone unimpeded for decades. It has amassed exclusive rights to sell these spare parts to the Pentagon. In fact, the Defense Department accounted for 34% of its sales in 2017. TransDigm exploited its business model and took advantage of its sole-source position to leverage higher prices.
Monopolies invite government regulation. If that’s the road TransDigm wants to continue following, I’m here to deliver a message. The jig is up on this cozy relationship. The buck stops here.
The rising heat from Congress seems to be making an impact, as the company announced on May 24 that it would reimburse the government for $16 million. That decision followed May 15 testimony from Assistant Secretary of Defense for Acquisition Kevin Fahey that TransDigm was “gouging the taxpayers with their sickening business practices.” A TransDigm spokeswoman told the Washington Post that the “decision to voluntarily issue refunds was a demonstration of good faith and a reflection of the importance of our DoD customers.”
If so, TDG would be turning over a new leaf, according to the Capitol Forum, which reported in 2017 that the company conducted quarterly training sessions “on how best to navigate the [government] procurement process to maximize price increases. . . seminars taught subsidiary leadership to deny the government’s requests for cost and pricing information.”
Needless to say, TransDigm’s business model has been a successful one, as the company boasts an income statement that is the envy of the industry: TDG’s trailing 12-month EBITDA margins stand at a princely 48%, triple the peer group average as compiled by Bloomberg and nearly double the next highest, HEICO Corp. (HEI on the NYSE), which was identified as a world class operator by John Hughes of Quantum Capital Management, LLC at the Grant’s Spring Conference in April.
Might the rampant overcharging suggested by the Inspector General explain TransDigm’s remarkable profitability? Mr. Market gives the company its due, as TDG shares command a fancy valuation of 28 times 2019 EPS, with the company’s $40 billion enterprise value standing at 17.5 times 2019 consensus EBITDA. As noted by J.P. Morgan Securities, LLC analyst Seth Seifman, who has a “sell” rating on TransDigm, the bipartisan congressional outrage might not translate into much, in the short term at least:
TDG has a successful business model based partially on aggressive pricing and no one has alleged that the company broke the law; therefore, we have little doubt that TransDigm will remain as aggressive as ever in pushing price until Congress and/or DoD change the rules.
Not just in hiking prices does B1-rated TransDigm distinguish itself. Thanks in large part to no fewer than 22 acquisitions since 2012 (headlined by a $4 billion cash deal announced last October for Esterline Technologies Corp., at a 41% premium), TDG is highly leveraged, carrying a net debt load of 6.5 times consensus 2019 EBITDA. That compares to an average debt to EBITDA ratio of 5.2 for the average B-rated company within Moody’s Investor Service coverage universe, per an October report from the ratings agency.
Management has further tipped the capital structure scales, issuing a $22-per-share special cash dividend in September 2017 as well as a $24-per-share dividend in 2016, for a total disbursement of $2.6 billion. For context, the company generated $2.3 billion in free cash flow across 2016, 2017 and 2018 (TransDigm’s fiscal year ends on Sept. 30).
With a hefty debt burden built on a foundation of perhaps unsustainable profitability levels, TransDigm creditors have no shortage of reasons to lie awake at night. The compensation on offer? The first lien 6 1/4 notes due 2026 currently trade at 105 cents on the dollar, for a 5.14% yield-to-worst and a 323 basis point pickup over Treasurys. A government crackdown or simple interruption in TransDigm’s growth-by-acquisition model would potentially reverberate: That debt issue is the third largest in the iShares iBoxx High Yield ETF (HYG on NYSE Arca), accounting for 51 basis points of the fund’s total assets.
As for TDG stock, a 76% levitation over the past two years has chased the bears, as short interest currently stands at 5%, down from near 13% in spring 2017. As the shorts cover, TransDigm management hits the bid. Year-to-date, corporate insiders have sold 137,205 shares, cashing out some $61 million. CEO Kevin M. Stein owns just 8,300 shares for a current market value of $3.8 million. Stein took home $29 million in total compensation last year.
Recap June 11
Status quo today, as stocks gave back strong early gains to finish unchanged, while oil and gold also cruised sideways and long rates likewise held steady. The two-year yield rose to 1.93%, up from a post-2017 low of 1.83% last Monday, and the VIX closed near 16 for a fifth straight session.
- Philip Grant
Monday, June 10, 2019
Alberta king
A rebound north of the border? Toronto-area real estate saw a relatively brisk showing in May, as total transactions jumped 18.9% to 9,989, not so far below the 10-year average of 10,300, while the average sales price rose 3.8% year-over-year to C$839,000 ($629,000), within range of the C$862,000 seen in May 2017 near the peak of the market. Nationwide, GDP expanded by 0.5% sequentially in March (the most recent reading), matching the strongest growth rate since 2016. The labor market remains red hot, as the unemployment rate for May fell to 5.4%, down from 5.7% in April and the lowest on record dating back to 1976.
The stronger data have the attention of Bank of Canada governor Stephen Poloz, who told BNN Bloomberg on May 17 that he maintains a hawkish bias: “The natural tendency is for interest rates to still go up a bit.” The market seems to feel differently. On Friday, the Canadian 30-year yield closed at 1.72%, (below the current BoC 1.75% overnight rate), while interest rate futures suggest 30% odds of a rate cut by October, with no chance of a hike.
Despite the improvement in Toronto, it’s safe to say that the sun has set on Canada’s long-running housing boom. Nationwide, price growth has abated, with the Teranet-National Bank House Price Index rising just 1.2% in April, the worst reading since 2009 and well below the 2% year-over-year rise in April CPI. By comparison, April 2018 and 2017 saw year-over-year gains of 5.6% and 13.2%, respectively.
As housing cools, the leveraged Canadian consumer shows signs of strain. Canadian household borrowings rose to a record 179% of disposable income at year-end 2018, well above the 144% U.S. peak in 2007. That burden looks to be taking a toll. On Monday, the Office of the Superintendent of Bankruptcy reported that nationwide consumer insolvencies footed to 11,785 in April, down slightly from the eight-year high of 11,963 logged in March but up 9.3% year-over-year. The annual home renovation poll conducted by the Canadian Imperial Bank of Commerce (CIBC) finds that respondents plan to spend an average C$10,200 on home repairs this year, down from C$11,000 last year and C$11,800 in 2017.
A downshift in activity likewise crimped recent results from some of Canada’s largest banks. In the most recent quarter, the Royal Bank of Canada reported a 2.4% year-over-year rise in earnings from its domestic unit, the slowest growth rate in five years. Toronto-Dominion Bank’s Canadian unit saw a 1% year-over-year uptick in net income, while CIBC generated $570 million in earnings from its personal and small business banking unit, down 2.4% from a year ago. The slow- or no-growth domestic environment casts shade on some premium valuations: RBC shares currently trade at two times book value, TD Bank at 1.31 times and CIBC at 1.35 times book. By comparison, the U.S. KBW Bank Index currently trades at 1.15 times book.
CIBC, which is particularly exposed to the local housing market (see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer), seems to have been caught off guard by the recent sea change. On the May 22 conference call, executive vice president Christina Kramer explained:
And that’s due to the market turning out different than we had anticipated, impacting us more than our peers due to our strategic focus. In the large urban markets, [the] pullback in activity has been more pronounced and more prolonged than we assumed.
But that shift in conditions isn’t cause for concern to the CIBC c-suite. CFO Kevin Glass remarked on the call that “there’s nothing on the horizon that would give us any indication that economic conditions are about to change significantly that would give rise to significant loan losses.” As noted by Fitch Ratings, the average impaired loan ratio for Canada’s Big Six ticked to 53 basis points in the second quarter, up from 48 basis points year-over-year but still comparable to the net 47 basis points seen among U.S. banks in the first quarter (the most recent data available), according to the St. Louis Fed. For context, the prior U.S. credit cycle culminated with a 312 basis point loan loss ratio in the first quarter of 2010.
Signs of more acute distress are evident away from the largest banks. ATB Financial, an institution owned by the Province of Alberta, reported credit metrics for its fiscal year ended March 31 that could be described as shocking. Namely, ATB’s provision for loan losses jumped to C$338 million, more than triple the C$105 million logged in 2018. That increase in bad debt led directly to a 50% drop in net income, as the pre-provision bottom line rose 12% from a year ago.
Seth Daniels, founding partner at JKD Capital Management, tells Grant’s today that ATB’s plight is instructive:
ATB Financial arguably provides the most accurate glimpse into credit quality in Alberta and can be considered another major domino to fall in the Canadian credit cycle. ATB’s impaired loans and provisions for bad debt stand in stark relief to its publicly traded financial counterparts, and potentially point to a larger problem--the systemic under provisioning for bad loans while actual impaired loans are building, thereby artificially inflating earnings and capital ratios.
Recap June 10
Stocks continued their rampage, with the S&P 500 catching another solid bid to extend its five day winning streak to more than 5% and close to within 2% of its April 30 highs. Key commodities took a breather, with WTI crude and gold each falling about 1% as the Money of Kings saw its eight-session winning streak snapped, and interest rates jumped higher with the 10-year yield rising six basis points to 2.15%. The VIX held near 16, remaining relatively sturdy during this bull move.
- Philip Grant
Friday, June 7, 2019
Step Brothers 2
Alternative lodging by the Bay
Alternative lodging by the Bay
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex)
Recap June 7
Step Brothers 2
Alternative lodging by the Bay from real estate blog Curbed San Francisco:
How much does it cost for bare minimum accommodations in San Francisco—i.e., a bed and a roof?
In the Tenderloin, that’ll be $60 per night, or $1,200 per month. That’s what the Southern California-based startup Podshare charges for one of its “pods” at the company’s first San Francisco locale.
According to the company, “A pod is a hand-built, high-end bunk bed complete with your own flat screen TV and night light.”
Renting with Podshare buys access to the bed and the communal spaces in the building in what’s essentially a hostel-like setup—complete with a dearth of privacy thanks to the wide open, multi-pod layout of rooms Podshare offers.
Behold the sharing economy.
Right place wrong time
Yesterday, Fitch Ratings downgraded Petróleos Mexicanos (A.K.A. Pemex) into junk territory (to double-B-plus from triple-B-minus) one day after cutting its rating of Mexican sovereign debt to triple-B from triple-B-plus. “This assessment,” said Fitch, "reflects the very high level of transfers to the government at the expense of underinvestment in the company’s business.” A recent $5.5 billion bailout package wasn’t enough to move the needle.
For Pemex, a vicious cycle of long-term decay is at hand: “the company continues to severely underinvest in its upstream business, which could lead to further production and reserves decline.”
The symbiotic relationship was on full display last month, when President Andrés Manuel López Obrador, or AMLO, announced that Pemex would be tasked with building a mega-refinery in his home state of Tabasco at an expected cost of $8 billion, with a targeted completion date of 2022. That’s better than anything the private sector could muster, as a trio of bidders provided cost and completion estimates ranging from $10 billion to $12 billion and 2023 to 2025.
Those heady ambitions run headlong into unpleasant facts. Pemex, which has an outstanding debt stock of $106 billion along with $54 billion in pension liabilities (combining for six times 2018 adjusted EBITDA of $28 billion), faces a protracted decline in reserves and production, as first quarter output slumped to 1.66 million barrels per day (mbpd), down 12% year-over-year and less than half of the 2004 peak of 3.4mbpd. That erosion is evident on the financial statements, as $87.5 billion in 2018 revenue is little changed from an $85.3 billion top line in 2005. Over that period, external debt less cash has jumped to $102 billion from $39 billion.
Perhaps most concerningly, the deepwater Ku-Maloob-Zaap (KMZ) oil field, which now represents more than half of Pemex’s production and has remained rock steady (the larger Cantarell field saw production peak in 2004) in recent years, saw output slide 4% in the first quarter. Though that’s far less than the 12% aggregate decline, John Padilla, partner and managing director at energy consulting firm IPD Latin America, told Grant’s last year that any drop at KMZ is ominous indeed:
They [Pemex] have managed it infinitely better [at KMZ] than what they did at Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery tech-niques . . . you squeeze it faster and there is less of it at the end. That pro¬duction will fall, and when it falls, it is going to fall very significantly.
Since a bearish analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer, Pemex’s senior unsecured dollar-pay bonds due 2047 have fallen to 88 cents from 99 cents, pushing the spread over Treasurys to 572 basis points from 477 basis points. There may be more pain to come, potentially necessitating drastic measures from the Mexican government that may, in turn, augur further pain in the sovereign. Padilla summed it up: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
Recap June 7
A softer than expected reading of April nonfarm payrolls did nothing to dampen raging animal spirits, as stocks enjoyed another strong rally to leave the S&P 500 higher by a meaty 4.5% for the week. A weaker dollar helped stoke a strong bounce in energy, with WTI crude rising to $54 a barrel, while gold edged to a new 52-week high at $1,341 an ounce, extending its winning streak to eight. Despite the bullish action, the VIX reversed early losses to finish near 16.
Interest rates continue to collapse, as the two- and 10-year yields finished the day at 1.85% and 2.08%, respectively, down from 2.97% and 3.24% in early November. The 10-year remains 20 basis points below the three-month bill yield.
- Philip Grant
Thursday, June 6, 2019
Grand central
Following today’s press conference at the European Central Bank, Mario Draghi struck a contented tone, assessing a “very low” probability of recession and “no probability” of deflation, while citing risks such as “protectionism, geopolitics [and] emerging markets,” which are outside of Frankfurt’s purview.
However, that sanguine outlook doesn’t mean that hawkish, or even neutral policy is called for. In his statement, Draghi said that the ECB “is determined to act in the case of adverse contingencies.”
More specifically, he told reporters that some members of the ECB governing council discussed both cutting interest rates from the current negative 40 basis point deposit rate, as well as restarting the QE program (which has already boosted balance sheet holdings to 40% of 2018 eurozone GDP, compared to 18% of 2018 U.S. GDP for the Fed). Indeed, the ECB “has considerable headroom” to restart QE, in Draghi’s judgement.
That rosy assessment, in tandem with the suggestion of still-easier money, didn’t spark Mr. Market’s interest, as the Stoxx 600 Index gave back a near 1% gain at midday to finish in the red. More broadly, Europe’s banks have floundered despite (or, perhaps because of) the ECB’s exertions. The Stoxx 600 Banks Index trades at a feeble 0.54 times book value and generated a 6.91% return on equity over the past 12 months, compared to the KBW Bank Index’s 1.2 times book and 11.7% trailing-12 month ROE.
While negative rates and indiscriminate asset purchases haven’t helped Europe’s banks, the ECB is considering tweaks to ease the burden of negative rates. Thus, today’s statement referenced “mitigating measures” that may be used to offset “possible side effects on bank-based intermediation” resulting from the policy prescriptions of Draghi et al, such as a tiering system for deposit rates.
Rather than ease back on the negative-rate throttle, the ECB suggests other remedies. On May 15, executive board member Benoit Coeuré argued that negative rates are costing banks €8 billion ($9 billion) annually, “really peanuts.” Europe has too many banks and needs industry consolidation, per Coeuré.
Stateside, central bankers indulge in their own sympathetic self-analysis. Earlier this week, the Federal Reserve conducted a confab in Chicago to culminate their nationwide “listening tour,” at which chairman Jerome Powell assured listeners that he “will act as appropriate to sustain the expansion,” as well as approvingly assessing past QE and ZIRP programs: “These policies provided meaningful support for demand.”
Tinkering was also on the agenda, as attendees debated the utility of the so-called dot plot predictions, along with the concepts of implementing nominal GDP and “average inflation” (meaning that periods of below-2% price growth should be offset by symmetrically higher ones) targeting. The Fed plans on announcing new policy goals next year.
But after all that listening, new concepts aren’t likely to be implemented soon. Fed vice chairman Richard Clarida told CNBC on Tuesday that “we are going to have a high hurdle for any major change to the [existing] framework.”
Instead, the Fed has more prosaic, and immediate concerns. Namely, the future course of interest rates. Interest rate futures now point to 98% odds of a rate cut by year end, pricing in a 1.74% funds rate compared to the current 2.38%. Two months ago, those figures were 54% and 2.23%, respectively.
There is good reason for the market’s increasingly dovish expectations. As noted by Bianco Research, LLC, the inversion of the 10-year Treasury yield below that of the three-month bill for at least 10 straight days is a reliable indicator of trouble, occurring eight times in the past 50 years and followed on each occasion by recession, 311 days later on average. Today, with the 10-year closing at 2.11% and the three-month at 2.30%, marks the 10th straight day of inversion. Jim Bianco, president and eponym of Bianco Research, writes this morning that the implications are clear:
The Fed is too tight. The longer an inversion lasts, the more damage it does to the economy. Once an inversion hits 10 consecutive days, history shows it continues for weeks, if not months. The Fed understands this. Will they heed the yield curve’s warning?
QT progress report
The Fed’s portfolio of securities held outright fell to $3.668 trillion, down $5 billion from last week’s reading and $18 billion from the trailing four-week average. As is usually the case on the first week of the month, Treasury securities accounted for the change in holdings. Since the Oct. 1, 2017 start of QT, total balance sheet assets are down by 13.6%, an 8.4% simple annualized rate.
Recap June 6
The bulls have retaken control of the proceedings, as another strong day for stocks left the S&P 500 3.3% higher for the week and back within 3.5% of its April 30 high water mark. Energy prices finally caught a bounce with WTI crude popping back over $53 a barrel, while gold managed a seventh straight green finish, advancing to $1,333 an ounce and closing within 50 basis points of a 52-week high. The Treasury curve flattened a bit after pronounced recent widening, and the VIX fell below 16.
- Philip Grant
Wednesday, June 5, 2019
The world is yours
Received in the Grant’s inbox today,
Received in the Grant’s inbox today,
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award,
The Department of Defense’s forthcoming $10 billion cloud computing award,
Recap June 5
The world is yours
Received in the Grant’s inbox today, via investor Paul Isaac:
Coming soon: The first blockchain-accelerated early payment default.
The blind side
Forbes reports this afternoon that Green Bay Packers quarterback Aaron Rodgers has formed a new venture capital fund, Rx3 Partners with Byron Roth, chairman and CEO of Roth Capital Partners.
Rodgers, who threw 25 touchdowns and just two interceptions in 2018 but whose Packers failed to make the playoffs for a second straight year, commented: “With Rx3, I saw the opportunity to create an investment platform that brings together a group of like-minded influential investors and their respective networks with the backing of institutional resources.”
In other words: motion right, end-around, play-action fake on two.
Lobby horse
The Department of Defense’s forthcoming $10 billion cloud computing award, known as JEDI, has been mired in controversy and allegations of misconduct involving Amazon.com, Inc.’s web services division (AWS). Does a potential scandal involving AWS and Uncle Sam present a risk to the continuation of Amazon’s unparalleled success?
On May 24, Amazon competitor Oracle Corp. which vied for the JEDI contract and was eliminated from contention (AWS and Microsoft Corp. are the remaining bidders), filed an updated complaint with the U.S. Court of Federal Claims alleging that the procurement process for JEDI has been rife with conflicts of interest.
Oracle alleges that at least two employees, Deap Ubhi and Anthony DeMartino, improperly influenced the process to favor AWS at the expense of other competitors, as detailed by Almost Daily Grant’s on April 18. On March 4, the Federal News Network reported that the DoD Inspector General and FBI’s Public Corruption Unit have opened a joint investigation into the JEDI procurement process.
The updated court filing contains no shortage of explosive allegations:
The Department of Defense deviated from its procurement policy and did not require Ubhi, [redacted] or DeMartino (and many others) to complete conflict of interest forms and sign nondisclosure agreements prior to JEDI involvement. Consequently, several DoD officials with clear financial interests in AWS participated in JEDI in violation of applicable laws and regulations.
Mere sour grapes from a losing contestant? In its filing, Oracle cites correspondence on the Slack messaging platform suggesting that Ubhi (who worked at AWS from 2014 to 2016 before joining the Pentagon, and then returned to AWS in November 2017) pressed senior DoD official Jane Rathbun to favor a single-award approach, which is widely believed to favor AWS:
In one message, Ubhi reports “we just won this conversation’ because ‘Jane R. is now moved to our side and is supportive of a single provider.” Ubhi later advised the Defense Digital Service team to “check your email, and see Jane coming to the light”. . . In subsequent messages, Ubhi noted it “puts multi vs. single to bed once and for all hopefully (at least from a technical standpoint.”
Ubhi later indicated to [DDS general counsel Sharon] Woods that he was not worried about the “single vs. double” awardee approach and “if there are people in the building (Pentagon) that (he) need(s) to go see and school, or ally, let’s do that too.”
Beyond lobbying DoD officials to structure JEDI as a winner-take-all, Oracle claims that Ubhi used his position to accumulate intelligence about competitors cloud capabilities, while preparing for his return to Amazon:
In mid-September 2017 (during his employment discussions with AWS), Ubhi helped set up the Google Drive to act as DoD’s “repository for *everything*” JEDI related. Ubhi and the DDS team subsequently convinced all DoD JEDI participants “to data dump” everything into the Google folder.
Ubhi managed untold amounts of nonpublic and acquisition sensitive JEDI-related information based on his access to the JEDI Google drive. At some point prior to rejoining AWS, Ubhi synced the Google Team Drives to his laptop.
Amazon will have a hard time distancing itself from Ubhi’s conduct, if Oracle’s allegations are accurate:
AWS knew of Ubhi’s central JEDI role as AWS courted Ubhi to rejoin AWS. AWS also knew that Ubhi had not recused himself as legally required. Still neither Ubhi nor AWS notified DoD of the employment negotiations.
On October 2, 2017, Ubhi emailed AWS advising that he is “running point on all [JEDI] industry touch points.”
Apart from the criminal investigation into JEDI, Congress has taken a dim view of the winner-take-all approach to the massive contract. In its 2020 budget released on May 20, the House Appropriations Committee stated that due to concerns about committing to a single provider for a 10-year term:
The Committee directs that no funds may be obligated or expended to migrate data and applications to the JEDI cloud until the Chief Information Officer of the Department of Defense provides a report to the Congressional Defense Committees on how the Department plans to eventually transition to a multi-cloud environment, as described in its January 2019 Cloud Initiative Report to Congress.
That follows an early April decision from the C.I.A. to shift to a multi-cloud strategy by 2021, after signing a $600 million contract with AWS in 2013.
No matter what happens with the government investigation, the competition is collectively taking aim at AWS. Today, Microsoft and Oracle announced an agreement to connect cloud computing units by linking their respective data centers, as well as letting users log into either company with a single user name.
As for Amazon, a $10 billion award over 10 years doesn’t stand out as critical, considering the company reported $242 billion in revenue and $11.4 billion in net income over the 12 months ended March 31. But a loss of government confidence in AWS (which generated $2.2 billion of net income in the first quarter, up 57% year-over-year and representing two thirds of the consolidated total) could be significant. As a D.C.-based observer told ADG in April: “The AWS story, as sold to enterprise customers and the Street, is built upon the [C.I.A] reference case and the cash that has come in from that deal.”
Recap June 5
A second straight rally in stocks pushed the S&P 500 higher by 2.7% this week, while short-dated Treasurys partially reversed yesterday’s pullback with the two-year yield finishing at 1.84%, down from 2.22% just two weeks ago. Energy was once again hammered, with Brent crude falling below $60 a barrel this morning for the first time since January, while gold continues to diverge, finishing at $1,330 an ounce for a near-four month high. The VIX closed at 16, its lowest in two weeks.
- Philip Grant
Tuesday, June 4, 2019
Minority report
Many unhappy returns.
Many unhappy returns.
Today's debt hearings
An analysis of the leveraged loan market
An analysis of the leveraged loan market
Recap June 4
Minority report
Many unhappy returns. Thirty years ago, British ambassador Sir Alan Donald cabled home his classified report on the bloody goings-on in Tiananmen Square: “Students linked arms but were mown down. Armored personnel carriers then ran over the bodies time and time again to make, ‘pie’, and remains collected by bulldozer, incinerated and then hosed down drains. . .”
Unsurprisingly, the Xi Jinping-led government has little interest in commemorating the event, or in allowing others to pause and remember. Domestic social media platforms have “barred users from changing their profile photos and other information,” Bloomberg says, while financial data company Refinitiv has blocked all Tiananmen-related stories from its Eikon terminals, after the Cyberspace Administration of China “threatened to suspend the company’s service,” according to Reuters.
While Refinitiv may suffer a reputational knock in the West for this evident kowtow, its social credit score looks poised for an upgrade.
If only the recent trouble in China’s banking system could be so easily suppressed. Following the government’s takeover of distressed Baoshang Bank Co., the People’s Bank of China tried to calm the situation by assuring investors that no further such interventions were in the cards: “Everyone,” says a message on the PBOC website: “please don’t worry. At present we don’t have this plan.” But Bloomberg reports today that a pair of smaller institutions, Guilin Bank Co., Ltd. and Jincheng Bank Co., Ltd., have delayed plans to sell RMB 1 billion ($140 million) in tier-2 bond sales following the Baoshang news.
Over the weekend, Bank of Jinzhou, which holds $113 billion and $53 billion of assets and deposits, respectively, saw its auditor Ernst & Young Hua Ming LLP resign due to “indications that some loans to institutional customers weren’t used in ways consistent with the purposes stated in documents,” per Bloomberg. In response, the bank’s 5.5% dollar-pay perpetual bonds fell below 65 from 81 a week ago, for a 19.2% yield-to-call.
In a report on May 28, Anne Stevenson-Yang, co-founder of J Capital Research explains that the emergence of systemic balance-sheet risk is inevitable in China’s command economy:
What regulators fail to see, or at least to admit, is that there is fundamentally a contradiction between clean banks and targeted growth. The growth can be achieved only by heroic additions of credit, which has been growing at about 2.5 times the rate of GDP, itself clearly exaggerated.
Stevenson-Yang points out the contradiction between healthy reported metrics and the abrupt seizure of Baoshang and apparent stress at small and medium-size lenders:
One of the more unusual aspects of the Baoshang drama is that it’s been reported – not only that, but high-level authorities have publicly expressed concerns that there may be bank runs and financial institutions that ‘disappear.’ This is peculiar for an economy that claims to be growing at 6.5%, have average non-performing loan rates under 1.5% and that has buoyant construction and property markets.
Today's debt hearings
An analysis of the leveraged loan market (“Tomorrow’s debt hearings”) in the July 13, 2018 edition of Grant’s Interest Rate Observer predicted that a cyclical crack-up would lead to unwanted (for industry practitioners) attention from Washington. Sure enough, the House Committee on Financial Services conducted a hearing today titled: “Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending.”
That July 2018 examination identified the erosion of creditor protection via widespread cov-lite documentation, deteriorating credit quality and aggressive earnings additions or cost-savings assumptions from issuers, called add-backs that can artificially inflate projected results. As noted by S&P’s LCD unit in a report last year, loans related to mergers and acquisitions are particularly susceptible to such add-backs of late, with a record 22% of M&A related-loans featuring add-backs greater than 50% of EBITDA in the first half of 2018, double the pre-2008 high.
Despite a suddenly-wobbly stock market, the M&A train keeps rolling. According to data from Bloomberg, more than $40 billion in corporate transactions were logged yesterday, the second-busiest deal day of the year.
Credit quality continues to wane. As noted by investment fund Driehaus Capital Management, LLC’s Twitter account this morning, the proportion of loans rated double-B (the high end of junk territory) now foot to less than 30%, down from 50% at the beginning of 2008. Single-B-rated issuers now comprise nearly 30% of loans, up from less than 10% in early ‘08.
Those red flags haven’t yielded much pain yet, as the S&P/LSTA Leveraged Loans Index has returned a solid 5.5% year-to-date, while LCD reported yesterday that the May default rate registered a skinny 0.93%, well below its historical average of 2.93%. But some investors aren’t waiting around: According to Bloomberg, the Invesco Senior Loan ETF saw its largest funds outflow on record yesterday.
Recap June 4
Remarks from Fed chairman Jerome Powell that the FOMC “will act as appropriate to sustain the expansion” helped spur a steep rally in stocks, as the S&P 500 gained 2% and the tech-heavy NYSE FANG+ Index enjoyed a 4% rebound. But Treasury yields also jumped across the curve after a sharp recent rally, perhaps suggesting that today’s action was more of a bounce off recent moves than a sea-change in investor perception.
Elsewhere, energy prices managed a feeble bounce of their own with WTI crude rising less than 1% to $53.50 a barrel, while gold finished unchanged. The VIX fell by 10% to settle near 17.
- Philip Grant
Monday, June 3, 2019
Bar none
Per USA Today:
A rat-infested pop-up bar is opening up in San Francisco later this month.
Guests who dare to venture to the Rat Bar will be served the bar's ‘signature cocktail,’ the ‘Ama-RAT-to Sour.’ It's billed as a traditional amaretto sour with a ‘rat's tail’ as garnish. Then, Rat Bar crawlers will have a half-hour to play with their newfound rodent buddies.
A rat rescue non-profit called the Ratical Rodent Rescue will be providing the rats. Just in case an attendee falls in love with a newfound rodent drinking buddy, the organization has rats up for adoption.
Tickets cost about $50 a head.
Typical San Francisco pricing. The New York City subway system provides a similar experience for just $2.75.
Dots plotted
Change is afoot. Across venture capital, high-end real estate and the retail sector of the stock market, investor behavior has seen a notable shift recently. A trio of sightings:
The Wall Street Journal reports today that SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) has been “met with a chilly reception” in efforts to raise capital for a sequel to the $100 billion Vision Fund.
Contributing factors, per the Journal, include the fact that the larger investment firms generally have the capability to invest in start-ups directly and are thus reluctant to pay an additional round of fees, as well as concerns over the Vision Funds’ “lack of transparency.” Cantor Fitzgerald, L.P., tasked with raising funds for the project, approached would-be investors for commitments of as little as $50 million, a move which “tends to be a last resort for firms raising big investment pools. . . in part because of the cost of servicing multiple accounts.” Cantor scrapped the strategy “after [SoftBank] objected.”
Not just for SoftBank (termed “the epitome of the cycle in the Dec. 15, 2017 edition of Grant’s Interest Rate Observer) does the environment appear less hospitable. Last week, The Real Deal reported that Secured Capital Partners LLC., which owns a 157-acre land parcel in Beverly Hills, filed for Chapter 11 bankruptcy protection in Los Angeles federal court. Secured Capital listed the property for a record-breaking $1 billion last summer. Finding no takers, the list price was dropped to $650 million in February.
In its bankruptcy filing, Secured Capital listed $50 million to $100 million in liabilities, and assets of between $500 million to $1 billion (that was revised from less than $500,000 initially, an apparent typo). Ronald Richards, the fund’s lawyer, asserted in the filing that “the property will be sold or refinanced utilizing the best value the market or lending environment will bear.” The inability of this asset-rich, cash-poor borrower to extend terms on its debts may be a new development in this cycle.
While the winds seem to be shifting in the V.C. and real estate realms, a key corridor of the economy has fallen into deep freeze, if the stock market is any guide. Thus, independent retail analyst Mitch Nolen notes on Twitter today that apparel retailers have logged a brutal recent stretch, with each of the 24 clothing store stocks he tracks falling last month, with all but three absorbing double-digit declines in May.
More broadly, trouble in the apparel sector has spared neither the established players nor high-flying newcomers. Last week, industry mainstays Gap, Inc. and Abercrombie & Fitch Co. shares plunged 10% and 27%, respectively, after reporting weaker than expected sales in the most recent quarters. At the luxury end of the spectrum, Canada Goose Holdings, Inc. absorbed a 27% selloff last Wednesday after missing revenue expectations for the first time since its 2015 IPO. Since ripping higher by 450% from March 2017 to November of last year, GOOS shares have since lost more than 50%.
Recap June 3
News that the Federal Trade Commission is investigating Facebook, Inc. and Amazon.com, Inc. while the Department of Justice is probing Google parent Alphabet, Inc. as well as Apple, Inc. for potential antitrust violations was not well received, as the Nasdaq 100 Index lost 2% while the NYSE FANG+ Index shed 4%. On the bright side, the damage was localized, as the S&P 500 managed to finish just 25 basis points below unchanged.
Treasurys continued their head-spinning rally, as language from the Fed’s Jim Bullard suggesting a rate cut might be imminent helped push the two-year yield lower by eight basis points to 1.84%, while the 10-year yield dropped five basis points to 2.07%. Energy continued its losing streak with WTI crude falling below $53 a barrel for the first time since January, while gold jumped to a three month high near $1,325 per ounce.
- Philip Grant
Friday, May 31, 2019
Hail Mary
Sports business publication VenuesNow reported yesterday:
Social Finance, Inc., the private lender known as SoFi that specializes in refinancing student loans, has acquired naming rights for the $5.2 billion NFL stadium under construction in Inglewood, Calif., according to multiple sources.
Terms are believed to be in the range of $20 million a year over 20 years, sources said.
Buying naming rights, like erecting skyscrapers, is a bull-time endeavor.
Some corporate namesakes at the end of the 1990-2000 economic expansion:
Enron Field in Houston, CMGI Field in Foxboro, Mass., PSINet Stadium in Baltimore, Adelphia Coliseum in Nashville, Trans World Dome in St. Louis, MCI Center in Washington, D.C.
And more recently:
Chesapeake Energy Arena in Oklahoma City, American Airlines Arena in Miami, American Airlines Center in Dallas, Wachovia Center in Philadelphia, Citi Field in New York.
Ominous historical comparisons aside, it’s a pretty good day for V.C.-owned SoFi, which managed to close a $500 million funding round led by private-equity firm Silver Lake Partners at a $4.3 billion valuation, according to TechCrunch. That brings SoFi’s total funding to $2.3 billion, including a $1 billion round in fall 2015 led by SoftBank Group Corp.
This is what happens Larry
In an interview with the Financial Times today, Trump’s economic advisor and potential Fed nominee Judy Shelton offered some eye-catching remarks about the discretionary, “Ph.D. standard” of monetary policy that is currently in force:
How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?
In response, Lawrence Summers took to Twitter to attack:
Judy Shelton does what I would not have thought possible. She falls well below [Herman] Cain or [Stephen] Moore as a potential @federalreserve governor. Hers would be a dangerous appointment.
Another feather in her cap.
Trading sardines?
What selloff? The recent eruption in risk aversion hasn’t dented the digital HODLers, as cryptocurrencies have enjoyed a sterling start to 2019. At a current price of $8,500, bitcoin sits higher by 123% year-to-date, and touched $9,000 yesterday for the first time since spring 2018.
Michael Novogratz, founder and CEO of crypto investment fund Galaxy Digital Holdings, Ltd. told listeners on a conference call yesterday that he expects things to simmer down in the short term, forecasting a range of $7,000 to $10,000 for bitcoin, but “if I’m wrong on that, I think I’m wrong to the upside.”
To Novogratz, the latest rally is evidence of broader adoption of the digital ducats: “We have gone from, you know, crypto as an experiment, is it real? Is it tulips? To crypto is going to be a substantial part of the financial and consumer infrastructure of the world.”
But as Bloomberg reports today, bitcoin has thus far struggled to expand much beyond a trading sardine. Data from research firm Chainalysis, Inc. find that 1.3% of bitcoin transactions took place through merchants in the first four months of the year, little changed from 2017 and 2018. Kim Grauer, senior economist at Chainalysis, commented to Bloomberg: “Bitcoin economic activity continues to be dominated by exchange trading. This suggests bitcoin’s top use case remains speculative, and the mainstream use of bitcoin for everyday purchases is not yet a reality.”
There are also questions about the utility of the blockchain technology that underpins the cryptos (see, for instance, the Grant’s Current Yield podcast on Jan. 22, 2018 with Kai Stinchcombe). More recently, German central bank president Jens Weidmann told Bloomberg Wednesday that a trial project using blockchain to transfer and settle cash and securities was found lacking in terms of both costs and speed when compared to traditional methods: “The blockchain solutions did not fare better in [any] way . . . despite numerous tests in blockchain-based prototypes, a real breakthrough in application is missing so far.”
The rally in bitcoin comes as a familiar force in the background ramps up activity once more. Tether, the purportedly dollar-for-dollar-backed crypto which is widely used by crypto exchanges as a workaround for know-your-customer and anti money-laundering laws, has issued more than $1 billion in fresh supply over the last seven weeks, bringing tether outstanding to $3.1 billion as of yesterday from less than $2.1 billion on April 7.
While that $3.1 billion puts tether as the ninth-highest crypto by market cap, trading volume over the past 24 hours foots to $27.7 billion, according to Coinmarketcap.com. That nearly matches the $27 billion in 24 hour trading volume for bitcoin, which sports a market cap of $149 billion.
On April 25, New York Attorney General Letitia James accused the Bitfinex exchange (which shares ownership with Tether) of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.” Bitfinex covered Tether’s lost greenbacks with an I.O.U. Then, after that bit of prestidigitation, crypto investors supposedly sent a fresh $1 billion to purchase more tether.
The episode recalls the late 2017 explosion in tether supply, to $4.6 billion on Dec. 22 from $800 million eighteen days earlier, as bitcoin was racing to its all-time high near $20,000. A month later, Bloomberg reported that the CFTC issued subpoenas to Bitfinex and Tether on Dec. 6, 2017. By early February, bitcoin fell to $6,200.
This afternoon, Bitfinex announced on Twitter:
Due to the outage of one of our network providers we temporarily paused deposits and withdrawals. Funds are safe in cold storage. Situation should be restored ASAP. Apologies for the inconvenience.
Recap May 31
Another ugly day saw stocks slammed to the tune of 1.3% on the S&P 500, extending the post April 30 selloff to 6.5% and narrowing the year-to-date gains to just under 10% for the broad index.
Action elsewhere might have been even more bearish, as Treasurys caught another panic-type bid with the 10-year yield dropping to 2.13%, down nearly 20 basis points for the week and 21 basis points below the three-month bill yield. Interest rate futures now imply 51% odds of a rate cut at the July Fed meeting.
Energy was once again hammered, with WTI crude extending its two-day loss to nearly 10% to fall below $54 a barrel, while gold rose more than 1% to finish above $1,300 an ounce for the first time since mid-April.
- Philip Grant
Thursday, May 30, 2019
With a side of fries
Yesterday, the Department of Energy
Yesterday, the Department of Energy
Down in the bottom
Credit-centric consumer business models are in focus today,
Credit-centric consumer business models are in focus today,
QT Progress report
Recap May 30
With a side of fries
Yesterday, the Department of Energy announced the approval of gas exports from the Freeport LNG Terminal on Quintana Island, Texas. In the press release, under secretary of energy Mark Menezes laid it on thick:
Increasing export capacity from the Freeport LNG project is critical to spreading freedom gas throughout the world.
With the U.S. in another year of record-setting natural gas production, I am pleased that the Department of Energy is doing what it can to promote an efficient regulatory system that allows for molecules of U.S. freedom to be exported around the world.
Cleaner burning than tyranny gas.
Down in the bottom
Credit-centric consumer business models are in focus today, with a review of a pair of past picks-to-not-click: Signet Jewelers Ltd. (SIG on the NYSE) and Aaron’s, Inc. (AAN on the NYSE), which are featured in the issues of Grant's Interest Rate Observer dated June 3, 2016 and June 30, 2017, respectively. Since those publications, the duo’s fortunes have gone their seperate ways, with SIG shares slumping by 79% while AAN has thrived, jumping 41%. Yet the pair have more in common than the divergent price action might suggest.
Signet, the baubles retailer, has since been beset by slumping sales and P.R. woes, while the company’s highly anticipated efforts to sell its credit portfolio left the bulls wanting. In May 2017, Signet managed to unload $1 billion in prime loans at par and divested its subprime book at 72 cents on the dollar one year later. That 2016 bearish verdict from Grant’s hinged on the contention that the company’s "recency" accounting methodology flattered its underlying business metrics and credit performance. In July 2017, 55-year old CEO Mark Light resigned citing health reasons, following the departure of COO Bryan Morgan on account of “violations of company policy unrelated to financial matters.”
Aaron’s, founded in 1955, is the largest “rent-to-own” retailer in the United States. Thus, generally credit-constrained customers pay monthly rates for the use of home furnishings for a given lease term, and, if current on their payments at the end of that period, own the product outright. Customers also have the option of returning the item or purchasing it at the full list price during the lease term.
As Aaron’s brick-and-mortar business gradually shrinks under the competitive pressures partially supplied by Amazon.com, Inc., the company’s Progressive Leasing unit, a subprime lender to third-party merchants, picks up the slack. Progressive’s leasing volume (a.k.a. new sales financed by rent-to-own) jumped 14.5% year-over-year to $394 million in the first quarter, accounting for virtually all of Aaron’s consolidated 5.9% first quarter revenue growth to $1.02 billion. Locations are either company-owned or franchised, with the former increasingly prevalent. As of the first quarter, Aaron’s systemwide store count registered at 1,530, down from 1,864 at year-end 2016. Franchise locations have declined to 369 from 699 during that period.
What’s not to like? Profitability has grown while the store count shrinks. First quarter results featured $1.08 in adjusted earnings per share, well above the highest analyst estimate of $0.96. AAN has generated positive free cash flow in every year since 2015, and trades at a reasonable 14.5 times consensus 2019 earnings. The corporate balance sheet (in contrast to that of the composite Aaron’s client) is pristine, with net debt of just under $700 million compared to $430 million in trailing 12-month EBITDA, and The Street is bulled up, with eight “buy” ratings and one “hold” among the nine analysts tracked by Bloomberg.
Now for the bear case. Aaron’s has bought out 152 franchise locations in 2017 and 2018, along with two more in the first quarter. As noted in that June 2017 analysis of AAN, those repurchase transactions flatter the company’s cash flow statement. Deputy editor Evan Lorenz explained:
The cost of acquiring franchisee stores shows up in cash flows from investing activities under ‘acquisition of businesses and contracts, net of cash acquired’. The purchase price of a franchisee’s store includes that seller’s floor inventory. Normally the cost of acquiring retail stock is a charge to cash flow. Not so when you buy a store lock, stock and barrel.
So when Aaron’s leases a couch or a TV which it hauls out from the storeroom of a former franchisee, the cash-flow metrics look better than they really are. Still and all, the store net-work is declining.
In May 2017, Signet Jewelers announced the formation of a seven-year partnership with Progressive, “to provide a lease-purchase payment program to Signet customers who do not qualify for Signet’s credit programs.” The press release further spells things out, explaining that “Progressive leasing will assume any financial risk from leasing the merchandise.”
Signs of a downshift in Aaron’s credit quality are visible. According to the most recent form 10-Q, the proportion of the credit portfolio to consumers with a FICO score of 600 or below stood at 4.1% as of March 31, double the 2% figure from a year ago. At the same time, the percentage of loans to those with a FICO score of 700 or greater declined to 16.9% from 21% year-over-year. Recall that Fair Isaac Corp., changed the methodology it uses to calculate FICO scores “to boost the number of approvals for credit cards, personal loans and other debt,” according to The Wall Street Journal.
Analysts are expecting a major increase in profitability. While revenue is projected to decline to $3.3 billion in 2020 from $3.7 billion in the twelve months ended March 31, adjusted net income will rise to $295 million in 2020 from $226 million over the past 12 months if estimates are on point, indicating more than 300 basis points of margin expansion. But while the sell-side is expecting big things, Aaron’s management has been hitting the bid. Since March 21, seven corporate insiders have sold a combined 184,220 shares, cashing out some $9.7 million.
The Signet and Aaron’s pair continue to exhibit a type of corporate symmetry. As the market continues to punish Signet, which has unloaded its subprime credit exposure, Aaron’s has been rewarded for doubling down on the same.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.67 trillion, down by $8.8 billion from a week ago with mortgage-backed securities supplying the change. Since the commencement of QT, total balance sheet assets are down by 13.4%, for a simple annualized pace of 8.3%.
Also this afternoon, the New York Fed formally announced plans to reinvest the proceeds from maturing mortgage-backed securities and agency debt into Treasurys beginning in October.
Recap May 30
Stocks finished little changed, with the S&P 500 managing to eke out a green finish after back-to-back selloffs to start this holiday-shortened week. The broad average remains higher by 11% year-to-date.
Price action elsewhere remained ominous. Another sharp rally in Treasurys pushed the 10-year yield below 2.22%, now 16 basis points below the three-month bill to leave the curve inverted for a sixth straight day. Energy prices were hammered, with WTI crude falling back below $57 a barrel. The Dollar Index remained at the cusp of its 52-week high.
- Philip Grant
Tuesday, May 28, 2019
ETF phone home
Time to batten down the hatches? The Wall Street Journal reports today that the recent uptick in stock-market volatility has spurred a search for safety. Risk-mitigation, “low-vol” strategies have seen an inflow of $10 billion year-to-date, taking assets to a record $77 billion, according to data from Morningstar, Inc.
Two ETFs, the Invesco S&P 500 Low Volatility ETF (SPLV on the NYSE Arca) along with BlackRock, Inc.’s iShares MSCI Min Vol USA ETF (USMV on the CBOE’s BZX Exchange) have alone raked in $6.4 billion. Impressive recent performance at least partially explains the pair’s popularity: SPLV has gained 15.3% over the past 52 weeks, while USMV has rallied by 14%. That compares to a less-than 5% gain for the S&P 500.
Kevin Duffy, co-founder and principal at Bearing Asset Management LLC, argues to Grant’s today that such vehicles may not necessarily act as effective hedges in times of trouble, noting that the top five holdings of the iShares Min Vol ETF (Visa, Inc., Waste Management, Inc., McDonalds Corp., PepsiCo., Inc. and The Coca-Cola Co.) each carry a forward P/E ratio of more than 21 times. That compares to a 16.5 times consensus 2019 price-to-earnings ratio for the S&P 500. The fund manager asks:
Even if these businesses weather the next recession, will their valuations hold up in a bear market? Other than Visa (analysts expect 11% revenue growth next year), these companies sport mediocre growth prospects (4% at WM, PEP and KO; 2% at MCD).
More broadly, the relentless growth in the ETF industry and indexation strategies continues. ETFs pulled in $311 billion in fresh capital last year, the second-most on record following a $471 billion inflow in 2017, according to the Investment Company Institute Fact Book for 2019. The number of ETFs rose to 2,057 as of Dec. 31, nearly triple the 743 available in 2008. The ICI likewise finds that index equity mutual funds accounted for 29% of total equity mutual fund assets as of year-end, up from 14% in 2008.
But, as noted in investment firm Horizon Kinetics, LLC’s first quarter market commentary, the secular growth of indexation and ETF strategies comes during a period of historic market calm:
There is a certain price volatility that people accept with stock investing, an accepted tradeoff for the higher expected return. That volatility has been measured, and is based on 92 years of data, starting from 1926.
It is expressed as the standard deviation of share price changes, and this figure is 19.8%, meaning that in a given year, stock prices have tended (meaning roughly two-thirds of the time) to vary by as much as 20% points above and below the long-term average return. So if the expected average return is 10%, one should expect a return as high as 30% or a loss as much as 10% in most years.
The current standard deviation of the Vanguard S&P 500 ETF (VOO) over the past 3 years is 10.7%; over the last 10 years, it’s 12.7%. For the Vanguard Total International Stock ETF, the 3- and 10-year standard deviations are 10.5% and 15.9%. Both are way below the long-term figure.
In other words, the migration toward indexation seen this cycle has coincided with a historically-anomalous low-vol era. Of course, that relationship presents a potential corollary: A reversal of this trend could see volatility return with a vengeance.
How might an active manager contend with this sea change toward indexation? Perhaps by venturing outside the lines. Speaking at the Grant’s 2016 fall conference, Steven Bregman, president and co-founder of Horizon Kinetics, offered this council: “If you’re willing to take a bit of illiquidity risk – in those securities that have been discarded by the indexes – your degrees of freedom and optionality expand tremendously.”
Recap May 28
Stocks came under late pressure after a sideways start to the day, with the S&P 500 finishing at session lows, down 0.8% with traditionally defensive groups health care, utilities and consumer staples losing 1.4%, 1.6% and 1.8%, respectively. Treasurys likewise rallied sharply, with the 10-year yield falling to 2.27%, well below the 2.35% three-month bill as well as the 2.39% effective Fed Funds rate. The VIX rose 10% to 17.50.
- Philip Grant
Friday, May 24, 2019
Bouncy-bouncy
This is no joke.
This is no joke.
Damage control
Big doings in the Middle Kingdom.
Big doings in the Middle Kingdom.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s
Dem bones
Yesterday, French retailer Rallye S.A.,
Yesterday, French retailer Rallye S.A.,
Recap May 24
Bouncy-bouncy
This is no joke. Tech-focused website The Next Web reported yesterday on mobility startup Cangoroo, which offers users access to pogo-sticks as they travel around Stockholm and Malmö, Sweden. CEO Adam Mikkelsen assured the skeptical publication:
It is a real venture. . . with the pogo stick, the way we’ve branded it is as a product you can actually use for last-mile transportation. A lot of people in Sweden had pogo sticks as children, so we see them using them as adults.
Bullish for the orthopedic profession, at least.
Damage control
Big doings in the Middle Kingdom. Reuters reports:
China’s financial regulators said on Friday the country’s banking and insurance regulator will take control of Inner Mongolia-based Baoshang Bank Co., Ltd. due to the serious credit risks it poses, in a rare takeover of a domestic lender.
Baoshang had a total of 156.5 billion yuan ($22.68 billion) of outstanding loans by the end of 2016, a 65% jump from the end of 2014, according to the bank’s last filing on its assets and liabilities on its website. Its non-performing loan ratio was at 1.68% as of December 2016.
The bank, which has not published an annual report since 2016, carries a double-A-plus rating from local agency Dagong Global Credit Rating Co., though Dagong cut its outlook on Baoshang to negative last year. This is the first state takeover of a Chinese bank since at least the 1990s.
The Wall Street Journal, citing local media, notes today that Baoshang was linked to missing financier Xiao Jianhua, who was apparently abducted upon returning to the Chinese mainland from Hong Kong in early 2017.
House of cards
Bloomberg asserts today that Brazilian President Jair Bolsonaro’s right wing government is beginning to teeter, with “talk of impeachment” beginning to surface just five months into his four year presidential term. Bloomberg reports that “the situation has become so tense that, earlier this month, a senior player at the heart of Brazil’s political wranglings had a nervous breakdown during an interview.”
Trouble in the Bolsonaro administration is beginning to show up in the polls. According to a May 21 XP Investments/Ipespe survey, more Brazilians disapprove than approve of Bolsonaro for the first time, while 36% of respondents say the government “is bad or terrible.” That’s up from 31% one month ago.
Those ominous signs haven’t dimmed hopes for successful pension reform, a crucial issue for Brazil. Yesterday, economy minister Paulo Guedes predicted at a São Paolo event that “in 60 days there will be a favorable surprise in the Senate.” Reuters however reports that sources in Brazil’s congress “say the government remains well short of the 308 votes required in the lower house to even take it up to the Senate.”
For his part, Marcelo Ramos, chairman of the congressional committee on pension reform, had some sharp words for the president, telling Reuters on Wednesday: “Bolsonaro despises democracy. We have to isolate his anti-democratic attitude and lack of respect for institutions, so this does not paralyze the country.”
The stakes are high. In an interview with Veja magazine published today, Guedes said: “If we don’t make the reforms, Brazil will go down in flames. There will be chaos in the public sector, both in the federal government as well as the states and municipalities.”
The economy minster also detailed his back-up plan in the event of legislative failure: “I will take a plane and go live abroad. I am already old enough to retire.”
Dem bones
Yesterday, French retailer Rallye S.A., parent company of supermarket chain Casino Guichard-Perrachon (a.k.a. Groupe Casino, CO on the Euronext Paris Exchange) entered a court-led creditor protection program, as the distressed conglomerate looks to avoid bankruptcy.
The collection of companies, each headed by majority shareholder and CEO Jean-Charles Naouri, have an interconnected structure, as the Financial Times notes a 41% decline in Casino stock since March “hurt Rallye because the parent company has used it as collateral to secure credit lines at banks.”
Nauri, who told the FT in October that those selling short his company do so “at their risk and peril,” has received unwanted attention before. In December 2015, research firm Muddy Waters initiated a short position in Casino shares, asserting that the company’s opaque, highly leveraged capital structure presented risks well beyond market expectations.
The episode is instructive beyond the specific travails of Casino and its related entities. The Jan. 15, 2016 edition of Grant’s Interest Rate Observer featured a look at European hybrid securities, which, as an anonymity-seeking, London-based correspondent noted, act as something of an investment panacea:
For ratings and regulatory purposes, a hybrid is neither exactly debt nor exactly equity. It answers the needs of leveraged issuers and yield-starved investors alike. It offers incremental returns relative to senior bonds in the same capital structure. Plainly, there must be something wrong with it.
Here, as in other areas of financial innovation, we are dealing with an arbitrage; of credit-rating methodologies, of tax rules and, yes, of investor sophistication.
The analysis identified a pair of picks-to-not click among these hybrid contraptions, including the Groupe Casino’s perpetual 4.875% note, then priced at 88 cents on the euro for a 9.5% yield-to-call. The securities, which saw the coupon reset in January to a floating rate of 357 basis points over the mid-swap benchmark, have since declined to 61 cents on the euro for a 16.6% yield-to-call.
Recap May 24
Stocks finished slightly higher after giving back bigger early gains, leaving the S&P 500 in the red by just over 1% for the week. Treasurys finished little changed, as the three-month vs. 10-year spread remained inverted for a second day, while oil bounced with WTI crude finishing near $59 a barrel. The VIX settled at 16.
- Philip Grant
Thursday, May 23, 2019
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa
Sports talk radio mainstay and overall renaissance man Mike Francesa
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said
Today, Facebook, Inc. (FB on the Nasdaq) said
Yield yodel
QT Progress report
Recap May 23
He said it
Sports talk radio mainstay and overall renaissance man Mike Francesa weighed in on the stock market this morning on Twitter:
The market is quickly becoming less about finding good businesses and more about managing the day’s headlines.
Fake schmooze
Today, Facebook, Inc. (FB on the Nasdaq) said it removed 2.19 billion bogus accounts from its platform in the first quarter, more than double the 1.2 billion faux-users the company booted in the fourth quarter of 2018.
Those combined figures might represent 45% of the global population, as reckoned by the U.S. Census population clock, but Facebook reassured investors today: “Because we remove these accounts so quickly, they are never considered active and we don’t count them as monthly active users.” Instead, the company reckons that only 5% of its reported 2.38 billion monthly active user accounts are fake.
Yield yodel
Junk has been the place to be for credit investors, as the Bloomberg Barclays High Yield Index has delivered an 8.3% total return year-to-date, topping the 7.1% gain in the iBoxx Liquid Investment Grade Index and outpacing the 5.7% generated by the S&P/LSTA Leveraged Loan Index. Even after a recent pullback in prices, the ICE BAML High Yield option-adjusted spread sits at just 403 basis points over Treasurys, well below the 552 basis point average going back to 1997.
What’s driving the superior performance in high-yield? The prospect of an easier Fed is one key contributor, helping increase the perceived value of fixed-rate junk bonds as opposed to floating-rate loans. Relatively robust economic growth (GDP growth has averaged an annualized 3.3% over the last four quarters) has likewise helped, as has a buoyant stock market. Meanwhile, defaults have remained low, with Fitch Ratings forecasting that May’s trailing 12-month high-yield default rate will settle at 2%. That compares to 4.7% in calendar 2016 and 14% in 2009, per Fitch.
Some investors expect the good times to continue. Vivek Bommi, senior portfolio manager at Neuberger Berman, told Bloomberg over the weekend that the junk bond market “is very attractive, given that the fundamentals are still very good and corporate credit quality is still good.” Bommi notes that the post-crisis boom in leveraged loan issuance has shifted risks away from high-yield: “In the last 10 years, a lot of the more aggressive issuance that may have gone into the high-yield market has gone into other markets like private credit or loans.”
But with the economic expansion set to match the post-World War II record of 110 months in June and the stock market still less than 5% below its closing high-water mark, some concerning signs have emerged. Economic growth looks set to slow, as the Atlanta Fed’s GDPNow tracker indicates second quarter output growth at just 1.2%, revised down from 1.6% on May 14. Retail sales for April fell by 0.2% on a sequential basis, vs. expectations of a 0.2% gain. Resource prices likewise look to be rolling over, with the Goldman Sachs Commodity Index down 5% over the last month.
Broad cracks in credit are also appearing. On Monday, the Financial Times published an analysis showing that non-performing loans among the 10 largest commercial lenders in the U.S. jumped by 20% sequentially in the first quarter, snapping a streak of improvement in that metric dating back to 2016. Brian Foran, a bank analyst at Autonomous Research, tells the FT that unlike three years ago, when plunging oil prices pushed a number of energy-related borrowers into distress, the recent uptick is broad-based: “There hasn’t been a clear theme.”
Meanwhile, rich valuations leave little room for error. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, writes in S&P Global’s LCD publication that his fair value estimate of the ICE BAML option adjusted spread is 648 basis points, far above the 405 currently on offer. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.” Reached by Grant’s this afternoon, Fridson added that even supposing a new round of QE, high-yield is overvalued by more than 100 basis points by his analysis.
With high-yield priced for perfection, where might a yield-starved investor turn? The March 22 edition of Grant’s Interest Rate Observer offers a survey of income-producing securities that may offer an attractive substitute for junk bonds.
QT Progress report
The Fed’s portfolio of securities held outright ticked to $3.681 trillion, down $5 billion from a week ago. Mortgage-backed securities accounted for the change, as Treasury holdings remained flat at $2.11 trillion.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 13.4%, at a simple annualized pace of 8.3%.
Recap May 23
Risk aversion reigned supreme as stocks fell and Treasury yields darted lower, with the 10-year yield falling seven basis points to 2.32%, well below the Fed Funds Rate and once again inverted against the three-month bill.
Energy prices were hammered, with WTI crude falling 5% to less than $59 a barrel for its worst session of the year and the S&P 500 energy sector extending its two-day drop to nearly 5%, following a surprise build in yesterday’s weekly inventory report from the DoE. The VIX jumped 15% to finish just below 17.
- Philip Grant
Wednesday, May 22, 2019
In the shop
The auto industry caught a break last week, as the Trump administration announced that planned tariffs would be placed on six month delay. Global industry trade group The Alliance of Automobile Manufacturers expressed relief, commenting that “at the end of the day, you can have tariffs or investment, but you can’t have both.”
The removal of additional taxation (for now at least) is some welcome good news for an industry that has entered something of a rough patch. April U.S. auto sales footed to a seasonally adjusted annual pace of 16.4 million vehicles, down from a comparable 17.2 million pace a year ago.
Stateside, pricing remains strong both in the primary and secondary market. Kelly Blue Book pegs the average transaction price for a new auto at $36,843 in April, up 2% year-over-year. Likewise, the J.D. Power Valuation Services’ Used Vehicle Price Index rose by 1.7% year-over-year last month, with strength in the wholesale market pushing the price of used units (up to eight years old) higher by 1.4%, “the best April performance on record.” At the same time, dealers are increasingly holding the line, as incentive spending fell 6.8% year-over-year in April according to J.D. Power. That’s the tenth consecutive decrease after 54 straight months of rising incentives.
But as pricing continues to strengthen and sales remain in the upper end of the cyclical range, trends in credit augur trouble. According to data from the New York Fed, serious (meaning 90 days or more) auto loan and lease delinquencies rose to 4.69% in the first quarter, up from less than 3.5% in 2016 and just 58 basis points below the post-crisis peak of 5.27% in 2010.
As the cycle has progressed, the auto loan market has grown significantly. Thus, the New York Fed reports that first quarter auto loan and lease balances rose 4% year-over-year to $1.28 trillio, leaving that figure 65% above its first quarter 2009 level. But, as pointed out by financial blogger Wolf Richter, the number of auto-loan accounts has risen by only 34% over the same period, suggesting that “much of the increase in the auto-loan balances is the ballooning amount financed with each new loan and longer loan terms.”
Daniel Ruiz, founder of automotive research firm Blinders Off, LLC, expects that the uptick in bad auto debt will have a broader impact. Ruiz tells Grant’s by email that as the auto market is dependent on trade-in values on financed vehicles, used prices are the lynchpin to sales:
The real risk is not in the length of the loan, but rather the amount of time that it takes for the value of the asset to meet or exceed the principal balance owed on the loan. Used vehicle values have been relatively strong so far this year but not strong enough to offset the increased loan lengths and interest rates of three years past.
Aside from the risk of significant loan losses for lenders with high exposure to subprime auto loans, increased default rates will also increase wholesale volume at auctions.
Indeed, despite the strong recent pricing environment, J.D. Power notes that secondary supply is on the upswing, as auction volumes through the first four months of the year are up by 6.5% from 2018.
As for the broader health of the market, Ruiz utilizes a bespoke indicator he dubs “time-to-equity,” meaning the interval until a vehicle’s trade-in value exceeds the principal balance outstanding on a given auto loan, as a key indicator:
To sum it all up, increased wholesale volume from subprime auto loan defaults will impact used-vehicle retail inventory levels. If that happens, time-to-equity will spike, slowing new-vehicle sales further and causing an even larger increase in subprime auto loan delinquencies.
In essence, longer loan terms and higher interest rates will lead to increased time to equity going forward even if used-vehicle values remain strong. If/when used-vehicle values fall, the situation will get worse until time to equity falls sometime in the future due to shorter loan terms, lower interest rates and or a rebound in used-vehicle values; exactly what happened after our last recession.
The automakers themselves are tightening their belts. Yesterday, Ford Motor Co. announced it will cut 7,000 white-collar jobs, roughly 10% of its global salaried workforce as part of a companywide “redesign.” As noted by Bloomberg today, that brings the total number of announced global job cuts among U.S. vehicle manufacturers to 38,000 employees over the last six months.
Recap May 22
Stocks fluttered a bit lower, as a sharp oil downdraft pushed WTI crude back near $61 a barrel and the S&P Energy Index 1.5% into the red. The VIX held little changed near 15, but risk aversion was evident in rates as Treasury yields dove, with the 10-year falling to 2.38%, near the lowest of 2019 so far and below the 2.39% effective Fed Funds rate.
- Philip Grant
Tuesday, May 21, 2019
Peanut allergy
The Gauls are on the rampage, The Wall Street Journal reports today. Citing data from Dealogic, The Journal notes that French corporations have allocated a post-2008 high of roughly $100 billion to foreign acquisitions in each of the last two years (equating to roughly 4% of France’s 2018 nominal GDP) with the United States a particularly attractive target. Eighteen stateside deals have been consummated by French companies already this year.
That shopping spree coincides with an increase in France’s corporate debt load, now at 143% of GDP, up from 116% in 2008 and well above the 74% seen in the U.S., per the Bank for International Settlements. The rise in corporate debt comes as the European Central Bank marks the fifth anniversary of its foray into negative interest rates, along with the recently-paused corporate bond buying program which was in place since 2016 and held some €178 billion in assets as of April 30.
A spokesperson for drug maker Sanofi S.A., which bought Waltham, Mass.-based Bioverativ, Inc. for $11.6 billion in March 2018, got to the crux of the matter, explaining to The Journal: “Obviously, cost of funding is one of the key elements to take into account for debt-funded deals.”
While the ECB’s aggressive monetary policy has helped spur corporate consolidation, underlying economic activity remains turgid. Thus, euro-area core CPI rose to 1.3% year-over-year in April, the highest reading since April 2017 but still far below the near-2% threshold favored by the central bankers (core CPI growth has averaged 1% since the ECB pushed the deposit rate below zero). Meanwhile, the European Commission now forecasts 1.2% real GDP growth this year in the eurozone, down from a 1.9% guesstimate for 2019 at the end of last year.
But hope springs eternal. Over the weekend, ECB governing council member Klaas Knot said in an interview with Corriere della Sera that “if the economy continues to rebound. . . then I think we are on course” to reach that 2% inflation bogey. Knot attributed weak European growth to globalization, stating: “the only thing that we can do is to keep the pressure up, make sure the economy continues to perform at high levels of capacity utilization and the economy continues to print GDP numbers in excess of potential growth.”
Taking no chances, the mandarins are prepared to go back to the well. In an April press conference, soon-to-be-outgoing President Mario Draghi said that the ECB is prepared to “adjust all its instruments” if data aren’t to their liking. More specifically, the Financial Times surmises that “additional measures [designed] to keep the cost of credit cheaper for longer” will be in store if growth and inflation continue to disappoint.
Then, too, investors see no policy normalization any time soon. Interest rate futures currently predict 29% odds of a rate cut by year end and virtually no chance of a hike. One month ago, the odds of a rate cut, and rate hike were both between 7% and 8%. Meanwhile, the March 2020 three-month Euribor futures contract has risen to 100.35, suggesting a deposit rate of negative 35 basis points 10 months from now. That compares to 99.88 last spring, when investors were expecting a return to positive rates and the April 6, 2018 edition of Grant’s Interest Rate Observer suggested that call options on this instrument would be a good way to profit from the ongoing financial repression in the eurozone.
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March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
With positive nominal interest rates not forthcoming any time soon, Europe’s financial institutions continue to falter. The Stoxx 600 Banks Index is now down 25% over the last 52 weeks, badly lagging the 5% decline in the broad Stoxx 600 Index. Bank valuations have descended into consignment-type depths, with that Stoxx gauge now trading at 0.58 times book value, less than half of the 1.23 times book value fetched by the KBW Banks Index in the U.S.
The travails of Deutsche Bank, A.G., which has seen shares plummet by 93% since 2007 and carries a €43.5 trillion ($48.8 trillion) derivatives book equal to nearly three times 2018 Eurozone GDP, are front and center. But other institutions are also attracting unwanted attention. Last week, BlackRock, Inc. backed out of a deal to rescue Banca Carige S.p.A. (founded in 1483), which the ECB had placed the Italian lender in administration in January. In response, Italian deputy prime minster Matteo Salvini told reporters: “It’s an important bank. Obviously, we won’t let things collapse.”
Don’t blame the ECB, according to governing council member Benoit Coeuré. Speaking in French parliament last Wednesday, Coeuré estimated that negative interest rates are costing eurozone banks €8 billion in annual lost income, which he termed “really peanuts.” Instead of positive nominal rates, Coeuré offered a familiar solution for the banks’ woes: Industry consolidation.
Recap May 21
Stocks rallied, with the S&P 500 rising back above yesterday’s opening level while the NYSE FANG+ Index was able to recoup about half of yesterday’s 2.7% drop. Treasury yields edged higher as rangebound action continues in rates, and the VIX finished below 15 for the first time since May 3.
- Philip Grant
Monday, May 20, 2019
Concession stand
One down, two to go?
One down, two to go?
Track changes
Morningstar reports today
Morningstar reports today
Recap May 20
Concession stand
One down, two to go? This morning, the Federal Communications Commission announced it will recommend approval of the proposed merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq), the fourth- and third-largest wireless carriers in the U.S., respectively. That follows a Bloomberg report from Sunday evening that the pair had agreed to concessions including the divestiture of Sprint’s Boost Mobile pre-paid unit, as well as commitments to build out 5G network infrastructure in rural areas of the country.
FCC chairman Ajit Pai explained his rationale in a statement: “Two of the FCC’s top priorities are closing the digital divide in rural America and advancing United States leadership in 5G, the next generation in wireless connectivity. The commitments made today by T-Mobile and Sprint would substantially advance each of these critical objectives.”
While the FCC’s blessing is an important step for the pair, regulatory roadblocks remain. The Department of Justice must also sign off on the combination, a decision which could come relatively soon as the DoJ’s 180-day review period is set to conclude in early June. Then, too, the attorneys general of more than a dozen states have signaled opposition to the merger (Almost Daily Grant’s, March 29).
But the concessions announced today could swing the tide in the company’s favor. Bloomberg Intelligence analyst Jennifer Rie took an optimistic bent in a note today, assessing the odds of both DoJ and state attorneys general approval as “more likely than not.”
The initial reaction suggested Mr. Market concurred with Rie’s viewpoint. Sprint shares surged by as much as 27%, closing the gap to T-Mobile’s all-stock offer to just 4% following the market open. That’s down from a 26% discount seen last week. Likewise, Sprint’s senior unsecured 6 7/8 notes due 2028 jumped more than points to 104, narrowing the spread over Treasurys to 401 basis points from 501 basis points.
For its part, The Wall Street Journal notes that Pai’s endorsement “marks a departure from the stance taken by past FCC leaders who stood in the way of deals that would leave the U.S. wireless market with fewer than four nationwide competitors.” Sure enough, Bloomberg reports this afternoon that the DoJ continues to “lean against” clearing the merger, a headline which helped widen Sprint’s discount to T-Mobile’s all-stock offer back to 11% in the late afternoon.
It is no stretch to say that Sprint’s financial health might depend on the tie-up. On May 7, CEO Michel Combes referenced his company’s shaky stand-alone prospects after revealing a larger than expected loss of higher-value, postpaid wireless users: “We are making the best of the limited financial and low-band spectrum resources that we have. . . we are hopeful to complete our merger with T-Mobile.”
For an updated look at the potential broader implications of a scuttled Sprint/T-Mobile tie up, see the most recent, May 17 edition of Grant’s Interest Rate Observer.
Track changes
Morningstar reports today that a $39 billion inflow in passively-managed assets in April pushed the total to $4.3 trillion, within $6 billion of eclipsing the total assets invested in active management, (which saw a $22 billion outflow for April) for the first time.
“This is a milestone that has been a long time coming as the trend toward low-cost fund investing has gained momentum,” noted Kevin McDevitt, senior analyst at Morningstar and author of the report. McDevitt relays that active U.S. equity managers have seen funds decrease in every year since 2006, with passive strategies enjoying symmetrically-consistent growth over the same period.
With passive investing on the cusp of supremacy, the index makers mix in some active management of their own. Last week, S&P announced that Uber Technologies, Inc. (UBER on the NYSE), will be added to various S&P Dow Jones Indices, including the S&P Total Market Index, as early as tomorrow. As noted in a Bloomberg interview with an S&P spokesperson, Uber is the first company to achieve “fast-track” entry into S&P indices, since the methodology for prompt index inclusion was changed earlier this year.
As Uber gets the fast-track treatment, ride share drivers cut corners to keep their heads above water. On Thursday, Washington, D.C.’s ABC 7 news reported that drivers at Regan National Airport have been “simultaneously turn[ing] off their ride share apps for a minute or two to trick the app into thinking there are no drivers available -- creating a price surge.” Sam Sweeney reports: “These drivers tell ABC 7 they do have a sense of guilt. They say they don’t want to do this, but because Uber and Lyft keep reducing their pay, they tell us they have no choice.”
Recap May 20
A tech-led selloff left the S&P 500 down by 0.7%, while the NYSE FANG+ Index shed 2.7%, leaving that gauge of ten popular stocks down 13% from its May 6 close. Treasury yields rose across the curve, while oil bucked largely bearish commodity action to leave WTI back over $63 a barrel. The VIX held steady north of 16.
- Philip Grant
Friday, May 17, 2019
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
An emailed invitation from the Federal Reserve Bank of New York:
Fruit flies
Chinese fruit prices have been on the march,
Chinese fruit prices have been on the march,
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out
Yesterday, VanEck Securities Corp. rolled out
Recap May 17
The sound of silence
An emailed invitation from the Federal Reserve Bank of New York:
John Williams, President and CEO (Speaker)
Date: Monday, May 20, 2019
Time: 1:00 PM EDT
Subject: Welcome Remarks
Event: Fed Listens Capstone Roundtable Discussion
Organizers: Federal Reserve Bank of New York
Location: Federal Reserve Bank of New York
33 Liberty Street, New York, NY 10045
Text is not expected. Q&A with the audience in the room is expected. This event is open to the press to watch via webcast, though not to attend in-person.
In other words, on Monday you can watch the Fed listen.
Fruit flies
Chinese fruit prices have been on the march, with a benchmark index of seven fruits compiled by the Ministry of Agriculture and Rural Affairs jumping to RMB 7.59 ($1.07) per kilogram today. That’s up 23.3% from a month ago and 33.4% year-over-year.
Those figures are downright conservative compared to statistics from the Xinfadi Produce Wholesale Center in Beijing, which reports to state-run The Beijing News that its calculation of average fruit prices shows a 78% year-over-year increase to RMB 6.15, with so-called golden nuggets (A.K.A. tangerines) doubling from a year ago. For context, the World Bank pegged Chinese per capita gross national income at RMB 62,000 at year-end 2017.
Asked by Caixin for comment, a spokesperson for the National Bureau of Statistics cited extreme weather for the price spike, “but did not elaborate.”
Consumers in the Middle Kingdom have been more loquacious. The Epoch Times notes that an online article posted by the Chinese Nutrition Society urging citizens to eat a pound of vegetables and half a pound of fruit per day featured a recurring reaction in the comment section: “We cannot afford it.” Caixin likewise notes that “the phrase ‘fruit freedom’ – or the ability to buy as much fruit as one wants – [has become] a buzzword in China’s online lexicon.”
More broadly, the NBS reported yesterday that its consumer price index rose 2.5% year-over-year in April, matching the third-highest reading since 2013, with the measured rise in food prices at 6.1% year-over-year. The NBS finds that fruit prices are higher by 11.9% year-over-year, while pork prices have jumped by 14.4% on account of the African swine fever outbreak among China’s pig population (Almost Daily Grant’s, April 2).
Meanwhile, the Sino-American trade spat grinds on. On Sunday, the Chinese side offered some topical rhetoric, stating that they won’t swallow any “bitter fruit.”
Influx capacitor
Yesterday, VanEck Securities Corp. rolled out the VanEck Vectors Municipal Allocation exchange-traded fund (MAAX on the NYSE Arca).
This is no ordinary collection of muni bonds. As explained in the press release, the ETF “is designed around a proprietary model that uses momentum, along with both duration and credit risk indicators, to tactically allocate among selected VanEck Vectors Municipal Bond ETFs.”
In other words, as noted by Bloomberg’s Brian Chappatta, MAAX is “an ETF of ETFs.” For his part, Chappatta rhetorically wonders why the “traditionally buy-and-hold [muni] market need[s] an ETF that allocates among other ETFs?”
Unsurprisingly, an uptick in popularity goes a long way toward explaining the newfound financial innovation. Inflows into muni bond ETFs reached $661 million at the end of April, says Bloomberg, the second-strongest weekly capital infusion in the past eighteen months.
That comes on the heels of strong performance, as the Bloomberg Barclays Municipal Bond Index has generated a 6.8% total return over the past year, topping both the Bloomberg Barclays High Yield Index’s 6.1% and the 4.1% generated by the S&P/LSTA Leveraged Loan Index.
That strong rally has led to some fancy prices. The ratio of the 30-year benchmark municipal bond yield to the Treasury long bond fell below 87% yesterday (the lower the ratio, the more expensive munis are on a relative basis), a record low going back to at least 2001. On a shorter horizon, the ratio of 10-year benchmark munis fell to 72.5% of the comparable Treasury yield, itself near a record low.
For a survey of some less-horrifically overvalued municipal bonds, see the Feb. 9, Oct. 19, 2018 and Aug. 10, 2018 editions of Grant’s Interest Rate Observer.
Recap May 17
Stocks came under some pressure, with the S&P 500 falling back into the red for the week as higher beta groups such as industrials, tech and consumer discretionary underperformed. Gold fell for a fourth straight day after touching $1,300 an ounce on Monday, while Treasury yields finished little changed. The VIX settled near 16.
- Philip Grant
Thursday, May 16, 2019
Looney tunes
From CNN:
From CNN:
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker
An update on Post Holdings, Inc., the cereal and processed food maker
QT Progress report
Recap May 16
Looney tunes
From CNN:
A playful rabbit sculpture by Jeff Koons has become the most expensive work by a living artist ever to sell at auction.
The American artist's "Rabbit," a stainless steel figure measuring just over 3 feet tall, sold for more than $91 million Wednesday evening at Christie's in New York, smashing auction estimates.
Christie's initially estimated that Koons' faceless "Rabbit" would sell for between $50 and $70 million. But after more than 10 minutes' bidding, the winning offer came in at $80 million which -- including auctioneer's fees -- resulted in a final sale price of $91,075,000.
Evidently, Trix aren’t just for kids.
Post no bills
An update on Post Holdings, Inc., the cereal and processed food maker which was a Grant’s pick-to-not-click in the Sept. 16, 2016 issue. Since publication time, POST shares are up 36% counting dividends, compared to a 41% total return in the Russell 3000 Index. On the credit side, the senior unsecured 5% notes due 2026 last changed hands at 99.5 cents on the dollar and have generated a 15.1% total return, compared to 17% for the Bloomberg Barclays U.S. Corporate High Yield Index.
Improving margins figure prominently in the bull story. Over the 12 months ending Sept. 30 (the company’s fiscal year-end), Post will generate $382 million in adjusted net income on $5.8 billion in revenue, if analyst consensus is on the beam. That compares to just $187 million in adjusted net income on $5.2 billion in revenue two years prior.
That margin expansion is all the more impressive considering the secular decline in cereal, Post’s core business. U.S. consumers bought $8.3 billion worth of cereal in 2017 according to Nielsen. That’s down from $8.8 billion in 2016 and compares to $12.7 billion in cereal bought by Americans in 2009, per the estimate of research firm IBISWorld. In fiscal 2018, Post’s consumer brands unit chipped in 29% of revenue and 38% of gross profit.
As the legacy business shrinks, Post management wheels and deals. One day before the earnings release, Post announced the acquisition of TreeHouse Foods, Inc.’s private, ready-to-eat cereal business. Later this year, the company is expected to IPO a minority stake in the Active Nutrition segment, the highest-growth portion of the Post portfolio with a 5.5% year-over-year revenue advance in the latest quarter. Proceeds from that offering can be used to help pay down the company’s $6.2 billion debt load, which equates to five times fiscal 2019 consensus adjusted EBITDA.
Mr. Market continues to give his blessing to single-B-plus rated (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) Post, bestowing a relatively generous 23 times trailing adjusted earnings multiple. That compares to 14.7 times trailing earnings for the S&P 500 Packaged Foods Index.
For Post bulls, the deal-making acumen of a management team headlined by the venerated 84 year-old nonexecutive chairman William P. Stiritz, counts as a primary attraction. Since its 2012 formation as a spinoff from Ralcorp, Inc., Post has undertaken more than a dozen acquisitions, for total considerations of at least $8.2 billion (financial terms for several deals, including the recently announced TreeHouse private brands label, were undisclosed). For context, Post's current market cap is just over $8 billion.
Vicki Bryan, founder and CEO of BondAngle, LLC, tells Grant’s today that Post’s chronic deal-making helps prevent investors from getting a true picture of the company’s performance and financial health.
On top of the stream of acquisitions, Post is constantly rejiggering their segment reporting, including in the second quarter. This prevents investors from getting an apples-to-apples look at their performance. I call it ‘structured amnesia.’
Post’s financial machinations extend beyond the gathering of corporate assets. On Aug. 2, the company announced the spin-off of its private brands business into a newly formed entity called 8th Avenue Food & Provisions, in partnership with private equity firm Thomas H. Lee Partners, Inc. The unit chipped in $849 million in revenues last year, equivalent to 13.6% of Post’s top-line for fiscal 2018.
In carving out that business unit, Post received proceeds of $250 million, as well as 8th Avenue’s assumption of $625 million in debt. Post maintains 60.5% of the common equity for 8th Avenue, while Thomas H. Lee received preferred stock with a cumulative, quarterly compounding dividend, as well as the remaining 39.5% ownership in the venture. As Thomas H. Lee controls voting rights to the newly formed company, those results are no longer consolidated onto Post’s financial statements.
For her part, Bryan flags the 8th Avenue deal as a concerning one, particularly for Post’s creditors:
By spinning off the private brands unit, Post has reduced profit visibility and, more importantly, reduced asset coverage against its substantial borrowings. This is particularly worrisome considering that intangible assets such as goodwill foot to $8 billion, more than two-thirds of the $11.3 billion in total assets on the balance sheet.
What’s more, 60.5% Post-owned 8th Avenue is itself highly leveraged. Accordingly, the parent company may be currently or in the future compelled to support the unit through paying expenses or disbursing additional cash. We know that it is one of Post’s lower-margin businesses, reporting gross margins of 16.2% in the six months ended March 31, compared to 31.4% for the parent company.
In short, they have further weakened what was already a weak hand for bondholders.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.686 trillion this week, down $15.5 billion on a sequential basis, with mortgage-backed securities and Treasury holdings down by $5.8 billion and $9.7 billion, respectively, from a week ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down 13.3%, for a simple annualized pace of 8.4%.
Recap May 16
Stocks rose again, with the S&P 500 gaining nearly 1% to claw back to unchanged for the week after Monday’s steep selloff, back within 2.5% of the closing highs reached on April 30. Treasury yields ticked higher, with the short end underperforming to leave the curve a bit flatter, and strength in the energy patch helped WTI crude rebound to $63 a barrel. After touching 21 earlier in the week, the VIX settled below 15.5.
- Philip Grant
Tuesday, May 14, 2019
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE)
Recap May 14
Can you hear me now?
Yesterday, Bloomberg reported that Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq) have opted for new tactics in lobbying government regulators to approve their merger announced in April 2018. In the face of apparent opposition from staffers at the Department of Justice and Federal Communications Commission, the pair (the fourth- and third-largest wireless carriers in the U.S., respectively) are discussing concessions, including potentially selling pre-paid business units or airwave licenses as well as “far less attractive options,” such as establishing a new fourth carrier which would lease network capacity from the combined entity.
On April 16, The Wall Street Journal reported that DoJ staffers told the pair the merger “is unlikely to be approved as currently structured.” That same day, the Capitol Forum relayed that the DoJ expressed “continued concerns regarding efficiencies and a potential delay in any of the deal’s benefits reaching consumers” at an early April meeting with the pair.
But investors remain relatively sanguine about single-B-plus rated Sprint’s prospects. The company’s senior unsecured 6 7/8 notes due 2028 trade near 96 cents on the dollar, while Sprint shares remain at a 26% discount to the all-stock offer price (as reflected in T-Mobile shares), both little changed from six weeks ago. That steady price action in the face of less-than encouraging media reports stands in contrast to the precipitous decline in Sprint’s bond and stock prices in early 2016, when its status as a viable enterprise came into question.
A bearish analysis of Sprint in the Dec. 23, 2016 edition of Grant’s Interest Rate Observer argued that Sprint’s stagnating top-line, persistent cash burn (negative on a free cash flow basis in each of the last four years, with more red ink in store for fiscal 2019 and 2020 according to estimates compiled by Bloomberg), and hefty debt load presented risks in excess of the prospective skimpy returns.
While likely delivered with an eye toward influencing regulators, recent language from Sprint management seems to concur with that assessment, as CEO Michel Combes remarked on the Jan. 31 conference call: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments and without additional low-band spectrum, we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
For its part, T-Mobile management is preparing for life as a standalone company. Last week, Germany’s Handelsblatt reported that the TMUS c-suite is preparing a plan B if the merger is blocked.
As for the remedies proposed by the pair, Amir Anvarzadeh of Asymmetric Advisors writes this morning that the suggestions are both unlikely to move the needle and impractical from a business competition standpoint:
The problem is that spinning off the prepaid business (which makes the bulk of both carriers' customer base) leaves them at a huge disadvantage in terms of converting customers to post-paid users in the future.
Selling off airwaves would also be silly given that Sprint was just saying that without adequate low band radio spectrum, they will be at a great disadvantage while its 2.5Ghz spectrum is one of the most attractive assets they have. I’m not sure if either option is feasible.
Meanwhile, one anonymity-seeking investor acquainted with the situation finds the contrast between widespread reports suggesting the merger will fail to garner regulatory approval on the one hand, and the sanguine trading in Sprint’s equity and debt on the other, to be curious, telling Grant’s:
I continue to believe that the DOJ, FCC and state attorneys-general are not convinced that the proposed deal efficiencies are merger specific or verifiable enough to accept highly visible harms that inure from a permanent change in industry structure (four players to three).
Resolution to this saga is likely near. The Capitol Forum notes that the DoJ is expected to reach a final decision before early June, when the FCC’s scheduled 180-day review period comes to conclusion.
Recap May 14
Stocks staged a solid rebound with the S&P gaining nearly 1% after falling to a six-week closing low yesterday, but the broad index did lose some steam by day’s end. The VIX fell back to 18, down 12% on the day, and Treasury yields edged higher after yesterday’s strong rally with the 10-year yield rising back above the three-month by one basis point after inverting yesterday. WTI crude ticked back to near $62 a barrel.
- Philip Grant
Monday, May 13, 2019
Cut rate
The latest escalation of the U.S./China
The latest escalation of the U.S./China
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled
Recap May 13
Cut rate
The latest escalation of the U.S./China trade spat has both countries considering their options. This morning, Hu Xijin, editor-in-chief of The Global Times, speculated on Twitter that China might retaliate against the latest tariff hikes by selling down their $1.1 trillion pile of Treasury bonds (representing nearly 7% of the $16.1 trillion in U.S. debt held by the public). But that potential supply deluge didn’t prevent a strong rally in rates: The 10-year yield dropped this morning to 2.40%, the lowest since March, crossing below the three-month bill yield to once again push the curve into inversion.
As international tensions percolate and risk appetite withers, the market increasingly expects the Fed to ride to the rescue. Interest rate futures currently price 59% odds of a rate cut by October, nearly double the 31% likelihood anticipated one month ago.
But comments from a pair of senior Fed officials suggest the FOMC is less than eager to follow Mr. Market’s suggested path. This morning, Minneapolis Fed president Neel Kashkari told CNBC that a still-robust labor market indicates no pressing need for policy support: “If we saw job growth really slowing down, then you might say. . . we need to do something. I’m not quite in that camp yet because we continue to see the job market exceed expectations.”
Fed vice chairman Richard Clarida likewise took a sanguine view in a Boston speech this morning, remarking that “the U.S. economy is operating at or close to our maximum-employment and price stability [meaning a measured 2% annual loss in purchasing power] goals.”
Jim Bianco, president and eponym of Bianco Research, argues today that the Fed would be wise to heed the market’s advice. The 10-year yield has dropped below the three-month yield on seven occasions in the last 50 years, and recession has followed each time, commencing 311 days later on average. Bianco writes:
The yield curve is a market signal that the Fed is too tight. Many think it ‘predicts’ a recession. We believe it actually ‘causes’ a recession.
A recession occurs because something ‘breaks’ the economy. FOMC policy that is overly restrictive is perhaps the leading reason an economy breaks. It is the cumulative effect of a Fed mistake week after week, month after month that causes a recession.
Swing LO
This morning, Mexican President Andrés Manuel López Obrador (AMLO) unveiled a fresh series of measures designed to bolster the cash-leaking state-owned oil company Petróleos Mexicanos (Pemex), including an $8 billion syndicated loan as well as fresh tax breaks. Proceeds from the loan will be used to refinance a portion of Pemex’s towering $106.5 billion debt load. The new measures follow a $5.5 billion aid package disbursed in March.
But with that generosity comes the expectation that Pemex will do some heavy lifting. Last Thursday, AMLO announced that his administration has rejected a trio of private company bids to build an oil refinery in his home state of Tabasco, instead tapping Pemex for the job. The outside bidders had submitted budgets in the range of $10 billion to $12 billion for the project, and anticipated completion between 2023 and 2025. Instead, Pemex will build the facility for $8 billion, and target completion by May 2022. “We’re not going to start any work we can’t finish in my term,” AMLO declared.
Count some observers as skeptical. Gonzalo Monroy, an independent energy analyst in Mexico City, told The Wall Street Journal that: “You can’t build a monster refinery like this, at such a low cost, on such a short timeline. López Obrador will have to sacrifice one of those things. That’s what the companies that were bidding on this project were saying.”
Pemex investors are likewise uneasy about the ambitious plan. Luis Maizel, senior managing director at LM Capital Group, LLC, remarked to Bloomberg: “Building it yourself is stupid, and its bad for Pemex because they don’t know what their costs will be or when they will finish it.” Maizel anticipates further government support for split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) Pemex: “[AMLO] can calm things down by saying ‘we assure you that Pemex will always fulfill its obligations prior to the government withholding taxes.’”
Creditors are taking these developments in stride, as the Pemex senior unsecured 6 3/4 notes due 2047 traded at 91 cents on the dollar this morning, little changed from last week’s levels. By contrast the Mexican 4.6% dollar-pay bond due 2047 slumped to 95.8 today, down from an average 96.8 seen last week.
For more on the implications of the increasingly intertwined relationship between Pemex and its sovereign patron, see the March 23, 2018 edition of Grant’s Interest Rate Observer.
Recap May 13
Stocks were clobbered with the S&P 500 falling 2.5%, the biggest decline since Jan. 3 to leave the broad index roughly 5% below its high water mark reached April 30. Treasury yields gapped lower across the curve, and monetary alternatives rallied as gold rose above $1,300 an ounce for the first time in a month and bitcoin ripped 11% to $7,800. The VIX closed above 20 for the first time since January.
- Philip Grant
Friday, May 10, 2019
Bank teller
From Reuters:
Millions of $50 Australian dollars ($35) banknotes in Australia have an embarrassing typographical error that was overlooked by the country's central bank before they were printed and circulated.
The goof first became known on Thursday when a listener on radio outlet Triple M sent the station a magnified photo of the Reserve Bank of Australia's (RBA) new A$50 note highlighting the word "responsibility" misspelt as "responsibilty" three times.
An RBA spokeswoman said in an emailed statement to Reuters the Bank "is aware of it and the spelling will be corrected at the next print run."
Practice makes perfect.
Mr. Erdogan's wild ride
The Turkish whipsaw continues. This morning the lira rallied by 2% against the dollar after the local central bank suspended its one-week repo auction, effectively raising interest rates by 150 basis points to 25.5% without effecting a direct change to the benchmark rate. Jason Tuvey, senior emerging markets economist at Capital Economics, told Reuters that political considerations likely dictated the roundabout policy tightening: “The central bank’s moves suggest it is under political pressure to not hike interest rates, so it has to go through the back door.”
Politics indeed loom large for Turkish asset prices, as the lira swooned on Tuesday after the country’s top court annulled local election results that saw the opposition CHP party take control of the Istanbul mayoralty. The lira is down 14% against the dollar since late March, the weakest of any currency tracked by Bloomberg. The do-over elections are set for June 23.
President Recep Erdogan addressed the spiraling lira in a speech to parliament Tuesday, declaring that “full blown economic sabotage” was afoot and promising that “whatever we did to the terrorists threatening our borders, we will do the same” to those economic saboteurs.
Key indicators suggest Erdogan has some work to do. The measured rate of Turkish inflation jumped 19.5% year-over-year in April, almost double the average five-year monthly inflation rate of 10.5%. At the same time, the year-over-year change in GDP declined throughout 2018, reaching negative 3% in the fourth quarter for its worst showing since 2009. The lira has lost 66% of its value against the greenback over the last five years.
There are some signs of relief, however. According to data from the central bank, Turkish households and businesses sold a net $1.2 billion in dollars and euros in the week ended May 3, the fourth straight week of net sales of so-called hard currency.
Then, too, Turkish banks are hard at work propping up the lira. Bloomberg reports that financial institutions were selling dollars and buying lira in Asia overnight “in order to give maximum impact to their purchases.” That follows a report from the Financial Times on April 30 noting that the Turkish central bank has engaged in swap transactions with local banks designed to bulk up its holdings of FX reserves. Those moves came with some curious accounting techniques: “The central bank had told the FT that the dollars borrowed in these transactions were added to the asset side of its balance sheet while the corresponding lent liras were not deducted.” But even with those maneuvers, the coffers are dwindling. As of May 3, foreign exchange reserves fell for a third straight week to $72.5 billion, down 30% from the failed coup attempt in July 2016.
Turkey FX reserves, five-year chart. Source: The Bloomberg
Mr. Market is registering increasing concern, as Turkish credit default swaps rose to 494 basis points yesterday, almost double the five-year average of 252 basis points. Meanwhile, the 7 5/8 dollar-pay bonds due in 2029 have fallen to 96 cents, down from 104 in mid-March for a meaty 582 basis point spread to Treasurys.
With outsized risks, and commensurate potential rewards, some investors are taking the plunge.Thomas Clarke, partner and portfolio manager at William Blair International in London, told Bloomberg yesterday that: “I don’t want to lose sight of the fact that [the lira] is a very, very cheap currency with also a very, very high carry. We have a predisposition to buy more.” As for Erdogan, Clarke noted that: “he does have a lot of executive power over Turkey and Turkish institutions, but he does not have executive power over the financial markets.”
Not yet anyway.
Thursday, May 9, 2019
To infinity, and beyond
A slide from SoftBank
A slide from SoftBank
He said it
Art Cashin,
Art Cashin,
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
Retail magnate Yusaku Maezawa, founder of Zozo, Inc.
QT Progress report
Recap May 9
To infinity, and beyond
A slide from SoftBank Group Corp.’s 2018 investor presentation released today:
He said it
Art Cashin, longtime director of NYSE floor operations for UBS Financial Services, Inc., summed the market up this afternoon to CNBC:
You're living in a world where one Trump tweet can change everything.
Suffer for your art
Retail magnate Yusaku Maezawa, founder of Zozo, Inc. and the 22nd richest person in Japan with a net worth of $2 billion according to Forbes, is having cash flow troubles. On Sunday, Maezawa told his followers on Twitter that “I have no money. I spend it so quickly (smiley face).” The tycoon is amply leveraged, with 88% of his Zozo stock holdings pledged as loan collateral according to regulatory filings.
Maezawa’s liquidity shortage is no welcome news within the art world, as Bloomberg likewise notes that he has earned a spendthrift reputation by “pouring hundreds of millions of dollars into everything from Basquiat paintings to a Hermes-upholstered private jet and a down payment for a ride on Elon Musk’s rocket around the moon.” In May 2017, Maezawa shelled out a record $110.5 million for Basquiat’s Untitled. Four months later, an article on the auction house Christie’s website dubbed Maezawa “the art world’s new rock star.”
For Sotheby’s, the publicly-traded half of the global auction house duopoly and the oldest company listed on the New York Stock Exchange (BID is the ticker), the prospective retreat of a major bidder hasn’t dented an upbeat outlook. On last week’s earnings call, CEO Tad Smith told listeners that management: “feel[s] very good about second quarter results based on great works of art and strong demand from Asia and the Americas.” A decisive event looms in the form of next week’s impressionist and modern art auction in New York, which carries a low estimate of $305.5 million according to the company.
Sotheby’s shareholders are eager for good news. Since a bearish analysis in the September 8 edition of Grant’s Interest Rate Observer, shares are down by 18%, compared to an 8% drop in the Russell 2000 Index during that period.
With BID’s top-line in a holding pattern (forecast 2020 revenues of $1.04 billion trails the $1.06 billion achieved in 2017), margin expansion figures prominently in the bull case. The Street expects EBITDA to foot to 24.8% of revenues in 2020, up from 21.8% last year and 18.1% in 2017. Net income margins will likewise fatten to 13.1% in 2020 from 11.3% in 2017, if the analysts are on point. Sotheby’s and Christie’s together dominate the auction market, acting as the liquidity providers of first resort in the fine-art resale market. But an anonymity-seeking senior auction house executive told Grant’s last September that the model has its limitations:
It’s a duopoly without pricing power. That is the thing that is hard for people to understand. They always think the prices and volume go up, we are going to clip a standard commission against ever increasing prices and volumes. They must be printing money. The auction houses don’t manufacture anything. Every sale, they need to find new properties. They don’t do original issues. They don’t do IPOs. It is a pure secondary market.
Indeed, the art market acts as something of a derivative on global financial and economic conditions. Thus, according to the 2019 “Art Market Report” by Art Basel and UBS, auction sales registered at $29.1 billion last year, up 3% year-over-year and 30% from 2016, a year marred by Chinese capital controls, weak commodity prices and the short but sharp global equity selloff at the beginning of that year.
Meanwhile, the post-2008 surge in art prices has led to a quandary, as buyers have become wary of overpaying while sellers contend with the prospect of busted auctions. By way of response, the auction houses issue guarantees to attract new business, exposing themselves to losses if bidding interest fails to reach the reserve price, or to margin erosion if the piece in question is offloaded to a third-party guarantor.
To help offset those extra costs, the auction houses have recently hiked their commissions. As noted by Giulia Costantini, co-founder of Art Strategy Partners, at the Grant’s spring conference on April 9, buyers at the lower end (up to and including $400,000) can end up paying as much as 40% above the hammer price when factoring in taxes and the U.K. value-added tax.
Fellow Art Strategy Partners co-founder Wendy Battleson likewise noted that the fierce competition within the auction houses can present a perverse dynamic for Sotheby’s investors:
We also believe that when there is good news in the press about Sotheby’s that usually means very bad things. It is always shocking to us about the announcement of a wonderful sale at Sotheby’s that will be coming up in 2-3 months and there is a lot of talk about how much value there is in the sale and how important it is and on and on and on. Then you see the stock price creep up based on that news.
What people should really be doing is shorting the stock because if there is a great announcement it means that Sotheby’s went against Christie’s and potentially Phillips and pitched the business to the client that was selling. Then there was margin erosion, margin erosion, margin erosion and negotiations back and forth.
Ultimately that great piece of business that Sotheby’s is raving about is probably a loss leader and in a best-case scenario is probably breakeven. Good news at Sotheby’s means very bad news for their stock price.
QT Progress report
The Fed’s portfolio of securities held outright remained steady at $3.7 trillion following the $37 billion sequential decline of a week ago, the largest seen thus far. Since the Oct. 1, 2017 commencement of QT run-off, the Fed’s total balance sheet assets are down by 12.6%, a 7.9% simple annualized pace.
Recap May 9
Stocks recouped the bulk of early losses to leave the S&P 500 just below unchanged on the day, and down 2.5% for the week. A weaker dollar wasn’t enough to keep WTI crude from sliding below $62 a barrel and a strong rally in Treasurys pushed the 10-year yield to 2.45%, within eight basis points of a 52-week low.
- Philip Grant
Monday, May 6, 2019
Drivers' side
From the Associated Press:
From the Associated Press:
Service industry
The Toronto Real Estate Board released its monthly report for April today,
The Toronto Real Estate Board released its monthly report for April today,
Recap May 6
Drivers' side
From the Associated Press:
An organization representing for-hire drivers in New York City says its members will go on a two-hour strike against Uber and Lyft ahead of Uber's planned initial public stock offering.
The New York City Taxi Workers Alliance says its members voted not to drive for Uber or Lyft between 7 and 9 a.m. Wednesday.
San Francisco-based Uber is aiming to raise $9 billion in its initial public offering Thursday.
Service industry
The Toronto Real Estate Board released its monthly report for April today, showing a brisk 16.8% year-over-year sales uptick to 9,042 units. Prices likewise edged higher to C$820,000 ($607,000), up by 1.9% from a year ago, while average days on the market declined to 19 from 20. Though improved from 2018, those figures are well below the 11,630 transactions logged at an average price of C$921,000 and an average of nine days on the market seen in April 2017.
While Toronto’s housing market shows signs of stabilizing, action in formerly white-hot Vancouver remains at a standstill. April sales in the metro Vancouver region totaled just 1,829 according to the local real estate board, down 29.1% from a year ago and the weakest activity in April since 2000. Prices are also in retreat, with the benchmark index sliding 8.5% year-over-year to C$1,008,000, the lowest since May 2017.
Some participants still have hope. Tamara Vrooman, CEO the Vancouver City Savings Credit Union, which provides banking services for roughly one-quarter of the city’s residents, told Bloomberg: “We see no evidence of a [housing] freefall. We have certainly seen a lot of sitting on the sidelines and wait-and-see, but we’re also seeing signs that we may be at the trough.”
However, national data through the first three months of the year add further weight to the idea that the long-running Canadian housing boom is over. The Teranet-National Bank House Price Index has averaged a 1.9% year-over-year gain in January, February and March, down from 7.6% growth in the first quarter last year and 13% in 2017. The pace of new credit has slowed commensurately, with residential mortgage credit up 3.3% year-over-year in the first quarter according to the Bank of Canada, down from a 5.1% yearly advance in the first three months of 2018 and the weakest first quarter growth rate since 2001.
As housing turns, the Canadian economy is showing signs of strain. On Tuesday, Statistics Canada reported that February GDP grew just 1.1% year-over-year, below the 1.4% expected. A day later, IHS Markit reported that the Canadian manufacturing PMI slipped to 49.7 in April, the first contractionary (meaning sub-50) reading since February 2016, with the employment and new orders components falling to their lowest since September 2016 and December 2015, respectively.
But those worrisome economic signs haven’t discouraged Bank of Canada governor Stephen Poloz from maintaining a hawkish rhetorical bent. Speaking to Canadian lawmakers after keeping the overnight range unchanged at 1.75%, Poloz noted that with unemployment at a 40-year low and real rates in negative territory (March CPI grew by 2.1% year-over-year), policy tightening could be in order: “If [economic] headwinds dissipate, then interest rates would rise.” In an interview with Global News’ The West Block on April 28, Poloz blamed the recent slowdown on a variety of outside factors, including the fall 2018 decline in oil prices and “very nasty weather,” as well as the global trade war “that has basically been initiated by the United States.”
The central banker predicted that GDP growth will recover to a 2% pace by mid-year and will remain in that accelerated range through year-end 2020. In a speech today, Poloz played down the housing slowdown as a broader economic risk, stating that “the fundamentals of the Canadian housing market remain solid,” and forecasting that “growth will resume once the effects of reduced expectations for house price inflation,” along with the B-20 mortgage regulations requiring borrower stress tests, have been digested.
As Poloz talks up the economy and the prospect of higher rates, the debt-soaked Canadian consumer is up against the wall. According to a March report from Statistics Canada, household debt climbed to 178.5% of disposable income at year-end 2018, up for a fifth consecutive quarter. That compares to 85% of disposable income in the U.S. in the fourth quarter. Meanwhile, debt service chewed up 14.9% of Canadian household income in the fourth quarter, up from 14.2% year-over-year. By comparison, that metric peaked in the U.S. at 13.2% in the third quarter of 2007 and stood at 9.9% at year-end.
For an analysis of the potential ramifications of a Canadian housing bust, see the Feb. 9, 2018 edition of Grant’s Interest Rate Observer.
Recap May 6
No trade deal, no problem. Stocks recovered the bulk of steep early losses following the apparent breakdown of Sino/American trade negotiations over the weekend, leaving the S&P 500 less than 50 basis points in the red. By comparison, China’s Shanghai Composite Index lost more than 5% on the day.
Treasurys rallied across the curve, with the 10-year yield dipping below 2.5%. WTI crude edged back over $62 a barrel, and the VIX volatility index rose 20% for its highest close in six weeks.
- Philip Grant
Friday, May 3, 2019
Ticker tailor
Speaking on CNBC today,
Speaking on CNBC today,
If you build it
From last weekend's edition of the London Sunday Times:
From last weekend's edition of the London Sunday Times:
The buck stops over there
In a Wednesday speech in London, European Central Bank
In a Wednesday speech in London, European Central Bank
Recap May 3
Ticker tailor
Speaking on CNBC today, Vice President Michael Pence said the Fed should slash rates and abandon its mandate to keep prices low and stable.
Data dependence, Trump-style
If you build it
From last weekend's edition of the London Sunday Times:
The world’s first luxury development to be sold in bitcoin, which was promoted by the Conservative peer Baroness Mone, has stalled.
Mone, a former Tory business “start-up tsar”, and her partner, Doug Barrowman, launched the £250m development in September 2017 to worldwide publicity, with the promotional material saying the two residential towers would be completed by this summer.
The Aston Plaza project in Dubai, in which a two-bedroom flat was going to cost the bitcoin equivalent of about £185,000, is still being described on its website as “25% complete”, the figure used in the promotional material. However, government inspectors who visited the site at the Dubai science park in January last year described the venture as “on hold”, and construction has stopped.
The buck stops over there
In a Wednesday speech in London, European Central Bank vice president Luis de Guindos expressed concern over the state of the European banking system. The central banker noted that despite a lengthy period of economic expansion, Europe’s banks continue to earn returns on equity that fail to match their costs of capital. Indeed, the market takes a dim view of the sector, as the Stoxx 600 Banks Index trades at just 0.64 times book value, half of the 1.22 times book value fetched by the U.S. KBW Bank Index.
Perhaps unsurprisingly, de Guindos played down the role of the ECB’s aggressive monetary policy in that valuation gap, making only one passing mention of negative rates, and noting that: “European bank profitability has been structurally weak since well before unconventional monetary policy measures were introduced.” Instead, he cites inefficient cost structures, competition from non-financial companies and “cyclical factors” as the culprits constraining interest income. De Guindos concludes:
The structurally low profitability of the euro area banking sector remains a concern for financial stability and for monetary policy. Return on equity below the cost of capital is unsustainable in the long run. The causes of low profitability are for the most part structural and hence require structural solutions. Successful implementation of long-run profitable business plans is essential.
Consolidation remains necessary.
That advice follows the failed merger attempt between Deutsche Bank A.G. and Commerzbank A.G., Germany’s two largest financial institutions. Yesterday, the Financial Times published a postmortem of the scuttled transaction, noting that the pair would have needed to raise at least €8 billion to close the deal, a sum equal to nearly one-third of their combined current market cap. The FT quoted an unnamed regulator who described the break thusly: “Calling off the merger wasn’t a strategic transaction. They could just not afford the deal.”
For Deutsche Bank, the euro area’s third-largest bank by assets, it’s back to the drawing board. A dispatch from Bloomberg yesterday was headlined: “Deutsche Bank said to have virtually no new plan for what’s next.” Deutsche Bank shares currently trade at 0.24 times their Dec. 31 book value, down from 0.51 times at year-end 2017.
Recap May 3
Stocks snapped higher following a stronger than expected reading of April non-farm payrolls, with the S&P 500 gaining near 1% to edge back into positive territory for the week. That broad index is up 17.5% year-to-date.
Elsewhere, Treasury yields ticked lower with the 10-year settling at 2.53%, while oil managed to buck bearish commodity price action with WTI finishing near $62 a barrel. The VIX shed nearly 10% to fall back towards 13.
- Philip Grant
Thursday, May 2, 2019
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex)
QT progress report
Recap May 2
Downhill from here
On Tuesday, Mexico’s state-owned oil company Petróleos Mexicanos (Pemex) reported an operating loss of MXN 36 billion ($1.9 billion) in the first quarter. That’s an improvement from the MXN 157 billion fourth quarter shortfall, as the rampant oil theft from company pipelines seen last fall has largely abated. Pemex likewise pledged to keep its MXN 2.1 trillion debt load stable, a move the Financial Times terms “a big change in policy.”
Chief financial officer Alberto Velázquez hailed the results: “We have advanced in all areas. The challenges will require time to resolve but the trend is clear. . . Pemex is moving in the right direction.”
Yet production continues to move in the wrong direction. First quarter output averaged 1.66 million barrels per day (mbpd), down 12% year-over-year and the lowest figure on record going back to 1990. For 2019, Pemex management is targeting 1.725 mbpd, which compares to 1.82 mbpd in 2018 and a high of 3.4 mbpd in 2004.
The Mexican government looks set to provide more help for its energy champion. Back in March, deputy finance minister Arturo Herrera told reporters that the government was considering paying up to $7 billion of Pemex’s obligations out of the public coffers. That follows a $5.5 billion rescue package including tax relief and direct recapitalization announced by President Andrés Manuel López Obrador (AMLO) in February. Pemex has some $16 billion worth of debt coming due this year and has posted negative free cash flow in every year since at least 2008.
As the state continues to cough up cash in support of Pemex, worrisome economic signs abound. Mexico's first quarter GDP contracted by 0.2% on a sequential basis, worse than any of the 11 economist estimates tabulated by Bloomberg. That follows a 6.8% year-over-year decline in gross fixed investment in December, the second-worst reading since 2009.
An analysis in the March 23, 2018 edition of Grant’s Interest Rate Observer argued that thanks to dwindling production, structural unprofitability and a hefty $166 billion in liabilities, equating to six times trailing 12-month EBITDA including pension obligations, Pemex’s debts may one day soon become those of the Mexican government.
To that end, a potentially ominous sign in Tuesday’s update: Output at the deepwater Ku-Maloob-Zaap (KMZ) oil field, which provides just over half of Pemex’s total output, fell to 837,000 barrels per day in the first quarter, down from 875,000 barrels a year ago. While that 4% decline is less severe than the aggregate 12% production drop-off, KMZ has been a rock-steady producer in the past 10 years, in contrast to the fast-depleting Cantarell oil field, which was one of the largest in the world at its 2004 peak and now generates just 158,000 bpd. Bloomberg Intelligence analyst Fernando Valle tells Grant’s today that structural factors loom large for KMZ:
Deepwater fields tend to decline quickly, and you will need capital to keep production flat. Unfortunately, as you know, Pemex required capital injections and has a very bloated cost structure, so it seems difficult to believe that they will have the wherewithal to make those required investments.
For his part, John Padilla, partner and managing director at IPD Latin America, flagged KMZ as an important catalyst in that March 2018 issue of Grant’s:
The thing to keep your eye on from Pemex’s perspective is . . . going to be when KMZ starts declining, which it will.
They [Pemex] have managed it infinitely better [at KMZ] than what they did with Cantarell. If there is one glorious thing that they’ve been able to do to date, [it] is that they’ve been able to manage KMZ’s production well, but any field that you use secondary, tertiary recovery techniques . . . you squeeze it faster and there is less of it at the end. That production will fall, and when it falls, it is going to fall very significantly.
But creditors aren’t concerned, as the company’s debt continues to rebound. After falling from near par at publication time to below 82 cents on the dollar in the fall, Pemex’s split-rated (triple-B-plus at S&P, triple-B-minus at Fitch) senior unsecured 6 3/4 bonds due 2047 have rallied back above 90, yielding a 465 basis point premium to Treasurys. Mexican sovereign credit default swaps likewise cost 114 basis points, down from 163 basis points in November.
QT progress report
The Fed’s portfolio of securities outright registered at $3.745 trillion this week, down a meaty $38 billion from a week ago for the biggest sequential decline of the program so far. Treasury holdings fell by $30 billion as the calendar flips to May, with mortgage-backed securities accounting for the remainder.
Since the Oct. 1, 2017 commencement of QT portfolio run-off, the Fed’s total balance sheet assets are down by 12.7%, for a simple annualized pace of 8.2%.
Recap May 2
Stocks finished slightly lower, extending yesterday’s selloff to leave the S&P 500 roughly 80 basis points in the red for the week so far. Treasurys also sold off with the 10-year yield rising back to 2.55%, and energy continued its pullback with WTI crude falling below $62 a barrel from $66 one week ago. The VIX jumped as high as 16 in midday before settling at 14.5.
- Philip Grant
Tuesday, April 30, 2019
Cross check
This morning, McDonald’s Corp. (MCD on the NYSE) reported mixed first quarter results. Revenues of $4.96 billion rose 2% year-over-year on a constant-currency basis to top the consensus $4.93 billion, driven by a 5.4% rise in comparable store sales. Yet that strong growth didn’t translate into improved profitability, as operating income fell 2% year-over-year to $2.09 billion. MCD shares finished the day little changed.
McDonald’s growth may be coming at the expense of its competitors. Same-store sales at Burger King, Popeye’s Louisiana Kitchen and Tim Horton’s, the trio of eateries managed by Restaurant Brands International, Inc. (QSR on the NYSE), generated same-store sales growth of 2.2%, 0.6% and negative 0.6%, respectively, in the first quarter. Overall, QSR revenues grew 1% year-over-year, matching Street expectations, driven by a 5.1% rise in restaurant count. Adjusted earnings per share fell to 55 cents from 64 cents a year ago, trailing the expected 58 cents. QSR shares fell 3% in response, and are up by 7% since June 2017, trailing the S&P 500’s 21% gain over that period.
Restaurant Brands’ difficulties are especially acute north of the border. The Tim Horton’s unit saw same-store sales contract by 0.6% and adjusted EBITDA fall by 3.2% from a year ago, while system-wide Tim Horton’s sales rose by just 0.5% on a constant-currency basis despite a 1.9% increase in the restaurant count. By way of explanation, QSR management cited adverse winter weather (what, in Canada?), along with increased promotional activity related to an advertising campaign that “did not drive the incremental engagement [the company] expected.”
Tim Horton’s is a crucial profit center of QSR, accounting for 20% of system-wide sales but 47% of total EBITDA during the first quarter.
With key operating metrics on the wane, Restaurant Brands generates shareholder value in other ways. On Jan. 23, QSR raised its quarterly dividend to 50 cents a share from 45 cents, pushing the dividend yield to 3.1% and spurring a 10% rally in the share price. The move further extends Ba3-rated QSR’s already-stretched balance sheet, as net debt stands at 5.1 times 2019 consensus EBITDA. That compares to an average 3.6 times debt to EBITDA seen in the Ba-ratings group, per an October analysis from Moody’s Investor Service.
But with an A-list cast of investors including Warren Buffett’s Berkshire Hathaway, Bill Ackman’s Pershing Square Capital and Brazilian private equity firm 3G Capital, Inc. (the majority owner), Wall Street remains unabashedly bullish on Restaurant Brands: Of the 22 sell-side analysts covering the name, 17 rate shares “buy,” with five “hold” ratings and zero “sells.” The Street likewise expects free cash flow to jump to $1.43 billion this year and $1.66 billion in 2020, well above last year’s $1.08 billion figure.
Today, QSR is valued at 18.3 times enterprise value to EBITDA, richer than the 16.8 times EV to EBITDA commanded by McDonald’s, the standard-bearer in fast food. On the credit side, Restaurant Brands’ first-lien 4 1/4 notes due 2024 trade just below par for a 209 basis point premium to Treasurys, well inside the 373 basis point spread on offer in the sub-investment grade Invesco Senior Loan ETF (BKLN on NYSE Arca).
Is that lofty valuation justified? Grant’s has argued no, laying out the bearish case for QSR’s “capital-light and debt heavy” business model in the June 2, 2017 edition. The analysis documented Restaurant Brands’ tussle with the Tim Horton's Great White North Franchisee Association, which accused the company of shifting costs from the corporate P&L to the operators in 2017, including through improper use of the franchisee marketing fund for other expenses. That discord suggested potential operating difficulties that would put a dent in QSR’s then-valuation of 38 times trailing adjusted EPS (that figure has since come down to 24 times).
More broadly, the tension between fee-generating, asset-light franchisors and their increasingly cost-squeezed franchisees continues. Even premiere operator McDonald’s is not immune. In October, 400 franchisees voted to form a self-funded alliance called the National Owners Association to advocate for their interests, including retaining control of pricing decisions. That news bodes poorly for the rest of the industry, considering the average McDonald’s generates $2.7 million per year in revenue according to monthly trade magazine QSR. That compares to $1.6 million for Wendy’s Co. and nearly double the $1.4 million average for Restaurant Brands’ Burger King.
Speaking at the Grant’s spring 2018 conference, John Hamburger, president of Franchise Times Corp., crystallized the problem:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
Recap April 30
An 8% post earnings downdraft in Google parent Alphabet, Inc. wasn’t enough to keep stocks out of the green, as the S&P 500 erased moderate early losses to edge back above yesterday’s close, while the tech-heavy NYSE FANG+ Index lost just 1% on the day.
Treasurys rallied across the curve, with the 10-year yield dropping back to 2.5%, and commodities could only manage a flat showing despite a weaker dollar. The VIX gave back an early rally to remain just above 13.
- Philip Grant
Monday, April 29, 2019
Come on in, the water's warm
Owe negative
The Chinese economy continues to muddle along,
The Chinese economy continues to muddle along,
Recap April 29
Come on in, the water's warm
From Bloomberg:
As equities surge to all-time highs, volatility has all but vanished. Hedge funds are betting the calm will last, shorting the CBOE Volatility Index, or VIX, at rates not seen in at least 15 years.
Large speculators, mostly hedge funds, were net short about 178,000 VIX futures contracts on April 23, the largest such position on record, weekly Commodity Futures Trading Commission data that dates back to 2004 show.
Owe negative
The Chinese economy continues to muddle along, as a series of eight indicators compiled by Bloomberg encompassing market sentiment, key commodity prices and overall business conditions showed solid levels of activity in April. That follows a 6.4% reported year-over-year GDP growth rate in the first quarter, above the expected 6.3% but below last year’s 6.6% figure, itself the slowest recorded growth rate since 1990.
But even that middling (by Chinese standards) growth has come through significant exertion, as total new credit footed to 9% of last year’s GDP in the first quarter, a figure which almost matches 2009’s (on an annualized basis) credit injection of 40% of GDP. Bloomberg China economist Qian Wan writes that “policy support is still necessary – that means the government needs to keep spending and driving investment to keep domestic demand stable.”
Loose monetary policy likewise hasn’t been able to forestall increasingly frequent signs of corporate distress. Bloomberg notes today that each of China’s four biggest banks have seen their non-performing loan ratios rise to multi-year highs in the most recent quarter, with bad loans at the Bank of China Ltd. reaching the highest since at least 2006. Data from Bloomberg likewise shows that bonds from 44 Chinese companies totaling $42.9 billion are currently “facing repayment pressure,” up 23% from the end of March. Indeed, a trio of prominent names are in the headlines for all the wrong reasons.
Today, Fitch Ratings cut its appraisal of commodity trader Tewoo Group Co.’s dollar-pay bonds by six notches, to single-B-minus from triple-B-minus following a failed debt-for-equity swap late last year. Tewoo, ranked 132nd on the Fortune Global 500 list, saw its senior unsecured 4 5/8 notes due in April 2020 plunge to 71 cents on the dollar from 95 earlier this month.
Tewoo Group 4 5/8s of 2020. Source: The Bloomberg
Over the weekend, conglomerate CITIC Guoan Group Co., Ltd. failed to make an RMB 3 billion ($450 million) bond payment. Guoan, which reported RMB 178.3 billion in total liabilities as of Sept. 30, saw local courts seize RMB 7.9 billion worth of assets in March. China Lianhe Credit Rating Agency cut its assessment of Guoan to single-A from double-A-minus on April 17. One day later, courts froze the company’s 36.4% stake in Shenzhen-listed CITIC Guoan Information Industry Co., Ltd., which boasts a current market cap of RMB 17.6 billion.
Then there’s HNA Group Co., Ltd., the once-massive roll-up now listing under the weight of its gargantuan $80 billion debt load, $25 billion of which matures in less than one year. Since reversing its acquisitive business model last year, HNA sold roughly $45 billion worth of assets in 2018 according to Caijing magazine, but it hasn’t been enough. On April 17, creditors seized golf courses and other pledged assets after the conglomerate was unable to make debt payments.
Brock Silvers, managing director at Kaiyuan Capital, told Bloomberg that we can expect more of the same: “While the company seeks further liquidity, it may become increasingly selective in honoring obligations. It’s possible that HNA might not survive 2019’s planned debt obligations in its current form.” Silvers sums it up: “The situation is dire.”
China’s efforts to control its bloated credit system carry potentially wide-ranging implications. Chinese banking assets footed to $39 trillion as of Dec. 31, equivalent to 44% of total world GDP in 2018. By comparison, the U.S. and Japan, the world’s largest and third-largest economies (China is second), hold a combined $27 trillion in bank assets.
Recap April 29
More bullish price action left the S&P 500 at a closing high for a second-straight session, while the Nasdaq 100 logged a high-water mark of its own. Commodities came under pressure despite a softer dollar, and Treasury yields rose with the two- and 10-year spread ticking to 23 basis points, its widest of the year.
- Philip Grant
Friday, April 26, 2019
'gram reaper
Trouble in paradise, 2019 style.
Trouble in paradise, 2019 style.
Augean stable
Yesterday, New York attorney general’s office announced
Yesterday, New York attorney general’s office announced
Rubber duck
This morning, Uber Technologies, Inc.
This morning, Uber Technologies, Inc.
Recap April 26
'gram reaper
Trouble in paradise, 2019 style. A (translated) headline from Milan-based online news site Affaritaliani suggests discord within the Italian governing coalition of Luigi Di Maio’s Five Star Movement and Matteo Salvini’s League:
Di Maio and Salvini no longer follow each other on Instagram
Augean stable
Yesterday, New York attorney general’s office announced a court order against iFinex, Inc., parent company of crypto-trading venue Bitfinex, for “ongoing activities that may have defrauded New York investors” that trade crypto-currencies. In the complaint, AG Letitia James didn’t mince words:
Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million of co-mingled client and corporate funds.
Bitfinex and Tether responded today with identical blog posts on their respective websites, writing that the filings “were written in bad faith and are riddled with false assertions,” while also asserting that “we have been informed that these Crypto Capital amounts are not lost but have been, in fact, seized and safeguarded.”
The AG’s involvement represents the latest chapter in the saga of Bitfinex, the exchange behind purportedly dollar-backed tether, which is used by crypto traders for conversion from fiat to crypto and back again (roughly 80% of all bitcoin trading is done through tether, according to research site CryptoCompare).
Bloomberg reported in November that the Commodity Futures Trading Commission subpoenaed Bitfinex and Tether over suspicions of manipulating the price of bitcoin. In March, Frances Coppola of Forbes spotted language changes on the Tether website to note that the so-called stablecoin is backed not only by cash but also “other assets and loans made by Tether to third parties, which may include affiliated entities.” By way of response to the AG announcement, the price of bitcoin fell 5% today to $5,250.
For an early, and in-depth, look at the curious Bitfinex/Tether relationship, see the Sept. 8. 2017 edition of Grant’s Interest Rate Observer.
Rubber duck
This morning, Uber Technologies, Inc. filed an amended form S-1 with the Securities and Exchange Commission ahead of a planned IPO later this spring. The ride-share giant set a target price range of $44 to $50 per share, valuing the company at $91.5 billion on a fully-diluted basis at the top end of the range.
That’s down from a purported $100 billion high-end valuation previously reported by The Wall Street Journal on April 10, as well as a $120 billion figure pushed by lead underwriters Goldman Sachs and Morgan Stanley last year. But that’s not to say Mr. Market has cooled too much. A top-of-the-range IPO price would value Uber at more than eight times 2018 revenues of $11.3 billion. By comparison, the NYSE FANG+ Index of ten popular tech stocks currently trades at 4.5 times 2018 sales.
As Uber sets its sights lower, the red ink continues to flow. Operating losses footed to $1.13 billion for the first three months of the year (the results have yet to be audited), up slightly from the $1.05 billion loss a year ago. In the five years ended 2018, Uber’s cumulative operating loss stands at $12.1 billion.
Perhaps more concerningly, revenue growth is dwindling. The unaudited $3.1 billion first quarter top line represents a 19% year-over-year increase. That compares to 69%, 53%, 37% and 22% year-over-year revenue increases across the first, second, third and fourth quarters of 2018, respectively. (Figures have been adjusted for divested assets in Russia and China.)
The persistent losses and top-line slowdown haven’t dented the ambitions of Uber’s c-suite. In a February interview with the Financial Times, CEO Dara Khosrowshahi outlined his long-term goals: “I want to run the bus systems for a city. I want you to be able to take an Uber and get into the subway. . . get out and have an Uber waiting for you." The Uber boss likewise drew inspiration from perhaps the premiere corporate success story of this cycle: “Cars are to us what books are to Amazon.”
Of course, Amazon was profitable on a net income basis by 2003, its ninth year of existence. By contrast, 10-year old Uber warned in its S-1 that they “expect our operating expenses to increase significantly in the foreseeable future, and we may not achieve profitability.” Colleague Fabiano Santin noted some other differences in the Nov. 2 edition of Grant’s:
Jeff Bezos’s business was something truly different, offering customer-written book reviews and suggestions of other books and products of interest. Uber lacks such differentiation. Amazon’s physical infrastructure depended mostly on scalable warehous¬es and servers, whereas Uber depends on vehicles and roads over which it has no control. Bezos had a clear plan that, from day one, was contingent only on logistics and scale, whereas Uber’s plan hinges on yet-undeveloped [self-driving] technology and the political will of governments.
Uber’s problem is a fundamental one: There is no indication that the ride-share business model, in which vehicle maintenance and other costs are shunted onto the company drivers (famously designated as “independent contractors,” rather than employees who might otherwise qualify for health insurance and other benefits) is a better one than that of legacy cab companies. Writing in Vol. 44 of Transportation Law Journal in 2017, transportation analyst Hubert Horan got to the heart of the matter:
It is inconceivable that hundreds of thousands of independent, poorly-financed Uber drivers could ever achieve lower vehicle ownership, financing, licensing and maintenance costs than professional fleet managers at tradi¬tional taxi/limo companies, or that the drivers could do a better job balancing long-term asset costs against local market revenue potential.
Not only does shifting operating costs and capital risk from Uber’s investors onto its drivers fail to eliminate them from the overall business model, but the shifting makes the costs and risks higher.
Meanwhile, ride-sharing competition continues to rage. On Wednesday, the Nikkei Asian Review reported that China’s Didi Chuxing, which is 15.4% owned by Uber, “has started recruiting drivers in Bogotá as it readies its Colombian roll out,” intensifying Didi’s attempted Latin American land grab. SoftBank Group Corp. owns a stake in both Uber and Didi.
Recap April 26
Another green day for stocks left the S&P 500 at a fresh closing high and up 1.1 % for the week. A weaker dollar didn’t prevent a sharp oil selloff, as WTI fell back below $63 per barrel following some Trump Twitter commentary. Treasurys rallied with the 10-year yield dropping to 2.5%, and the VIX fell back below 13.
- Philip Grant
Thursday, April 25, 2019
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan
At the end of today’s policy communique, the Bank of Japan
Sincerely yours
Things are once again heating up in emerging markets,
Things are once again heating up in emerging markets,
QT Progress report
Recap April 25
Modern monetary practice
At the end of today’s policy communique, the Bank of Japan said it is considering “the introduction of an ETF Lending Facility, which will make it possible to temporarily lend ETFs that the Bank holds to market participants.” The BoJ’s QE program has already sucked volume out of the Japanese Government Bond market, as entire days now pass without benchmark issues changing hands. With approximately 80% of Japan’s ETF market in the hands of the BoJ, the central bank is opting to play market maker rather than take a step back.
While the BoJ eyes the securities lending business, the Swiss National Bank posted first quarter results that would make any fund manager jealous. Profits for the period registered at CHF 30.7 billion ($30.1 billion), with overall mark-to-market gains on its equity portfolio footing to CHF 17.4 billion. That compares to an overall CHF 6.8 billion loss, including CHF 3.3 billion in equity-related losses, in the first quarter last year.
In a bid to prevent unwanted currency appreciation, the SNB prints francs out of thin air, sells them to buy euros then diversifies into other assets like U.S. equities. In doing so, the gnomes have accumulated an asset stockpile equivalent to 115% of last year’s GDP, compared to 39% for the European Central Bank and 19% for the Federal Reserve. Then, too, the SNB’s negative 0.75% overnight interest rate stands apart from the ECB’s negative 0.40% deposit rate, let alone the positive 2.4% Fed Funds Rate.
Sincerely yours
Things are once again heating up in emerging markets, as a pair of mainstays appear to be running headlong into crisis.
Argentina is one such specimen, with Bloomberg noting that based on credit default swaps, the implied probability of default over the next five years had risen to 61% this morning. The country is beset on all sides, with runaway inflation (CPI rose 54.7% year-over-year in March) occurring in tandem with a sharp economic contraction as fourth quarter GDP fell 6.2% year-over-year. Even with a $56 billion bailout from the International Monetary Fund last year (the IMFs largest ever), the Argentine peso continues to sink, now trading at 45 per U.S. dollar, compared to less than 21 a year ago.
With Argentina’s economy on the ropes, an unfriendly face (to investors at least) looks to return to the scene. Left-wing former President Cristina Fernández de Kirchner appears eager to reclaim her old job, releasing a new book tomorrow titled “Sincerely.” Fernández, who oversaw Argentina’s prior descent into default in 2014 and famously feuded with creditors including Elliott Management thereafter, currently enjoys the upper hand. An April poll conducted by Buenos Aires-based consulting firm Elypsis showed 44% of respondents with a positive view of the former president, compared to 28% for the more market-minded incumbent Mauricio Macri.
Writing today, strategists at Brazil’s XP Investments note that markets appear to be pricing in a Fernández return to power and accompanying leftward lurch, a prospect which is overshadowing positive developments including an improving Argentine trade balance. The XP team concludes: “After having followed emerging markets for 18 years, we know that fundamentals are all but irrelevant in panic times like this one.”
The political upheaval has added further woe to Argentina’s beleaguered creditors. The dollar-denominated century bonds due 2117 have fallen to their lowest since issuance, now fetching 68 on the dollar for a yield-to-maturity of 10.6%.
As Argentina faces potentially drastic political change, Turkey resumes its economic slide. Today, the Turkish lira fell to its weakest level in six months, now fetching 5.95 per dollar compared to 5.2 in February. With inflation continuing to rage (CPI rose 19.7% year-over-year in March), the Central Bank of the Republic of Turkey has opted for a counterintuitive approach. Today, in announcing no change in rates, the CBRT dropped language in the statement suggesting it will tighten policy as needed.
That decision didn’t sit well with some investors. Win Thin, global head of currency strategy at Brown Brothers Harriman & Co., told Bloomberg: “This is much worse than expected and supports the view that policy has gone off the rails. . . no sane central bank would be leaning dovish at a time like this for Turkey.”
Mr. Market shrugs. The iShares J.P Morgan U.S. Dollar Bond ETF remains near 52-week highs despite the evident struggles of Turkey and Argentina, which account for a combined 6.4% of the fund’s total assets. More broadly, the U.S. Dollar Index sits at a 52-week high of its own, pressuring foreign borrowers who have seen local currencies lose value against the greenback.
Meanwhile, a pair of ominous economic signs have appeared in the last 24 hours. Bloomberg, citing data from the Dutch statistics office, reports that global trade suffered a sequential 1.9% decline in the three-months through February, the worst three-month period in a decade. Also, yesterday evening, bellwether South Korea logged a 0.3% sequential GDP decline in the first quarter compared to an expected 0.3% gain. Exports, which account for roughly half of the South Korean economy, saw volumes fall by 2.6% from the fourth quarter.
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.739 trillion this week, down $4.5 billion on a sequential basis and $13.6 billion below the trailing four-week average. Mortgage-backed securities accounted for all of the decline for a second straight week.
Recap April 25
A second straight sideways showing saw the S&P 500 remain just under Tuesday’s closing highs, up by just under 1% for the week so far. Treasury yields edged higher across the board, while another dollar rip helped push WTI crude back under $65 per barrel. After spiking to a two-week intraday high in midday, the VIX retreated this afternoon to finish at 13.
- Philip Grant
Wednesday, April 24, 2019
Beast of burden
This morning, AT&T, Inc. (T on the NYSE) reported mixed first quarter results. Adjusted EBITDA of $14.8 billion topped the expected $14.76 billion, while revenues of $44.8 billion were a bit light of the $45.11 billion top-line consensus.
But as headline figures were broadly in-line, other key metrics showed sharp deterioration. Namely, subscriber counts shrank by a greater-than expected pace across the video division (which lost 627,000 compared to an expected decline of 389,000) as well as the postpaid wireless unit (down 204,000 versus a consensus loss of 50,000). Investors voted with their feet, as T shares fell by 4%. But the bond market took a different tack, as the senior unsecured 3.4% notes due 2025 climbed back above par this morning for the first time since 2016, and up from 93 cents on the dollar in late November.
For Baa2/triple-B-rated AT&T, which has undertaken a pair of ambitious acquisitions (DirecTV in 2015 for $67 billion and Time Warner, Inc. in 2018 for $110 billion) in recent years, a towering debt load is the elephant in the phone booth. The company carries $176 billion in borrowings, which, along with additional operating lease and unfunded pension liabilities, brings its total indebtedness to $213 billion, the most for any investor-owned, nonfinancial company in the world. The consolidated leverage ratio sits at 3.8 times 2019 consensus EBITDA, well above the 2.7 times average for the Baa category according to data compiled by Moody’s Investors Service in October.
Eager to avoid a credit-rating downgrade, management is now prioritizing the paydown of that debt load. In the earnings release, CEO Randall Stephenson reported that the company is “on plan to meet our de-leveraging goals with strong free cash flow and asset sales.” Concurrent with today’s first quarter results, AT&T announced it will sell office space at 30 Hudson Yards, the third-tallest building in New York, to real estate firm Related Cos. for $2.2 billion.
AT&T’s newfound emphasis on balance sheet repair at the expense of growth comes as no surprise to Craig Moffett, co-founder and one-half eponym of research firm MoffettNathanson, LLC. Speaking at the Grant’s fall 2018 conference, Moffett said AT&T will be forced to pivot toward shareholder unfriendly strategies in the pursuit of debt reduction. The analyst noted that even after coughing up that hefty price tag for Time Warner, the Street’s expectation for fiscal 2019 adjusted EBITDA remained below where it had been at the end of 2016, i.e. prior to the merger.
Following today’s first quarter results, Moffett zeroed in on the broader implications of AT&T’s strategic about-face toward creditors, and away from the stock market.
For the better part of a year, we’ve warned that AT&T’s servitude to the debt market would translate to better short-term profitability but weaker long-term growth. . . This narrative is no longer controversial; there is now broad consensus about what we will see in 2019: better EBITDA, perhaps, but weak subscriber trends.
Moffett also draws attention to the sprawling and less than complementary nature of AT&T’s asset portfolio following its corporate shopping spree:
Beyond the short-term narrative about prioritizing the debt markets (free cash flow), over the equity markets (growth), a bigger and more fundamental question looms. How do all these pieces fit together?
AT&T is delivering on their short-term free cash flow commitments, but, in the process, they are paying a rather steep long-term price.
For our part, Grant’s believes that the former Ma Bell’s machinations are something of an allegory for this EZ money era (see the Jan. 25 edition of Grant’s Interest Rate Observer for more on AT&T). Central bank administered, bottom-scraping interest rates serve to pull forward demand, incentivizing corporate investment, share buybacks and increased leverage. In a research report today, analysts at Bernstein Research suggest that this dynamic may be close to exhausting itself:
U.S. equities are highly dependent on buybacks. 2018 saw $1 trillion of buybacks announced by U.S. companies compared to a total net flow of all active and passive funds of ‘merely’ $100 billion. Many investors seem comfortable that, with the Fed on hold, U.S. corporates can merrily carry on issuing issuing triple-B-rated debt and buying back stock. We disagree.
The low quality of U.S. corporate debt plus a slowing in growth, we think, leads to rising credit spreads over the next 12 months which [will] in turn put the kibosh on buybacks.
Recap April 24
Stocks cruised to a sideways finish, with the S&P 500 hardly wandering more than a few basis points from the unchanged mark all day to consolidate yesterday’s push to a closing high-water mark. A greenback rally that pushed the U.S. Dollar Index to a ten month closing high didn’t prevent the Goldman Sachs Commodity Index from likewise finishing in the green, while Treasurys were again well bid as the 10-year yield fell back to 2.52%. The VIX edged higher to 12.8, its highest close in two weeks.
- Philip Grant
Tuesday, April 23, 2019
So, they'll have two?
An afternoon headline from The Wall Street Journal:
An afternoon headline from The Wall Street Journal:
Cyprus hill
Kicked in the 'coin
Timing is everything.
Timing is everything.
Recap April 23
So, they'll have two?
An afternoon headline from The Wall Street Journal:
Deutsche Bank Considers Forming ‘Bad Bank’
Cyprus hill
Bloomberg reports today that the Republic of Cyprus is preparing to come to market in a two-part euro bond offering with issues maturing in 2024 and 2049. Proceeds are earmarked for the repayment of an emergency €2.5 billion ($2.8 billion) Russian loan from 2012, in the teeth of the European debt crisis.
With fundamentals improving, the small E.U. member state continues to strike while the iron is hot. Just two months ago, triple-B-minus-rated Cyprus managed to place €1 billion in 15-year notes (then the longest issue in Cyprus’ history) at a 2.75% coupon. That issue was oversubscribed by eight times according to International Financing Review and has since rallied to 107 cents on the euro for a yield-to-worst of 2.19%. By comparison, the split-rated U.S. borrows at 2.57% for 10 years.
Following the banking crisis of 2012 to 2013, in which Cyprus became the first eurozone country to employ capital controls and, also, inflict haircuts on deposit holders, things are clearly on the upswing in the eastern Mediterranean. In September, S&P Global Ratings upgraded Cyprus’ credit rating to investment-grade territory, citing an anticipated growth acceleration through 2021 that will allow the government further to ease its debt burden, which stood at 102.5% of GDP as of year-end according to Eurostat, down from 108% in 2014. At a business forum last Thursday, finance minister Harris Georgiades said the government is targeting a debt to GDP ratio of 90% by the end of 2020.
Then, too, the banking system is on the mend, as an IMF research report from November found that non-performing loans had declined to 39% of debt outstanding, representing 85% of GDP, as of June 30. That’s down from 48% of total loans and 161% of GDP at the peak of the crisis in 2014.
A feel-good comeback, to be sure (move over, Tiger Woods). But 2.19%?
Kicked in the 'coin
Timing is everything. From The Wall Street Journal:
Masayoshi Son, the billionaire founder of SoftBank Group Corp., made a huge personal bet on bitcoin just as prices for the digital currency peaked, losing more than $130 million when he sold out, according to people familiar with the matter.
The investment came at the peak of the bitcoin frenzy in late 2017 after the digital currency had already risen more than 10 fold that year. The exact size of the bet couldn’t be determined, but bitcoin peaked at nearly $20,000 in mid-December 2017 and Mr. Son sold in early 2018 after bitcoin had plummeted, the people said.
Still, one needn’t weep for Masa Son, who has a net worth of $24 billion according to Forbes and whose SoftBank Group Corp. (9984 on the Tokyo Stock Exchange) is worth ¥12.6 trillion ($113 billion), with shares up a whopping 58% thus far in 2019.
A 37% year-to-date rally in Alibaba Group Holding Ltd. (BABA on the NYSE), which is 29% owned by SoftBank and now sports a market cap of $485 billion, has helped. A ¥600 billion share buyback, equal to just over 5% of SoftBank’s current market capitalization, has also contributed to the ascent. Announced on Feb. 6, the buyback was 64% completed as of the end of March, according to the company.
With shares riding high, the deal-minded Son continues to look for new targets. This afternoon, Bloomberg reports that SoftBank is considering an investment to buy 5% of German online payment company Wirecard A.G. Wirecard has seen its shares fall by more than 25% since January following investigative reports published by the Financial Times questioning the company’s accounting practices.
For more on Son and SoftBank, see the Dec. 13, 2017 and Feb. 22 editions of Grant’s Interest Rate Observer.
Recap April 23
A big day for the bulls saw the S&P 500 rise nearly 1%, finishing at a fresh record high and extending the year-to-date gains to 17%. The tech-heavy NYSE FANG+ Index jumped nearly 3% to sit higher by 29% for 2019, and within 8% of its own high-water mark.
Elsewhere, a strong U.S. dollar rally didn’t prevent another green finish in the energy patch, as WTI crude rose above $66 a barrel for the first time this year. Treasurys were also bid, with the 10-year yield falling two basis points to 2.57%.
- Philip Grant
Monday, April 22, 2019
Meet the new boss
This morning, The Kraft Heinz Co.
This morning, The Kraft Heinz Co.
Sold to you
China’s Shanghai Composite fell by nearly 2% today,
China’s Shanghai Composite fell by nearly 2% today,
Recap April 22
Meet the new boss
This morning, The Kraft Heinz Co. (KHC on the Nasdaq) announced that CEO Bernardo Hees will be leaving the company at the end of June. Hees, who was named CEO in 2015, has overseen a rough recent stretch including a $15.4 billion noncash asset write down, stagnant revenues, shrinking operating profits and a subpoena from the Securities and Exchange Commission related to questionable accounting practices. Upon his departure, Hees will return to Brazilian private equity firm 3G Capital, LLC (which owns a 22% stake in KHC), where he has been a partner since 2010.
As for succession at Kraft Heinz, 3G is keeping it in the family. Hees will be replaced by Miguel Patricio, fresh from a 20 year career at fellow 3G portfolio company Anheuser-Busch InBev S.A./N.V. (ABI on the Brussels Stock Exchange and BUD on the NYSE), most recently as chief marketing officer.
Kraft Heinz and Anheuser-Busch share something in common besides management overlap and 3G ownership: Daunting debt loads, particularly so for their investment-grade status. According to an October analysis from Moody’s, the average North American non-financial corporate rated Baa (the lowest rung of investment grade) carried net debt of 2.7 times EBITDA as of year-end 2017. By comparison, Baa3-rated Kraft-Heinz carries 4.3 turns of leverage based off 2019 consensus estimates, while Baa1-rated Anheuser-Busch is leveraged to the tune of 4.8 times estimated EBITDA.
Let it be said that Grant’s Interest Rate Observer had the Brazilians’ number. See the issues dated March 25, 2016, March 24, 2017, and Feb. 9, 2018.
Sold to you
China’s Shanghai Composite fell by nearly 2% today, following a Friday statement from the politburo describing first quarter economic conditions as “generally stable and better than expected.” Of course, an abundance of new credit figures prominently in that better than expected start to 2019, as total new financing expanded by an amount equal to 9% of last year’s GDP, rivaling the full-year pace of 2009’s massive economic stimulus (Almost Daily Grant’s, April 12).
The politburo statement potentially signifies that the burst of credit growth will be soon abating. Dai Ming, fund manager at Hengsheng Asset Management Co., told Bloomberg that “people have come to a clear consensus that there won’t be any aggressive stimulus that floods the economy with excessive liquidity, indicating limited room for valuation recovery.” Valuations have already been fattening. Even after yesterday’s pullback, the Shanghai Composite has been the best performing stock market in the world, up 29% year-to-date.
As Beijing hints that it may tap the monetary brakes, China’s corporate sector races to raise cash. Bloomberg relays today that since January, nine companies have announced plans to issue rights offerings totaling RMB 40.5 billion ($6 billion), more than double the full-year 2018 figure. Anne Stevenson-Yang of J Capital Research concurs, noting in a report today that 200 Chinese firms have conducted initial public offerings across the local A-share, Hong Kong and U.S. markets over the past 12 months, as companies look “to grab everything that is not nailed down.” Stevenson-Yang cautions that financial shenanigans are particularly prevalent among this cash-raising cohort:
Investors know well—or should know—that fraud is thick on the IPO playing grounds in China, and the incentives to generate nosebleed valuations by fraudulent means are core to the playbook. After all, there are no penalties in China for committing securities fraud in the U.S., where Chinese authorities believe U.S. regulators should look out for their own.
As we recently reported, three insiders at UXIN Ltd., an online dealer and financier of used cars that listed in the U.S. at the end of June last year, managed to take home around $450 million in cash before lock-up had even expired. Listing in an overseas market. . . is the lowest-risk way known to man of robbing a bank.
Among the tricks employed by Chinese IPO candidates to achieve more favorable valuations: Making up profits and, then, overstating capital expenditures to explain away the lack of cash on the balance sheet, generating revenues by selling products below cost (i.e. the Uber model) and using up-front fees generated from a franchise network business model to goose gross revenues on a one-time basis.
Recap April 22
Stocks erased early losses to finish little changed in very light trading, as the SPDR S&P 500 ETF saw just 38 million shares change hands, the lowest volume session since August and less than half of the one-year average daily turnover of 86 million shares.
A strong day for oil headlined the commodity action, with WTI crude approaching $66 a barrel on news the Trump administration will reportedly end sanctions waivers for Iranian exports. Treasurys sold off, with the 10-year yield rising three basis points to 2.58%, and the VIX gave back most of its early gains to finish below 12.5.
- Philip Grant
Thursday, April 18, 2019
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit
Amazon.com, Inc.’s Web Services (AWS) unit
QT progress report
Recap April 18
Born on the bayou
Amazon.com, Inc.’s Web Services (AWS) unit has been the engine behind the company’s spectacular recent performance, with operating income of $7.2 billion last year, up 68% year-over-year and accounting for 59% of Amazon’s total operating income. The near-consensus cadre of bullish analysts (48 out of 50 tracked by Bloomberg have a “buy” rating on Amazon) call for more of the same. But will an ongoing government kerfuffle derail the AWS miracle?
Last Wednesday, the Department of Defense (DoD) cleared itself of wrongdoing following an internal investigation into the forthcoming award of the $10 billion cloud computing Joint Enterprise Defense Initiative (JEDI) program. Yet the Pentagon’s self-exoneration was not comprehensive, as Bloomberg noted that: “The investigation uncovered evidence of unethical conduct that will be referred to the DoD inspector general for a separate review.”
The JEDI contract has been hotly contested among some of the largest cloud-computing companies in the U.S., and for good reason. The winner-take-all award has been narrowed to two contenders, AWS and Microsoft Corp. According to an updated timeline issued by a Federal judge Tuesday, the JEDI mandate will be awarded sometime after mid-July.
With the stakes high, Uncle Sam’s corporate suitors are pulling no punches. In December, recently-eliminated Oracle Corp. filed suit with U.S. Court of Federal Claims asserting that the JEDI process has been marred by conflicts of interest. The suit alleges that a pair of Amazon-connected former DoD staffers unduly influenced the proceedings in favor of AWS. One of whom, Deap Ubhi, worked in business development at AWS from 2014 to 2016 before joining the DoD, during which period he continued to praise Amazon from his Twitter account (including tweeting “once an Amazonian, always an Amazonian” in January 2017) while criticizing Oracle, Alphabet, Inc.’s Google and other Silicon Valley firms.
According to an April 5 report by The Capitol Forum, in January 2017 Ubhi lamented missing a conference call between Defense Department officials and AWS personnel, writing via email: “I am ex-AWS, and would have liked to have been on the call.” Eight months later, when acting as the DoD’s lead JEDI project manager, Ubhi asked DoD higher-ups to name him “the point of contact for all industry conversations.” After reportedly recusing himself from the JEDI procurement process in late October, Ubhi left the DoD, returning to AWS in November 2017.
In March, the Federal News Network reported that the FBI is involved in the DoD inspector general investigation, potentially signaling “some sort of wrongdoing involving DoD civilian personnel and/or DoD procurement procedures.”
In addition to Ubhi, other former DoD officials have seen their actions around JEDI come under scrutiny. In August, Vanity Fair reported that Sally Donnelly, a former senior advisor to Secretary of Defense James Mattis from January 2017 to March 2018, “sold her stake in [consulting firm] SBD Advisors, LLC for $1.17 million two days before she went to work for Mattis.” But Donnelly continued to receive payments from the company, which counted Amazon as an active client. Two weeks after Donnelly left the Pentagon, SBD was purchased by C5 Capital, “a private equity firm with direct ties to Amazon.”
Anthony DeMartino, Donnelly’s colleague at SBD, who was also named in the Oracle lawsuit, likewise consulted for Amazon before moving to the DoD to serve as Mattis’ deputy chief of staff.
The close proximity of Donnelly and DeMartino to the Secretary of Defense was a favorable development for AWS, as The Capitol Forum reported on March 15 that Mattis “expressed interest in meeting with Amazon CEO Jeff Bezos at a dinner” with Donnelly in early 2017, according to emails received via a Freedom of Information Act request. Mattis and Bezos met in Seattle in August 2017.
As controversy over JEDI continues to swirl, another government agency pivots away from the winner-take-all format. On March 22, the CIA unveiled a new Commercial Cloud Enterprise (C2E) initiative, in which the agency disclosed plans to use “multiple commercial cloud vendors that can provide” necessary services.
An anonymity-seeking, D.C.-based source believes that the CIA’s move might suggest wider government dissatisfaction with AWS, which commanded 46% of worldwide public cloud infrastructure market share as of year-end 2017 according to the International Data Corporation:
The AWS story, as sold to enterprise customers and the Street, is built upon the intelligence community (IC) reference case and the cash that has come in from that deal. The IC’s movement toward a multi-cloud environment is an admission that use of AWS has not been successful as claimed, increasing the likelihood of massive IC contracts for the other hyperscale cloud providers.
Amazon.com, Inc. ten-year stock price, 37% compound annual growth rate. Source: The Bloomberg
Continued cloud dominance is crucial to sustaining Amazon’s success. Analyst consensus calls for Amazon’s net income margin to jump to 6.4% in 2019 from 4.3% a year ago, thanks to expected growth in AWS. But at the same time, the core e-commerce business is showing signs of a slowdown, as Bloomberg estimated last week that gross merchandise volume growth fell to 19% last year from 24% and 27% in 2017 and 2016, respectively.
While the C.I.A.’s move toward multiple cloud vendors highlights the difficulty in growing AWS’ commanding public cloud market share, legal risks surrounding JEDI represent a potentially underappreciated pitfall to the AMZN bull case. Our D.C.-based observer concludes:
If AWS is found to have committed wrongdoing related to DoD’s JEDI contract, it could be debarred as a government contractor. My prediction: Amazon bulls expecting continued blistering growth from AWS will be in for disappointment.
Asked for comment on Thursday afternoon, Amazon had not responded by press time.
QT progress report
A $5 billion sequential decline in mortgage-backed securities holdings left the Fed’s portfolio of securities held outright at $3.744 trillion, a figure which sits $17.6 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 11.8%, a 7.7% annualized pace.
Recap April 18
Stocks traded flat once again to finish the holiday shortened-week little changed, as the Nasdaq 100 Index managed to eke to a fresh closing high while the S&P 500 sits about 1% below its own high-water mark. Commodities finished mixed with WTI crude and gold finishing at $64 per barrel and $1,275 per ounce, respectively, and Treasurys rallied as the 10-year yield retreated from a near one-month high to 2.56%. The VIX closed just above 12, near the year-to-date low.
- Philip Grant
Tuesday, April 16, 2019
Sick Burn
Revenge of the Squares?
Revenge of the Squares?
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE)
Today, Bank of America Corp. (BAC on the NYSE)
Recap April 16
Sick Burn
Revenge of the Squares? Authorities are trying to put the clamps down on Burning Man, the annual Nevada gathering “that connects each individual to his or her creative powers, to participation in community, to the larger realm of civic life, and to the even greater world of nature that exists beyond society,” according to the festival’s website. From today’s Wall Street Journal:
The Bureau of Land Management wants to encircle Burning Man’s makeshift desert town with thousands of physical barriers and have security guards screen attendees, called “Burners,” for contraband. The agency. . . is also calling for organizers to place dumpsters on site and to haul out trash privately to lessen the impact on nearby communities.
If implemented, the measures would send the festival’s total expenses up nearly 60% from its current $38 million, said Marnee Benson, the festival’s associate director of government affairs. Money isn’t the only issue, though. “The vision the BLM has laid out for Burning Man is not the vision we would choose to produce,” Ms. Benson said.
All sorts of visions have emanated from the desert festival. From an Oct. 9, 2013 GreenBiz profile of SolarCity Corp. founder Lyndon Rive:
The idea of starting SolarCity came in 2004 during a drive to the Burning Man festival with his cousin, famed tech entrepreneur Elon Musk. Rive said he wanted to start another company and that he was passionate about trying to solve global environmental challenges. Musk suggested going into solar. Musk is now chairman of SolarCity as well as CEO of Tesla Motors and SpaceX.
Indication of interest
Today, Bank of America Corp. (BAC on the NYSE) chief financial officer Paul Donofrio told listeners-in to the first quarter earnings call to expect net interest income (NII) growth of 3% this year, down from 6% in 2018.
Peer Wells Fargo & Co. (WFC on the NYSE) telegraphed similar deterioration last Thursday. CFO John Shrewsberry said he now anticipates NII will decline by 2% and 5% for 2019, down from an estimated range of plus 2% to minus 2% supplied just two months ago, owing to “tightening loan spreads resulting from a competitive market with ample liquidity and continued upward pressure on deposit pricing.”
For the money center banks, the recent rate hikes have spurred a margin-eroding consumer migration into income generating accounts. In the first quarter, Bank of America saw interest bearing deposits rise 11.8% year-over-year to $907 billion, while non-interest bearing deposits fell 9% year-over-year to $395.5 billion.
The margin pressures cited by both Bank of America and Wells Fargo were anticipated by Christopher Whalen, publisher of the Institutional Risk Analyst, in the Oct. 19 edition of Grant’s Interest Rate Observer. Arguing that rising interest rates would confer less of an advantage on the big institutions than was widely anticipated, Whalen identified the key problem:
The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net in¬terest margin contract by Q1. How do you think the Street will react to that?
Whalen reiterated his views in a blog post Sunday, while quantifying the extent to which rising costs could impact profitability:
At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014, when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate.
As lending spreads have collapsed, with the 10-year yield currently offering a 17 basis point premium over the three month Treasury note compared to 267 basis points five years ago, the environment has swung from accommodative to constricting for the banks:
Between 2008 and 2014, the FOMC subsidized the U.S. banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates.
Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for banks to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates.
As lending spreads contract, the credit cycle continues to age. “We are in the trough,” Whalen told Grant’s today. “Defaults are going to rise in 18 to 24 months,”
Recap April 16
A flat finish for stocks saw the S&P 500 give back early gains as well as recoup a sharp afternoon downdraft, while the tech-heavy Nasdaq 100 reached an all-time intraday high before pulling back a bit to finish just below the Aug. 29 peak.
Commodities came under pressure, with gold falling to a fresh 2019 low of $1,276 an ounce, and Treasurys were also for sale with the 10-year yield rising to 2.59%, the highest since late March.
- Philip Grant
Monday, April 15, 2019
I really think so
Last Thursday, European Central Bank
Last Thursday, European Central Bank
Strangers things
A new frontier in innovation: Annoyance-as-a-service.
A new frontier in innovation: Annoyance-as-a-service.
Down the rabbit hole
In a recent research note,
In a recent research note,
From hunger
Analytics firm TDn2K reports
Analytics firm TDn2K reports
Recap April 15
I really think so
Last Thursday, European Central Bank governing council member François Villeroy de Galhau dismissed comparisons between the Eurozone and Japan. Speaking at the International Monetary Fund’s semi-annual meeting in Washington, Villeroy noted that it might be “fashionable” to make such a comparison but retorted: “I don’t think it is accurate. The Eurozone is not a situation of Japanization.”
Yet the results in measured rate of inflation suggest some merit to the comparison. Since April 2013, the year-over-year change in Eurozone CPI inflation has averaged 0.9%, matching that of Japan during the same period.
Strangers things
A new frontier in innovation: Annoyance-as-a-service. From Bay Area online news site Mission Local:
In recent weeks, Mission residents have been receiving curious missives in their mailboxes inquiring whether they’d be game to monetize their kitchens and living rooms by having strangers drop in and start doing office work.
It’s a [pitch] from Cobo, a startup hoping to capitalize on what its founder calls “a billion-dollar market”: Placing lonely freelancers pining for company into people’s homes, monetizing that home, and taking a cut.
Down the rabbit hole
In a recent research note, UBS Group A.G. chief economist Daniel Kalt forecast tighter monetary policy in Switzerland, writing that the Swiss National Bank will likely raise interest rates from the current negative 0.75%, which is the lowest of any major central bank according to Bloomberg.
But on Saturday, SNB chairman Thomas Jordan talked about about pushing rates deeper into negative territory. In a speech in Washington, Jordan remarked that: “We always stress the point that we have room to lower interest rates still further.”
From hunger
Analytics firm TDn2K reports that comparable restaurant store sales rose by 1.15% year-over-year in March, raising the rolling three-month growth rate to 0.8%. TDn2K notes that for the first time since 2015, restaurants have managed four consecutive quarters of positive same-store sales growth.
But is that upturn in industry fortunes enough? Over the last 12 months, TDn2K’s same-store sales figure has shown an average year-over-year growth rate of 0.96%, far below the 2.3% average rise in headline CPI since April 2018.
The less-than-stellar growth profile doesn’t seem to bother Mr. Market, as the S&P Restaurants Index commands an enterprise value of a healthy 16.5 times 2019 consensus EBITDA, compared to 11.7 times enterprise value to forward EBITDA for the S&P 500 Ex-Financials Index. But as growth in sales lags behind the rate of inflation, franchise operators continue to be squeezed. According to a November franchisee survey reported by Restaurant News, almost 90% of respondents were “unsatisfied with their cash flows.”
For more on the group, including an analysis of a pair of picks-to-not-click, see the Feb. 8 issue of Grant’s Interest Rate Observer.
Recap April 15
Stocks recouped modest early losses to leave the S&P 500 within 1% of the Sept. 20 high water mark, while the Goldman Sachs Commodity Index rose back to near its 2019 high despite weakness in WTI crude and gold, which finished at $63.50 per barrel and $1,288 per ounce, respectively. Treasurys caught a modest bid with the 10-year yield finishing at 2.55%, and options volatility remains muted as the VIX settled below 12.5.
- Philip Grant
Friday, April 12, 2019
A TAM too far
In a form S-1 filed yesterday ahead of an initial public offering, Uber Technologies, Inc. calculated the total addressable market (TAM) of $5.7 trillion for its core ride share business, along with a $2.8 trillion TAM for its Uber Eats business and a $3.8 trillion total market for its Uber Freight unit. In total, the $12.3 trillion market identified by Uber for those three businesses represents 14.5% of 2018 world GDP.
The unicorn, which racked up an $11.3 billion operating loss last year, is expected to garner a valuation of $90 billion to $120 billion upon listing.
Faulty transmission
Some eye-catching credit data out of the People’s Bank of China today: Total credit grew by a record RMB 2.8 trillion ($420 billion) in March, far above the RMB 1.85 trillion consensus estimate. During the first quarter, total new financing ballooned to RMB 8.2 trillion, up 40% from a year ago and equivalent to 9% of China’s reported 2018 GDP. Extrapolated to a full year, the credit expansion is just behind the 40% jump in total financing as a percentage of GDP seen in the massive stimulus year of 2009.
That liquidity surge coincides with a “recovery extending across both sectors and geographies, with every major sector and each one of our regions showing better revenue results than Q4,” according to the China Beige Book.
Beyond opening the credit spigots, Beijing is trying to stoke economic growth in other ways. Last week, Xinhua’s Economic Information Daily reported that policymakers are crafting tax cuts and other fiscal policies to help spur consumption. In addition, the National Development and Reform Commission announced Monday that small and midsize cities (populations of between one and five million) will relax hukou, or household registrations, in a bid to boost real estate markets.
Regulators have also targeted the stock market. Bloomberg reports that nearly 700 firms bought back stock between December and January after authorities relaxed rules around the practice, up from 609 corporate buybacks in 2018 through early November. Mark Huang, analyst at Bright Smart Securities, explained to Bloomberg that: “China is looking to developed markets like the U.S., where buybacks are a key approach to sustaining a long-term bull market.”
Those exertions are bearing fruit, if asset prices are any guide. Thus, China’s Shanghai Composite Index has ripped higher by 28% year-to-date, while contracted project sales from an index of nine property developers jumped 20% in March, according to data from Bloomberg. That follows a 9.4% year-over-year advance in February property investment according to the National Bureau of Statistics, the hottest reading since 2014.
But the stimulus barrage has yet to translate into much acceleration in the money supply (M2 grew at 8.6% year-over-year, up from 8.3% average growth in 2018 but far below the 16% average since March 1996), nor improve the balance sheets of China’s debt-soaked corporations. S&P Global Ratings cut its assessment of 13 companies in the first quarter, the highest level of downgrades since 2016, with analyst Cindy Huang noting that “despite a slew of easing measures from the policy makers, small private firms still lack sufficient liquidity.” Peer Fitch Ratings has issued 30 corporate downgrades year-to-date, compared to just five upgrades. That follows a jump in yuan-denominated debt defaults to RMB 119.6 billion last year according to Singapore-based DBS Bank, four times 2017’s level.
With RMB 2 trillion of bad debt sitting on Chinese bank balance sheets according to research from UBS Group A.G., things are likely to get worse before they get better. A survey of 202 bankers conducted by China Orient Asset Management Co. finds that 83% of respondents believe that bad loans will increase in 2020.
Why that disconnect between free flowing liquidity and rising corporate distress? Zhu Min, head of Tsinghua University’s National Institute of Financial Research and former deputy governor of the PBoC, told Caixin that while a decade of easy money has goosed financial markets, stimulus has not helped larger banks adequately lend to smaller companies which need liquidity and can often offer little collateral. Zhu asks: “How can financial institutions lend money to small-to-micro companies if all of their money has been invested in the stock market?”
- Philip Grant
Thursday, April 11, 2019
A permanently low plateau
“As I say, we wish they hadn't raised,”
“As I say, we wish they hadn't raised,”
Tip of the iceberg
From Caixin
From Caixin
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history
The Saudi Arabian Oil Co. (Aramco) made history
QT Progress report
Recap April 11
A permanently low plateau
“As I say, we wish they hadn't raised,” Larry Kudlow, director of the National Economic Council, told The Hill about the Fed’s December hike. “I notice from the various reports and so forth that they've changed their view. I don't think rates will rise in the foreseeable future, maybe never again in my lifetime.”
Kudlow is 71 years old.
Tip of the iceberg
From Caixin:
Figures from China’s Ministry of Finance (MOF) show that official on-budget borrowing, known as explicit debt, of all local governments combined amounted to nearly 18.4 trillion yuan [$2.8 trillion] at the end of last year. But an official with one of the country’s financial regulatory bodies told Caixin that the unofficial, off-the-books liabilities of most provinces, known as implicit debt, could be around 2.5 times bigger. Added together, the total debt of local governments would amount to more than 70% of the country’s gross domestic product (GDP) in 2018.
Field of dreams
The Saudi Arabian Oil Co. (Aramco) made history this week by placing $12 billion in bonds in a deal that attracted a massive $100 billion order book. That’s a record level of demand for an emerging market issuer and one of the most oversubscribed bond offerings in history according to Bloomberg. By comparison, Saudi Arabia itself attracted $67 billion in orders for its international bond market debut in 2016.
That impressive order book didn’t translate into favorable price action, as all five of the 3- to 30-year Aramco tranches saw their prices decline and spreads over Treasurys widen in the first three days of trading. Yet even after that pullback, Aramco’s senior unsecured notes of 2029 trade at a 118 basis point spread, compared to 126 basis points over Treasurys for the identically rated single-A-plus Saudi sovereign 10-year note. The relationship between the pair (Aramco chairman Khalid Al-Falih is also the Saudi oil minister) is close and ambiguous enough to give some pause. One unnamed investor who met with the company told The Wall Street Journal that political unknowns loom large:
All the cash flow and [earnings] numbers are good, but who owns the reserves? It’s the Kingdom. And who takes the big decisions on whether Aramco should pay a special dividend, or help in some other way with funding Saudi? You have to assume it’s the government.
More broadly, the rabid investor appetite for Aramco debt underscores the current euphoria in credit. Year-to-date global corporate issuance stands at a record $695 billion and represents more than half of full-year 2018’s new supply of $1.34 trillion, according to data from Refinitiv. Hans Mikkelsen, head of investment-grade strategy at Bank of America Corp., summed it up: “The new issue market is wide open. It’s probably never been as open as it is now.”
Favorable market conditions have helped that record queue for Aramco debt, but what else are investors signing up for? As noted in the prospectus, Saudi Arabia’s famous Ghawar oil field (the world’s largest) is currently capable of producing just 3.8 million barrels per day, far below the Energy Information Administration’s 2017 estimate of 5.8mbpd.
That revelation comes as no surprise to Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates who have long argued (including on the Oct. 2, 2017 edition of the Current Yield podcast) that the Ghawar future potential is far more limited than widely believed. Reached by Grant’s this afternoon, Goehring commented:
Ghawar output will continue to decline, and we can now model it going forward. Most reservoir engineers believe that an oil field’s production will begin to decline when half the recoverable reserves are produced (there are all sorts of theories of why this is true, but it’s grudgingly accepted).
The problem with Ghawar is that we have never had an updated reserve report on what the recoverable reserves of the field might be. We have tried using various indirect methods, which led us to believe that Ghawar had about 25 billion barrels of reserve left. Given that Ghawar has produced about 75-80 billion barrels of oil already, this would mean that the field was way past its half-way point.
But these are all indirect measurements (and guesses).
However, with the publishing of the Aramco prospectus, we have now audited Ghawar numbers for the first time in almost 45 years. The numbers state (page 88 in the prospectus) that Ghawar has 48 billion barrels of liquids left. They have produced say 75 to 80 billion, so we know that total recoverable reserves are approximately 125 to 130 billion barrels. With only 48 billion barrels remaining, the field is over 60% depleted.
QT Progress report
The Fed’s portfolio of securities held outright remained at $3.748 trillion this week, a figure that sits $22 billion below the trailing four-week average. Since the Oct. 1, 2017 commencement of the QT balance sheet run-off, the Fed’s total assets are down by 11.7%, for a simple annualized pace of 7.8%.
Recap April 11
A quiet session saw stocks drift sideways, leaving the S&P 500 little changed for the week and within 1.5% of its closing high reached on Sept. 20 of last year. Commodities saw their recent winning streak emphatically snapped with the CRB Index falling more than 1%, and Treasurys traded weaker across the curve to push the 10-year yield back to 2.5%. The VIX held just above 13.
- Philip Grant
Wednesday, April 10, 2019
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
“U.S. hedge funds from time to time have appeared in this country over the last 10 years,
Recap April 10
I'm your huckleberry
“U.S. hedge funds from time to time have appeared in this country over the last 10 years, with the same hypothesis of shorting Canadian banks, and it hasn’t worked out very well for them,” Brian Porter, CEO of the Bank of Nova Scotia, said yesterday. “There are always going to be those that take an opposing view, and we’ll prove them wrong over the long term.”
Gabriel Dechaine, banking analyst at the National Bank of Canada, likewise came to his industry’s defense in a note today: “A trend that is making us believe that sector sentiment is becoming too bearish is the re-emergence of a vocal ‘short Canada’ investment crowd.” Dechaine writes that a Stanley Cup victory for the woebegone Toronto Maple Leafs (last title, 1967) is more likely than a jump in loan losses.
One well-known investor is publicly taking the challenge: Steve Eisman, portfolio manager at Neuberger Berman and a protagonist in Michael Lewis’ The Big Short. “Canada has not had a credit cycle in a few decades and I don’t think there’s a Canadian bank CEO that knows what a credit cycle really looks like,” Eisman, who is short various Canadian banks and mortgage lenders, fired back in an interview yesterday with BNN Bloomberg television. “I just think psychologically they’re extremely ill prepared.”
While Canadian bank advocates and their skeptics exchange words, the formerly-white hot housing market is now in deep freeze. March sales in Vancouver collapsed by 31.4% year-over-year according to the local real estate board, the worst showing since 1986 and down 46% from the 10-year average for March. Prices also lurched lower, with the benchmark detached home price falling 10.5% year-over-year to C$1.44 million ($1.08 million). Things are more stable in Toronto, where March sales and benchmark prices were little changed from a year earlier, but those figures remain 40% and 14% below their respective levels from March 2017.
As the housing market sputters, the highly-leveraged Canadian consumer displays increasing signs of distress. According to the Bank for International Settlements, Canada’s household debt stands at 100.2% of GDP as of the end of September, by far the highest ratio among G7 economies (the U.K. is next at 86.5%), while the debt service ratio, or the percentage of disposable income allocated to principal and interest payments, rose to 14.9% in the fourth quarter per Statistics Canada, just shy of the 2007 peak.
That debt burden is starting to weigh on consumers. Auto loan delinquencies rose to 0.97% at year-end according to Equifax, Inc., the highest since 2009. At the same time, 36% of new auto loans in the fourth quarter were leases, the largest such share since 2007. Bill Johnston, vice president of data and analytics at Equifax Canada Co., noted that “we’re starting to see consumer behavior shift to keep the payments as low as possible.”
On the credit card front, delinquencies of at least 90 days remained at a relatively low 0.79% as of February, down from 0.88% in the same month last year according to data from Bloomberg. But, as noted by the Royal Bank of Canada, consumers cut their average monthly payment to just 38% of outstanding balances in February, down from 50% in October and the lowest such ratio since 2015. RBC credit analyst Vivek Selot commented:
That deterioration in payment rates may be attributed to some stress on the consumer. Considering that fragile household balance sheets could be a precipitating factor for the credit cycle to turn, any signs of consumer credit quality deterioration seem worthy of attention.
Indeed, the Office of the Superintendent of Bankruptcy reports that consumer insolvencies rose 5.4% year-over-year in February, bringing the rolling three-month average to its highest level since 2011.
The slowing housing market and increased consumer stress has taken a toll on one of the banks’ primary profit centers. According to the Bank of Canada, residential mortgage growth registered at 3.2% year-over-year in February, the lowest reading since 2001 and barely half of the 6% monthly average logged since the housing boom gathered steam in 2009. Back in March, Edward Jones & Co. investment strategist Craig Fehr noted to Bloomberg that mortgages frequently represent “the largest and most profitable and steady of the businesses that these banks operate.” Fehr concluded: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.” Meanwhile, expectations remain high, with a 2019 analyst consensus of 15.7% return on equity for the S&P/TSX Bank Index, up from 14.2% last year and a five year average of 15%.
For those unfazed by CEO taunts and eager to investigate the bearish case for Canada’s lenders, an analysis in the Feb. 9, 2018 edition of Grant’s Interest Rate Observer identifies one bank that stands out from the rest.
Recap April 10
Stocks caught a modest bid, recouping some of yesterday’s losses as the small-cap Russell 2000 rose more than 1% to extend its year-to-date gains past 17%. Treasurys rallied across the board as the 10-year yield dropped three basis points to 2.47%, and commodities continued their impressive advance with the CRB Index rising to a five month high with WTI crude and gold finishing at $64.5 a barrel and $1,308 an ounce, respectively.
- Philip Grant
Monday, April 8, 2019
Discount double check
The passive price war goes stealth.
The passive price war goes stealth.
Permanently high plateau 2.0
Cheez whiz
Recap April 8
Discount double check
The passive price war goes stealth. From Bloomberg today:
BlackRock, Inc., the world’s largest issuer of exchange-traded funds, has slashed the cost of its iShares Broad USD High Yield Corporate Bond ETF by waiving part of the management fee, regulatory documents show. But rather than shout about the move, the discount was announced without fanfare – in a footnote on page 94 of a revised filing last month.
Permanently high plateau 2.0
In Barron’s this weekend, J.P Morgan chief U.S. equity strategist Dubravko Lakos-Bujas offered a novel perspective on the nature of asset prices in the modern era:
We are all used to using the word “cycle”; we’re all used to looking at historical charts and graphs and equations and relationships. The reality is that maybe the word “cycle” is no longer even relevant, given that we have so much unconventional central-bank involvement.
Cheez whiz
So far this year, the Renaissance U.S. IPO Index is up a cool 32%, more than double the 15% advance logged by the S&P 500. The booming market for new issues is making bull-market noises.
This morning, CEC Entertainment, Inc., parent company of children’s restaurant Chuck E. Cheese’s, announced plans to list shares on the New York Stock Exchange. This will be no straightforward offering. Instead, the transaction will feature a reverse merger between CEC’s own parent company Queso Holdings, Inc. with a special purpose acquisition company called Leo Holdings Corp. The press release explains:
Concurrent with the closing of the transaction, Leo will domesticate as a Delaware corporation, following which Queso will merge with and into Leo with the result that CEC will continue as a wholly-owned subsidiary of Leo, which will be renamed Chuck E. Cheese Brands, Inc.
CEC was bought by Apollo Global Management, LLC in 2014 for $1.3 billion including debt. In February 2017 Reuters reported that the private equity giant had hired Deutsche Bank A.G. and Credit Suisse A.G. to solicit bids for its portfolio company, with Bloomberg reporting that Apollo was seeking a roughly $2 billion sale price.
With no buyer in hand, the deal was withdrawn six months later. As a public entity, CEC is expected to garner an enterprise valuation of about $1.4 billion, which is 7.5 times forecast 2019 adjusted EBITDA of $187 million, while the anticipated $300 million of proceeds “will be used to pay transaction expenses and de-leverage the Company’s existing capital structure.”
De-leveraging appears wise. CEC ended 2018 with total debt of $982 million, 6.5 times trailing 12-month adjusted EBITDA, while operating income of $66 million failed to cover the $76.3 million in interest expense.
As Chuck-E-Cheese’s prepares to re-join the ranks of publicly-traded companies, recent IPO Lyft, Inc. has a bone to pick with its underwriters. Digital news site The Information relayed Friday that the ride-share company, which debuted on March 29, threatened to sue Morgan Stanley after the New York Post reported the investment bank had offered Lyft investors a chance to hedge their positions through short sales, despite being subject to lock-up restrictions.
For Lyft, which generated a $943 million adjusted-EBITDA loss in 2018 on revenues of $2.2 billion and warned in its S-1 filing that it “may not be able to achieve or maintain profitability in the future,” the attention paid to short-sellers has been mutual. According to S3 Partners, LLC, short interest in LYFT exceeded 38% of the 32.5 million share float as of Tuesday, despite prohibitive borrowing costs that reached an annualized rate 101.4% as of Tuesday. Lyft stock finished the day at $70.23 a share, down from the $72 issue price and 20% below the intraday peak see on its March 29 debut.
Meanwhile, new issue supply continues apace as the IPO pipeline remains robust. This morning, social media site Pinterest, Inc. filed a form S-1 detailing plans to offer up to 75 million shares at a range of $15 to $17 per share, valuing the company at $11.3 billion using the high end of the range. That’s down from a $12.3 billion valuation achieved during the most recent fundraising round in 2017. As noted by Business Insider on March 24, an unusual bit of language in Pinterest’s filing may give some investors pause:
Pinterest's S-1 paperwork, filed publicly Friday, disclosed an unusual stipulation that retains full voting rights for CEO Ben Silbermann's shares in the company from 90 days to 540 days after his "death or permanent incapacity."
The clause means that after Silbermann dies, whoever inherits his shares will retain his super-voting powers for a period of time.
Recap April 8
A reflation-type trade headlined today’s action, as commodity prices continue to run with the CRB Index green for a fifth straight day to leave WTI crude and gold near $65 a barrel and $1,300 an ounce, respectively. Treasury yields also rose, with the 10-year finishing at 2.52%, well off the 52-week low of 2.36% reached on March 27. Stocks finished sideways, with the S&P 500 erasing early losses, and the VIX settled just above 13.
- Philip Grant
Friday, April 5, 2019
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc.
Recap April 5
Nevertheless, he persisted
Today, the Nikkei Asian Review reports that Nomura Holdings, Inc. (8604 on the Tokyo Stock Exchange) expects to close over 30 of its 156 domestic retail branches, “previously considered a sacred cow by the group.” In addition, Nomura will eliminate roughly half of its 11 administrative departments and “revisit its policy of maintaining hubs in Japan, the U.S. and Europe.” That comes after the investment bank reported a ¥101.2 billion ($911 million) loss for the nine months ended Dec. 31, its worst such showing since 2008.
Nomura’s misadventures are no outlier. In early March, Mizuho Financial Group, Inc. was forced to take a ¥680 billion write down that included ¥150 billion worth of losses related to its portfolio of overseas bonds (Almost Daily Grant’s, March 7). More broadly, the Tokyo Stock Exchange Bank Index has seen its return on equity decline in each of the last five years, to 5.33% in 2018 from 9.77% in 2013. The index trades at a paltry 0.47 times book value, worse than even the EURO Stoxx Bank Index’s similarly-depressed 0.62 price-to-book ratio and far below the 1.18 times book valuation commanded by the U.S. KBW Bank Index.
Of course, much like Europe, Japan’s macro-economic backdrop features negative interest rates and aggressive central bank asset purchases. The BoJ has accumulated ¥557 trillion in assets, equivalent to 101% of 2018 nominal GDP (that compares to about 39% in Europe and 19% in the U.S.), as policymakers continue to up the ante in their quest to achieve a 2% measured rate of inflation.
With its gargantuan portfolio, the BoJ wields substantial control of the country’s capital markets. As noted by the Financial Times on Sunday, the central bank now holds close to 80% of outstanding ETF assets, equating to approximately 5% of Japan’s total market capitalization, while data from Bloomberg pegs the BoJ ownership of the Japanese Government Bond Market at 43%.
Financial institutions are beginning to publicly balk at these monetary machinations. Last week, Makoto Takashima, president of Sumitomo Mitsui Banking Corp. and chairman of the Japanese Bankers Association, told Bloomberg that the Bank of Japan must “carefully consider” the impact of deepening its subzero interest rate policy: “It will be a quite difficult decision to make. Simply speaking, that would cause policy side-effects to further grow.” Back on March 3, Mizuho Bank, Ltd. CEO Koji Fujiwara expressed similar reservations over any escalation of Japan’s radical monetary policy: “I think the BoJ’s actions so far have been beneficial, but I think the time has come to look carefully at the negative side effects and reconsider.”
For his part, BoJ Governor Haruhiko Kuroda opined in March that “I don’t think our ETF buying is having any effect on market function.” The central banker said in a speech today that the BoJ “needs to continue easing persistently.” Of Japan’s banks, Kuroda attributed their profit woes to “structural factors, such as a dwindling population,” while pledging vigilance “to the risk [these structural factors] could erode [banks’] capital base and have a negative impact on financial intermediation.”
With BoJ policy already extreme by most objective measures, Kuroda’s determination to maintain ultra-loose policies in the face of banking industry protests can be potentially explained by a speech at Oxford University on June 12, 2017. In that address, the BoJ governor articulated his plan to rouse the Land of the Rising Sun from its longstanding disinflationary torpor. Namely, manipulate expectations such that citizens begin to expect rising prices, which would then presage the real McCoy:
I took office as Governor of the Bank of Japan in March 2013 and immediately introduced a monetary policy regime -- quantitative and qualitative monetary easing, (QQE) -- that is quite different from past regimes. QQE consists of two pillars: (1) directly working on people's expectations through a price stability target of 2 percent and a strong and clear commitment to doing whatever it takes to achieve this, and (2) directly encouraging a decline in long-term interest rates through large-scale purchases of long-term Japanese government bonds (JGBs).
In practice, QQE has produced its intended effects. Inflation expectations climbed notably after the introduction of QQE. This demonstrates that a strong determination by the central bank pushes up people's forward-looking inflation expectations.
On that score, success remains elusive. According to a Bloomberg survey of 2,127 Japanese households conducted in February and March, half of respondents “have never heard of” Kuroda’s grand monetary stimulus, “the highest level since the question was introduced in September 2013.” Meanwhile, year-over-year CPI inflation has averaged 0.45% over the last 36 months.
Recap April 5
Stocks rallied once again, with the S&P 500 tacking on a 2% gain this week to bring the year-to-date advance to a gaudy 15.5%.
Commodities finished higher for a sixth straight day to push the CRB Index to its best close since November, despite strength in the greenback as the Dollar Index finished within a few ticks of its own 52-week high. Treasury yields finished little changed, but with some flattening across the curve as the three month vs. 10-year spread narrowed to (positive) seven basis points.
- Philip Grant
Thursday, April 4, 2019
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis
The May 30, 2014 issue of Grant’s featured a bullish analysis
QT progress report
Recap April 4
Off to sea once more
The May 30, 2014 issue of Grant’s featured a bullish analysis of Dorian LPG Ltd. (LPG on the NYSE), which ships liquified petroleum gas (LPG) worldwide through its fleet of 22 very large gas carriers (VLGC). Trading at $20.31 a share at publication time, LPG stock cratered to $6 two years later, and currently fetch $7.22. Now following is a look at what happened and where things stand.
That May 2014 analysis noted that “a bet on Dorian is a clear bet on the earnings power of its ships – and the price of crude and on the demand for LPG.” Instead, over the last five years Dorian has been run aground by low prices, overcapacity and accompanying concerns over the appraised value of the company’s VLGC fleet.
Industry growth has been brisk, as LPG (a mix of propane and butane which can be used for cooking, heating and fuel) is a clean and relatively easy to transport form of energy. But those virtues – plus an accommodating credit market – have helped spur a capacity glut. The overall VLGC count has jumped to 270 as of Feb. 5, up from 158 as of April 2014. An additional 46 ships, representing 17% of global supply, are on order.
Dorian’s income statement reflects those difficult business conditions. Adjusted EBITDA fell to $62 million in calendar 2018, from $202 million in the fiscal year ended March 31, 2016. Meanwhile, net debt stands at a hefty $676 million, although refinancing needs are distant as the next principal repayment, in the form of a $179 million term loan, isn’t due until 2022.
The company’s latest form 10-Q addressed the potential for asset write-downs on its ships, noting that outside appraisals “showed indications of impairment on 21 of our ships.” However, a company-conducted sensitivity analysis found that no impairments would need to be taken if daily spot time charter equivalent (TCE) rates fell 25% below their 10-year average of roughly $30,000 per day, while a 30% drop would trigger $34.6 million worth of write-downs on six VLGCs. CFO Ted Young explained the discrepancy, and Dorian’s reasoning, to Grant’s:
Getting a shipbroker assessment is like getting an assessment on your home from the local realtor. It is based on last done. Well, guess what? There was no last done. No modern ships have really changed hands at all. There has been one fleet sale in 2015/16 that included some modern ECO VLGCs which was a distressed situation and the buyer clearly got a really good deal. So, those assessments will imply values that are somewhat below our depreciated carrying value.
Are better days ahead? TCE rates rebounded in the quarter ended Dec. 31, rising to $30,000 per day, up from $17,000 a day in 2016 but still well below the $45,000 seen in 2014. Then, too, the overcapacity problem is mitigated by the fact that 9% of world VLGC supply is aged 25 years or older, with another 3% between 20 and 25 years old. For its part, Dorian boasts a particularly young fleet, with an average age of 4.6 years, less than half the 9.4 year industry average.
Mr. Market has applied his own inventory discount. Dorian’s $1.08 billion enterprise value equates to roughly $49 million for each of its 22 VLGCs. In early January, peer DryShips, Inc. took delivery on four VLGCs at a price of $83.5 million per vessel. Assuming a 25 year life and five years of straight line depreciation (equating with Dorian’s average VLGC age), yields a per ship valuation of roughly $66 million.
That newer fleet, which includes three ships fitted with eco-friendly exhaust scrubbers and another ten vessels set to be retrofitted in 2019 and 2020, represents a significant competitive advantage for Dorian. Next year, the International Maritime Organization will implement new regulations that include capping the sulphur emissions of seaborne vessels/VLGCs at 0.5% from the current 3.5%, an ordinance that Bloomberg reports will be enforceable in Singapore with jail time of up to two years for violators. Young tells Grant’s that the company is well positioned for those changes:
Putting aside the scrubbers that we’ll have on ships, if you just look at some of the fuel differences we put out there the savings can be anywhere from $2,000 to $3,000 a day.
One of the big things is that the younger, newer ships, of which we have the largest fleet, end up making more money per day because freight is quoted in dollars per metric ton. When you make that calculation, from dollars per metric ton to time charter equivalent per day, the biggest part of that calculation is the fuel consumed. Our newer and fuel efficient vessels not only carry a bit more cargo but they also consume less fuel over the course of the voyage so that translates to a higher voyage return.
The company has its admirers. Last May Norway’s BW LPG Ltd., which sports a market cap of NOK 4.9 billion ($571 million) compared to Dorian’s $402 million, launched an unsolicited all-stock bid that would have left Dorian shareholders with 46% ownership of the combined entity, before withdrawing its deal in October after reportedly declining Dorian’s request to improve the terms.
At the current price and sporting a daunting leverage ratio of 10.9 times net debt to trailing 12-month EBITDA, LPG shares represent an option. Should fundamentals continue to improve, the stock should do quite well, but if they flatline or deteriorate for an extended period, Dorian will face the risk of insolvency. Short interest currently stands at 5.4% of the float, and the Street is bullish, with five “buy” ratings, one “hold” and zero “sells.”
QT progress report
The Donald is not going to like this. The Fed’s portfolio of securities held outright fell to $3.78 trillion, down a meaty $23 billion from a week ago, with Treasurys accounting for all the sequential decline. Today’s figure represents a $31.4 billion drop from the trailing four-week average.
Since the Oct. 1, 2017 commencement of the QT run-off, total balance sheet assets are down by 11.7%, for an annualized pace of 7.9%.
Recap April 4
Another rangebound session saw the S&P 500 finish higher by 0.2%, near its best levels of the day, while Treasurys also finished little changed with the 10-year yield settling at 2.51%. Commodities and the dollar both finished higher, with the CRB Index rising for a fifth straight session despite weakness in crude as WTI fell back to $62 a barrel. The VIX finished below 14.
- Philip Grant
Tuesday, April 2, 2019
They mostly come at night, mostly
It’s alive! Just after midnight eastern time,
It’s alive! Just after midnight eastern time,
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry,
It’s been a tough road for the U.S. farming industry,
Recap April 2
They mostly come at night, mostly
It’s alive! Just after midnight eastern time, the price of bitcoin surged by as much as 23% to cross back over $5,000 for the first time since November, while remaining 15% in the green this afternoon.
What accounts for the abrupt liftoff in the world’s premier cryptocurrency? One potential clue is the nearly identical level of activity in tether, the purportedly dollar-backed crypto. While bitcoin (with an aggregate market value of $83.3 billion) has logged $18.7 billion of trading volume in the past 24 hours, the much-smaller tether (market value: $2.1 billion) has registered $18.8 billion over the same period, according to data from CoinMarketCap.com. By comparison, ethereum, which sports a market cap of $16.6 billion, has seen 24 hour trading volume of $8.5 billion.
For more on tether, see the Sept. 8, 2017 edition of Grant’s.
I'm a hog for you baby
It’s been a tough road for the U.S. farming industry, which is seemingly beset on all sides. Agricultural commodity prices remain low, with spot corn and soybean currently fetching $3.62 and $8.99 per bushel, respectively, each roughly 22% below their respective 10-year average prices.
Meanwhile, the ongoing Sino-American trade war continues to crimp overseas demand, as the U.S. Department of Agriculture reports that soybean deliveries to China fell more than 80% year-over-year since September. That helped push soybean stocks to a record 3.7 billion bushels as of year-end 2018.
By the same token, the USDA forecast Friday that corn plantings will rise 4.1% in 2019 to 92.8 million this year, an unwelcome development considering that “American silos are already bulging with the grain,” according to Bloomberg. Adding insult to injury, devastating floods have afflicted large swaths of the Midwest during the heart of spring planting season.
The USDA estimates that net farm incomes plunged 16% year-over-year in 2018 to $63.1 billion, down from more than $120 billion as recently as 2013. Rising operating costs play a prominent role in that shrinkage. According to the All Farms Index tabulated by the Federal Reserve Bank of Minneapolis, the prices received component fell to 84.9 in January from 95.1 in June, while prices paid registered 109.3 and has remained north of 100 since 2011.
Source: The Federal Reserve Bank of Minneapolis
Things are particularly grim in Minnesota and surrounding states. The Minneapolis Fed reports that in-state farmers have seen total input costs for seed, fertilizer, pesticides, fuel and electricity rise by 50% since 2006, after adjusting for CPI-measured inflation. As a result, Minnesota farmers reported real median net income of $26,055 last year, down 8% from 2017 and the lowest figure since the early 1980’s, per an estimate from Dale Nordquist with the University of Minnesota’s Center for Farm Financial Management.
Unsurprisingly, that one-two punch is leading to increasing distress. The Minneapolis Fed reports that the ninth district (encompassing Minnesota, Wisconsin, North and South Dakota and Montana) has seen farm bankruptcies rise to more than 100 in the 12 months ended in December, up from 46 in calendar 2015.
As farmers struggle under the weight of low prices, bulging stockpiles and the wrath of mother nature, Grant’s asked grains expert and paid-up subscriber Keith Bronstein whether a supply disruption could augur better days ahead:
The flooding is currently a localized disaster for those producers in areas affected.
Can this become sufficiently widespread to have a true impact on U S production of row crops? The answer is a resounding yes, but it is too soon to make that statement. Early planting is a boon to yields and, given relatively depressed prices, it is easy to imagine farmers making extensive use of crop insurance policies if things get very late. I think we need to revisit this in 2.5 weeks to see how conditions have changed (or not) as snow melt and runoff and rain or lack thereof play themselves out over this period.
In summary, some notable areas are experiencing great misfortune but it is not yet a “national” story.
One farm commodity that has decisively broken higher is hogs. The emergence of African swine fever in China has led to the culling of an estimated 100 million hogs, a figure that compares to the U.S. inventory of 74.3 million hogs as of the first quarter. That sudden shortage of Chinese supply has spurred a major change in world fundamentals. Arlan Suderman, chief commodities analyst at INTL FCStone, Inc., estimates that “hog feeding in China is down by more than 30%, while some estimates coming out of China are much higher than that.” The Farm Journal notes that replacing a 31% decline in Chinese output “would require all of the annual production of Canada, the U.S., Mexico and Brazil.”
That supply swing is already having a major impact, as lean hog prices have jumped to $84 per hundredweight, up 58% since Feb. 22. Bronstein observes:
China will be an increasingly aggressive buyer of pork around the world yet is not the only place experiencing the spread of this particular disease. . . China is restricting imports from Vietnam to try and preclude a more aggressive disease spread.
North America, probably thanks to distance and very advanced containment regimens, seems pretty safe now. North America should have an expanding hog population and expanding exports. With cheap feed, it’s a pretty good business to be in.
Recap April 2
A quiet day for stocks saw the S&P 500 test either side of unchanged early before settling into a sideways drift, while Treasurys rebounded from yesterday’s selloff as the 10-year yield dropped three basis points to 2.47%.
Commodities continued their recent rip, as the CRB Index finished at its best level since late November. That move is all the more impressive considering the U.S. Dollar Index also finished green and remains near a 52-week high.
- Philip Grant
Monday, April 1, 2019
Motley Crew
Asset prices are off to the races, as the S&P 500 logged a 13% gain through March 31, the best quarterly showing since the summer of 2009. Credit has likewise marched higher, with the Bloomberg Barclays High Yield Index jumping 7.3%, the steepest quarterly rise since 2003, while the Markit iBoxx Leveraged Loan Total Return Index rose by 4.8% for its best quarter since 2010.
The Fed’s dovish swivel figures prominently in the bull move in credit, as interest rate futures now expect rate cuts instead of further tightening and the “QT” asset run-off is set to end in six months. At the same time, loan defaults reached a seven-year low in March as the post-2009 economic expansion is now three months shy of a record length.
A mismatch between new supply and demand also helps. Junk bond volumes tallied $59 billion in the first quarter, down 5.5% year-over-year and the slowest pace of issuance since 2016. On the loan side, new volume fell to $85.2 billion in the first quarter, down a hefty 68% year-over-year according to data compiled by Bloomberg.
That dearth of supply has further tilted the balance of power in favor of the borrowers. On March 22, the Financial Times reported on the “near-total control” of sellers in the leveraged loan market, a development raising “concerns that a borrower could load up on more debt, extract cash from the company or seek expensive acquisitions.” Even the sharp downdraft seen at the end of 2018 has done little to level the playing field. An unnamed fund manager told the FT that “we were hoping there would be an improvement [in terms for investors] after December’s volatility, but that doesn’t seem to be the case.”
Last Thursday a report from Moody’s Investor Services noted “unprecedented flexibility” on the part of borrowers to make investments free of obligations to maintain certain leverage levels, as well as an “aggressive use of investment capacity” that allows issuers to shift assets beyond creditors’ reach, leaving investors “in uncharted territory.” Indeed, Moody’s determines that 2018 saw the weakest credit agreement protections on record, a fact that bodes ill for recoveries when the cycle turns.
On that score, a prominent cautionary tale finds itself back in the news. On Thursday, the J. Crew Group, Inc. term-loan B fell to 66 from 92 as recently as Oct. 22, 2018, after the fashion retailer reported a full-year adjusted EBITDA decline of more than 50% with cash on hand dropping to $25.7 million at the beginning of February from $107 million a year earlier. The company, taken private in 2011 by Leonard Green & Partners, L.P. and TPG Capital, earned the ire of creditors in 2017 by transferring $250 million worth of intellectual property to a foreign subsidiary (out of the grasp of supposedly-senior bondholders) and then issuing $250 million in fresh debt backed by the same IP.
A slightly different saga featuring private-equity owned PetSmart, Inc. continues to unfold. In April 2017, PetSmart bought online pet supply company Chewy, Inc. for $3.35 billion. Just over a year later, PetSmart transferred a chunk of Chewy’s equity to an unrestricted subsidiary, out of the reach of the company’s creditors. Those jilted bondholders sought legal recourse against PetSmart for alleged “fraudulent” behavior, claiming that PetSmart was already out of compliance with a fixed-charge coverage ratio test. On Thursday, a federal judge ordered the company to turn over documents related to the transfer of Chewy equity. A day later, Bloomberg reported that PetSmart creditors rejected the company’s offer to add new investor protections in return for dropping their litigation. PetSmart’s term loan reached a post-2017 high of 89 cents on the dollar Friday, potentially indicating that the lawsuit is gaining traction.
More recently, the March term loan and senior note offering financing the $10 billion leveraged buyout of Johnson Controls International plc’s car-battery unit represents another measuring stick. After analyzing the senior notes documentation, credit research firm Covenant Review called those covenants “extremely aggressive and containing numerous flaws.” Features that might make creditors cringe include “wildly off-market” compliance calculations that “arbitrarily” exclude various borrowings, as well as a “phony” test that could overlook additional debt used to fund such restricted payments and the ability to “transfer unlimited IP to unrestricted subsidiaries and other entities.” What’s more, so-called add-backs to EBITDA give “the company credit for expected revenues that have not yet been (and may not be) earned.”
As issuers continue to push the envelope, the cycle continues to age. In a March 4 interview with Bloomberg, Carlyn Taylor, global co-leader of corporate finance and restructuring at FTI Consulting, predicted that a spike in defaults is on the way, sooner or later:
The expansion is pretty long in the tooth and there's definitely a lot of buildup. The activity level of restructuring is rising, maybe not at the rate of bankruptcies, but the pipeline of companies we think are going to end up in restructuring, based on metrics that we analyze, that volume has gone up. And we're so busy, which we don't think is just market share, because we think our competitors are also very busy.
Recap April 1
The second quarter started in familiar fashion, as stocks raced higher with the S&P 500 gaining more than 1% and the financials index tacking on nearly 2.5%. Treasury yields likewise ripped higher across the curve, with the 10-year back to 2.5% from less than 2.38% on Wednesday, and commodities also enjoyed a strong rally with the CRB Index gaining 1%. WTI crude finished near $62 a barrel and is up by 42% from the Dec. 24 lows.
- Philip Grant
Friday, March 29, 2019
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq).
Recap March 29
Blocked number
It’s crunch time for the proposed all-stock merger between Sprint Corp. (S on the NYSE) and T-Mobile U.S., Inc. (TMUS on the Nasdaq). Yesterday, Charles Gasparino of Fox Business reported that regulators will begin their “final review” of the pending deal next Thursday, following a three week hiatus in which the Federal Communications Commission heard additional arguments from both sides of the debate.
The Trump administration appears sympathetic to the combination. Gasparino tweeted on Tuesday that T-Mobile and Sprint management were making “headway” on their lobbying efforts, with Department of Justice antitrust chief Makan Delrahim purportedly “open” to allowing the combination of America’s third- and fourth-largest wireless carriers. Back in May 2017, FCC chairman Ajit Pai told listeners at the American Enterprise Institute that the prospective consolidation of national carries to three from four wouldn’t necessarily concern him: “I don’t claim to know in a vacuum what. . . the right number of competitors should be.”
Sprint and T-Mobile have taken an offensive tack of late. On March 18, the Capitol Forum reported that the pair jointly submitted an FCC filing accusing rival Dish Network Corp. and consulting firm The Brattle Group of making “serious false statements” in producing a study “that fabricates harms on low income consumers when none exist.”
Apart from attacking its enemies, Sprint has argued that it must merge with T-Mobile to ensure its viability. On Sprint’s Jan. 28 earnings call, CEO Michel Combes told listeners that: “As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments, and without additional low-band spectrum we will face challenges to provide customers with coverage comparable to that of the big two carriers.”
The effectiveness of that tactic is in question, with Bloomberg reporting yesterday that “some U.S. officials” are “skeptical” of Sprint’s claims “that it won’t be an effective competitor if they block the merger.” One unnamed individual “said Sprint asserted it may eventually run out of cash if the merger fails.” Former FCC wireless bureau chief Fred Campbell went on the record to dub Sprint’s arguments as “relatively weak” and “probably not enough to get a merger through that’s anti-competitive.”
An analysis in the Dec. 23, 2016 edition of Grant’s drew a different conclusion, based on Sprint’s onerous debt burden, stagnant revenues and five straight years of cash burn (more of the same is expected in 2019 and 2020). Research firm MoffettNathanson, LLC concluded in a Jan. 31 report that if the deal is rejected, Sprint’s debt “will likely have to be restructured,” while Bloomberg Industries analyst Stephen Flynn writes today that “Sprint may need financial help from its 84.5% equity owner SoftBank Group Corp.” if the merger is blocked.
Mr. Market has expressed only mild concern about the deal prospects, as Sprint’s senior unsecured 6 7/8 notes due 2028 have ticked below 96 cents on the dollar, compared to above 99 a month ago. Sprint shares likewise trade at a 26% discount to the deal closing price based on T-Mobile stock price. Yet those markdowns pale in comparison to the dual credit and equity swoon in early 2016 when the company’s survival prospects appeared to be in question.
Sprint 6 7/8s of 2028. Source: The Bloomberg
A thumbs-up from federal regulators wouldn’t necessarily signal an all-clear. Dealreporter relayed yesterday that a coalition of 18 state attorneys general led by New York are considering a lawsuit to stop the deal, regardless of the DoJ and FCC’s findings. Bloomberg adds that “there’s some concern among the states that political considerations could be influencing the Justice Department’s decisions on mergers,” with Delrahim’s prior attempt to block the AT&T, Inc./Time Warner, Inc. tie up due to Trump’s “incessant criticism” of CNN one such example.
With the TMUS deal decidedly up in the air, Sprint’s problems could soon become SoftBank’s. In a commentary yesterday, Amir Anvarzadeh of Asymmetric Advisors writes that the state-level opposition and DoJ skepticism over Sprint’s claims of financial hardship as a standalone entity have pushed his forecasted approval odds south of 40%: “None of this is good news for SoftBank, which has been banking on taking Sprint’s $30 billion of net debt and its negative cash flow from its balance sheet.”
Meanwhile, SoftBank, which Grant’s dubbed “the epitome of the cycle” (it wasn’t a compliment) on Dec. 15, 2017, has enjoyed a rollicking rally. Shares have risen 48% year-to-date, as a buyback encompassing more than 10% of shares outstanding and a 32% rise in Alibaba, Inc. (SoftBank owns 29% of BABA) have provided the bullish jet fuel. Anvarzadeh writes that the Sprint saga, along with pricing pressure in SoftBank’s domestic telecom unit, may soon change the narrative: “We think investors should be positioned for these negative catalysts before the buyback program comes to completion.”
Recap March 29
Stocks rose again to leave the S&P 500 with a solid 1% gain for the week and 13% for the quarter (the best such performance since 2009), as Lyft, Inc. shares enjoyed a 9% gain in their first day of trading.
Commodities were also bid, with WTI crude popping back above $60 a barrel. Treasury yields ticked mostly higher across the board, as the 10-year yield rose back above the three-month for the first time since last Thursday.
- Philip Grant
Thursday, March 28, 2019
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G.
Today, the Financial Times reports that Deutsche Bank A.G.
QT progress report
Recap March 28
Prognosis negative
Today, the Financial Times reports that Deutsche Bank A.G. is looking to raise between €3 billion ($3.4 billion) and €10 billion in equity to help consummate the planned merger with peer Commerzbank A.G., “a move designed to end the debate over whether Germany’s largest lender has enough capital.” That sum is not insignificant: The duo combined are worth €23.6 billion. Meanwhile, the FT notes that Deutsche Bank has raised some €30 billion since 2010, twice its standalone market cap.
The Deutsche Bank/Commerzbank saga puts into relief the struggles of Europe’s banks. More broadly, the Euro STOXX Bank Index generated an aggregate 7.51% return-on-equity last year, far behind the 11.82% ROE logged by the U.S. KBW Bank Index. The valuation gap is also substantial, as the Stoxx Bank Index trades at 0.58 times forward 2019 book value, compared to 1.12 times for the KBW U.S. Banking Index.
What gives? Borrowing costs are one key difference. The European Central Bank’s deposit rate has been negative since June 2014, penalizing banks for their reserves, while the Fed Funds rate sits at (positive) 2.4%. The less-than vigorous state of Europe’s financial institutions has gotten the attention of ECB president Mario Draghi. In a Frankfurt speech yesterday, Draghi raised the possibility of providing some assistance to the banks: “If necessary, we need to reflect on possible measures that can preserve the favorable implications of negative rates for the economy, while mitigating the side effects, if any.”
While the outgoing Draghi (his term ends on Oct. 31) didn’t elaborate on what sort of “mitigating” steps the ECB might take, Bloomberg notes that other central banks with sub-zero benchmark rates such as the Bank of Japan and the Swiss National Bank have adopted “a so-called tiering system that excludes most of the reserves commercial banks deposit from the penalty that a negative policy rate imposes.”
Draghi’s potential negative rate workaround has elicited a range of reactions from his fellow functionaries. ECB governing council member Ewald Nowotny told the press in Vienna today he “would like to see a certain mitigation” for the effects of sub-zero rates, terming the SNB’s tiering practice a “nuanced system.” ECB chief economist Peter Praet advocated further study in an interview with Bloomberg today, saying “we need to be convinced that it would address a monetary-policy question in an efficient way.” Dutch central bank governor Klaas Knot is adamantly opposed: “We as policy makers should stay far away from [tiering].” Bloomberg notes that Knot “argued that there’s little proof that banks’ low profits are the result of low interest rates.”
But as the monetary mandarins debate further interventions to minimize the “side effects, if any” of the ongoing negative-rate epoch, one observer argues that the central bankers are missing the point. In a commentary yesterday, Jeffrey Snider of Alhambra Investment Partners wrote that the ECB’s efforts to incentivize credit growth through penalizing idle reserves has backfired, demonstrating the differences between theory and practice:
It all sounds very good on the chalkboard, in the regression analysis of complex yet oversimplified computer models. Give banks reserves and then punish them when they aren’t put to good use; problem solved.
The real world, however, is much more complicated – and in many ways far simpler. Maybe banks don’t want to use reserves because the implications, meaning risks, of doing so are perceived to be consistently much greater than the deposit rate NIRP penalty.
Thus, the real solution would instead be to figure out why banks are perceiving the world this way rather than rejiggering the NIRP nonsense one more time.
Monetary competence does not come easily to the modern central bank. It has morphed into expectations manipulation, which, ironically, requires everyone to believe that it is the most technically capable instrument for policy there is. This is why we are all taught from Econ 101 forward the near infallibility of the central banker, and also why at the very same time through experience and observation we see that’s just not the case.
They really have no idea what they are doing. The ECB is not a collection of newfound doves, they are chickens without their heads. Either way, it does not amount to anything good, and adds more weight to the considerable and growing list of everything bad.
That’s not to say the ECB doesn’t have advocates for more activism. Bjorn Wahlroos, outgoing chairman of Nordea Bank, expressed eagerness for more intervention at a shareholder meeting in Helsinki today. Referencing Draghi’s famous 2012 promise to do “whatever it takes” to defend the Euro, Wahlroos said of the ECB, which carries assets on its balance sheet equivalent to 39% of 2018 Eurozone GDP (compared to the Fed’s 19% of American output): “I call upon the ECB to remember that statement and realize that they haven’t done whatever it takes.” Wahlroos believes that Draghi and co. should once again ramp up asset purchases, “on a scale that will create an upward-sloping yield curve,” in order to ensure that “any idiot who can borrow money can make money.”
QT progress report
The Fed’s portfolio of securities held outright registered at $3.77 trillion, down $6.7 billion from a week ago and $14.5 billion below the trailing four-week average. Mortgage-backed securities accounted for the bulk of this week’s decline, with Federal agency debt securities holdings also dropping by $62 million, the first change for that line item since the second week of June.
Since the fall 2017 commencement of QT, total balance sheet assets are down by 11.2%, for a simple annualized pace of 7.7%.
Recap March 28
Stocks rose a bit, leaving the S&P 500 virtually unchanged over the past two weeks and higher by 12% year-to-date. Treasury yields ticked higher across the board, while the Dollar Index enjoyed a strong rally.
The surging greenback put the crimps on gold, as the Money of Kings dropped nearly 1% to a three-week low of $1,290 an ounce, but the iShares Emerging Markets USD Bond ETF managed to rise to near its best levels of the year. The VIX fell below 14.5.
- Philip Grant
Wednesday, March 27, 2019
Play ball!
A historical quirk in tomorrow’s Opening Day schedule.
A historical quirk in tomorrow’s Opening Day schedule.
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350%
Recap March 27
Play ball!
A historical quirk in tomorrow’s Opening Day schedule. From MLB.com:
The Jacob deGrom-Max Scherzer and Blake Snell-Justin Verlander matchups represent just the third and fourth times the top two finishers in Cy Young voting faced each other the following Opening Day -- and the other two were also in the same year!
On Opening Day 1979, the 1978 winner in the AL (Ron Guidry, Yankees) took on runner-up Mike Caldwell (Brewers), while the reigning NL Cy Young winner (Gaylord Perry, Padres) faced off against Burt Hooton (Dodgers).
Back to the well
This morning, the Turkish offshore lira borrowing rate briefly touched 1,350% and settled at 750%, up from 23% on Friday. The reason for this skyward catapult? A government-manufactured shortage of liras. Today, Bloomberg reports that “some foreign banks were unable to meet their obligations at the close of trading [yesterday], forcing the central bank to extend hours for transferring funds to Turkey to 9 p.m., according to a senior Turkish official, who spoke on condition of anonymity.”
The measures imposed by Turkish President Recep Erdogan’s government have had one desired effect, as the lira has strengthened to 5.35 to the dollar, well ahead of the 5.85 conversion rate seen on Friday. That rebound was cause for celebration within Erdogan’s inner circle. The state-run Anadolu Agency quotes Treasury & Finance Minister Berat Albayrak (and the President’s son-in-law) as taunting the naysayers in Istanbul yesterday evening, asking: “Did we not witness some people claiming that one dollar would rise to eight liras, 15 liras as we head to [Sunday’s] elections? Check your phones and see how much liras to the dollar. Inshallah [God willing], it’ll be better.”
But that modest currency appreciation (the lira was 5.42 to the dollar last week) has come at the expense of other assets. The Borsa Istanbul 100 Index has seen an 8% decline through three sessions this week, including a 5.7% plunge today. The yield on Turkey’s 10-year, dollar pay bonds has jumped to 7.74% from 7.02% a week ago, while five-year sovereign credit default swaps have jumped to 459 basis points from 334 in the past week, approaching the 14-year wides of 575 basis points reached in September.
Meanwhile, the fallout has spread to other emerging market mainstays, as the South African rand fell as much as 1.7% against the dollar to its worst level since Christmas. Henrik Gullberg, currency strategist at Nomura International plc, writes today that “given prohibitively high rates in lira, it looks like the rand’s high external beta makes it the favorite currency to use as a proxy for emerging market risks.”
More broadly, the lira depreciation and sharp upward pressure on Turkish bond yields over the past year has claimed at least one institutional victim. Today, GF Securities Co. disclosed its GTEC Pandion Multi-Strategy Fund SP lost $139 million last year to leave the fund with a negative capital position and prime-broker Citigroup, Inc. holding the bag on “as much as $180 million in losses.” According to Bloomberg, Pandion’s demise “stemmed mainly from trades in the Turkish lira.”
In the Aug. 7, 2015 edition of Grant’s, Russell Napier, independent strategist and founder of the Electronic Research Interchange, suggested that the imposition of Turkish capital controls would spur a broader emerging markets crisis. Grant’s asked Napier today whether Turkey’s decision to effectively prevent investors from withdrawing capital from the country will indeed presage larger-scale trouble:
This is a major step in this direction. It will be something of a test case as to whether one can move to de facto capital controls without de jure capital controls. So, in theory capital moves freely but in practice through de facto state control of the banks, selling lira and buying foreign currency is almost impossible. Most governments have beefed up their tools for 'macro prudential regulation' and I have long argued that these can be used as capital controls.
As an example, if the government of Italy mandates that a certain percentage of Italian bank assets must be committed to Italian government debt then is that a capital control? I would argue it is, but they would say its macro prudential regulation. I have argued that the possible new monetary goal of the Fed is something unlikely to be implementable without de facto capital controls. Yield curve management, through enforced buying of Treasurys on savings institutions, is a firm of capital control and I think something that is necessary given the nature of the new strategic monetary target the Fed is discussing.
I do expect this to spread. Argentina signed a deal for the largest support package in IMF history. Even that has not been enough to stop the currency from falling to an all-time low.
Restricting the free movement of capital was imposed on Cyprus by the European Commission. We need to realize that this is not a policy only likely in emerging markets.
Turkey’s decision to jam overseas borrowing costs skyward has historical precedent. In the fall of 1997 the Hong Kong Monetary Authority took its overnight rate to 280% in a bid to protect a currency peg to the dollar as the Asian financial crisis was getting underway. Napier (who is speaking at the April 9 Grant’s spring conference – advt.), identified some crucial differences between the two situations:
The key to defending an exchange rate is not the interest rates you are prepared to set but the ensuing level of deflation you are prepared to endure. Hong Kong is not a democracy and it had a very sound commercial banking system.
In 1998 the high interest rates led to major declines in both wages and property prices. Commercial bank balance capital was not impaired by that major decline in property prices. The people did not go to the polls to demand action against lower wages as there were no polls to go to. They did not go to the streets either possibly as the PLA had just arrived. I think it is stating the obvious to say that Turkey is no Hong Kong. Hong Kong weathered all that with open capital accounts - Turkey will not.
As mentioned above, Turks turn out to vote this weekend.
Recap March 27
Stocks ticked moderately lower, as ten of eleven S&P 500 sector groups finished red but none by more than 1%, while another feverish rally in the Treasury complex saw the 30-year yield drop to 2.83%, just 43 basis points above the effective Federal Funds Rate.
Commodities came under pressure, with WTI crude and gold falling to $59 a barrel and $1,309 an ounce, respectively, as the Dollar Index enjoyed its fourth green finish in the last five sessions. The VIX edged higher to 15.
- Philip Grant
Tuesday, March 26, 2019
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
On Friday, the Turkish lira plummeted by more than 6% against the dollar.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions.
Recap March 26
TRY hard
On Friday, the Turkish lira plummeted by more than 6% against the dollar. Persistently high inflation, economic retrenchment (fourth quarter GDP fell 3% year-over-year) and dwindling foreign exchange reserves helped set the stage for that mini-panic (Almost Daily Grant’s, March 22), while a J.P. Morgan Chase & Co. analyst call for further lira depreciation likely exacerbated the rout.
Two days later, Turkish President Recep Erdogan warned that investors speculating on a weaker lira would face unpleasant side effects, telling listeners at an Istanbul campaign stop that “If you get involved in provocative acts, saying ‘foreign currencies will strengthen, this will happen, that will happen,’ you will pay a very heavy price.” It didn’t take long for Erdogan’s threats to come to pass. Over the weekend, both the country’s Banking Regulation and Supervision Agency and Capital Markets Board separately announced they were investigating J.P. Morgan.
Turkey also put the clamps down on investors looking to cash out of the local currency. Bloomberg reports today that foreigners seeking to exit their positions “are finding they cannot execute their trades because local lenders are under pressure not to provide liras, according to four bankers who declined to be identified.”
That logjam has helped drive the offshore lira rate to a staggering 367% overnight implied yield today. That’s up from 96% yesterday and 23% Friday.
Turkey’s offshore borrowing rate goes skyward. Source: The Bloomberg
The repressive measures have been moderately successful thus far; as the lira has rallied back to 5.4 per dollar, compared to 5.76 on Friday and 5.42 one week ago. Turkey is holding local elections across the country on Sunday.
Depends where you sit
The hotly anticipated public debut of Lyft, Inc. is drawing a wide range of reactions. Today, The Wall Street Journal reports that the ride-share company is expecting shares to price above the previously indicated range of $62 to $68 thanks to “strong investor demand” on the company’s roadshow. Last week, Reuters relayed that the offering was already oversubscribed by the second day of the investor tour.
With pricing for the deal expected tomorrow, analyst Tom White of D.A. Davidson is looking to get the jump on things. Last week, White gave Lyft its first “buy” rating and applied a $75 price target on the company. In an interview with Bloomberg yesterday, the analyst explained that while he can confidently forecast revenue growth, the other side of the ledger is more difficult to predict:
The expenses side is a little trickier, especially when it comes to the incentives Lyft deploys to attract drivers. They give an overall number, but you don’t understand how much is attracting riders versus drivers.
That’s where the art comes into play. With investing I think there’s an element of science and hard numbers and math, but there’s also a bit of art and creativity that you need to employ as well.
Those waiting for profitability best get themselves comfortable. White expects red ink out to at least 2022, the furthest year in his model.
While investors don’t seem to mind operating losses as far as the eye can see, a different set of Lyft stakeholders is a bit less sanguine. Yesterday, Business Insider reported that the company was forced to move the location of its San Francisco roadshow after protesting drivers blocked the entrance to the Omni Hotel.
Less art, more math. Source: Business Insider
Recap March 26
Stocks finished off their best intraday levels but still managed a solid advance on the S&P 500, with energy taking the lead as WTI crude edged back over $60 a barrel. Commodities performed well as a whole, with the CRB Index rising 0.5% despite the best close for the U.S. Dollar Index in two weeks.
Treasury yields ticked higher across the curve, as the 10-year settled at 2.42%, one basis point above the overnight Fed Funds rate. The VIX lost 9% to fall back below 15.
- Philip Grant
Monday, March 25, 2019
Platform heels
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay:
Turf wars
Earlier today, former Fed chair turned
Earlier today, former Fed chair turned
Private investigations
On Friday, the Securities and Exchange Commission filed suit against private
On Friday, the Securities and Exchange Commission filed suit against private
Recap March 25
Platform heels
The Financial Times’ Alphaville blog relays today that a piece of cyclical history is now available on eBay: The documents for a shelved initial coin offering (ICO) called the “Sponsy blockchain project.” For a starting ask price of $60,000, would-be buyers would receive “thousands of lines of code,” and “industry-leading” software, along with a full set of fundraising documents “designed and approved by investment bankers.”
Alphaville’s Jemima Kelly spoke with Sponsy progenitor Ivan Komar, who lamented the legal advice which hindered the coin launch:
We hired a lawyer and that was a big mistake for us. Because our lawyer basically told us that we should not launch any ICO before we built a real product that might have some users. And I asked him why, because I saw so many ICOs out there who did not have any idea for any product, yet they managed to raise tens of millions of dollars.
We would not have tried to build a product first, we would have tried to run a token sale as soon as possible, to jump into this crypto craze bandwagon, and raise as much money as possible before building any product. And that’s exactly what others were doing.
Komar also observed:
The core business model would run just as well in the centralized world without any tokens or crypto or blockchain... They can easily eliminate the crypto functionality out of this. The core component is a platform — it doesn’t require any crypto or blockchain component to work. Just a typical, centralized server.
As for the auction, no bids have been submitted, yet.
Turf wars
Earlier today, former Fed chair turned distinguished fellow at the Brookings Institution Janet Yellen weighed in on modern monetary theory. Yellen told attendees at a Credit Suisse conference in Hong Kong that she “is not a fan” of the idea that the government can finance its own spending through money printing (with the Fed monetizing the government’s debts) as opposed to taxation.
But while Yellen scorns MMT in name, she endorses something like it in spirit. According to Reuters, Yellen told a group of bankers last Thursday that were the Fed to “reach the limits in terms of purchasing safe assets like longer-term government bonds,” expanded QE covering corporate debt and equities would be an attractive option. Though not currently allowed under federal law, “it could be useful to intervene directly in assets where the prices have a more direct link to spending decisions.”
The Feb. 22 edition of Grant’s examined the relationship between MMT, which is largely dismissed by mainstream economists, and post-2008 monetary machinations, which suffer no such establishment derision:
There’s a refreshing candor in radical polemic. [Economist Stephanie] Kelton et al. want the Fed to print the money and turn it over to the Treasury without the intermediate, Wall Street-fattening step of issuing securities. And for their inquisitive trouble, they are shouted down as crazies.
What’s crazy? Bond-market-destroying negative interest rates, enforced by the central banks, would be one candidate; asset-price-levitating (and society-polarizing) QE, another.
The San Francisco Fed the other day issued an economic report posing the question “How Much Could Negative Rates Have Helped the [Post-2008] Recovery?” The author’s conclusion, in a word: plenty.
Query: Just who’s crazy?
Private investigations
On Friday, the Securities and Exchange Commission filed suit against private, peer-to-peer lender Direct Lending Investments, accusing the firm of systematically overstating returns by 2-3% per annum. The SEC’s move adds another chapter to the Direct Lending saga. In a March 8 analysis of corporate health at this stage in the economic cycle, Grant’s noted the curiously consistent performance of the vehicle before an abrupt end to the proceedings:
A 2017 [Direct Lending] presentation featured performance data that showed an almost unvarying monthly appreciation of a little less than 1%. In 2016, net monthly returns varied by no more than six basis points. In five of those 12 months, investors earned exactly 85 basis points. A splendid, soothing, reassuring achievement it was: “The Fund’s $1 billion portfolio has generated consistent returns,” said the sales documents, not exaggerating. Yet assets under management did not grow.
The default came two weeks ago [investor redemptions were halted on Feb. 11]. Voip Guardian Partners I, the non-payer, represented no less than-one quarter of Direct’s portfolio. According to Bloomberg, Voip lends to small telecommunications companies against the collateral of accounts receivable. The big telecoms pay the small telecoms, the small telecoms pay Voip, and Voip pays direct.
Or did. Unpaid, Direct has run to federal prosecutors. Voip, denying criminality, asserts its financials are “immaculate” and that they have been for the “years” in which its faithfully done business with Direct. Pending clarification of the facts and resolution of the charges, it’s worth recalling that Direct was committed to preserving capital “during a recession.” It seems to have made no representation about the tail end of the corporate credit boom.
Indeed, there appears to be much more to the story than the dispute with Voip. Bloomberg, which reported the lawsuit this morning, also noted that Direct Lending founder Brendan Ross resigned a week ago, after the company “found evidence that the valuations of another investment may have been materially overstated.”
Recap March 25
A quiet day in equities saw the S&P 500 drift sideways in a tight range, while the largest sector-level move was a modest 0.55% gain for consumer discretionary. But the calm stock market contrasts with wild action in rates. Today, another powerful rally took the two-year Treasury yield to 2.25% (it stood at 2.97% in November), while the 10-year yield dropped as low as 2.38% intraday, below the 2.41% effective Fed Funds overnight rate.
Elsewhere, gold caught a bid to rise to $1,322 an ounce, near a one-month high, while a weaker dollar also helped the iShares J.P. Morgan USD Emerging Market Bond ETF recoup most of Friday’s losses. The VIX gave back early gains to remain at 16.5.
- Philip Grant
Friday, March 22, 2019
Still the smartest guys in the room
From The Wall Street Journal:
From The Wall Street Journal:
Salt in the wound
It’s been a smooth ride for third world debtors,
It’s been a smooth ride for third world debtors,
Recap March 22
Still the smartest guys in the room
From The Wall Street Journal:
Former Enron Corp. Chief Executive Jeffrey Skilling is looking to get back into the energy business, with a little help from his friends.
Just weeks after serving more than 12 years in federal custody on fraud, conspiracy and insider-trading convictions following Enron’s fall, Mr. Skilling has been holding meetings with former Enron executives and others, hoping to win backing for a new energy venture, people familiar with the matter said.
At least one former colleague has agreed to support Mr. Skilling’s comeback attempt: Lou L. Pai, the onetime head of Enron’s energy-services unit, has pledged to invest in the venture and indicated to others he is involved with Mr. Skilling, the people said.
Mr. Skilling has met with individuals who specialize in cryptocurrency, blockchain and software development in recent weeks, two of the people said.
Salt in the wound
It’s been a smooth ride for third world debtors, as the iShares J.P. Morgan U.S. Dollar Bond ETF reached a 10-month high Wednesday despite the Dollar Index remaining in the upper end of its 52-week range. Yet Turkey and Argentina, the largest and sixth-largest weightings in the index, respectively, are back in the soup.
Yesterday’s reading of Argentina’s fourth quarter GDP registered an alarming 6.2% year-over-year decline; the worst reading since 2009. As output goes into reverse, inflation accelerates. February CPI rose a whopping 51.28% year-over-year, more than double the 25.44% CPI reading logged in February 2018.
Those grim figures are spurring the government into action. Yesterday, the Central Bank of Argentina raised the policy rate by 87 basis points to 65.76%. On Wednesday, Bloomberg reported that the central bank asked Argentinian bank treasurers to raise their deposit rates, as the 30-day Badlar savings rate of 42.06% lags well behind both the overnight rate and the measured rate of inflation.
Meanwhile, the Argentina single-B-rated, dollar-pay 7 1/8 century bonds due 2117 trade at 75 cents on the dollar (they were issued at 90 cents), for a yield-to-worst of 9.52%. That’s off from the 80 cents seen in early February but above the sub-70 cent lows logged in December.
A relatively strong FX reserve position burnishes the bull case. Argentina’s central bank reported $68.2 billion in international reserves as of yesterday, the highest in at least five years and compared to less than $50 billion three months ago, while the country reached an agreement with the IMF Monday for an additional $10.9 billion in funding. The inviting yield and bountiful reserves aside, history isn’t exactly on the side of the creditors: The Land of Silver has defaulted on its international obligations on eight separate occasions in less than 200 years of modern history (Almost Daily Grant’s, June 19, 2017).
Trouble is likewise reappearing in Turkey. As the lira came under heavy pressure against the dollar this morning, the Central Bank of the Republic of Turkey announced that “considering the developments in financial markets,” it will suspend one-week lira repurchase auctions “for a period of time.” That move did little to stem the lira rout, as the Turkish currency fell more than 6% against the dollar to 5.81, the weakest level since October.
The developments in Turkey’s economy have likewise been grim. Inflation is heating up, with CPI rising 18.7% year-over-year in February, while GDP contracted 3% year-over-year in the fourth quarter. Turkish citizens are hoarding dollars, with central bank data showing that foreign currency holdings among residents rose to a record $175.8 billion as of March 15, up $4 billion in a week.
That rush out of liras is taking a toll. The Turkish central bank reported yesterday that international reserves fell to $28.5 billion as of March 15, down $6.3 billion in the first two weeks of the month. Henrik Gullberg, strategist at Nomura plc. in London, told Bloomberg that there’s only one reasonable explanation for that decline: “Since external debt payments can’t explain the decline in reserves, markets are assuming there is intervention going on.”
The lira’s sharp slide is putting the squeeze to those who borrowed in dollars. The Turkish government dollar-pay 5 3/4s of 2047, issued in May 2017 at 98.25, traded at 77.86 at midday for a yield-to-worst of 7.66%. On the corporate front, Bloomberg reported Wednesday that Turkish conglomerate Dogus Holding A.S., owner of the Nusr-Et steakhouses featuring celebrity chef Nusret Gökce (a.k.a. “Salt Bae”) is struggling to repay its obligations despite restructuring $2.5 billion in debt in December. The company, which has been selling assets, reported TRY 28.6 billion ($4.92) in liabilities at year-end, up 17% year-over-year.
Thanks, but do you have any pepper? “Salt bae” in action.
Two emerging market mainstays may be on the rocks, but hope springs eternal. Today, the Financial Times reports that single-B-rated Ghana’s $3 billion debt sale attracted a whopping $21 billion order book, allowing the West African nation to cut the yield on its 31-year bond to 8.95% from an expected 9.5%. After the rousing success of that sale, Ghana’s deputy finance minister Charles Adu Boahen is thinking big: “I think right now a 50-year bond is very possible but the question is at what price. This is a market-sounding exercise and there’s encouraging appetite.”
Recap March 22
Risk off, bigly. The three-month vs. 10-year Treasury spread inverted today for the first time since 2007, sending a historically unmistakable recession signal (if the inversion remains for 10 days, that is), and triggering a massive rally across the yield curve as the 10-year fell 10 basis points to 2.41%.
Stocks were hammered, with the S&P 500 losing 1.7% and the small-cap Russell 2000 suffering a 3.6% swan-dive. The VIX raced higher by 23% to 16.75, the most elevated weekly close since January. Gold bucked largely bearish commodity action to edge higher by $4 to $1,313 an ounce.
- Philip Grant
Thursday, March 21, 2019
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta.
Yesterday’s Fed meeting featured a dovish trifecta.
Canada goosed
Things are no great shakes in the Great White North.
Things are no great shakes in the Great White North.
QT Progress report
Recap March 21
You're un-fired
Yesterday’s Fed meeting featured a dovish trifecta. The central bank cut its view of 2019 U.S. economic growth, announced the end to “QT” balance sheet runoff in September and suggested that the tightening cycle underway since late 2015 would be put on ice “for some time,” leaving the overnight Fed Funds Rate in a 2.25% to 2.5% range.
This is a big shift from just three months ago when Chairman Jerome Powell proclaimed that “we have a strong forecast for 2019” and to expect “some further gradual [rate] increases” this year. Of QT, Powell remarked: “I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that.” Two days later, Bloomberg reported that President Trump “has discussed firing” the Fed chairman. We can surmise that those discussions have abated in the interim.
Anyway, interest rates swiftly adjusted to the Fed’s new tack. Yields dove across the curve, with the seven-year note trading as low as 2.38% this morning, well below the 2.41% effective Fed funds rate. In addition, the gap between the three-month Treasury bill and the 10-year note flattened to as little as three basis points this morning, the narrowest differential in nearly 12 years.
The spread between the 10-year and three-month yields is an important indicator, James Bianco, president and eponym of Bianco Research LLC notes today. On six occasions over the past 50 years when the three-month yield exceeded that of the 10-year, economic recession invariably followed, commencing an average of 311 days after the initial signal. Bianco concludes that the market, like Trump, believes that the current Funds rate isn’t low enough:
While Powell stressed over and over that the Fed is at “neutral,” . . . the market is saying the rate hike cycle ended last December and the economy will weaken enough for the Fed to see a reason to cut in less than a year.
Canada goosed
Things are no great shakes in the Great White North. After reviewing the latest fiscal budget released yesterday, Fitch Ratings this morning commented that Canada’s gross government debt load “is higher than other triple-A-rated sovereigns, excepting the U.S., and remains close to a level that is incompatible with triple-A status.”
As a spendthrift government spurs rating agency-angst, the Canadian yield curve augurs a different kind of trouble. Today, the Canadian 10-year yield trades at 1.68%, down from 2.6% in the fall and well below the Bank of Canada’s 1.75% overnight funds rate.
Meanwhile, the correction in Canada’s long-running housing bubble continues apace: Statistics Canada reported last week that the new home price index saw its first year-over-year decline since 2009 in January (see the March 5 Almost Daily Grant’s for more).
That news augurs poorly, according to Steve Eisman, portfolio manager at Neuberger Berman who famously shorted mortgage-backed securities in the run-up to the U.S. housing bust and financial crisis. In an interview today in the Financial Times, Eisman reiterated he is short various Canadian banks. While not calling for an outright housing collapse, the manager believes that “a simple normalization of credit that hasn’t happened in 20 years” is nigh.
QT Progress report
An $8.2 sequential decline in mortgage-backed securities left the Fed’s portfolio of securities held outright at $3.78 trillion. That’s down $13.1 billion from the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, total balance sheet assets are down by 11.1%, a 7.6% simple annualized pace.
Recap March 21
No slowdown here. Stocks ripped higher with the S&P 500 gaining more than 1% to finish at its best level since Oct. 10, as tech led the way with a 2.5% advance and a 3.5% gain in the Philadelphia Semiconductor Index to a record close. Treasury yields finished mostly higher after yesterday’s aggressive rally, though the long bond rallied to leave the 30-year yield at 2.96%.
The greenback staged a nice recovery, as the Dollar Index jumped nearly 1% to recoup all of yesterday’s losses. Commodities held up pretty well considering, with the CRB Index losing only 0.1% while gold and WTI crude held near $1,310 an ounce and $60 a barrel, respectively.
- Philip Grant
Tuesday, March 19, 2019
Lyfted
From Reuters:
Lyft, Inc.’s initial public offering is oversubscribed based on commitments made so far by investors, making it more likely that the ride-hailing startup will fetch or even exceed the $23 billion valuation it is seeking, people familiar with the matter said on Tuesday.
The roadshow began yesterday.
Our man in Rio
“Waste places” no more? Emerging market equities have fared well of late, with the MSCI Emerging Market Index rising 14% from its late October lows as the Fed has backed off its rate hike regime and hinted at an imminent end to the QT balance sheet runoff program.
If market expectations are on the beam, more good tidings could be on the way for EMs. According to the latest Bank of America Merrill Lynch Investor Survey, a net 50% of respondents believe the dollar is overvalued, a 16-year high. A weaker greenback of course allows smaller countries to more easily service their largely dollar-denominated debt loads.
Brazil, the fifth-largest constituent in the MSCI gauge, has been at the forefront of the recent bull move. After suffering a 28% dollar-denominated decline from January to September of last year, the benchmark Ibovespa Index has since risen by 48% in dollar terms (when now-President Jair Bolsonaro pulled into the campaign lead shortly after being stabbed), taking the benchmark index above the 100,000 level for the first time yesterday.
There’s more where that came from, according to Bernd Berg, strategist at Woodman Asset Management who anticipated both the real (Brazil’s local currency) selloff of 2015 and asset price rally last fall: “The Brazilian stock rally should accelerate this summer. Pension reform would be a major boost and fresh impetus for a second leg of gains.” Berg sees the Ibovespa rising to 150,000 by the end of next year.
Beyond the possibility of pension reform, bulls can point to the relatively low cost of money, as the benchmark SELIC interest rate remains at a record-low 6.5%, down from 13.75% as recently as January 2017 (the Brazilian Central Bank is expected to leave rates unchanged at tomorrow’s meeting). Inflation remains relatively subdued despite a recent uptick, with the CPI up 3.89% year-over-year in February, well below the 6.17% five-year average reading.
Meanwhile, Brazil looks to solidify economic ties with world powers. Bolsonaro is in the U.S. to meet with Donald Trump today after visiting CIA headquarters on Monday, while economy minister Paulo Guedes told reporters that commerce secretary Wilbur Ross has agreed to visit Brazil, the first such trip in 10 years. That’s not to say the Brazilians are putting all their eggs in a red, white and blue basket. The University of Chicago-educated Guedes said of economic ties with the world’s second-largest economy: “We are dancing with the Chinese, and they dance well.”
But faltering growth presents a risk to the bull case. Yesterday’s release of the IBC-Br Economic Activity Index fell 0.41% on a sequential basis, far worse than the expected 0.1% decline and the third month-over-month drop in the last five readings. On Friday, analysts surveyed by the central bank cut their 2019 GDP growth forecast to 2.01% from 2.28% on March 8 and 2.49% one month ago, while local brokerage XP Securities LLC slashed its own estimated growth level to 1.5% from 2%, noting that “it’s entirely plausible to see 2019 GDP below that” lowered 1.5% figure. Hopes for a growth pickup are abating, says XP, “as cries of a confidence-led expansion get drowned in a sea of poor economic data this quarter.” Declining GDP expectations match last year’s pattern, when the Central Bank-surveyed analysts predicted 2.6% real growth at the outset of the year. Actual 2018 output growth footed to 1.1%.
Then there’s pension reform, crucial to both stabilizing Brazil’s shaky fiscal position as well as bulls’ hopes for higher asset prices. A report from Fitch Ratings on Thursday argues that the measures “will face significant legislative hurdles and is likely to under-deliver on market expectations for long-term fiscal savings.” Analysts at XP also argue that passage will be more drawn out than investors might hope:
Success in the House will not depend on just one vote session, but on successive rounds in which, after the basic text, re¬presentatives will vote on the so-called highlights, themes that will be separated from the rest of the proposal, so they can be voted on individually. This series of voting sessions will be the most critical moments, real tests of strength and en-durance for the negotiating skills of Bol¬sonaro’s government.
It is for this exact reason that we assert that this short proceeding heralded by the government is too optimistic.
An analysis in the Jan. 12, 2018 edition of Grant’s contended that the strong post-2016 rally in Brazilian asset prices, in tandem with rising deficits and limited political will for pension reform, left both local equities and the real vulnerable to a tumble.
An Oct. 5 follow-up said of Bolsonaro and socialist opponent Fernando Haddad: “The question is not, ‘Which of the two candidates is more bullish?’ but rather, ‘Who’s the less bearish?’” One thing’s for sure, policy success is more priced-in than it was six months ago.
Recap March 19
Stocks gave back early gains to leave the S&P 500 unchanged on the day, while Treasury yields ticked slightly higher across the board with the 10-year settling at 2.61%. Modest dollar weakness helped the CRB Index edge into the green, and the VIX closed at 13.56, a one-week high.
- Philip Grant
Monday, March 18, 2019
If you build it they will come?
From The Wall Street Journal:
From The Wall Street Journal:
Racing to a red light
This morning, Lyft, Inc. took another step
This morning, Lyft, Inc. took another step
Recap March 18
If you build it they will come?
From The Wall Street Journal:
The first U.S. exchange company to launch bitcoin futures has pulled the plug on them, the latest sign that mainstream financial firms are losing their enthusiasm for cryptocurrencies.
Cboe Global Markets, Inc. said in a notice to traders last week that it “does not currently intend to list additional XBT futures contracts for trading.” XBT is the symbol for the bitcoin futures listed by Cboe.
Racing to a red light
This morning, Lyft, Inc. took another step towards an initial public offering, disclosing in an amended SEC form S-1 that it will offer 30.8 million shares at a price of between $62 and $68 per share. If priced at the high end of that range, Lyft will garner a total valuation of between $21 billion and $23 billion, according to a Bloomberg report citing a company source.
Projected to debut in the second quarter, Lyft is on pace to beat its fellow ride-share unicorn Uber Technologies, Inc. to the public markets, with Uber expected to file its own IPO paperwork some time in April according to Bloomberg. As Reuters noted on Thursday, being first to market is important to Lyft, as Uber is expected to garner a valuation of as much as $120 billion according to investment bankers, potentially crowding out its smaller rival.
Upstart Lyft’s brisk domestic growth will underpin its marketing strategy to investors, as U.S. market share rose to 39% at year-end 2018, up from 22% in 2016. The company will also emphasize its profile as a pure play on the ride share market, in contrast with Uber, which “plans to portray itself as a global logistics and mobility platform, and will spend less time on metrics specific to its core ride-hailing business,” per Reuters. Back in the fall, Uber CEO Dara Khosrowshahi drew a parallel between his company and Jeff Bezos’ behemoth, telling the Financial Times that “[C]ars are to us what books were to Amazon.” On that score, Khosrowshahi has his work cut out for him.
The Nov. 2 edition of Grant’s included an analysis of just why Uber’s Amazonian ambitions seem far-fetched: Primarily, a lack of profits. Last year, as Lyft’s revenues doubled to $2.2 billion from $1.1 billion, net losses on an adjusted EBITDA basis grew by 36% to $943 million. Uber, which last year generated 43% year-over-year revenue growth and an $11.3 billion top line, reported negative $1.8 billion in adjusted EBITDA, an improvement from the $2.2 billion adjusted EBITDA shortfall in 2017.
Might the passage of time allow the pair to eventually transition into the black? Writing in the Naked Capitalism blog on March 5 following the release of Lyft’s original S-1 filing, transportation expert Hubert Horan concludes that the filing documents provide little comfort:
Lyft’s prospectus provides absolutely no data demonstrating that it has the ability to profitably raise prices over time, increase operational efficiency or win significantly greater market share. It cites “growing the rider base” as the first plank of its future growth strategy, but provides no data showing what it thinks its current share of the market is, no estimates of future aggregate market growth, no evidence of what might drive that growth, and no explanation of what its future growth potential might be. Lyft makes no attempt to lay out a possible path to future profitability, or even a timeline as to when breakeven might be achieved.
With profitability a far-flung hope, the ride-share companies are getting creative. Lyft’s S-1 notes that the company utilizes a bespoke metric called “contribution.” Yes, contribution. Contribution is intended “to evaluate the effectiveness of our business strategies, and to communicate with our board of directors concerning our financial performance.” Unsurprisingly, the results are flattering. The contribution line-item showed a $920 million gain last year, compared to the $943 million adjusted EBITDA loss.
In a Breakingviews post Friday, columnist Richard Beales wrote of that newfound accounting innovation: “It’s a metric that’s supposed to represent a steady-state level of profitability, excluding the costs associated with growth.” But, of course, growth is what investors are paying for. The prospective valuation represents “the kind of eye-watering multiple of sales that only rapidly expanding companies attract. Switching off growth in the foreseeable future, even in return for profit, would knock that down sharply."
As the pair’s IPO preparations continue, one major Uber investor is looking to ensure that things go smoothly. On Wednesday, The Wall Street Journal reported that a SoftBank Group-led consortium “is in late-stage talks to invest $1 billion or more into Uber’s self-driving unit. . . a move that would help the ride-hailing firm bolster its pitch to investors.” Lyft looks to be following a similar script in hopes of showing a good top line this quarter. Recently, some users have received email promotions offering discounts of as much as 50% for 10 rides.
Recap March 18
Another solid day for stocks saw the S&P 500 extend its year-to-date-gains to 13%, as a 1% rip in the Dow Transport Index helped offset a red finish in the tech-heavy NYSE FANG+ Index. Commodities remained strong with the CRB Index making its best close since late November and WTI crude rising to $59 a barrel. Treasury yields rose across the curve with the 10-year ticking back above 2.6%.
- Philip Grant
Friday, March 15, 2019
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE)
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant
The Organization of the Petroleum Exporting Countries struck a vigilant
Recap March 15
There's one for you, 19 for me
On Tuesday evening, beauty products company Coty, Inc. (COTY on the NYSE) issued an alarming press release: “After a periodic review of our tax books and records, Coty now estimates that our pending March 15, 2019 dividend will be classified as a taxable dividend.” What’s more, six prior quarterly dividends paid out since Sept. 14, 2017 that had been designated as tax-free returns of capital have been reclassified as taxable dividends.
COTY shareholders have been inconvenienced but may not mind too much. Shares rose by 1% the day after the disclosure, and are up a cool 67% year-to-date. The short interest stands at just over 15% of the float, according to Bloomberg.
Patch work
The Organization of the Petroleum Exporting Countries struck a vigilant tone in its monthly report released yesterday. Noting a combination of softer-than expected global demand and an uptick in anticipated non-OPEC supply, the cartel urged its members to stick to their quotas: “This highlights the continued shared responsibility of all participating producing countries to avoid a relapse of the imbalance and continue to support oil-market stability in 2019.”
Recent fundamental trends help explain the producers’ concern. The International Energy Agency estimates world oil demand at 99.8 million barrels per day (mbpd) as of Jan. 31, up from 98.8 million year-over-year. Supply growth has outpaced that, reaching 100.4 mbpd at the end of January, up from 97.6 million in the first month of 2018.
Yet energy prices have enjoyed a solid rebound, recouping nearly half of the plunge seen in the fourth quarter with West Texas Intermediate crude rising 27% this year to $58 a barrel.
The OPEC (and Russian) supply cuts agreed to in December, in tandem with involuntary, politically-driven Venezuelan export declines, have already made an impact. Total OPEC production footed to 30.5 mbpd as of Feb. 28, down from over 33 mbpd as recently as November. Stateside, production growth continues apace, standing at a near-record 12 mbpd as of March 8, according to the Department of Energy. But the increased production hasn’t translated into much excess supply: U.S. inventories stand at 44.9 million barrels, just over the five-year average of 43.9 million.
Meanwhile, the Kingdom of Saudi Arabia, OPEC’s biggest swing producer, has slashed production to 10.1 mbpd in February from 11.1 mbpd three months ago. The Saudis were whipsawed last fall by President Trump’s decision to issue broad waivers to previously announced Iranian sanctions, leaving the market in oversupply. Mohammad Darwazah, director at Medley Global Advisors, tells Bloomberg that the Saudis are now less inclined to listen to Trump’s exhortations for lower prices: “We’re going to see quite a different Saudi Arabia maybe than what we saw in the fall. I don’t think they’re going to be as accommodative.”
Domestic demand has been solid. Colin Fenton, managing partner at BlackLight Research LLC, notes in a report Monday that the crucial PADD 3 region covering the U.S. Gulf Coast saw runs (meaning refiner demand) at 8.6 mbpd in the week ending March 1, “916,000 bpd above the cyclical average, by our math.” The Midwest PADD 2 region saw 3.5 mbpd that same week, 54,000 bpd above Blacklight’s cyclical average.
More broadly, there is good reason to expect that the IEA’s demand forecast of 100.6 mbpd in 2019 will be upgraded. “Please remember that the IEA has now revised its demand projection higher in seven of the last eight years, by 1.2 mbpd on average,” notes Leigh Goehring and Adam Rozencwajg, the eponyms of natural resource investment firm Goehring and Rozencwajg Associates. The pair “don’t expect 2019 to be any different.”
Grant’s, continuing to cast our analytical lot with BlackLight, Goehring and Rozencwajg in a bullish stance on energy prices, last fall identified a quartet of cheap companies that, we believe, offer attractive investment propositions. For more, see the Nov. 30 issue.
Recap March 15
Another strong day in stocks wrapped up a great week for the bulls, as the S&P 500 rose nearly 3% to close to within 4% of the all-time highs reached Sept. 20. By comparison, the tech- and momentum-heavy NYSE FANG+ Index sits 15% below its June high water mark.
Elsewhere, a weaker dollar helped commodities erase early losses, while Treasurys rallied again with the 10-year yield falling to 2.58%, its lowest in ten weeks. The VIX fell for a fourth time in five tries for its first sub-13 finish since October.
- Philip Grant
Thursday, March 14, 2019
All politics are local
From the New York Post:
From the New York Post:
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle,
A report today from Frances Coppola of Forbes identifies a subtle,
QT Progress report
Recap March 14
All politics are local
From the New York Post:
The new honorary mayor of Fair Haven, Vermont — a 3-year-old goat named Lincoln — was officially sworn into office this week. Lincoln was dressed in a sash reading “Mayor” for the Tuesday ceremony at the Fair Haven town offices.
Fair Haven, a town of about 2,500 along the border with New York just west of Rutland, does not have an actual mayor. Town Manager Joseph Gunter says the honorary pet mayor idea was conceived as a fundraiser for a playground, but it turned into a civics lesson for kids.
On the way out of the office, the honorary mayor defecated on the floor — leaving clean-up to the police chief and other attendees.
Tethered to what again?
A report today from Frances Coppola of Forbes identifies a subtle, yet significant, development in the Tether cryptocurrency saga. Tether, which has long claimed to be backed on a one-for-one basis with U.S. dollars, is a crucial mechanism for the easy conversion of fiat currency to cryptos and back again, as digital exchanges do not have access to the U.S. banking system. The purportedly dollar-backed crypto was part of a skeptical Grant’s analysis in the Sept. 8, 2017 edition subheadlined: “Tethered to what?”
As noted by Coppola, seemingly minor recent changes to language on the Tether website could carry major implications for the crypto realm. Whereas the front page had claimed that the company’s reserves were “subject to frequent professional audits,” that language was subsequently switched to “professional verifications.” A second revision removed any reference to outside oversight, instead telling website visitors that “reserve holdings are published daily” and that “all tethers in circulation always match our reserves.”
In addition, the site had claimed that tethers were “always backed one-to-one, by traditional currency held in our reserves.” An addendum, which appeared to take place on Feb. 26 (found using the Internet Archive’s “Wayback Machine”), now broadens the definition of “100% backed” to cover not only currency and cash equivalents but potentially also “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.”
As Tether gives itself rhetorical breathing room, a Silicon Valley heavyweight lurks. In December, Bloomberg reported that Facebook, Inc. (FB on the Nasdaq) is working to launch its own “stablecoin,” or dollar-backed crypto, that will allow users to transfer funds via the WhatsApp encrypted messaging service.
That potential development is rife with possibility. Barclays analyst Ross Sandler estimated in a report Monday that such a foray into payments could translate into as much as $19 billion in revenue, with a $3 billion top-line boost as the base case (for reference, FB reported $55.8 billion in revenue for 2018). Sandler believes that “merely establishing this revenue stream starts to change the story for Facebook shares in our view.”
One potential problem with this scenario: Cryptos are something of a regulatory black hole, with anti-money laundering and “know your customer” regulations likely factoring in to Wells Fargo’s spring 2017 decision to cut ties with exchange Bitfinex and Tether (the two companies share a management team). Such stablecoins present even greater risk, as the dollar link provides regulators even more incentive to investigate potential violations. Were such “Facebookcoins” (or, perhaps, “Zuckerbucks”) found to be used for nefarious purposes such as terrorism, money laundering or disguised campaign funding, the political target on Facebook’s back would grow even larger.
QT Progress report
No change this week, as the Fed’s portfolio of securities outright holds at $3.786 trillion, with Treasurys accounting for just under 58% of the total, unchanged from six weeks ago.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 10.9%, for a 7.6% simple annualized pace of decline.
Recap March 14
Stocks drifted sideways, with the S&P 500 consolidating its steep rally to remain in the green by 2.5% for the week. The dollar caught a bid and commodities finished flat, with WTI crude advancing to $58.50 a barrel while gold tumbled back below $1,300 an ounce. Treasury yields generally finished little changed, though strength at the front end and softness in longer issues left the curve a bit steeper. The VIX fell to 13.27, its lowest close since Oct. 3.
After the close, Facebook announced that Christopher Cox, chief product officer since 2014 is leaving the company. FB shares ticked lower by 1.7% in extended hours trading.
- Philip Grant
Wednesday, March 13, 2019
Patent pending
A new chapter in financial innovation.
A new chapter in financial innovation.
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated
An analysis from S&P’s LCD unit yesterday calculated
Recap March 13
Patent pending
A new chapter in financial innovation. From Barron’s yesterday:
Salt Financial, an exchange-traded fund shop with less than two years under its belt, filed on Tuesday to launch an ETF that will actually pay investors for investing in it, at least at the start. The negative-fee ETF is finally here, making online lender Social Financial or SoFi’s zero-fee ETFs old news.
Like SoFi’s zero-fee ETFs, Salt’s ETF will effectively zero out the cost and then some via what is called a management fee waiver. Salt’s investment advisor has pledged to add 0.05% [five basis points] of assets to the ETF, but only on the first $100 million in assets or until April 30, 2020. Once the ETF crosses that level or hits that date, it will charge its true fee of 29 basis points.
Negative-fee investment products may be the hot new thing, but a more familiar, if equally confounding, phenomenon persists: Lenders paying borrowers for taking their money. After falling below $6 trillion last year, the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index has seen its market capitalization jump back above $9 trillion. On the authority of Sidney Homer and Richard Sylla, negative interest rates had not been seen in substantial size during 3,000 years of financial history prior to this cycle.
Market cap of the Bloomberg Barclays Global Aggregate Negative Yielding Debt Index. Source: The Bloomberg
Arc of the covenant
An analysis from S&P’s LCD unit yesterday calculated that the trailing 12-month default rate for leveraged loans has fallen to just 0.93%, down from 1.62% in February and from a long-term average of 3.1%. The sharp sequential decline is the result of iHeartMedia, Inc., which defaulted last March, being removed from the trailing 12-month calculation.
The low default rate provides another enticement to lend and borrow. LCD reports that institutional loans outstanding in the U.S. now total a record $1.17 trillion, up from $1 trillion last May. Across the U.S. and Europe, total term loans outstanding have doubled in the last 10 years to $2.65 trillion, according to the Bank for International Settlements.
That breakneck growth pace is making regulators nervous. Last Thursday, the Financial Times reported that the Financial Stability Board is investigating components of the leveraged loan market, particularly the practice of bundling loans into collateralized loan obligations (according to LCD, CLOs now account for 50% to 60% of U.S. leveraged loans). On Feb. 28, Bloomberg reported that Japan’s Financial Services Agency has been questioning local lenders about their CLO concentration, particularly Norinchukin Bank, which itself holds a nearly $62 billion CLO portfolio (roughly 9% of global supply) and bought one-third of all U.S. and European issuance in the fourth quarter (Almost Daily Grant’s, Feb. 21).
A Sept. 7 cautionary Grant’s CLO analysis, noting that the securities are divided into tranches based on risk profile and recovery potential, called attention to the acute cyclical risks that reside in the lower-rated and higher-yielding tranches:
It’s not quite true that a CLO is only as good as its loans. What is true is that a portion of a CLO is only as good as its loans, that portion being the junior one, equity and mezzanine debt. Deterioration in the quality of late-boom debt puts those segments at risk.
Late-boom conditions are on full display. Yesterday brought word that Moody’s covenant quality indicator reached a record-worst in February, eclipsing the prior nadir set in August 2015. The deterioration is comprehensive, as the agency notes that “weak covenant packages are clearing the market in all rating categories.”
Meanwhile, high profile deals continue to push the envelope. Yesterday, Bloomberg reported that a $10 billion loan and bond syndication financing Brookfield Asset Management, Inc. and Caisse de dépôt et placement du Québec’s leveraged buyout of Johnson Controls International plc is attracting strong bidding interest, “even after Xtract Research categorized its covenants, terms that protect investors, as some of the weakest and ‘most aggressive’ the firm’s analysts have seen.” Yield indications are now below initial guidance, even though some investors “had balked in particular at terms related to how easily the company can pay itself dividends.”
Recap March 13
Another solid rally in stocks pushed the S&P 500 to its best close since Nov. 7, up 12% year-to-date. Commodities fared even better, with the broad CRB ripping more than 1.1%, as WTI crude and gold rose to finish above $58 a barrel and $1,310 an ounce, respectively. Treasury yields rose slightly to snap the recent rally, while high yield was bid with equities and investment grade trading a bit lower with rates.
- Philip Grant
Tuesday, March 12, 2019
Drumroll
Confusion reigns down Mexico way. This morning, deputy finance minister Arturo Herrera told the Financial Times that the MXN 48 billion ($2.5 billion) Dos Bocas oil refinery project would be put on hold, instead using those funds to help state-owned Petroleos Mexicanos (Pemex) burnish its long-flagging oil production. But president Andrés Manuel López Obrador (AMLO for short) contradicted that assertion just hours later, stating that the refinery project will move ahead as planned. That proclamation helped spur a whipsaw in the Mexican peso, which had rallied nearly 1% against the greenback following Herrera’s claim in the FT.
Communication breakdowns aside, the Mexican government has loosened the purse strings to aid Pemex. On Feb. 15, AMLO announced a MXN 107 billion ($5.5 billion) bailout package, including tax relief and $1.3 billion in direct recapitalization to the state-owned enterprise, promising that “if more is needed, we’ll allocate more funds.” More state monies are likely on the way, according to remarks from finance minister Carlos Urzua on Friday, although he noted the timeline remains fluid: “I think in March. We still don’t know exactly.”
One thing’s for sure – Pemex can use the help. Between 2008 and 2017, the company spent $77.4 billion more on capital expenditures than it generated in cash flow from operations (non-Spanish speakers looking for full 2018 results are hindered by the non-working condition of the company’s English-language website). Meanwhile, production remains in persistent decline, with output falling to a record low 1.62 million barrels per day in January, less than half of the 3.4 million barrels per day peak achieved in 2004.
While production shrinks and losses mount, the debt pile keeps growing, with total borrowings at $106 billion on top of $66 billion in pension liabilities. The rating agencies are concerned: Fitch issued a two-notch ratings downgrade, to triple-B-minus (one notch above junk) on Jan. 29. S&P cited the oil giant’s precarious finances as rationale for lowering Mexico’s sovereign rating outlook to negative on March 1, noting the “added burden” placed on Pemex by AMLOs populist energy policies that include the planned Dos Bocas refinery discussed today. In a Feb. 29 report, Moody’s called attention to the implications of Pemex’s struggles on Mexico’s sovereign credit profile: “If market sentiment does not improve, Pemex will require additional sovereign support in 2020 and beyond, further eroding government finances.”
By way of response, the president placed the blame on past administrations, complaining that the rating agencies “are punishing the country for the neoliberal policies implemented over the last 36 years, which were a total failure. Especially the last few years [predecessor Enrique Peña Nieto opened the oil and gas industry to private exploration in 2014].” On the bright side, AMLO continues to enjoy popular support, with a Reforma poll of 1,500 adults conducted between Feb. 28 and March 6 finding that 78% of respondents approve his performance.
But will investors share that enthusiasm? Following the February bailout, Fitch noted that that $5.5 billion bailout falls well short of the agencies’ estimated $12 billion to $17 billion of annual cash requirements needed to arrest production declines and pay down debt. Shamaila Khan, head of emerging markets at AllianceBernstein tells the FT that: “I don’t think Pemex can cling to investment grade much longer unless the government takes drastic action – and the government thinks it is taking drastic action. That’s what’s concerning.”
Grant’s issued its own bearish verdict on Pemex and Mexican sovereign credit in the March 23, 2018 edition, noting the not-insubstantial risk that the flagging oil company’s debts may one day become the liabilities of the government. That analysis included a blunt assessment from John Padilla, partner and managing director of energy consulting firm IPD Latin America: “Pemex, in any private sector context, would absolutely be considered bankrupt.”
The bond market is still optimistic, as the senior unsecured 4 7/8% notes due 2024 trade at 97.25 cents on the dollar to yield 5.53% a 312 basis point premium over Treasurys. That’s down from 101 to yield 4.7% and 199 basis point pickup last year, but well above the recent trading lows of 92 cents on the dollar reached last fall. Longer-term credits have reacted a bit more, with the senior unsecured 6 3/4% notes of 2047 now trading just below 91 cents on the dollar, down from 99 last March.
Recap March 12
Stocks built off yesterday’s strong rally with the S&P 500 extending the week’s gains to nearly 2% and come within a few ticks of the 2019 closing high, while a softer greenback helped commodities as gold pushed back above $1,300 an ounce.
Treasurys were likewise strongly bid as yields fell across the curve, with a brisk 10-year auction this afternoon helping the benchmark rate close at 2.61%, breaking out of a narrow six-week trading range. The VIX finished below 14 for the first time in more than a week.
- Philip Grant
Monday, March 11, 2019
To everything there is a season
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy
Recap March 11
To everything there is a season
From KDKA in Pittsburgh:
A man is behind bars at the Allegheny County Jail after accusations that he choked another man for singing Christmas songs [this morning].
Bag of chips
This morning, Nvidia Corp. (NVDA on the Nasdaq) announced it will buy peer Mellanox Technologies Ltd. (MLNX on the Nasdaq) for $6.34 billion in cash. Mellanox, a chipmaker specializing in data center transmission and storage, has been a hot commodity, as a bidding war began in late January with a reported $5.5 billion approach from Intel Corp. Investors approved, with NVDA shares jumping 7%.
To bag its prize, Nvidia will pay just under six times trailing revenue and 57 times trailing adjusted EBITDA, though Mellanox’s EBITDA is expected to rise to $488 million this year, nearly double 2018’s $251 million figure. The $125 per share bid represents a 53% premium to MLNX’s Jan. 29 close. The deal is subject to regulatory approval in China, which famously helped scuttle the planned $44 billion 2018 combination between Qualcomm, Inc. and NXP Semiconductors N.V.
For Nvidia, the target offers the welcome prospect of diversification. The company’s core business has faltered of late, as the crypto boom that generated brisk demand for NVDA’s graphics-processing units (GPUs) has gone the way of the dodo. Analyst William Stein of SunTrust Robinson Humphrey writes today that “investors may view [the deal] as a defensive mechanism to offset current weakness in both gaming and datacenter sales,” while Rosenblatt Securities’ Hans Mosesmann notes that competitive factors loomed large: “Nvidia may have calculated that Mellanox as part of Intel would have hindered Nvidia’s long term growth rate.”
After more than doubling revenues and nearly quadrupling adjusted EBITDA (to $11.7 billion and $4.1 billion, respectively) in the three years ended Jan. 27, Nvidia has seen a sharp reversal in its fortunes. This year, sales and adjusted EBITDA are currently projected to decline to $11.2 billion and $3.5 billion, as the company has twice been forced to cut guidance since November. Mr. Market has reacted accordingly, with NVDA shares falling by 32% since June 29, compared to a 2% gain from the Nasdaq 100 Index.
NVDA five-year price chart. Source: The Bloomberg
A bearish June 29 Nvidia analysis in the pages of Grant’s argued that the bursting of the crypto bubble would deliver operating disappointment well beyond market expectation, while the virtuous cycle seen through 2017 of rising crypto prices and strong demand for high-end GPU’s from digital miners would be replaced by reciprocal weakness.
Before the crypto bubble, the demand for high-performance memory boards varied with the quality of new video game releases. Perhaps it will again. Falling crypto prices, by denting the returns to digital mining, have also dampened the demand for high-end GPUs.
The crypto bust has left Nvidia with a surplus of product. Inventories footed to $1.58 billion as of Jan. 27, nearly doubling year-over-year from $796 million. According to a report last Wednesday from Monica Chen and Joseph Tsai of Digitimes, liquidation efforts are now underway:
With the dissipation of the cryptocurrency mining fad, graphics card players have begun cutting product prices in a bid to clear out excess inventory at the expense of profitability, according to industry sources.
Although Nvidia, AMD and graphics card vendors are expected to see rising revenues, profits will be unsatisfactory and may even be halved from previous high levels. The inventory digestion process may not end until mid- to late-2019, the sources noted.
Recap March 11
It was a big day for the bulls, as stocks ripped to the tune of a 1.5% gain in the S&P 500, a near 2% advance in the Dow Transports and small cap Russell 2000 indices, and a 3% rip in the tech-heavy NYSE FANG+ Index to erase the bulk of last week’s declines. Commodities finished generally higher with WTI crude settling at $57 a barrel, and the VIX fell more than 10% to finish below 14.5.
Treasury yields ticked slightly higher across the curve, continuing the recently rangebound trading in rates. Since late January, the 10-year yield has remained between 2.76% and 2.63%, closing today at 2.64%.
- Philip Grant
Friday, March 8, 2019
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Set your DVR’s. From The Hill:
China check
Choose your own adventure
Blues brothers, 2019 edition
Set your DVR’s. From The Hill:
Federal Reserve Chairman Jerome Powell will appear on Sunday’s episode of “60 Minutes” for an interview on interest rates, the outlook for the U.S. economy and financial system cybersecurity risks, CBS announced Thursday. Powell was interviewed by Scott Pelley in Washington, D.C., this week, CBS said, and will appear beside his predecessors, former Fed chairs Ben Bernanke and Janet Yellen.
They’re on a mission alright.
China check
Earlier today, the Shanghai Composite Index plunged by 4.4%, the biggest one-day loss since November, as CITIC Securities Co.’s application of a rarely-seen “sell” rating on People’s Insurance Company (Group) of China Ltd. “was widely interpreted as a sign that the government wants [the recent] surge in Chinese stocks to slow down,” according to Bloomberg.
Perhaps more ominously for both China and the rest of the world, February exports from the Middle Kingdom were horrible, falling 20.7% year-over-year, compared to an expected 5% decline. It’s not just exports, as February auto sales crumbled by 18.5% from a year ago to 1.19 million units, the eighth consecutive drop.
Choose your own adventure
A pair of earnings releases you don’t see every day:
Fort Lauderdale, Fla.-based National Beverage Corp. (FIZZ on the Nasdaq), producer of the popular LaCroix soft drinks, reported fiscal third quarter results well short of expectations on both the top and bottom line. Shares fell by 20% at midday to extend the post-August decline to 53%.
CEO Nick A. Caporella broke the news to investors in style at least, via a press release titled: ‘”We Just Love our LaCroix,’ Consumers Chant.” Caporella went on to expound:
We are truly sorry for these results stated above. Negligence nor mismanagement nor woeful acts of God were not the reasons – much of this was the result of injustice!
Managing a brand is not so different from caring for someone who becomes handicapped. Brands do not see or hear, so they are at the mercy of their owners or care providers who must preserve the dignity and special character that the brand exemplifies. It is important that LaCroix’s true character is not devalued intentionally − in any way.
National Beverage Corp. is and will remain the preeminent innovator that adds zest and authenticity to the ‘sparkling water’ phenomenon in North America.
Meanwhile, Camping World Holdings, Inc. (CWH on the NYSE), which counts television personality Marcus Lemonis as CEO, issued its own fiscal fourth quarter figures yesterday. The press release was a study in suspenseful delivery, as the fourth bullet point on page one read:
Adjusted EBITDA was $312.5 million; and
We can fill in the blank: “down 21.7% year-over-year.” CWH shares lost more than 5% in early trading today.
That pair of notable releases follows Monday’s effort from Anheuser-Busch InBev S.A./N.V., (ABI:BB and BUD on the NYSE) which, though relatively lacking in entertainment value, did provide a study in confusion.
While dollar denominated revenues and “normalized” operating earnings fell year-over-year, the company reported “organic” growth figures of 5.3% and 12.4%, respectively, for those line items. A 100 basis point contraction in gross margins was reported as a 40 basis point shrinkage on an “organic” basis.
Drink organic: AB InBev fourth quarter press release
Thursday, March 7, 2019
Bottoms up
This morning, the European Central Bank cut its guesstimate
This morning, the European Central Bank cut its guesstimate
Product 19
A paper today from the Brookings Institution
A paper today from the Brookings Institution
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors
QT Progress report
Recap March 7
Bottoms up
This morning, the European Central Bank cut its guesstimate for 2019 GDP growth to 1.1% from 1.7%. In response to the bleaker expected growth, ECB president Mario Draghi once again pivoted towards easier monetary policy, reviving the “Targeted Longer-Term Refinancing Operations,” a lending program with favorable interest rates designed to prop up the Old Continent’s frail banking system, less than three months after wrapping up an aggressive asset purchase program (Almost Daily Grant’s, Feb. 28). “Super Mario” also made it known that the negative 40 basis point deposit rate which has been in place since March 2016 isn’t to blame, stating that negative rates “have been very successful for the ECB and were a powerful instrument in fostering a recovery.”
Instead, Draghi ascribed the latest bout of economic pain to outside forces, particularly “the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” With introspection in short supply in Frankfurt, Mr. Market picked up the slack, as the Stoxx E.U. Banks Index sank by 3.3% in reaction. The Index trades at 0.59 book value, less than half of the 1.26 times book value commanded by the KBW U.S. Banking Index.
Monetary policy, Homer Simpson style
The beatings will continue until morale improves.
Product 19
A paper today from the Brookings Institution put widely-held skepticism over China’s gross domestic product figures into quantitative terms. Researchers from the Chinese University of Hong Kong and the University of Chicago re-estimated The Middle Kingdom’s output growth from 2008 to 2016 using “several local economic indicators that are less likely to be manipulated by local governments to measure local and aggregate GDP.”
The analysis concluded that actual GDP growth over that period lagged officially reported statistics by 1.7% per annum. If the Brookings researchers are on the beam, that would reduce China’s year-end 2016 GDP by some 16%. Continuing to extrapolate a 1.7% GDP shortfall through 2018 leaves last year’s Chinese GDP at RMB 71.7 trillion, far below the RMB 90 trillion reported.
While China’s output is under question, the debt remains. The ratio of total banking assets to reported GDP stood at 297% in 2018. Under the Brookings-tabulated GDP methodology, that ratio expands to 374%. By comparison, U.S. banking assets stood at $17.9 trillion at year-end, or 86% of GDP.
Les Miz'
Yesterday, Japan’s Mizuho Financial Group, Inc. surprised investors with JPY 680 billion ($6.1 billion) worth of charges related to business restructurings in its securities portfolio, including losses on “past investments in foreign bonds.” The write-offs led the bank to cut its full-year net income forecast by 86%. Mizuho CEO Tatsufumi Sakai, who will forfeit performance-related pay as a result of the losses, told investors that the bank has subsequently cut “negative carry” exposure on its portfolio of overseas credits.
Mizuho’s pain is instructive. As the Bank of Japan continues its long-running experiment with negative interest rates, Japanese institutions went abroad in search of income. Tokyo-based Morningstar, Inc. analyst Michael Makdad explains:
There are lots and lots of deposits and not enough loans, so Japanese banks have had the incentive to go outside. Certainly the BoJ policy in place now for many years to keep rates extremely low – absolutely it’s a contribution.
Indeed, Makdad reports that Japanese lenders hold an aggregate of JPY 142 trillion in foreign bonds, up from JPY 48 trillion in March 2009. That’s an 11.8% compound annual growth rate.
Meanwhile, the BoJ plans its next monetary machinations. On Feb. 22, BoJ governor Haruhiko Kuroda told the Asahi newspaper that the central bank would “of course” consider additional stimulus should inflation continue to disappoint relative to the central bank’s 2% target. In January, CPI grew by 0.2% year-over-year.
QT Progress report
A $6.7 billion sequential decline left the Fed’s portfolio of securities held outright at $3.785 trillion, with Treasury securities accounting for all of this week’s portfolio runoff. Today’s figure is $27.3 billion below the trailing four-week moving average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.92%, at a 7.7% simple annualized pace.
Recap March 7
Risk is creeping back into the picture, as the S&P 500 fell for a fourth straight day to leave the broad index red by nearly 2% for the week. Treasurys were sharply bid across the curve as the 10-year yield fell to 2.65%, and the Dollar Index spiked to its highest finish since June 2017.
Commodities managed to hold up pretty well considering, as the CRB Index fell modestly while WTI crude inched higher to $56.50 and gold held at $1,285 an ounce. The VIX rose above 16.5.
- Philip Grant
Tuesday, March 5, 2019
Deep freeze
Yesterday, the Real Estate Board of Greater Vancouver reported February results that could be classified as ghastly, with residential home sales plummeting 32.8% year-over-year to 1,484 units. That’s the lowest February sales total since 1985 and 42.5% below the 10-year average. Prices have also broken lower, with the composite index sinking by 6.1% year-over-year. In addition, inventories have jumped, with total listings in metro Vancouver up to 11,590 homes at month end. That’s up 48.2% from February 2018.
Toronto, Canada’s largest city, has held up better, with February prices rising 1.6% year-over-year, while new listings dropped 6.2% to outpace the 2.4% decline in sales. Nevertheless, TREB president Gurcharan Bhaura asked for regulatory relief from the mortgage stress test mandated by the Office of the Superintendent of Financial Institutions. These subject borrowers to the greater of the five-year benchmark rate or the contracted mortgage rate plus 200 basis points (Almost Daily Grant’s, May 31):
The OSFI mandated mortgage stress test has left some buyers on the sidelines who have struggled to qualify for the type of home they want to buy. The stress test should be reviewed and consideration should be given to bringing back 30 year amortizations for federally insured mortgages. There is a federal budget and election on the horizon. It will be interesting to see what policy measures are announced to help with home ownership affordability.
On the score of home affordability, there is certainly room for improvement. According to Demographia’s International Affordability Survey for 2019, Toronto ranked 294th out of 309 metropolitan housing markets, with a median house price of 8.3 times median annual gross pre-tax household income, up from 7.9 times year-over-year. For context, the United States national median multiple registers at 3.5 times, while the organization designates anything beyond 5.1 times to be “severely unaffordable.” Vancouver puts Toronto in the shade, ranked second to last by Demographia (only Hong Kong is more expensive) with a median multiple of 12.6 times.
As Canada’s long-running housing bull market teeters, economic data continue to disappoint. Friday’s release of fourth quarter GDP showed annualized growth of just 0.4%, well below the 2% third quarter reading and the 1% consensus expectation, while December retail sales fell by 0.5% ex-automobiles, also worse than the expected 0.3% decline. M2 money supply growth registered 4.99% in December, down from 5.83% year-over-year and 8.65% in the final month of 2016.
Perhaps most importantly, total residential mortgage growth fell to just 3.1% year-over-year in December, the worst monthly reading since May 2001. That last data point may be especially concerning for Canada’s banks: Craig Fehr, investment strategist at Edward Jones & Co., told Bloomberg that the mortgages are, “in many cases, the largest and most profitable and steady of the businesses that these banks operate.” Fehr concludes: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.”
Early indications bear that out, as a trio (the Bank of Nova Scotia, Toronto-Dominion Bank and Canadian Imperial Bank of Commerce, or CIBC) of Canada’s five largest banks reported earnings shortfalls in the quarter ended Jan. 31. Increased credit losses figured in two of those reports, with Toronto-Dominion raising its loan loss provision to C$850 million ($645 million), up 23% year-over-year. CIBC’s provision for credit losses jumped to C$338 million, more than double last year’s C$153 million and well above the expected C$258.5 million.
CIBC CFO Kevin Glass told Bloomberg that “three big” non-performing loans across different sectors hurt the bank’s credit portfolio, while asserting that the jump “is certainly not representative of any sign of underlying problem.”
Glass may not be worried, but an extended housing downturn may cause CIBC particular discomfort. For more, see the Feb. 9, 2018 edition of Grant’s.
In other news from formerly-booming housing markets, yesterday The Australian reported that Queensland-based bank Suncorp Group Ltd. warned that some investors in an A$120 million ($85 million) residential mortgage bond may not be repaid. The problem: An increase in borrowers at least 60 days past due on their mortgages to above 3% of the loan pool has triggered a clause prioritizing senior claims holders, potentially diverting principal repayment from those farther down the creditor food chain.
Meanwhile, Australian new auto sales fell by 9.3% year-over-year in February, the eleventh straight decline. On Feb. 21, Fitch Ratings reported that Australian prime auto loan asset-backed securities in arrears rose to a record high in the fourth quarter, with loans past due more than 30 and 60 days rising to 2.05% and 1.03%, respectively. That compares to a five year net loss rate of 0.51%.
Recap March 5
Stocks mostly cruised sideways with the S&P 500 remaining in a tight range, though the Dow Transports Index broke lower late in the session to finish red for an eighth straight day. Nevertheless, the transport index is up 12.5% year-to-date, topping the S&P’s 11% gain for 2019 so far.
Treasury yields finished little changed, though the long end was modestly bid and short yields ticked a bit higher to leave the curve flatter. The VIX remained at 15, and gold managed to inch higher and snap a four-session losing streak.
- Philip Grant
Monday, March 4, 2019
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
On Thursday, global beer behemoth Anheuser-Busch InBev S.A.
Recap March 4
Head for the mountains
On Thursday, global beer behemoth Anheuser-Busch InBev S.A. (ABI:BB in Brussels and BUD on the NYSE) reported solid fourth quarter results. Bullish highlights included 5.3% and 10% year-over-year growth in revenues and EBITDA, respectively (those figures are self-reported “organic growth” across a range of currencies; in U.S. dollar terms, sales and EBITDA both fell), as strong pricing growth helped burnish a meager 0.3% uptick in volumes. In addition, company management pledged to continue paying down a hefty debt burden, with CEO Carlos Brito reiterating his expectation of a leverage ratio below four times by the end of 2019, compared to 4.6 times, by management’s reckoning, as of Dec. 31.
Mr. Market approved, as ABI shares jumped by nearly 5%. But strong fourth quarter aside, its been no picnic, as shares have fallen by 21% since Feb. 9, 2018 (the S&P 500 has gained 8% over that period) while the 3.65% dollar pay bonds due 2026 have seen their spread over Treasurys widen to 120 basis points from 75.
Reaction among the sell-side tended towards relief more than exuberance, with last week’s disastrous earnings report from fellow 3G Capital, Inc. investee Kraft Heinz Co. weighing on sentiment. James Edwardes Jones of RBC notes that North American operations were “less bad than expected,” while Citi’s Simon Hales wrote that while the fourth quarter did “not demonstrate a material improvement in volume growth. . . it should mark the inflection point after a prolonged period of downgrades.” Yet overall analyst expectations for 2019 continue to march lower:
Down and to the right. Chart of 2019 adjusted EPS consensus. Source: The Bloomberg
Ample leverage and 3G ownership are not the only similarities between AB InBev and Kraft Heinz. Secular difficulties in the form of changing consumer tastes is another, unwelcome roadblock for the pair. A Friday report from Bloomberg, citing data from IWSR, noted that American beer consumption has declined by 2.8% since 2015, despite a near 15% uptick in craft beer sales during that period. The increasing prominence of cannabis as an alternative intoxicant also presents a risk: A study conducted by professors in the U.S. and Peru found that between 2006 and 2015, overall alcohol sales declined by nearly 15% in states that have legalized medical marijuana.
Secular pressures aside, much of ABI’s current predicament is traceable to the October 2016 acquisition of SABMiller plc. for $65 billion, at a princely 18 times EBTIDA. The resulting influx of debt led to the company cutting its dividend by 50% on Oct. 25. Moody’s downgraded Anheuser-Busch’s credit rating to Baa1 from A3 in December. Even so, ABI’s leverage ratio towers above the 2.5 times EBITDA carried by (also Baa1 rated) global peer Heineken N.V.
At the same time, there is little to show for that expensive SAB deal thus far. Free cash flow is expected to register at $10.9 billion this year, hardly improved from 2012’s $10 billion, while net debt has ballooned to $110 billion from $35 billion during that period.
Even ABI management’s current reckoning appears optimistic, as the 4.6 times leverage ratio cited on the conference call omits a $12 billion working capital deficit. For instance, vendor financing remains on the upswing: Accounts payable footed to 274 days of turnover at year-end, up from 180 days in 2012. By comparison, Heineken’s balance sheet shows 216 days’ worth of payables.
Grant’s Feb. 9, 2018 bearish analysis of Anheuser-Busch argued that the company’s heavy debt load and struggles with changing consumer tastes presented problems not yet reflected in the company’s bonds:
As for us, we judge that there is a good chance of operational disappointment, therefore of ratings disappointment. As the market is seemingly willing to admit no possibilities but happy ones, downside risks are palpable.
Recap March 4
A sharp mid-day decline shook stocks from their recent inertia, though a late rebound narrowed the S&P 500’s loss to 0.4% and left the broad index just above its Dec. 3 close.
Treasurys were bid with the long end outperforming to push the curve flatter, as the 10-year yield settled at 2.73%. WTI crude rallied back to $56.5 a barrel while gold continued its slide, settling at $1,286 an ounce to extend its post-Feb. 19 selloff to 4%. The VIX jumped as high as 17 intraday, before finishing at 14.5.
- Philip Grant
Friday, March 1, 2019
Property tax
Everything must go. Yesterday, Chinese state media website The Paper quoted Hui Ka Yan, chairman of real estate developer China Evergrande Group (3333 on the Hong Kong exchange), urging his employees to ramp up efforts to sell homes, authorizing 10% price discounts on all properties to do so.
That’s one way to do it: Analysts are expecting Evergrande to generate RMB 574 billion ($85 billion) in revenues this year, nearly double 2017’s RMB 311 billion top line. Meanwhile, the company’s contract sales in January fell to RMB 43.2 billion, down 33% year-over-year (Grant’s, June 2, 2017).
Cooking with gas
On Wednesday, kitchen equipment producer Middleby Corp. (MIDD on the Nasdaq) reported year-over-year net sales and EPS growth of 21% and 26%, respectively, in the fourth quarter, easily beating consensus expectations. The company also announced it will acquire the Cooking Solutions Group from Standex Corp. (SXI on the NYSE) for $105 million. Shares rallied 5% in response, but it’s been tougher going of late for a stock that managed a 1,260% appreciation from year-end 2008 to mid-2016. Since a bearish Grant’s analysis on June 17, 2016, MIDD shares are up 6%, compared to a 30% rise in the S&P 500.
Acquisitions have helped fuel the growth spurt. Unrated MIDD has made 24 deals since the beginning of 2015 (more than one per quarter, on average), headlined by the $1 billion cash purchase of equipment concern the Taylor Company in May.
The add-ons drove top-line growth (revenue decreased 0.8% year-over-year when backing out acquisitions and currency swings) but have also helped push Middleby’s leverage ratio to over three times consensus 2019 EBITDA, from less than 1.5 times at year-end 2016. At the same time, the company is increasingly dependent on the restaurant industry, as the commercial foodservice unit chipped in 63.5% of 2018 sales. That’s up from 59.2% and 55.9% in 2017 and 2016, respectively. The food processing and residential kitchen divisions accounted for 14.3% and 22.2% of total revenues.
Restaurant sales have been soft, with research firm TDn2K reporting a 1.12% industry traffic decline in the three months ended Jan. 31, while the franchisees that purchase MIDD’s wares face declining profits and rising labor costs, as well as franchisor demands to undertake expensive store remodels. Nevertheless, Elgin, Ill.-based Middleby (founded in 1888), has thrived. The company has grown revenues and adjusted EBITDA to $2.7 billion and $563 million, respectively, in 2018, up from $1.8 billion and $392 million in 2015. The sell-side expects more of the same, with six buy ratings, three holds and zero sells. With that bullishness comes high expectations: projected 2019 free cash flow is expected to jump to $433 million from $333 million a year ago.
Meanwhile, margins are under pressure, with gross profits representing 36.9% of sales in 2018, down from 39.1% year-over-year and 42.1% in 2016. Asked about the waning profitability, brand new CEO Timothy FitzGerald, replacement for longtime boss Selim Bassoul (who retired, effective immediately, on Feb. 19) struck a hopeful tone noting that integrating a host of new businesses presents its problems:
I don't know off the top of my head exactly how many acquisitions, but we've had quite a few in the last two to three years. So certainly, there's a lot of heavy lifting that happens in year one but then there's continued fine tuning that happens in second and third years, as you kind of really move into higher fruit on the tree. So we do expect. . . that we’ll move the margins for the businesses forward as we go through the year.
Middleby’s roll-up business model presents other pitfalls for investors beyond rising debt and shrinking margins. The June 2016 Grant’s analysis zeroed in on the company’s use of so-called purchase accounting, noting the potential for results to appear stronger than they actually are:
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.
Sure enough, the “goodwill and other intangibles” line-item continues to bulge, reaching a balance of $1.74 billion at year-end 2018. That’s up from $1.26 billion year-over-year, and $1.09 billion in 2016.
Recap March 1
Stocks caught a bid, with the S&P 500 rising 0.7% to finish the week in positive territory, as the energy sector led the way higher despite pressure on prices as WTI crude slipped back below $56 a barrel. Commodities traded broadly lower with gold sinking to $1,291 an ounce, while the Dollar Index rose.
Treasurys continued their recent weakness as yields jumped across the curve, leaving the 10-year at 2.74% and the long bond at 3.14%, its highest since mid-December. The VIX took another tumble, falling to 13.5 and testing its lowest since the early-October stock market break.
- Philip Grant
Thursday, February 28, 2019
Hundred Dollar General
From CNBC:
From CNBC:
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times
QT Progress report
Recap Feb. 28
Hundred Dollar General
From CNBC:
The amount of $100 bills in circulation is surging. And it’s leaving some economists scratching their heads. The number of outstanding U.S. $100 bills has doubled since the financial crisis, with more than 12 billion of them across the world, according to the latest data from the Federal Reserve.
C-notes have passed $1 bills in circulation, Deutsche Bank chief international economist Torsten Slok said in a note to clients this week.
Trudge report
“Eurozone slowdown helps keep Draghi’s dissenters in line,” declares a headline in today’s Financial Times. The catalyst: Recent comments from Bundesbank president and European Central Bank governing council member Jens Weidmann acknowledging ongoing economic softness in Europe’s largest economy. No need to lift those rates, notes the FT, which breathes a journalistic sigh of relief for Mario Draghi, who has to spend so much of his precious time “trying to curtail sniping from the sidelines by policy hawks.”
So it goes on the Old Continent, where Draghi’s balance sheet has grown to 39% of GDP, twice the relative size of the Fed’s, and where the overnight rate rests at negative 0.4% (it first settled there in March 2016); the benchmark rate has remained below zero since June 2014.
Weak data points, including flat sequential German fourth quarter GDP, a surprise contraction in December factory orders and eight straight months of declining economic sentiment across the eurozone, plausibly argue for the status quo. Other factors do too: Succession at the ECB is unclear as Draghi’s term ends on Oct. 31, while political risk is on the upswing, evidenced by growing discord between Italy and other member states as well as popular discontent movements like France’s Gilets Jaunes.
Thus, the negative-rate epoch drags on and on. According to analysts at Bank of America, some $11 trillion worth of sovereign debt is priced to yield less than zero, up 21% from October and not so far off the $13 trillion peak logged in 2016.
The resurgence of such financial anomalies (historians Sidney Homer and Richard Sylla find that substantial volumes of negative-yielding notes had never been seen in 3,000 years of financial history prior to this cycle) has even some members of the ECB concerned. Of those negative yields, governing council member Francois Villeroy de Galhau was quoted as saying on Wednesday:
If maintained for too long, they could weigh negatively on the profitability of financial intermediation with possible adverse consequences for the smooth transmission of monetary policy.
Four years and counting aren’t long enough, apparently. An analysis in the April 6, 2018 edition of Grant’s (“Let the ECB pay you”) noted the realistic potential for the central bank to enter the next recession with rates already in negative territory. But how can investors, deprived of income by these monetary machinations, profit from the ECB’s demonstrated willingness to do “whatever it takes”, for however long it takes?
Deputy editor Evan Lorenz identified interbank lending rates as a potentially attractive investment proposition. In particular, the three-month Euribor futures contract expiring on March 2020 then traded at 99.88, implying a future rate of positive 0.12%. That compared to the negative 0.33% Euribor rate on offer at publication time, as expectations of so-called policy normalization were then widespread.
Lorenz observed that if Euribor remained unchanged through that March 20 expiration, the 100.125 strike call option would deliver a 183% return, with additional upside possible were the ECB forced to further cut rates during that period. Since publication time, that contract has rallied to 100.21, or an imputed negative 0.21% Euribor rate in March of next year. That compares to negative 0.31% currently.
March 2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
QT Progress report
The Fed’s portfolio of securities held outright registered at $3.792 trillion this week, down $6.7 billion from a week ago. Mortgage-backed securities accounted for almost all of the sequential decline, while Treasurys represented roughly two-thirds of the $33.6 billion drop compared to the trailing four-week average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets are down by 10.8%, for a simple annualized pace of 7.74%.
Recap Feb. 28
Stocks turned a bit lower, snapping three days of consolidation as the S&P 500 finished at a one-week low. Treasury yields ticked higher across the board with the belly (middle) of the curve seeing additional pressure, leaving the 10-year yield at 2.72%.
Commodities finished slightly weaker with gold retreating to $1,312 an ounce, and the VIX remained below 15.
- Philip Grant
Wednesday, February 27, 2019
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and
Recap Feb. 27
T-leaves
The moment of truth draws closer for Sprint Corp. (S on the NYSE) and T-Mobile US, Inc. (TMUS on the Nasdaq). The pair, America’s fourth- and third-largest wireless carriers, respectively, agreed to merge on April 29, 2018 and now await regulatory approval with an initial projected closing date just over four months away.
The credit markets have already given the deal a thumbs up. S&P’s LCD unit reported yesterday that Sprint managed to raise a $900 million term loan, upsized from an initial $400 million, at a smaller-than-expected issuer discount. Meanwhile, the Sprint 6 7/8s senior notes of 2028 have lifted above 99 cents on the dollar from 94.5 in early April (both the bonds and stock rallied into the deal announcement) narrowing the spread over Treasurys to 439 basis points from 510. During that period, the spread on the Bloomberg Barclays High Yield Index has widened to 387 basis points from just under 350.
Classically, bond investors, who stand to gain nothing more than the return of their principal with interest, are a conservative bunch, ever-cognizant of risk. Benjamin Graham and David Dodd’s Security Analysis notes that “bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”
Anyway, for single-B-rated Sprint, which is saddled with an extensive debt load as well as stagnant revenue growth and persistently negative free cash flow (Grant’s, Dec. 23, 2016), the stakes are high indeed. Deal approval could mean a nice payoff for creditors, with analysts at Bloomberg Intelligence estimating that those 6 7/8 senior notes would see nearly 200 basis points of spread tightening in the event of a green light from Uncle Sam.
The stock market is also optimistic, as market-implied odds of deal approval sit just above 50% based on the respective trading levels of each stock, under the assumption that Sprint shares would return to their early-April price of $5.18 a share if the merger is scuttled (Sprint trades at $6.35 a share, while T-Mobile’s all-stock bid is currently worth $7.40). Based on T-Mobile’s current share price, approval would likewise suggest a 17% gain for Sprint shareholders.
The CEOs of both companies have utilized differing tactics with an eye toward swaying regulators. Sprint boss Michel Combes painted a grim picture of his company’s standalone prospects on the most recent earnings call (Almost Daily Grant’s, Feb. 1), while T-Mobile CEO John Legere maintained his typically upbeat persona in a blog post Friday:
We have had some amazing discussions and the regulators we’ve talked with continue to impress me. Their process is thorough, and that is great news for us – because we have a lot to share!
The great news is things are moving forward positively! We now have approval from 16 of the 19 needed state utility commissions, which is a huge step forward. . . Despite what others may want you to think, we’ve made steady progress – and we remain confident that we’re going to see regulatory approval, as planned, in the first half of this year!
Some observers are less than sanguine, however. On Monday, The Capitol Forum reported that T-Mobile and Sprint’s pro-approval arguments “have yet to win over the staffs of competition enforcers and telecommunications regulators.” The prospective decline in national carriers to three from four, an absence of tangible consumer benefits like improved service prior to 2021 and the likelihood of higher prices count among the regulators “grave” concerns. The Forum notes that “time is running out for T-Mobile and Sprint to persuade Justice Department staff, which is preparing a recommendation for senior department officials.”
Even a green light from Washington wouldn’t mean the merger is in the clear. In a note Sunday, New Street Research relayed that state attorneys general have hired an unnamed “leading antitrust economist” to help conduct an investigation of the proposed tie-up, a development which is “certainly cause for concern” for deal advocates. More broadly, the state AGs present a “material risk” to the deal’s closing, per New Street.
A thumbs down from federal or state regulators could deal significant pain to Sprint investors beyond a reversal to early April prices, as a Jan. 31 analysis from MoffettNathanson, LLC concluded that if the deal is rejected, Sprint’s debt “will likely have to be restructured.” Investors in SoftBank Group Corp., (Grant’s, Nov. 30) which owns 84.5% of Sprint’s equity, are likewise exposed to regulatory whim: A return to the early 2016 trading levels for S shares would equate to a loss of roughly 12% of SoftBank’s total market capitalization.
Recap Feb. 27
Consolidation continues, as stocks shook off early losses to finish unchanged for a third straight day on the S&P 500 to leave the broad index near the highs for the year. Commodities caught a strong bid, with WTI crude pushing back to $57 a barrel while gold bucked the bullish trend to finish at $1,320 per ounce.
Treasury yields rose with another round of widening seen at the back end of the curve; the 30-year long bond finished the day at 3.07%, a one-month high.
- Philip Grant
Tuesday, February 26, 2019
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
A trio of Sonic Corp. restaurants in central Ohio closed abruptly
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
It’s not just U.S. equities that have enjoyed a blistering start to 2019.
Recap Feb. 26
Tip your waitress
A trio of Sonic Corp. restaurants in central Ohio closed abruptly over the weekend after employees quit en masse. At each location, the departing staff displayed some less-than polite messages for management on their way out the door.
What spurred the worker walkout? Local news site the Scioto Post reports:
One anonymous source close to management stated: “Circleville, Lancaster, and Grove City crews have all walked out and quit after the franchise was bought out by corporate. The regional director, two district managers and four general managers have all been let go. All of which have been working for the company in management for 7+ years.”
According to sources close to the situation, part of the dispute stems from pay cuts forced onto employees who saw wages reduced from at or near-minimum wage to a tipped employee wages at approximately $4.00/hr.
In December, Inspire Brands, Inc., a division of private-equity firm Roark Capital Group, acquired Sonic for $2.3 billion, or more than 15 times trailing EBITDA.
For a wide-ranging look at the troubles plaguing the restaurant industry, see the Feb. 8 edition of Grant’s.
Climate change
It’s not just U.S. equities that have enjoyed a blistering start to 2019. China’s broad CSI 300 Index ripped higher by 5.8% on Monday, which marks the biggest one-day gain in three years and brings the year-to-date advance to 22%. Mr. Market displayed particular enthusiasm towards the financial sector: Bloomberg notes that all 30 Shanghai- and Shenzhen-listed stocks that feature the word “securities” in their corporate title finished higher by the 10% daily limit yesterday.
The recent bull stampede can be chalked up to “substantial progress” on trade according to both Donald Trump and Xinhua News Agency, as well as to a friendly policy turn from Beijing. On Saturday, President-for-life Xi Jinping called for “strengthening the countercyclical adjustment of fiscal policy and monetary policy [to ensure] that the economy operates in a reasonable range.” Yesterday, Wang Zhaoxing, vice chairman of China’s Banking Regulatory Commission, declared that the Middle Kingdom’s deleveraging campaign has already achieved its goals.
With deleveraging apparently complete, re-leveraging begins anew. Thus, the People’s Bank of China reports that new aggregate financing footed to RMB 4.6 trillion in January, up 51% year-over-year. Meanwhile, Chinese margin debt outstanding has jumped by more than 8% in the last two weeks, according to the China Securities Finance Corporation, while research firm PY Standard reports that local banks increased issuance in so-called wealth-management products by 22% year-over-year in January.
The latest round of stimulus is having an impact, but will it be enough? Many corporations are already listing under the unwelcome combination of a pronounced economic slowdown (last year saw the slowest pace of real GDP growth since 1990) in tandem with stifling debt burdens. A Jan. 23 report from UBS Group A.G. found that work-out investors acquired RMB 1.75 trillion in bad debt last year, the busiest for distressed debt in two decades.
Back in December, Yu Liang, chairman of China Vanke Co. (the country’s second largest real estate developer) told employees that China’s housing market faces the prospect of an extended slump, commenting that “we need to ensure survival first, and then quality development,” according to a speech released yesterday on the company’s WeChat page.
In a Feb. 18 commentary, Anne Stevenson-Yang, co-founder of J Capital Research, wrote that while Beijing’s recent exertions have helped the banks, the reflation efforts seen in January are insufficient to stem the broad deterioration in financial conditions. If the powers-that-be hope to avoid a painful (and perhaps politically perilous) economic reckoning, they will be forced to double down:
It will take much more: The culture at Chinese banks has changed, and, if authorities really want bankers to lend, they must change incentives. Thus far, they have been unwilling to do that.
The structural problem, Stevenson-Yang relates, is that banks are obliged to increase financing efforts, while simultaneously facing scrutiny of their loan quality.
That means that China’s economy will likely continue in decline, until the tide of corporate and financial defaults swells to the point where authorities feel they have no choice but to launch a truly gargantuan stimulus, greater than the RMB 6.4 trillion in stimulus monies issued in 2016.
Recap Feb. 26
Stocks drifted sideways to finish virtually unchanged, with the VIX also cruising through a low-key session to again settle just below 15. Commodities and the dollar both ticked slightly lower.
Treasury yields traded lower across the curve, but recent moves have been far from lockstep. While the spread between five- and 30-year bonds has widened to 56 basis points from about 20 basis points in July, the short end remains inverted with the two-year yield residing four basis points above the five-year. Back in July, the two- and five-year spread also stood at (positive) 20 basis points.
- Philip Grant
Monday, February 25, 2019
Musical chairs
This morning, Barrick Gold Corp. (ABX on the TSX) announced it will launch a $17.8 billion all-stock bid for Colorado-based rival Newmont Mining Corp. (NEM on the NYSE), continuing the 2019 mining merger wave. Recall on Jan. 2, Barrick completed a no-premium, $5.4 billion takeover of South Africa’s Rangold Resources Ltd. Two weeks later, Newmont bid $12.6 billion in cash and stock for peer Goldcorp, Inc., which was 16% above the target’s closing price (Almost Daily Grant’s, Jan. 14).
The proposed Barrick-Newmont tie-up, which would take place in lieu of Newmont’s Goldcorp bid, would create the world’s largest gold miner by far, but Mr. Market wasn’t particularly impressed. NEM shares traded lower by 1%, while ABX sank by 3%.
Unsurprisingly, Newmont management is reluctant to accept Barrick’s terms, which were offered “at the market” and implied a slight discount to NEM’s closing price on Friday. NEM issued a press release this morning arguing that the planned Goldcorp merger offers superior value creation for its shareholders, noting that a prior internal analysis of Barrick “determined that Barrick’s risk and return profile is inferior on many fronts, including factoring Barrick’s comparatively ineffective operating model, poor track record on delivering shareholder returns and unfavorable jurisdictional risk.”
In an interview on Friday, after Barrick had publicly expressed interest in a deal, Newmont CEO Gary Goldberg pulled no punches: “It’s a desperate and bizarre attempt to muddle up our [Goldcorp] deal. And it’s certainly not the sort of behavior that will appeal to investors who want to invest in serious, well-run companies.”
Mark Bristow, former CEO of Rangold and current Barrick boss, shared his perspective in a Jan. 2 interview with Bloomberg: “[The] industry, if it had carried on the way it was, was going to become irrelevant, [with] too few assets with too many management teams and it needs reorganization.”
The matter at hand for investors: Will a wave of corporate consolidation help streamline production, increase operational efficiency and pave the way for higher share prices? Or do the low- or zero-premium prices being bid for these large mining assets foreshadow more disappointing days ahead?
Grant’s today put the question to John Hathaway, the co-manager of the Tocqueville Gold Fund, who anticipated a wave of industry consolidation at the Spring 2018 Grant’s conference. Hathaway believes that the proposed Barrick-Newmont combo faces an uphill battle, as “its hard to see where the value creation is coming from” in a $42 billion merger of equals while “the gold mining industry doesn’t necessarily lend itself to that kind of scale.”
Indeed, the longtime gold investor sees a substantial valuation gap between the mega players and smaller, sometimes single-asset miners. To that end Hathaway has co-founded a new investment venture named the Sprott Hathaway Special Situations Fund, designed to capitalize on the sudden thirst for deal-making.
Hathaway notes that the current market price of gold is about 35% below the cost to discover and extract the yellow metal, making it cheaper to mine for gold assets on Wall Street than underground. The fund will be a concentrated one, with position sizes of as much as 10% of total assets, while the new venture will have some attractive options from which to choose. Hathaway relays that some potential targets are currently valued at as little as three times (growing) EBITDA. The Sprott Hathaway fund will target smaller operators (i.e., no Barricks or Newmonts to be found), some of which do business in less-than ideal geographical jurisdictions. Nevertheless, that political risk can be more readily absorbed in an acquirer’s larger asset portfolio.
Recap Feb. 25
Stocks gave back the bulk of early gains but still managed a green finish on the S&P 500, leaving the broad index at 2019 closing highs for a second straight session and within 5% of the record finish logged on Sept. 20. That late selloff did coincide with a 10% spike in the VIX to leave the volatility indicator just under 15.
Elsewhere, a Trump tweet from this morning complaining about high oil prices helped send the energy complex sharply lower with WTI crude finishing near $55 a barrel, while Treasury yields ticked slightly higher across the curve.
- Philip Grant
Friday, February 22, 2019
Smothered
Cleanup in aisle four. Yesterday evening, longtime Grant’s pick-not-to-click Kraft Heinz Co. (KHC on the Nasdaq) reported fourth quarter results that could safely be described as calamitous. Net sales grew by a feeble 0.7% year-over-year, while EBITDA collapsed by 13.9%. Management guidance of another double digit slide in EBITDA in the first quarter adds to KHC’s woes, as does newly-revealed regulatory scrutiny and asset impairment charges. In response, shares suffered a 28% swan-dive to an all-time low, dragging down the S&P Packaged Foods Index to the tune of 4.5%.
With revenue stagnating, profitability on the wane and a hefty debt load of 4.5 times consensus 2019 adjusted EBITDA, balance sheet remedies are now in order. KHC announced a 36% dividend cut, to 40 cents a share per quarter, while CEO Bernardo Vieira Hees suggested the company will pursue additional asset sales after having disposed of its Heinz India and Canadian cheese businesses in the fall of 2018. Nevertheless, Standard and Poor’s placed triple-B-rated Kraft Heinz on negative watch today.
But poor operating results were just part of the problem. The company disclosed receipt of a subpoena from the SEC in October related to “an investigation into. . . the Company’s accounting policies, procedures and internal controls related to its procurement function.” Kraft Heinz took a $25 million charge for the period as a result, a figure management deemed immaterial both in the press release and subsequent conference call. So immaterial, in fact, that the C-suite declined to make note of the subpoena in either its Nov. 1 third-quarter press release or in the form 10-Q released the next day.
Perhaps the most significant problem: A $15.4 billion noncash write-down of goodwill assets related to domestic and Canadian business lines, as well as intangible assets such as the Kraft and Oscar Meyer trademarks. The writedowns are not important by themselves; they are, of course, non-cash. Rather, they tell us about management’s expectations about future profits, i.e., they will be lower. This was confirmed by CFO David Knopf on Thursday’s call.
KHC price chart from spring 2016. Source: The Bloomberg
To say the least, the Kraft Heinz business model of industry consolidation, ferocious cost cutting and focus on delivering high margins has reaped some less than welcome side effects. As growth in the packaged-foods industry remains anemic at best, KHC’s focus on maintaining “industry-leading margins” (a phrase repeated frequently during yesterday’s call) has manifested in brand erosion.
Grant’s produced its first analysis of KHC on March 25, 2016 (“Sell big food,” available here), followed by an equally bearish judgement on March 24, 2017 (“Price War for Warren Buffett,” available here). In a Feb. 23, 2018 follow-up, deputy editor Evan Lorenz noted that the company’s prioritizing of certain brands at the expense of others presented the potential for unwelcome surprises:
So, how should we assess Kraft Heinz’s ability to manage an operating business, apart from slashing its costs. “[T]he Heinz brand in the United States is now 17% bigger than it was in 2015,” CEO Bernardo Vieira Hees not¬ed of a key success on the Feb. 16 call, “which is a good example of the process we are going through with each cat¬egory.” The growth in the Heinz brand is part of KHC’s focus on big bets—on concentrating ad and innovation dollars on a few brands and product categories that management believes hold the most promise.
To put Heinz’s growth in context, overall organic sales in the United States fell by 0.3% in 2016 and by 1.5% in 2017. This implies that non-Heinz-branded sales contracted substantially over the past two years. Kraft Heinz owns 33 brands that reap $100 million or more in revenues. By focusing on a few designated winners rather than the overall portfolio, the company runs the risk of eroding the equity of its smaller brands. Neglected, the step-children may disappoint.
Whither the roll-up strategy? While Hees indicated that asset sales are on tap during the call, the CEO told the Financial Times just two days ago that industry valuations “are much more attractive than before.” On the call, Hees once again displayed an acquisitive mindset, stating that divestitures would merely set the stage for the next corporate shopping spree:
Our decision here is to execute the strategy on deleveraging faster, so we can better position the company for future consolidation.
The recent plunge begs the question of how KHC’s A-list investor roster will respond. Brazilian private equity shop 3G Capital and Berkshire Hathaway, Inc. bought H.J. Heinz Co. in 2013 and Kraft Foods Group, Inc. two years later. Last August, 3G sold 20.6 million shares of KHC (just under 2% of current shares outstanding), lowering their stake to 22%.
Might Warren Buffett ride to the rescue? Yesterday, The Wall Street Journal noted that Berkshire Hathaway, which already owns 27% of Kraft Heinz, boasted a cash balance of $103.6 billion as of Sept. 30 and has not completed a major acquisition since buying Precision Castparts Corp. for $32 billion in early 2016. Beleaguered KHC bulls won’t have to wait long for hints at the Oracle of Omaha’s next move: The annual Berkshire Hathaway letter is set to be released tomorrow.
Recap Feb. 22
Another equity bid pushed the S&P 500 back to a 2019 closing high, up 0.6% for the holiday-shortened week. Gold and oil both managed to finish a bit higher with a flat greenback, and Treasurys were stronger across the board to leave the 10-year yield at 2.65%.
It wasn’t just KHC that suffered rude treatment in a rising market. Stamps.com, Inc. (STMP on the Nasdaq) was shellacked by 58% after the company disclosed the termination of its partnership with the United States Postal Service. For a detailed rundown of the bear case in STMP, see the April 6, 2017 edition of the Grant’s Current Yield podcast with short seller extraordinaire Marc Cohodes.
- Philip Grant
Thursday, February 21, 2019
Loan ranger
On Tuesday, both the Financial Times and The Wall Street Journal ran stories highlighting the prominent presence of Japan’s Norinchukin Bank in the market for collateralized loan obligations, or CLOs. The Journal notes that the bank (Nochu for short), which was founded in 1923 as a collective for farmers and fisherman, holds a $62 billion CLO portfolio, nearly 9% of the roughly $700 billion in global outstanding supply. Nochu (whose English-language website prominently features the phrase “dedicated to sustaining all life”) added some $10 billion, roughly one-third of all U.S. and European issuance during the fourth quarter.
The FT reports that Nochu almost exclusively purchases triple-A-rated CLO tranches (in contrast to lower rated and higher yielding tranches), while also adhering to strict limits on accumulating so-called covenant-light debt, which carries limited legal protection for investors if trouble strikes. Nochu’s constrained appetite for covenant-light debt can lead to its own difficulties, as reporters Robert Smith and Leo Lewis note that “as nearly every new loan is ‘covenant-light’. . . Nochu’s stipulation can force CLO managers to buy the very riskiest loans, which still have covenants.”
Anyway, Nochu’s outsize CLO foray shines a light on an obscure but crucial asset class, one that has enjoyed a strong historical track record: No triple-A-rated CLOs have ever suffered a default, while the asset class came through the 2008-era trials largely intact on a credit basis, unlike other types of collateralized debt obligations which famously faltered.
Comprised of floating-rate leveraged loans, an attractive option for those concerned with rising interest rates, the CLO market has boomed of late. Analysts at Citigroup report that the aggregate market size has nearly doubled over the last four years. That growth in turn provides a ready source of demand for leveraged loans (roughly half of all syndicated loans have been packaged into CLOs).
As 2019 has ushered in an asset price thaw after the brutal fourth-quarter, some issuers are stepping back into the fray. Thus, Commercial Mortgage Alert reported on Feb. 15 that the real estate-CLO market is heating back up from a December freeze, with three new obligations issued so far this year with at least five more set to debut by quarter-end. The publication predicts that “issuance is expected to climb substantially this year, aided by the fact that the volatility that swept through fixed-income markets in December proved to be short lived.”
Prices have mostly recovered, with the LSTA/Leveraged Loan Index rising back to 96.4, from 93.8 on Dec. 28 to recoup more than half of the decline from 98.7 in early October. Analysts at Goldman Sachs are expecting the rebound to continue, and a continued pick-up in CLO issuance, writing that “we still see more room to run.”
But a recent report from Fitch Ratings on domestic life insurers should give the bulls pause. Noting that aggregate corporate credit quality is below the levels seen in 2007, the ratings agency zeroes in on CLOs:
CLOs are a particular point of focus for us, given the market’s rapid growth and signs that leveraged loan underwriting standards and covenants have deteriorated. We believe CLO exposure could represent a significant risk if investor protections weaken late in the credit cycle.
Grant’s, concurring with the judgement of Fitch, had this to say at the outset of an in-depth analysis of the loan and CLO market in the Sept. 7 edition:
On Wall Street, success begets failure. Take a good idea, emulate it and embellish it, drive it into the ground like a tomato stake. Voilà: It’s a bad idea.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.799 trillion this week, down a chunky $31.2 billion from last week’s reading for the second-largest sequential decline so far. Treasury securities accounted for about three-quarters of this week’s runoff, as well as the $40 billion decline relative to the trailing four-week average.
Since the Oct. 1, 2017 onset of QT, total assets on the Fed’s balance sheet are down by 10.6%, at a 7.7% simple annualized pace.
Recap Feb. 21
Stocks ticked a bit lower, taking the S&P 500 off the year-to-date highs reached yesterday and leaving the broad index green by just under 11% for 2019 so far. Corporate credit also traded weaker, while gold and oil fell despite a flat showing from the CRB Index to finish near $57 a barrel and $1,320 an ounce, respectively.
Perhaps the most interesting action lately has taken place in Treasurys, which saw yields jump across the board, particularly the 30-year long bond. As of now, the spread between the two- and 10-year yields remains near a 52-week low, while the spread between the five- and 30-year yields approaches a 52-week high. Go figure.
- Philip Grant
Tuesday, February 19, 2019
Art of the deal
Deficit reduction, outside the box.
Deficit reduction, outside the box.
Credit check
The bull run in junk bonds continues apace,
The bull run in junk bonds continues apace,
Recap Feb. 19
Art of the deal
Deficit reduction, outside the box. From a petition circulating on Change.org:
Sell Montana to Canada for $1 Trillion to eliminate the national debt.
We have too much debt and Montana is useless. Just tell them it has beavers or something.
So far, more than 8,700 people have signed the petition.
Credit check
The bull run in junk bonds continues apace, as the Bloomberg Barclays High-Yield Index is up 5.4% year-to-date, the best showing since 2009 and well ahead of the 2.56% and 3.26% logged by the Bloomberg Barclays Investment Grade and S&P/LSTA’s Leveraged Loan Indices, respectively. The bottom of the ratings heap has fared even better, with the triple-C component of high yield rising by 6.1% since 2019 began, for its best start since 2003.
On the other end of the high-yield spectrum, the double-B-rated index has seen its spread over investment grade-triple-B issues narrow to 87 basis points, down from 166 basis points at year end. Overall, the rally in speculative-grade debt has narrowed the option-adjusted spread to 402 basis points over Treasurys, down from 537 basis points on Jan. 3 and within 100 basis points of the post-crisis low reached on Oct. 3.
The rip in junk bonds has been spurred by a trio factors, including the prospect of easier monetary policy as elucidated by Fed chairman Jay Powell on Jan. 30. In addition, corporate performance continues to be solid, with the Moody’s speculative -grade default rate registering at 2.6% for the U.S. and 2.1% globally in January, down from 2.8% and 2.3% at the end of 2018 and the lowest rates in four years.
Meanwhile, new supply remains low. In total, 38 deals have priced this year for an aggregate $28.7 billion, down from 51 new issues totaling $30.9 billion at this time in 2018 and 66 deals for $35.7 billion through mid-February 2017. That relative lack of supply, coupled with recent strength, has forced investors into the secondary market. Last Wednesday saw $12.7 billion worth of high-yield debt change hands according to data from TRACE, the busiest session in almost a year.
But a pair of indicators created by Moody’s imply that things may not be so rosy. The agency’s Liquidity Stress Indicator ticked to a 21-month high of 4% in January, suggesting “that default risks are edging higher, albeit to a still-low level.” In addition, Moody’s Covenant Quality Indicator deteriorated back into the “weakest level” category in January, and sits just a hair away from the record-worst reading reached in August 2015.
At the same time, risks to the 116-month and counting economic expansion (it would become the longest on record if continued through July) are growing. A January survey of economists conducted by The Wall Street Journal found that the median expectation of recession in the next 12 months stands at 25%, the highest level since October 2011 and almost double the January 2018 guess. Retail sales in December sank by 1.2% sequentially, the largest one-month decline since August 2009, while January auto sales at a 16.6 million seasonally-adjusted annual rate were far below the expected 17.2 million.
In an analysis last Tuesday for S&P’s LCD, Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, calculates that the rally in junk bonds has left that asset class implying 12-month recession odds of just 10%. The Dean of High Yield cautions that junk bond investors might not be receiving adequate compensation, considering the evident risks:
Based on the historical relationship between economic forecasters’ estimate of the probability of a U.S. recession within one year and the high-yield spread-versus-Treasuries, the spread is currently 248 basis points too tight. That is the biggest gap since the Great Recession.
Fridson goes on to suggest a way to potentially profit from the sanguine spreads currently on offer in high-yield, via a pairs trade in tandem with other economically-sensitive assets:
If you are not willing to stake your performance on economists’ opinion of recession probability, you could look for another asset that you do find to be reflecting a 25% one-year probability of recession. Possible candidates could include industrial commodities, either individually or in baskets. The implied strategy would be to short high-yield bonds and go long the asset class that is priced to incorporate the economists’ recession probability estimate.
Recap Feb. 19
Stocks rose again, with the S&P 500 finishing green for a sixth time in seven tries to extend its 2019 gains to near 11%, while the small cap Russell 2000 now sits higher by nearly 17% year-to-date.
Elsewhere, commodities caught another bid with the CRB Index notching its best close in more than two months, with WTI crude and gold settling at $56 a barrel and $1,340 an ounce, respectively. Treasurys also rallied with the 10-year yield falling to 2.63%, toward the low end of its 52-week range, and the VIX traded sideways to end the day below 15.
- Philip Grant
Thursday, February 14, 2019
Halt, and catch fire?
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE)
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE)
QT progress report
Recap Feb. 14
Halt, and catch fire?
On a Monday earnings call, Rachelle Girard, Cameco Corp. (CCJ on the NYSE) vice president of investor relations, told listeners in that the blue-chip uranium producer will be keeping production idled in hopes of higher prices. It was not a hard decision:
While we are seeing some positive developments, we have not yet seen the type of response needed from the uranium market to restart. Unfortunately, today's prices are still nowhere near, not even close, to the levels needed. There's plenty of idle tier-one production and tier-one expansion capability, as well as tier-two production and expansion capability.
We were unwilling to risk having to sell those pounds into an oversupplied spot market at some point in the future. And we were unwilling to tie up our financial capacity and create an overhang in the market by producing only to place the pounds in inventory.
As might be surmised from that commentary, it’s been tough sledding for the world uranium market, as a 30% rebound in prices in the last 10 months to $29 per pound still leaves the compound scientifically known as U3O8 (Triuranium octoxide) far below its $136-per-pound peak in 2007 and a $73 interim top in 2011, before the Fukushima disaster spurred a broad revulsion toward nuclear power and faltering demand for the mineral.
Those post 2011 doldrums can at least be partially explained by the particular quirks of the commodity itself. The market for so-called yellowcake is a peculiar one, with thin liquidity, limited transparency and long cycles as utilities frequently lock in multi-year contracts with their providers.
There are reasons to think the difficult conditions will continue. In late January, Germany announced a plan to phase out all coal and nuclear power plants by 2038, as it looks to move off fossil fuel consumption (though nuclear is, of course, not a fossil fuel). Despite a production halt from Cameco and curtailment from other large producers like Kazakhstan’s Kazatomprom in 2017, global inventories remain elevated. Nicolas Carter, executive vice president of Ux Consulting Co., LLC, estimates in a Jan. 25 interview with The Northern Miner that the U.S. and Europe currently hold 2.7 and 3 years’ worth of supply, respectively. Carter, who expects the price of uranium to enjoy a gradual rise in the next few years, nevertheless notes that supply considerations can change rapidly, and unfavorably, for the bulls:
Between [Cameco’s] McArthur River mine, which is on standby, and excess capacity at operating low-cost Kazakh. . . mines, upwards of 35 million pounds [about 19% of total world supply, by his reckoning] of U3O8 can be brought back to the market relatively quickly.
Bulky inventory levels and the rise of renewable energy haven’t dulled the bull case. At a Cape Town industry conference in early February, Daniel Major, CEO of small-cap GoviEx Uranium, took a more sanguine view of both demand and supply, noting positive changes on each side of the equation while downplaying the risks of inventory oversupply:
The first thing is strong demand. Nuclear generation is now at the same level that it was pre-Fukushima. On the supply side you have a lot of projects closing down and you have the Kazatomprom and Cameco shutdowns which have effectively put the market into a deficit.
There was also an inventory overhang but now you have people like Yellow Cake (Yellow Cake plc., a specialist company buying and storing uranium) sucking metal out of the market as well. So you have a massive tightening of inventory; demand growth and big supply cuts.
The bigger fish concur with Major’s assessment. A press release from Kazatomprom (the world’s largest producer) last fall included the following assessment:
The Company believes that the supply side of the uranium market is undergoing a structural shift, following a prolonged period of depressed spot prices and oversupply, underpinned by the prevalence of legacy long-term contracts, the majority of which were concluded in the period between years 2005 and 2012.
As a significant portion of such contracts are set to expire in early 2020s, many utilities are likely to return to the market in the near-to medium-term to begin covering their future fuel needs through entering into medium- and long-term contracts.
Grant’s, likewise expecting better days ahead for the so-called heavy metal, reiterated a bullish analysis of Cameco on June 1, followed by approving assessments of Yellow Cake (YCA on the LSE) and Toronto-based Uranium Participation Corp. (U on the TSX) in the June 15 edition. Shares in each are up between 15% and 20% from publication.
QT progress report
The Fed’s portfolio of securities held outright registered at $3.83 trillion this week, unchanged from last week’s reading and following the $14.3 billion, Treasury-driven decline from Jan. 30.
Since the Oct. 1, 2017 commencement of QT, the Fed’s total balance sheet assets are down by 9.6%, a 7% simple annualized pace.
Recap Feb. 14
A relatively quiet day in the markets saw the S&P 500 cruise sideways to consolidate recent gains, while Treasurys rallied across the curve to leave the 10-year yield at 2.66%. Commodities were mostly flat but energy caught a bid to push WTI crude to near $55 a barrel, within about 50 cents of its 2019 highs, and the VIX settled below 16.
- Philip Grant
Wednesday, February 13, 2019
I thought you were pre-med?
This morning,
This morning,
Print and frame
Today,
Today,
Capital punishment
Call waiting.
Call waiting.
Recap Feb. 14
I thought you were pre-med?
This morning, microcap stock Auris Medical Holding A.G. (EARS on the Nasdaq) spiked by as much as 58%, as traders rushed to take a position in the company ahead of an announced takeover by Johnson & Johnson.
The only problem: JNJ is actually acquiring privately-held Auris Health, Inc. for $3.4 billion in cash. By contrast, the market capitalization of EARS currently stands at $12 million.
Print and frame
Today, the Swiss National Bank released its form 13-F for the fourth quarter, revealing that the central bank’s portfolio of 2,536 U.S. equities totaled $78 billion, a 13% decline for the quarter. That compares to a 14% drop in the S&P 500.
The SNB may be an uneconomic actor in the traditional sense (the bank conjures francs out of thin air, sells them to buy euros to prevent unwanted currency appreciation, then diversifies into other assets like U.S. equities), but the gnomes know how to buy the dip. The SNB’s fourth quarter filing shows 30 new positions, while the bank upsized positions in Microsoft Corp., Sprint Corp. and Amazon.com, Inc., (to pick just three) by 376,200, 99,700 and 31,200 shares, respectively.
Capital punishment
Call waiting. Holders of Banco Santander S.A.’s €1.5 billion ($1.7 billion) contingent convertible bonds (CoCos, for short) received an unpleasant surprise yesterday, when the Madrid-based bank announced it would not call (repay) the bonds, as had been hoped. The bonds traded as low as 97.5 cents on the euro in immediate response, down from 99.4 at the open on Monday.
A Santander spokesperson explained their rationale in a press statement: “When making call judgements we have an obligation to assess the economics and balance the interest of all investors.” Indeed, not calling the bonds allows the bank to convert those notes to a floating-rate structure next month with a coupon of roughly 5.53%, down from a fixed-rate of 6.25% prior to the call date.
Those who got the short end of the stick were understandably miffed, with Timothée Pubellier, portfolio manager at Financière de LA Cité S.A.S. proclaiming to Bloomberg: “The handling of the situation was truly disastrous. Credit investors will need some serious new issue premium to touch that name again.”
Santander issued a similar €1.2 billion in 7.5% contingent convertible notes one week ago, leading many observers to believe that the proceeds from that offering would be used to redeem the 6.25% securities. One unnamed banker who worked on that recent deal was less than sympathetic, telling Robert Smith of the Financial Times: “I think holders of the existing euro bond put two and two together and got five, to be honest.”
The episode shines a light on these CoCo bonds, which sit at the bottom of the credit capital structure and feature unique (and counterintuitive) characteristics. Instead of traditional convertible debt, which is eligible for call as the issuers share price rises, CoCos are converted in times of trouble to bolster the issuer’s balance sheet. Acting as a sort of financial failsafe, CoCos are designated “Tier 1” equity capital, the primary bulwark against credit losses.
Blessed by the regulators and favored by banks, the European CoCo market has grown rapidly in recent years, to €200 billion from €80 billion in the summer of 2014. Investors, squeezed by the European Central Bank’s negative interest-rate regime, have likewise thrived in the CoCo patch. The Bloomberg Barclays European Banks CoCo Tier 1 Total Return Index has jumped by 42% since July 2014, lapping the 16% gain in the Bloomberg Barclays Pan-European High Yield Index during that period.
But dangers in the CoCo market extend far beyond Santander’s maneuver yesterday. The July 11, 2014 edition of Grant’s argued that these securities present particularly acute contagion risks:
CoCos, indeed, pose potential risks to the whole world of leveraged finance, we think. 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.
For a timelier analysis of these CoCo contraptions, see the Jan. 11 edition of Grant’s.
Recap Feb. 14
Stocks rose for a fourth straight day, pushing the S&P 500 well above its 200-day moving average, while the VIX remained near four month lows and Treasury yields ticked higher with the short end catching the bulk of the selling.
The energy patch caught a solid bid, with WTI crude rising to $54 a barrel despite a larger-than-expected weekly inventory build. This morning’s data brought a whiff of inflation as the Bureau of Labor Statistics reports that January Core CPI grew 2.2% year-over-year, above the consensus 2.1%, while real average weekly earnings rose 1.9% year-over-year, the fastest growth rate since October 2015.
- Philip Grant
Tuesday, February 12, 2019
Funny how time slips awaty
Private equity to the rescue. This morning, mortgage service provider Ellie Mae, Inc. (ELLI on the NYSE) announced that p.e. firm Thoma Bravo, LLC is buying the company in an all-cash deal for $99 a share, or $3.7 billion.
The deal price represents a 49% premium to Ellie Mae’s average closing price in the 60-trading days ended Feb. 1 and includes a 35-day “go shop” period in which the target can solicit competing bids. In response, ELLI shares jumped 21% and for a time traded above that bid, indicating investors believe there is a chance they will indeed be able to find a better price. The deal confounds a hefty contingent of shorts (just over 21% of the float, according to Bloomberg), as well as a bearish assessment of Ellie Mae in the April 6, 2018 issue of Grant’s. Thanks to their recent surge, ELLI shares are up 6% from our publication, matching the 6% rise from the S&P 500.
Around and around. ELLI one-year price chart. Source: The Bloomberg
Ellie Mae, which provides software for the mortgage-finance industry, is the progenitor of the widely-used Encompass, used to close more than one-third of all U.S.-originated mortgages in 2017. The post-financial crisis regulatory regime, particularly the Dodd-Frank Act of 2010, has been a boon for ELLI, as small lenders, in particular, have rushed to tick regulatory boxes. According to data from the Home Mortgage Disclosure Act, non-bank lenders accounted for 56% of mortgage originations in 2017, up from just 26% in 2011. In tandem, the company grew revenues at a 38% compound annual rate from 2010 to 2017. In the third quarter, revenues grew 15% year-over-year.
From the buyer’s perspective, the deal appears to anticipate a return to the good old days. Yet, in a note published on Feb. 6, analysts at J.P. Morgan argued that Ellie’s recent performance made a takeover difficult to justify, even at its then-price of $81 a share:
[Ellie Mae’s] trailing four-quarter adjusted EBITDA is $87 million, and at $81, the enterprise value is $2.7 billion, so at a 5-6 times leverage level that is only $435 to $522 million borrowing capacity. That would make for a ~80%/20% split of equity/debt in a transaction at these current levels and we typically do not see private equity contributing above 60% equity in a transaction (and that tends to involve multiple private equity firms partnering in what is known as a club deal).
Thus, at that premium $3.7 billion ($99 a share) deal price, Ellie Mae’s theorized borrowing capacity covers about 13% of the total consideration.
Then, too, Ellie Mae’s business prospects may be dimmer than the bulls believe. That April 6 analysis in Grant’s argued that as most banks had already adopted Dodd-Frank-compliant mortgage underwriting systems, further growth for ELLI, with its 35% market share, will be harder to come by. Beyond the financial gravity of the law of large numbers, Ellie needs to contend with another immutable fact: Mortgages are a cyclical business, and Ellie’s customers skew to smaller, less well-financed lenders.
To that end, an article in the Institutional Risk Analyst on Sunday noted the sharp recent slowdown in mortgage lending activity. Citing data from The Securities Industry and Financial Markets Association, IRA publisher Christopher Whalen writes that issuance has plunged, and some industry players are hurting:
The U.S. has seen a ~ 40% decrease in issuance of mortgage backed securities since the end of September 2018, certainly reason for alarm in our book. The U.S. residential mortgage industry is looking at doing a lot less than $1.5 trillion in new mortgage origination volumes in 2018.
Market factors aside, the slump in residential lending volumes is more of the same, premium pricing for loans killing profitability for aggregators and banks, which are bidding points through the curve to buy larger jumbo assets for portfolio. Smaller retail lenders are dying due to high origination and funding costs. And even though rates have fallen since December, better yielding refinancing volumes are not yet returning.
But hope remains: Several operators in mortgage land tell The IRA that January will be a great month.
ELLI’s prospective backers surely hope that the fourth-quarter slowdown was just a blip and January’s evident revival the status quo. Regardless, the regulatory tide might be turning. On Jan. 29, The Real Deal reported that Ginnie Mae (the government-backed entity that guarantees mortgages, no relation to ELLI) has stepped up its scrutiny of nonbank lenders, which have risen to 61% of Ginnie Mae’s outstanding service volume from 34% in 2014. The Real Deal’s Kevin Sun wrote:
For the first time in years, the agency has asked a number of these lenders to improve financial metrics before receiving full approval to continue issuing Ginnie-backed mortgage bonds. . . The agency has also conducted its first ever stress tests of business partners, to see how well their monthly cash-flow obligations would hold up under reduced loan production and increased delinquencies.
Recap Feb. 12
The bulls remain firmly in control, as stocks ripped higher to leave the S&P 500 green by 9.5% year-to-date, while the NYSE FANG+ Index, Dow Transports and small-cap Russell 2000 have gained between 13% and 14% so far in 2019.
A dollar selloff helped commodities catch a bid with WTI crude ticking back above $53 a barrel, while Treasury yields rose for a second day to leave the 10-year at 2.68%, just below its simple 30-day average of 2.7%. The VIX fell to just above 15, its lowest close since October 5.
- Philip Grant
Monday, February 11, 2019
Snap-chat
The streak lives on. Industrial tools and diagnostics manufacturer Snap-on, Inc. (SNA on the NYSE) reported fourth quarter earnings featuring adjusted earnings per share of $3.03, edging past the consensus $3.02 to extend the company’s bottom-line “beat” streak to a 40th consecutive quarter. Figures beyond the headline were less impressive, as revenues were light of consensus across each of the company’s three business lines (commercial & industrial, tools and repair systems & information), while operating profit margins in the tools division (the largest) saw a 240 basis point decrease year-over-year, to 14%. Shares fell by 8% in response, and are down 5% since June 3, 2016, compared to a 29% rise in the S&P 500 over that period.
Snap-on, founded in 1920, has thrived in recent years despite a sluggish sales environment. While full-year 2018 revenues of $3.74 billion represent a 2.9% compound annual growth rate over the past five years, adjusted net income has leapt higher to over $680 million as compared to 2013’s $343 million, for a compound annual growth rate of 14.7%.
The company’s balance sheet is shipshape. On Dec. 21, Fitch Ratings reiterated its single-A rating for Snap-on, citing the firm’s “conservative financial management and consistent free cash flow generation.” Indeed, net debt stands at just $1 billion, while the Street expects SNA to generate just under $1.1 billion in adjusted EBITDA for 2019. Operating earnings of $956 million easily cover interest expense of just $50 million. The contrast between Snap-on’s sturdy credit profile and that of its customers is stark: On Thursday’s conference call, senior vice president Aldo Pagliari noted that the average yield in the financing division stood at 17.7%, “reflective of the credit quality of customers originating loans.” I.e., most borrowers are subprime.
Meanwhile, financing accounts for the bulk of that disproportionately-fattening bottom line. Thus, operating earnings from the financial services unit totaled $230 million last year, a 12.8% compound annual growth rate from the $126 million booked in 2013. Long-term net financing receivables (customer loans) footed to $1.07 billion at year-end compared to $561 million in 2013, a 13.8% compound annual growth rate.
The question before the house: How might Snap-on’s credit-centric business model fare in a less hospitable economic climate? A Jan. 16 survey from Bankrate.com finds that only 40% of respondents would be able to pay an unexpected $1,000 expense from savings on hand, with 34% needing to finance such an expense and an additional 10% unsure about how to proceed in such a scenario. Last month’s reading of consumer confidence showed a record negative disparity between the “present situations” and “future expectations” components, suggesting that Joe six pack is expecting tough times ahead.
A bearish analysis of SNA in the June 3, 2016 edition of Grant’s noted the contrast between then-strong sales growth with lackluster expansion in mechanical and automotive repair work that generates demand for Snap-on products. It argued that the company’s franchise dealer system understates credit risk and drew attention to the company’s exposure to the once-booming, now cooling, automobile market. According to WARD’s Automotive Group, January sales clocked in at a 16.6 million seasonally-adjusted annual rate, down from 17.07 million year-over-year and a 17.34 million reading in the opening month of 2017. Secular changes also present a problem, as increasingly complex and computerized cars often need to be repaired at licensed dealerships, as opposed to independent auto repair operations which are Snap-on’s bread and butter.
Bret D. Jordan, analyst at Jefferies Group, LLC, likewise noted that lengthy replacement cycles boded ill for Snap-on’s top-line growth, asking Grant's: “They are selling a product that is super premium and lasts forever. Once a guy buys a socket-wrench set from Snap-on – unless he is losing his sockets – he will never need to buy another one. How do you sustain that growth rate?”
Snap-on shares have attracted many a short-seller recently, as short interest currently stands at 12.7% of the float, according to Bloomberg. That’s up from just 3.8% in June 2016. Snap-on management seems to think the bears have a point. On Dec. 21, CEO Nicholas Pinchuk sold 22,433 shares into the open market, cashing out $3.2 million. Last year, directors made 13 open market sales, while the most recent open-market insider purchase came from former director Ruth Ann Gillis, for 265 shares, in August 2017.
Recap Feb.11
Stocks went nowhere, with the S&P 500 drifting sideways for a second straight session to remain higher by 8% year-to-date and about 7% below its early October levels, while the VIX held at 16 and Treasury yields ticked higher across the board.
The greenback caught a sharp bid, with the Dollar Index closing above 97 for the first time in six weeks, helping to pressure commodities with WTI crude finishing at $52.50 a barrel and gold closing at $1,308 per ounce. Emerging market equities and dollar-denominated debt also turned lower.
- Philip Grant
Friday, February 8, 2019
Xi student
The trade war grinds on. Yesterday, The Wall Street Journal reported that American business luminaries have been lobbying the Trump administration to break its trade-stalemate with China, with Blackstone Group boss Stephen Schwarzman arguing that “failure to strike a deal will undermine the economy and roil markets, which are anticipating an end to U.S.-China hostilities.”
So far, those efforts have been for naught, as Trump told reporters “no” yesterday when asked if he would meet with Chinese counterpart Xi Jinping by the March 1 conclusion of the 90-day trade truce agreed to in the fall. Bloomberg, citing an unnamed senior official, reported that the absence of high-level talks “should not be read as a sign that talks are breaking down.” Mr. Market appears to be more skeptical, as stocks immediately turned lower once Trump’s comments hit the wires yesterday.
While the two powers continue to posture, the U.S. is turning up the rhetorical heat. On Wednesday, the U.S. ambassador to Europe made some extraordinary comments in an interview with Politico:
We should. . . combine our mutual energies — we have a $40 trillion combined GDP, there is nothing on the planet that is more powerful than that — to meet China and check China in multiple respects: economically, from an intelligence standpoint, militarily.
As the Sino-American confrontation continues to unfold, Chinese authorities look to ease the burden on domestic business. Thus, on Jan. 23, the People’s Bank of China rolled out its so-called targeted medium-term lending facility, a mechanism aimed “at encouraging commercial banks to provide credit support to private and small firms,” according to the South China Morning Post.
One day later, the PBoC rolled out another contraption, termed the central bank bills swap, which allows owners of renminbi-denominated perpetual capital bonds to swap them for PBoC paper. One anonymous European investor described the arrangement as “very weird” to the Financial Times, noting that “nothing even remotely looking like it [exists] in any of the ECB rules today.” When Mario Draghi thinks your policies are unconventional…
Anyway, the central bank’s machinations come as economic indicators continue to point southward. Official GDP is expected to grow at 6% to 6.5% this year, the lowest growth rate since 1990. Last week’s release of the January Caixin China General Manufacturing PMI registered at 48.3, down from 49.7 in December and the weakest reading since the February 2016 deep freeze.
Meanwhile, public discontent appears to be on the upswing as companies tighten their belts. The New York Times reported yesterday that “thousands of Chinese workers are holding small-scale protests and strikes to fight efforts by businesses to withhold compensation and cut hours.” The Times cites data from the Hong Kong-based China Labor Bulletin, which found 1,700 labor disputes in 2018 compared to 1,200 the year prior, noting that “those figures represent only a fraction of disputes across China, since many conflicts go unreported and Mr. Xi has increased censorship.”
An extended economic downshift would be particularly unwelcome for China’s amply-leveraged real estate industry. Yesterday, real estate blog Curbed provided an update on the partially completed, now stalled $1 billion Los Angeles multi-use project developed by China’s Oceanwide Holdings Co., Ltd. (Almost Daily Grant’s, Jan. 29). Curbed reports that six subcontractors have recorded liens on the property totaling $62.5 million, with Webcor Construction claiming the developer still owes them $52.8 million, according to a lawsuit filed yesterday in Los Angeles County Superior Court. In addition, “a second Oceanwide subcontractor said it has been partially paid but was still owed about $550,000 – more than half the amount of its $877,471 lien.”
More broadly, the Middle Kingdom’s three largest mainland property developers, Country Garden Holdings Co., Ltd., China Evergrande Group and China Vanke Co., Ltd., saw year-over-year declines in housing contract sales of 52.2%, 32.9% and 28.1%, respectively, in January. Reuters’ BreakingViews notes today that Country Garden and Evergrande have issued $7.7 billion in offshore debt so far this year, nearly triple the $2.8 billion non-renminbi issuance in January 2018.
Overseas borrowers (the unhedged ones at least) may be in for a rude surprise. At the fall 2018 Grant’s conference, Logan Wright, director at the Rhodium Group, LLC, told the assembled that slowing economic growth, in tandem with China’s massive debt load, will eventually leave Beijing with little choice but to allow the renminbi to weaken:
Basically, in order to service this debt burden. . . Beijing is going to need interest rates lower, they are going to need to start to adjust credit conditions overall.
So, discussing the currency in more detail here, the key insight is that the severity of the domestic financial stress makes external adjustment a far easier path. . . They have a $27 trillion money supply growing at $2 – 2.5 trillion per year.
We would argue this leads to a faster path of yuan depreciation rather than a sustained defense. . . particularly if the trade conflict is not going particularly well for Beijing, given the severity of domestic stress that is underway.
Recap Feb. 8
A strong late rebound in stocks left the S&P 500 little changed both for the day and for the week, while commodities likewise traded sideways as the Dollar Index ticked to a five-week high. Treasurys were bid again, with the 10-year yield dropping below 2.64% for its lowest weekly close since January of 2018, and the VIX fell to 16, its lowest weekly close since the onset of market volatility in early October.
- Philip Grant
Thursday, February 7, 2019
Bottom of the barrel
Explosive growth in U.S. crude production continues apace,
Explosive growth in U.S. crude production continues apace,
Recap Feb. 7
Bottom of the barrel
Explosive growth in U.S. crude production continues apace, reaching a fresh record high of 11.9 million barrels per day (mbpd) at the end of November, according to the Department of Energy. That’s a record high, and up from less than 10 mbpd as recently as January 2018.
According to the U.S. Energy Information Administration, the U.S. will become a net exporter of oil by 2020 (the EIA expects production to grow to 14 mbpd by 2030), while the Financial Times noted Tuesday that the U.S. has become the United Kingdom’s largest supplier of oil for the first time since the Suez crisis of 1956. Yesterday, the FT reported on the corporate scramble to build out infrastructure in the Gulf of Mexico that can accommodate the sharp expected uptick in oil exports to the world: “The prize is the ability to fully load a Very Large Crude Carrier, a supertanker big enough to transport oil profitably to Asia.”
The supply surge has helped keep a lid on prices, as a barrel of West Texas Intermediate has fallen to $52 from $76 in early October, albeit off the late December lows of $43 per barrel. Meanwhile, President Trump’s surprise decision to issue wide-ranging waivers to the Iran sanctions allowed a greater than expected proportion of Iranian crude to hit the market and caught the Organization of the Petroleum Exporting Countries, which had already increased production to offset the expected shortfall, flat-footed. Instead, the world oil market tipped into oversupply after having drawn down on global inventories in the first half of 2018.
OPEC is not just sitting idly by as prices fall. Thus, S&P Global’s Platts Energy unit reported yesterday that the cartel pumped 30.86 mbpd in January, the lowest output since March 2015, while the 970,000 barrel sequential decline exceeds the 812,000 b/d supply cut agreed to in October (Russia and nine other non-OPEC countries are to supply the balance of the agreed 1.2 mbpd cut) and marks the biggest one-month drop off since December 2016. Swing producer Saudi Arabia slashed its January production to 10.21 mbpd, down from a record-high 11.1 mbpd in November and below the 10.31 mbpd quota agreed to by OPEC.
Then, too, the cuts are likely to remain in force for some time. Azerbaijan energy minister Parviz Shahbazov told Bloomberg that “it’s realistic [to expect] that the decision might have to be extended.” Shahbazov favors price stability, pegging the “$60 to $70 corridor” for Brent crude (currently trading at $62) as the “best price for producers and consumers.” Mr. Market is also expecting status quo for now, as John Kemp of Reuters notes that the Brent crude futures curve has returned to nearly flat from backwardation (meaning future prices fall below spot, a bearish signal) in that fourth-quarter selloff, “suggesting traders currently see the oil market close to balance this year.”
Might the oil market be girding for a renewed bull run instead? Commodity investors Leigh Goehring and Adam Rozencwajg think so. In their fourth-quarter investor letter, Goehring and Rozencwajg argue that declining output from the rest of the world will more than offset the U.S. production surge, while global demand is stronger than expected. The pair draw the historical analogy between current conditions and the 2001-2003 period, when energy prices retrenched towards their 1999 lows, before setting the stage for massive gains:
In many ways we are again in the same position as 2002. Because of the temporary imbalance in global oil markets, prices pulled back, and have now stabilized some 60-65% above their 2016 cycle-lows, (just as they did in 2001). Because of the US Federal Reserve’s quantitative tightening, Trump trade wars, and worries over potential debt problems in China, investors and energy market commenters believe we will see significant downward revisions in 2019 and 2020 global oil demand (also similar to 2001). Finally, we believe we’re going to see a significant overestimate of future non-OPEC oil supply, just as we did back in 2001.
As 2019 starts, we believe we are under¬estimating the forces that are driving global demand in the coming years as well as the forces that are driving conventional non-OPEC supply—a situation not dissimilar to what happened when oil prices bottomed at $17 per barrel in Q4 of 2001. We are repeating the trajectory of oil prices that started 20 years ago. It won’t be long before the financial press returns to talking of $100 oil.
Eighteen years ago, energy investors incorrectly judged the future of both demand and supply and we believe the same dynamic is playing out today. We are more convinced than ever that global oil markets have entered a multi-year bull market and that the 35% pullback in oil in the last three months has created another superb buying opportunity.
Grant’s, bullish on oil since March 2017, presented subscribers an analysis of a quartet of “very cheap” energy-related stocks in the Nov. 30 issue.
Recap Feb. 7
Stocks came under pressure with the S&P 500 falling nearly 1%, while commodities sold off sharply as the dollar enjoyed modest strength. The VIX rose by 6% to finish back above 16.
Perhaps the most interesting price action was in rates, as Treasury yields fell across the curve while three-month Libor plummeted by more than four basis points, its biggest one-day move since May 2009.
- Philip Grant
Tuesday, February 5, 2019
Crocodile done deed
A crackdown in the Lucky Country? Yesterday, the Australian Royal Commission released its highly-anticipated final report on alleged misconduct in the country’s financial services industry. Much to the delight of stock bulls, the Commission stopped short of proposing drastic structural changes such as a break-up of the big banks. In response, the S&P/ASX Index rose 2% for its biggest one-day gain since 2016, while the ASX Financials Index ripped higher by 4.5% for its best showing in more than five years.
But that’s not to say the Commission gave the banks and brokers a pass. The report refers more than 20 institutions and individuals for potential criminal or civil prosecution, while detailing scandalous alleged behavior such as charging fees for services not provided (including to the deceased) and deploying aggressive sales tactics toward a young man afflicted with Down syndrome. Commissioner Kenneth Hayne offered a particularly scathing assessment of National Australia Bank Ltd.:
I thought it telling that in the very week that NAB’s CEO and chair were to give evidence before the commission, one of its staff should be emailing banks urging them to sell at least five mortgages each before Christmas. Overall, my fear – that there may be a wide gap between the public face NAB looks to show and what it does in practice – remains.
The Commission’s report comes as Australia maintains a remarkable 27 years-and-counting string of uninterrupted economic growth (the last year-over-year decline in GDP took place in the fourth quarter of 1991). However, the housing boom that had long accompanied that growth streak is now firmly in reverse, as CoreLogic reported a 1% sequential drop in national dwelling values in January, extending the pullback in prices to 6.1% off their October 2017 peak.
While prices retrench, homeowners fall deeper into hock: The Australian Bureau of Statistics finds that household debt as a percentage of income rose to 188.6% in the third quarter (the most recent reading), up from 185.9% year-over-year, while the Home Price Index fell 1.9% over the same period.
The auction clearance rate, a key gauge as auctions are a primary mechanism for selling houses in Australia, has suffered a protracted decline to less than 48%, down from 70% early last year and 84% in spring 2015. Activity is likewise on the wane: CoreLogic also reports that 526 homes were put up for auction in the seven major “Capital Cities” during the first weekend in February (a busy one, coming right after the Australia Day holiday), down from 790 a year ago.
CoreLogic Australia auction clearance rate, five-year chart. Source: The Bloomberg
Whether a simple gravity-driven pullback, the result of political heat or some combination therein, lenders are tapping the brakes. Thus, Digital Finance Analytics reports that 40% of mortgage applications were rejected in December, down from 48% in November but still far above the 8% which didn’t make the cut in December 2017. In a Dec. 14 Grant’s Aussie analysis, deputy editor Evan Lorenz identified the unwelcome implications of that trend:
The rise in mortgage rejections comes at a particularly difficult time for borrowers. At the end of 2015, nearly two-fifths of mortgages were interest-only (IO). The typical Aussie IO starts amortizing after five years, at which point monthly payments increase by 30%-40%. The Reserve Bank estimates that around A$120 billion ($86.3 billion) of IOs will reset annually in 2018 through 2020. ‘About one-third of that won’t get refinanced,’ says Martin North, the principal of Digital Finance Analytics.
Will the Royal Commission report and potential regulatory crackdown, accelerate the housing market’s slide and expose the Australian banks to losses? Grant’s man on the scene, Roland Nelson of South Perth, forecasts an emphatic “yes” to that question:
The mortgage application systems of all the banks were intentionally designed to not look at incomes or expenses. Not merely not verify, not look. To accept borrowed deposits as unencumbered assets. Because they thought house prices always rose, and that this increase (which would improve the security of the loan) was occurring independently of their lending.
After yesterday’s announcements it will be extremely hard to return to faith-based mortgage credit checks. The stock of collateral on the banks balance sheet is worth what a future (less easily financed) buyer can afford.
Nelson draws a key distinction between the American experience of 2007-2009 and the current situation Down Under:
Australian Banks are NOT securitizing and selling their toxic near-NINJA [no income, no job or assets] mortgages. They are keeping them on their balance sheets. As safe assets, with minimal risk weights.
Recap Feb. 5
Another day, another green close for stocks as the S&P 500 rose for a fifth day to push the broad index higher by more than 9% year-to-date, while bonds were bid with Treasury yields dropping across the board and both investment grade and high yield corporates also faring well.
A rallying greenback pushed the Dollar Index back above its six-month range and pressured the energy patch, as WTI crude fell back below $54 a barrel. Interbank lending costs rose, with three-month Libor advancing for the second time in three sessions after ticking lower through much of January.
- Philip Grant
Monday, February 4, 2019
Drop a 'Digm
The junk-bond revival continues apace. The Bloomberg Barclays High Yield Total Return Index gained a whopping 4.52% in January, easily topping the 2.6% advance in the S&P/LSTA Leveraged Loan Index and marking the best one-month performance for high-yield in seven years, according to Bloomberg. Cellar-dwelling issues have fared even better, as the iBoxx U.S. Triple-C-rated Index has ripped higher by 6.6% year-to-date.
That swift recovery in prices has naturally spurred renewed deal activity: Last week saw $8 billion in fresh high-yield supply, the busiest week since August, according to Bloomberg. S&P’s LCD unit likewise notes that since Jan. 10, speculative-grade companies have raised $50 billion across both leveraged loans and high yield debt; that compares to just $29 billion during November and December.
That bulge in issuance includes some notables. On Friday, aircraft component manufacturer TransDigm Group, Inc. priced $550 million in senior unsecured 7.5% notes due 2027 and $200 million in 6.25% senior secured notes due 2026, with the secured tranche a follow-on offering to a $3.8 billion sale announced just two days earlier. That $4 billion in total size will likely place TDG’s 6.25% issue as the third-largest within the U.S. high-yield index, according to Bloomberg Intelligence. TransDigm will use the proceeds to retire the outstanding 5.5% senior unsecured notes maturing next year, as well as to fund the purchase of Esterline Technologies Corp., a $4 billion cash deal announced in October at a 41% premium to where Esterline shares traded prior to reports of TDG interest.
The Esterline deal is the biggest in TransDigm’s history, no small feat for a company that has made some 22 separate acquisitions since 2012. As is frequently the case with such roll-ups, debt figures prominently in the capital structure. Fitch Ratings calculates that TDG’s “adjusted” (to include restructuring costs, a recurring line item for the serial acquirer) leverage ratio is set to jump to 8.2-times EBITDA by year-end, up from 7.1 times in 2018, following the completion of the Esterline purchase. Indeed, the junk-bond thaw comes not a moment too soon for the company, as research firm CreditSights summed things up: “TransDigm is striking while the iron is hot.”
Issuers have gotten a reprieve. What about investors? In a note on Thursday explaining their decision to cut TransDigm’s senior subordinated notes to triple-C-plus, Fitch cited both “a material increase” in first lien debt “in excess” of the rating agency’s assumptions, as well as “weaker potential recovery” in the event of default.
The actions of TDG management betray no particular concern for creditors: In August 2017, the company issued stockholders a special dividend of $22 a share, with a $1.2 billion total payout compared to $717 million in 2017 free cash flow. That followed a $24 per share disbursement, at a total cost of $1.4 billion, made to shareholders in October 2016.
An analysis in the March 10, 2017 edition of Grant’s inspected the plight of corporate creditors in the context of asymmetric opportunity. The editorial verdict: With a best case scenario of the return of principal with interest, creditorsare not sufficiently compensated for the real risk of severe impairment should things go wrong. Of TransDigm, Grant’s wrote:
If the bears are wrong, the bondholders will earn their 6.33% yield to a 2020 call. If it’s the bulls who miscalculate, the creditors may suffer equity-like losses. In a bankruptcy, the lenders would probably secure recoveries no higher than 30% of par, according to the range of ratings-agency estimates (S&P calculated in May 2015 a recovery of zero, but allowed for a range of up to 10%).
A follow-up survey of unappealing corporate bonds on April 6, 2018 summarized the plight of corporate lenders in an analysis headlined: “Doormats of Wall Street:”
Creditors are the loneliest corporate stakeholders. Management disdains them. The Fed debases them. Give them this, at least (it’s a kind of virtue, anyway): They never complain.
Recap Feb. 4
The bull parade continues, as stocks rallied again with the S&P 500 rising for a fourth straight session to finish 16% above its interim lows less than six weeks ago. Meanwhile, another lurch lower in the VIX pushed the volatility gauge below 16, its lowest close since early October when the indices remained near their closing highs.
Treasury yields rose in near lockstep, with the 10-year settling at 2.72%, and WTI crude fell back below $55 a barrel. After the bell, Alphabet, Inc. (née Google) reported fourth quarter results featuring narrower-than expected margins, sending shares lower by 3% in immediate reaction.
- Philip Grant
Friday, February 1, 2019
Lockedchain
The downsides of digital security. From CoinDesk:
The downsides of digital security. From CoinDesk:
Pocket dial
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures,
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures,
Recap Feb. 1
Lockedchain
The downsides of digital security. From CoinDesk:
Troubled Canadian crypto exchange QuadrigaCX owes its customers $190 million and cannot access most of the funds, according to a court filing obtained by CoinDesk.
The problem: The exchange kept its digital ducats in a so-called cold wallet, which is not connected to the internet and accessible only by private key. Following the death of co-founder Gerald Cotton, investors were left with no way to access their cryptos.
In a sworn affidavit filed Jan. 31 with the Nova Scotia Supreme Court, Jennifer Robertson, identified as the widow of QuadrigaCX co-founder Gerald Cotten, said the exchange owes its customers roughly $250 million CAD ($190 million) in both cryptocurrency and fiat.
She later added that she has no business records whatsoever for QuadrigaCX or its affiliated companies. While she does have Cotten’s laptop, the device is encrypted, and she does not have its password or recovery key. While a consultant has been retained to try and recover the laptop’s contents, he has had limited success to date.
Pocket dial
Yesterday, Sprint Corp. (S on the NYSE) reported better-than-expected third quarter figures, with operating revenues of $8.6 billion and adjusted EBITDA of $3.1 billion topping the expected $8.38 billion and $2.89 billion, respectively. The wireless carrier also maintained its full-year adjusted EBITDA forecast and reiterated that it will roll out next-generation 5G wireless networks in the first half of 2019.
In response, Sprint shares rallied by 4% and remain in the upper end of their 52-week range, while creditors are also feeling their oats, as single-B-rated Sprint’s 7 7/8 notes of 2023 currently change hands at 107 cents on the dollar for a 358 basis point spread over Treasurys. That’s well below the 423 basis point pickup currently fetched by the Bloomberg Barclays High Yield Index.
But commentary from CEO Michel Combes belied those pleasing headline results. After detailing the company’s various accomplishments during the conference call, Combes then painted a grim picture of Sprint’s prospects should the company’s pending merger with T-Mobile US, Inc., (TMUS on the Nasdaq) fail to meet with regulatory approval:
We’re hopeful to complete our merger with T-Mobile which is the only path to delivering the breadth and depth of spectrum which will allow us to provide a truly consistent national-wide 5G experience to Americans.
As a stand-alone company, we lack the scale to keep pace with the bigger carriers, AT&T and Verizon, in sustained capital investments, and without additional low-band spectrum we will face challenges to provide customers with coverage comparable to that of the big two carriers.
It was a notable change in tone from a year ago, when Sprint chairman and current chief operating officer of SoftBank Group Corp. (which owns 84.5% of Sprint) Marcelo Claure had this to say, in discussing the 2019 arrival of 5G technology:
This latest development will put Sprint at the forefront of technology and innovation on par with other leading carriers around the world. . . While our network is much improved, we believe our Next-Gen Network will truly differentiate Sprint over the next couple of years due to our strong spectrum assets that enable Sprint to be the leader in the true mobile 5G.
From a lobbying point of view at least, Combes’ downbeat rhetoric is understandable. On Monday, Democratic leadership in the House of Representatives announced that Congress will hold a hearing on the merger on Feb. 13, and the ultimate outcome remains anyone’s guess. Reading the political tea leaves today, The Capitol Forum sees the market-implied odds of approval at 60%, identifying President Trump’s friendly rapport with SoftBank CEO Masayoshi Son as one factor that could help. Assistant attorney general Makan Delrahim’s recent comment that he sees no “magic number” of U.S. wireless carriers could also be construed positively, as the potential consolidation into three carriers from the current four is a popular talking point among deal opponents.
Then again, The Capitol Forum reported on Jan. 10 that Justice Department staff have been coordinating their review with skeptical state regulators in New York and California, “a setback” for the would-be merger, while the DoJ’s plans to depose third-party cable company executives is potentially “an ominous sign.”
Craig Moffett, co-founder and one-half eponym of firm MoffettNathanson, LLC likewise sees things as coming down to the wire, handicapping 50% odds of the deal closing. In a note yesterday, Moffett writes that Sprint management faces a daunting task: Convincing regulators that Sprint cannot go it alone as a viable company (see Combes’ rhetoric above), while at the same time projecting confidence to the bond market that the company can survive without T-Mobile, if need be.
Ultimately, Moffett concurs with Combes’ assessment, putting it bluntly: “If the merger is approved, the stock will go up. If it is rejected, [Sprint’s debt] will likely have to be restructured.”
A thumbs down from regulators would be bad news indeed for Masa Son, as even a return to Sprint’s early-2016 price (roughly 50% below current levels) would equate to a loss of approximately 15% of the parent’s market capitalization (Grant’s, Nov. 30). Regardless of the outcome, the SoftBank boss is keeping it all in the family: Bloomberg reports today that Son is preparing to tap Claure as head of a new Latin America-focused investment fund, which, though separate from SoftBank’s gargantuan in-house V.C. arm the Vision Fund, “could reach several billion dollars in size.”
Recap Feb. 1
Stocks finished little changed, shaking off a near-6% post-earning selloff in Amazon.com, Inc. to leave the broad S&P 500 up 1.5% for the week. A red-hot reading of January non-farm payrolls pushed Treasury yields sharply higher, erasing a chunk of this week’s rally, while energy prices caught another bid with WTI crude closing above $55 a barrel for its best finish in more than two months. The VIX fluttered to just above 16, its lowest close since early October.
- Philip Grant
Thursday, January 31, 2019
T Pain
Yesterday was a big day for monetary policy, as the first Fed meeting of 2019 featured a sharp dovish pivot, with chairman Jerome Powell suggesting not only a halt to the hiking cycle but also a sooner-than expected end to the “QT” balance sheet runoff. With monetary-traffic signals now blinking green, investors responded by bidding up equity prices, while interest rate futures went from pricing net 15% odds of a rate hike by the December meeting to pricing a net 17% chance of a cut in December. Analysts likewise cheered the move, with BofA Merrill Lynch releasing a note headlined: “The Fed is on your side.”
But a less discussed, yet potentially more impactful, long-term policy event also took place yesterday: The Treasury Borrowing Advisory Committee presented its quarterly recommendations to help tackle Uncle Sam’s ever-expanding financing needs.
The board estimates Treasury’s borrowing needs at more than $12 trillion for the next decade, assuming no recessions during that stretch (that $1.2 trillion annual average compares to an average $875 billion during the eight, recession-free years from 2010 to 2017, a 38% increase). The current business expansion stands at 115 months and counting, the second-longest in history behind the 120 months logged between 1991 and 2001. When the music stops, we can expect issuance to ratchet even further: TBAC notes that recessions typically increase the size of the deficit by between two and five percent of GDP.
Growth fluctuations aside, TBAC predicts that a greater proportion of U.S. debt will need to be placed domestically, noting that the portion of world FX reserves denominated in dollars has steadily declined, to a current 62% share from 72% in 2000. Over the five years ended in November, the total supply of Treasurys outstanding has grown at a compound annual rate of 4.9%, while foreign ownership has grown by just 1.7% compounded annually.
Among the TBAC’s suggestions:
- Targeting “pockets of savings” in the economy, from banks, pensions, insurance companies, corporations and asset managers.
- Broadening the types of debt issued to include perpetual and zero-coupon bonds, as well as expanding the usage of floating-rate and inflation-protected debt. The board also recommends increasing longer-dated issues, particularly 15-20 year maturities.
- Increasing the use of re-openings [providing additional supply] for popular issues, as well as of buybacks of issues that are trading cheaply to reduce interest costs.
The facts and ideas presented by TBAC have caused no great concern in the bond market. Indeed, Treasury prices have jumped across the board during the past two days, not just at the particularly policy-sensitive short end. That continues a strong rally that has seen the 10-year yield fall to 2.63% from 3.23% in November.
The contrast between falling borrowing costs while Treasury supply bounds higher shines a light on the interaction of these dual monetary and fiscal policy pillars. On May 18, Grant’s produced a mock prospectus for the U.S. Treasury, the sixth in a series going back to 1985. Among listed risk factors: the temptation of debt-soaked Uncle Sam to reduce the real weight of his burden through inflation. It has happened before:
As a substantial net borrower, the Government may be predisposed to conduct a monetary policy that reduces the real burden of its debt. The Government may pursue such a policy through the Federal Reserve, the senior officials of which the executive branch of the Government appoints.
The Government has conducted inflationary policies in the past. Thus, in 1933–34, the Government devalued the dollar to 1/35th of an ounce of gold from 1/20.67th of an ounce of gold. In affirming this policy, Congress voted to abrogate pre-existing public and private contracts denominated in gold coin, including contracts bearing on U.S. Treasury securities; in 1935, the Supreme Court upheld that Congressional action. In 1971, the Government rescinded its pledge to exchange dollars for gold at the fixed rate of 1/35th of an ounce of gold. Federal courts have held that the Government may do what it will with the nature and value of the dollar.
But the post-Bretton Woods monetary system confers extraordinary privileges on the dollar, and by extension, the U.S. government; benefits that have perhaps helped keep borrowing costs earthbound while debt piles higher. The editor’s foreword addresses that topic, arguing that those perceived advantages may not be all they’re cracked up to be:
As to the dollar-printing franchise and the reserve-currency privilege, commonly regarded as assets, we hold that they are either liabilities or traps. If the U.S. Government manages finally not to overprint the currency despite a pliable central bank, and not to overborrow despite the temptations presented by the dollar’s exalted status as a reserve asset, history will immortalize Washington, D.C. as the seat of the political wisdom of the ages.
What do you want to bet?
QT progress report
A $7.2 billion sequential decline left the Fed’s portfolio of securities held outright at $3.84 trillion. That’s down by $13.5 billion compared to the trailing four-week average, with mortgage-backed securities accounting for most of the drop.
Since the commencement of QT on Oct. 1, 2017, total balance sheet assets are down by 9.3%, at a simple annualized pace of 7%.
Recap Jan. 31
Another equity bid wrapped up a stellar January, with the Dow Jones Industrial Average, S&P 500 and Nasdaq 100 Indices rising by 7%, 8% and 9%, respectively, for the first month of the year. After the bell, Amazon.com, Inc. reported fourth quarter figures, topping consensus on the top and bottom line but offering lighter than expected first quarter revenue guidance, sending shares lower by 2% in immediate reaction.
Elsewhere, Treasurys continued their rally with slight outperformance from the short end leaving the curve a bit steeper, while commodities gave back early gains with WTI crude settling at $54 a barrel. The VIX dropped below 17 for its lowest close since Dec. 3.
- Philip Grant
Wednesday, January 30, 2019
Dancing in the Streets
New data from the European Central Bank comes to an interesting conclusion
New data from the European Central Bank comes to an interesting conclusion
Zuck Tales
The hits keep coming for Facebook, Inc. (FB on the Nasdaq).
The hits keep coming for Facebook, Inc. (FB on the Nasdaq).
Recap Jan. 30
Dancing in the Streets
New data from the European Central Bank comes to an interesting conclusion about the strenuous monetary stimulus undertaken in recent years. From the ECB Twitter account:
ECB asset purchases have reduced inequality in the eurozone, our research shows. They have especially benefited low-income households, which suffer the most from unemployment.
The proof is in the pudding: French citizens have been celebrating the ECB’s successes in the streets of Paris for weeks on end.
Zuck Tales
The hits keep coming for Facebook, Inc. (FB on the Nasdaq). Yesterday, TechCrunch reported that the social media behemoth “has been secretly paying people to install a ‘Facebook Research’ [app] that lets the company suck in all of a user’s phone and web activity.”
That is a violation of the rules that Apple, Inc. sets for its app store. In response, Apple this morning revoked Facebook’s app development credentials, a move which blocks FB employees from accessing both in-development “beta test” app projects as well as internal company apps used to organize lunch orders and transportation. According to tech website The Verge, Apple’s move is considered “a critical problem” for Facebook employees.
It’s the latest P.R. black eye for Mark Zuckerberg’s creation, which has recently endured data privacy scandals, political heat and unflattering press coverage such as the revelation from Rolling Stone that the Facebook boss slaughtered a goat with a “laser gun and then a knife” to eat at a dinner with Twitter, Inc. CEO Jack Dorsey (he's a real bleating heart). Meanwhile, insiders continue to aggressively sell stock in the open market. Zuckerberg halted his near-daily sales at the end August, but chief operating officer Sheryl Sandberg continues to forge ahead with sales of 55,000 shares twice per month, cashing out some $15.8 million of stock in January.
After ripping by 475% in the five years ended August 2017, FB stock has since fallen by 2% (Grant’s offered a bearish analysis at that time), compared to a 16% gain from the Nasdaq 100 Index. The pullback leaves FB shares priced at less than 18 times full-year 2019 consensus adjusted earnings per share, while the Street expects revenues to jump more than 23% this year from 2018. Today, the company reported fourth quarter figures (pleasant ones by Mr. Markets reckoning, as FB gained 9% after-hours), including daily active users of 186 million and monthly active users of 242 million in the U.S. and Canada, Facebook’s most profitable regions.
However, bulls must consider a potentially uncomfortable question: Is Facebook’s user engagement, which drives the advertising dollars that have propelled the stocks dizzying rise, what the company says it is? An in-depth report from investigative website Plainsite (available on the web here) on Jan. 24 summarized its findings thusly:
Facebook has been lying to the public about the scale of its problem with fake accounts, which likely exceed 50% of its network [vs. a company estimate of three to four percent of the total in 2017]. Its official metrics—many of which it has stopped reporting quarterly—are self-contradictory and even farcical. The company has lost control of its own product.
While Plainsite author Aaron Greenspan has long claimed to be the true inventor of “the Face Book” while at Harvard and may have an axe to grind, a September 2017 report from Pivotal Research analyst Brian Wieser (who has long carried a “sell” rating on FB shares, one of four to do so out of 53 tracked by Bloomberg) casts further doubt on the company’s claims:
Through Facebook’s Ads Managers we can see that Facebook claims a potential reach within the U.S. of 41 million 18-24 year-olds, 60 million 25-34 year-olds and 61 million 35-49 year-olds. By contrast, U.S. Census data indicates that last year there are a total of 31 million 18-24 year-olds, 45 million 25-34 year-olds and 61 million 35-49 year-olds. Nielsen estimates for the 2017-2018 season are close to the 2016 U.S. Census figures, with 31 million 18-24 year-olds, 43 million 25-34 year-olds and 61 million 35-49 year-olds.
A year later, a study from Pew Research reported that 42% of respondents had recently taken a “multiweek break” from the social network and 26% had outright deleted the Facebook app from their phones during the fallout from the Cambridge Analytica data-selling scandal. Yet the company reported curiously stable engagement during the course of 2018, with daily active users remaining at 185 million in the first, second and third quarters in North America.
Even taking the company’s figures at face value would imply growth potential that may disappoint the still well-represented bull crowd (41 analysts carry a buy rating on FB). North American daily active users and monthly users reported by Facebook today represent 80% and 105%, respectively, of the 231.2 million total population aged 15-64 in the U.S. and Canada as of December (comprising much of Facebook’s target demographic as users must be at least 13 years old), according to the Organization for Economic Co-operation and Development.
Recap Jan. 30
A dovish turn from the Fed: Language from chairman Jerome Powell suggesting the pace of rate hikes will slow and the “QT” balance sheet runoff may be near its end was just what the bulls wanted to hear, as the S&P 500 gained more than 1.5% while the NYSE FANG+ Index ripped by 4%, leaving those gauges in the green by 7% and 10%, respectively, for the year.
A sharp dollar downdraft paved the way for another commodity rally, with WTI crude finishing above $54 a barrel and gold approaching $1,320 an ounce, while Treasury yields fell across the board with the short-end outperforming to leave the curve steeper. The VIX fell below 18.
- Philip Grant
Tuesday, January 29, 2019
Scoreboard watching
Let’s take a look at the early returns for fourth quarter earnings season:
Let’s take a look at the early returns for fourth quarter earnings season:
All groan up
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom.
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom.
Recap Jan. 29
Scoreboard watching
Let’s take a look at the early returns for fourth quarter earnings season: In a note published yesterday, analysts at Bernstein find that with 21% of S&P 500 companies reporting through Jan. 24, 77% have managed to beat the bottom-line consensus estimate. That’s a pleasant-enough looking figure, but still “the lowest beat ratio since 2014, despite aggressive estimate cuts by analysts going into earnings season.”
Meanwhile, ambitions for 2019 have been scaled back significantly. While Wall Street consensus currently calls for aggregate 9.5% year-over-year earnings growth in the fourth quarter, bottom line growth is forecast to fall to 1.6% year-over-year in the first quarter. The primary source of slashed expectations? “Companies with the largest share of revenues coming from outside the U.S. are experiencing the most severe [forecast] cuts.”
While analysts lower the bar, Mr. Market remains in a charitable mood, the Bernstein team finds: “Companies who beat or met estimates outperformed the market by 1.5%, and those who missed estimates were able to outperform the [S&P 500] slightly by 0.6% within the five-day window [two days prior to two days after] surrounding the report date.”
All groan up
One defining feature of the ongoing earnings rush: Un-bullish tidings from the Middle Kingdom. This month, an array of companies has noted unexpected economic weakness in China, including the large-cap tech trio of Apple, Inc., Nvidia Corp. and Intel Corp. On the industrial side of things, tool maker Stanley Black & Decker, Inc. made note of a Chinese slowdown, glue manufacturer H.B. Fuller Co. CEO James Owens termed the deterioration “worse than expected,” and yesterday Caterpillar, Inc. CEO Donald Jim Umpleby forecast a “roughly” flat showing in the world’s second-largest economy, following back-to-back years of “significant growth.”
At the same time, Chinese companies continue to retrench. On Friday, Bloomberg reported that formerly-acquisitive conglomerate Anbang Insurance Group Co. “is looking to sell the Manhattan office building which houses its U.S. headquarters.” Yesterday, the Los Angeles Times reported that developer China Oceanwide Holdings Ltd. (code 715 on the Hong Kong stock exchange) abruptly halted a $1 billion downtown L.A. condominium, hotel and retail complex “due to a recapitalization of the project.” The development “is well underway and was expected to be completed this year.” Oceanwide shares fell by 1.4% today and are down by 79% from their 2015 highs.
Private companies are not the only ones girding for rougher seas. Today, Bloomberg notes that 23 out of 30 provincial governments have trimmed their own regional growth targets for this year relative to 2018, including Guangdong and Jiangsu, the regions with the highest GDP levels in China. Xinxiang, China’s largest province by land mass, slashed its 2019 growth target to 5.5% from 7% last year.
Caixin likewise relays that funding constraints have forced 17 separate provincial governments to cut their targets for construction under the “shantytown renovation” program (no euphemisms here). The program has drawn Beijing's scrutiny for the practice, increasingly common, of compensating displaced homeowners with cash rather than replacement housing, which “can drive more property purchases. . . because buyers can use the money for down payments on multiple homes.”
Might an otherwise routine economic slowdown metastasize into something much worse for super-encumbered China? Not if the powers that be can help it. In a report yesterday, Tim Murray of J Capital Research writes that a bond-market workaround may serve to frontload a burst of local government spending and stimulate the Chinese economy once more this spring:
The government has used legerdemain to boost funding without reneging on its commitment not to raise debt: Special Purpose Bonds (SPB). Issued by local governments, SPBs are for discrete infrastructure projects whose revenues, the issuer promises, will service the bonds. SPBs are not included in the fiscal budgets of local governments.
Chinese banks buy local government bonds under mandate, so the market for SPBs is not in doubt. . . This year, provisional approval was given in January for Rmb. 580 billion ($86 billion) of standard local government bonds and Rmb. 810 billion in SPBs to be issued in advance of the National People’s Congress [in March]. It is expected these bonds will be issued before April. This would create very strong liquidity for infrastructure projects in March.
Total expenditure in infrastructure may not rise, but we can expect more activity at the start of the construction season. Construction demand in March/April is critical for setting confidence in the economy.
Recap Jan. 29
Stocks finished slightly lower, with the S&P 500 continuing to consolidate near the midpoint of the all-time peak reached in late September and the Dec. 24 interim lows. Commodities caught a bid with gold rising above $1,310 an ounce and WTI crude popping back above $53 a barrel. Treasurys were also bid across the curve despite a mediocre seven-year note auction this afternoon, with the 10-year yield now at 2.71%.
The Fed will conclude its first meeting of the year tomorrow, with interest rate futures assigning zero odds of a rate hike. Stock bulls will be on the lookout for any dovish language from chairman Powell, particularly anything suggesting curtailment of the QT balance sheet runoff.
- Philip Grant
Monday, January 28, 2019
Strength in numbers
Fact of the day, from Bloomberg:
Fact of the day, from Bloomberg:
Mine over matter
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq)
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq)
Recap Jan. 28
Strength in numbers
Fact of the day, from Bloomberg:
The S&P 500 Equal Weight Index is trouncing the cap-weighted version YTD, putting up a total return of about 7.5% against 5.2% [for the S&P 500]. That ~230 basis point gap is the largest in 27 years.
Mine over matter
This morning, chip maker and hardware company Nvidia Corp. (NVDA on the Nasdaq) provided another unwelcome surprise in the form of sharply reduced fourth-quarter guidance. Revenues for the period are now projected at $2.2 billion, far below the $2.7 billion top-line guidance provided in November (which was itself cut from an initial $3.4 billion guesstimate) and the $2.91 billion logged in the last year’s fiscal fourth quarter. Profitability is likewise on the wane, with the company forecasting adjusted gross margins at about 56%, down from prior guidance of 62.5% and an average 62.6% over the past four quarters. Full results are expected on Feb. 14.
Whence came the banana peel? “Deteriorating macroeconomic conditions, particularly in China” was the primary factor according to the company press release. Increased customer price sensitivity in new, high-end graphics processing units (GPUs) and disappointing performance from its datacenter unit were also contributing factors, while several planned deals that were expected to close before quarter-end did not materialize, according to Nvidia.
Co-founder and CEO Jen-Hsun Huang offered some positive spin: “Looking forward, we are confident in our strategies and growth drivers. . . The foundation of our business is strong and more evident than ever.” Mr. Market logged his respectful disagreement, as NVDA shares fell by 14% and are now off 42% since June 29, compared to a 4% drop in the Nasdaq 100 Index.
NVDA five-year price chart. Source: The Bloomberg
It’s been a rapid change of fortunes for Santa Clara, Calif.-based Nvidia, inventor of the GPU in 1999 (“the brain of the computer,” is how the company puts it) which is used in video games, artificial intelligence and, of course, crypto-currency mining. The company rode the 2017-crypto boom to parabolic growth in both net income and share price, but it’s a different story now, as the combined crypto market cap currently stands at $112.7 billion, according to Coinmarketcap.com, down from more than $800 billion at the cyclical peak last January. As prices have retrenched, demand for equipment used to mine the digital ducats has likewise faded. The price of “add-in” memory boards, which rose as high as $1,500 in the teeth of the crypto mania, can be found online for fractions of that (the “Radeon E6460 PCIe 2.1 x16 add-in Board with Heatsink” is quoted by Symmetry Electronics at $189.04, before tax and shipping).
A bearish analysis of Nvidia in the June 29, edition of Grant’s rested on the idea that the then-underway crypto reversal would, in turn, crimp demand for the chip maker’s equipment, while a shift back toward video game GPU usage could lead to decreased demand for its high-end units and margin compression. At the same time, numerous tech peers were attempting to develop their own chips to undercut the “very expensive” GPUs (those words belong Sewon Chun, senior vice president of memory marketing at Samsung Electronics Co. Ltd) used in datacenter.
The analysis also took note of persistent selling across the company C-suite. The severe markdown in NVDA shares hasn’t quelled management’s evident bearishness, with five different officers selling shares September. On Oct. 2, senior vice president Ajay Puri rang the register on $26.3 million of stock.
It’s not just management which is eyeing the exits. On Dec. 11, Bloomberg reported that SoftBank Group Corp., which bought into the company in May 2017 and is Nvidia’s fourth-largest shareholder, was looking to sell its 4.9% NVDA stake “early [this] year,” and had hedged its position by purchasing out-of-the-money put options.
Hodl on loosely?
Recap Jan. 28
Stocks finished moderately weaker, as a late bounce helped the S&P 500 pare roughly half of its early 1.5% loss (Caterpillar, Inc. also offered weaker than expected guidance this morning). More bad corporate news hit the wires after the close, as Whirlpool Corp. guided its full-year earnings per share to well below the consensus estimate, sending shares lower by 5% in immediate reaction.
Elsewhere, commodities were hit hard with the CRB Index dropping nearly 2%, but gold managed to buck that bearish trend and remain above $1,300 an ounce, up 11% from the August interim lows. The VIX briefly rose above 20 before settling just below 19, and rates finished slightly lower across the Treasury curve. Interbank lending costs have turned lower in recent weeks, with three-month Libor now at 2.75%, down from 2.82% in late December, while The Secured Overnight Financing Rate (SOFR) now stands at 2.4%, down from 2.46% in mid-January.
- Philip Grant
Friday, January 25, 2019
Italian wedding
“Super Mario” isn’t finding things so super. At a press conference yesterday in Frankfurt, ECB president Mario Draghi said that the balance of risk “has moved to the downside,” a change from the “broadly balanced” assessment of conditions he offered six short weeks ago. The central banker went on to cite “uncertainties, in particular related to geopolitical factors” as a culprit for the recent turn for the worse.
Draghi’s remark appears at least partially directed at Europe’s problem child to the south, Italy, which has long been running harder just to stay in place. In the 12 years ended 2018, Italian nominal GDP has grown at a compound annual rate of just 0.11%, while public debt as a percentage of GDP has jumped to 130% from 100%.
The odds of much near-term improvement are scant. Last Friday, the Bank of Italy indicated that the country fell into recession in the back half of last year and cut its growth forecasts to 0.6% and 0.9% in 2019 and 2020, respectively, from prior guesstimates of 1% and 1.1%. Recent economic data have not helped: new and existing home prices logged 1.4% and 1.3% respective year-over-year declines in the third quarter, while November industrial production sank by 2.6% year-over-year. Economists had expected a 0.4% uptick.
Political risk is indeed front and center, as Italian media reports widespread rifts between populist coalition partners, the Five Star and The League parties, while Bloomberg relays that the political class “are poised for a snap election as early as this year.”
A need for economic growth is one area of agreement. Deputy prime minister and Five Star head Luigi Di Maio dismissed the Bank of Italy’s projections by telling Bloomberg that the central bank “is often wrong”, while prime minister Giuseppe Conte said Wednesday that he anticipates 1.5% output growth this year.
The stakes are high. Further economic deterioration could threaten ambitious spending plans under the populist coalition government run by the League and Five Star parties. A December agreement with the European Commission allows for a 2019 budget deficit of 2.04% of GDP, down from the original 2.4% deficit proposal which was rejected by Brussels.
Domestic political infighting aside, the Italian government still presents a united front (or target) for verbal barbs from E.U. peers. In Davos on Wednesday, the E.U. commisioner for economic affairs Pierre Moscovici turned up the rhetorical heat in describing the Italian government: “Changing Europe is one thing, destroying Europe is another thing. And that’s the difference between reform and populism, between pro Europeanism and nationalism.”
The pointed commentary isn’t just a one-way transmission. Today, prime minster Conte offered some blunt criticism of the recently signed Franco-German Treaty of Aachen, which calls for increased cooperation between the pair. Conte tells the Corriere della Sera: “Our allies certainly cannot think that we can sit at the table quietly, subscribing to decisions taken by others. . . the truth is that we have caught France and Germany with their hands in the jar.”
Meanwhile, negative interest rates continue to reign across Europe, with futures pricing in little change to the ECB’s negative 40 basis point deposit rate through year-end, while Draghi is set to retire at the end of his term this fall. Sub-zero interest rates have been no boon to the Old Continent’s banking system, as the Euro Stoxx Banks Index now trades at 0.61 times book value, down from 0.83 at year-end 2017 and less than half of the 1.27 times book currently fetched by the U.S. KBW Banks Index.
Euro Stoxx Banks Index, ten-year view. Source: The Bloomberg
As for triple-B-rated Italy (which, incidentally, borrows for 10 years at 2.64%, below the 2.75% interest rate fetched by a 10-year Treasury), Ignazio Visco, governor of the Bank of Italy and member of the ECB’s Governing Council remarked last May that “Italy’s destiny is that of Europe.”
Is that a promise or a threat?
Recap Jan. 25
A solid rally for stocks left the S&P 500 marginally in the red for the week, its first such decline of 2019, but the VIX closed at 17.5, near a two-month low. An outsize dollar selloff put a bid under the commodity complex, as gold tested $1,300 an ounce for the first time since June, as well as emerging markets, as the iShares MSCI Emerging Markets ETF reached its best close since early October.
In the bond market, Treasury yields ticked higher across the curve, while the iShares iBoxx USD Investment Grade Corporate Bond ETF rose for an eighth straight session to close at its highest since September.
- Philip Grant
Thursday, January 24, 2019
We must protect this planet
From a blog post on Virgin Galactic’s website:
From a blog post on Virgin Galactic’s website:
Junk food
The high yield drought is over.
The high yield drought is over.
Margin bawl
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange).
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange).
QT Progress report
Recap Jan. 24
We must protect this planet
From a blog post on Virgin Galactic’s website:
Virgin Galactic is proud to announce Under Armour as its Exclusive Technical Spacewear Partner to create a next generation of spacewear and astronaut performance programs.
The partnership will also see Under Armour create uniforms for Virgin Galactic’s world-class team at Spaceport America in New Mexico. Whether engineers, astronaut trainers and hosts, or mission control operatives, each member of the Virgin Galactic team will be wearing Under Armour apparel specifically chosen to enhance performance and to provide a tangible sense of shared purpose.
Perhaps also some new duds for Trump’s Space Force?
Junk food
The high yield drought is over. Today, Bloomberg reports that Altice USA, Inc. will issue $1 billion worth of 10-year senior guaranteed notes that will be used to refinance outstanding 8 5/8 notes due this year, as well as a portion of the 10 1/8 notes maturing in 2023. Price talk is set at 6.5% to 6.75% according to S&P’s LCD unit, with the books closed this afternoon and pricing expected shortly.
A successful refinancing would be a coup for single-B-plus-rated Altice, which is levered to five times consensus 2019 adjusted EBITDA. The cable operator incurred $1.5 billion in interest expense for the 12-months ended Sept. 30, three quarters of this year’s $2 billion in forecast operating income.
Indeed, the sharp post-Christmas rally in asset prices has spurred a winter thaw in junk bonds. December saw zero new issuance, the first such barren month since November 2008, and the $165 billion in newly priced deals last year was the lowest annual new supply since 2009. In contrast, four deals priced earlier this week totalling $4.15 billion, each drawing bidding interest of more than five times the original offering size.
Meanwhile, the Bloomberg Barclays U.S. High Yield Total Return Index has jumped by 3.64% in January, well ahead of both the 1.05% advance in the Bloomberg Barclays Investment Grade Index and the 2.64% gain in S&P/LSTA’s Leveraged Loan Index. In tandem, the spread on the BarCap U.S. Corporate High Yield 10-Year Index has dropped to 434 basis points from 537 basis points just three weeks ago.
Does the hot start to the year augur big things for speculative-grade credit in 2019? Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors LLC, notes that only 2001, 2003 and 2009 saw early performance on par with this year’s blistering beginning, and the index went on to enjoy resounding gains in two of those three instances (17.61% in 2003 and an incredible 43.69% in 2009). However, the Dean of High Yield cautions:
Based on that record and the hoary stock market adage, “As January goes, so goes the year,” some overeager high-yield promoters may get carried away suggesting that eye-popping gains are in store for 2019.
There is no basis even for predicting that a positive start to the year improves the chances for a full-year return greater than zero. Intra-month returns are available on the ICE BAML High Yield Index from 1991 onwards. Full-year returns have been negative in 13 out of 28 years. . . In seven of the 13 negative-price-return years, the subzero result occurred despite a positive price return in the first half of January.
Margin bawl
Behold the peculiar tale of Jiayuan International Group Ltd. (code 2768 on the Hong Kong Stock Exchange). Last Thursday, shares in the property developer endured an 80% swan-dive on no apparent news, erasing HKD $27 billion ($3.4 billion) in market capitalization.
Jiayuan initially claimed no knowledge of the reasons for the plunge, before coming clean the next day: A company owned by chairman Shum Tin Chiang was forced to sell 93.6 million Jiayuan shares (24.6 times the stock’s one-year average daily trading volume) in the open market in connection with a brokerage margin call.
On Monday, Jiayuan pointed the finger at short sellers in a meeting with investors, according to Chinese language-website qq.com and reported by Bloomberg, with Chiang claiming the shorts “sought to profit by misleading investors [and] sending messages with false information.” The company also told investors that the share plunge didn’t trip debt covenants, a claim that existing creditors might find to be cold comfort: The developer’s two-year senior secured dollar-pay bonds due in October currently fetch just under 85 cents, for a yield-to-worst of 36.97%. The stock was suspended by regulators until further notice on Tuesday after another 23% fall, a move that Bloomberg notes “came only hours after the company said trading would resume.”
QT Progress report
Another mostly steady week leaves the Fed’s portfolio of securities held outright at $3.85 trillion, down $3.9 billion from last week’s reading. Mortgage-backed securities accounted for most of the latest run-off and represent more than half of the $13.5 billion decline from the trailing four-week average, despite constituting about 42% of the portfolio.
Since QT began on Oct. 1 2017, the Fed’s total balance sheet assets are down by 9.2%.
Recap Jan. 24
A sideways showing for the S&P 500 leaves the broad average on the cusp of its first weekly decline of the year, down 1% from last Friday’s close. The Nasdaq outperformed thanks to a near-6% jump in the Philadelphia Semiconductor Index, a move that looks primed for reversal as Intel Corp. offered both relatively weak fourth quarter results and guidance that trailed consensus after the close, sending INTC shares lower by 8% in immediate reaction.
Elsewhere, Treasury yields dipped in near-lockstep across the curve, while commodities finished marginally higher as WTI crude edged over $53 a barrel. The VIX dropped back below 19.
- Philip Grant
Tuesday, January 22, 2019
Rock and a hard place
It’s not just a seasonal deep freeze. This morning’s data from Statistics Canada provided the latest evidence that things are less than hunky-dory in the Great White North, as November factory sales declined 1.4% and wholesale sales by 1%, both well below their consensus expectations of negative 0.3% and 1%, respectively. It was the weakest wholesale reading since March 2016. On Jan. 9, the Bank of Canada cut its real GDP forecast to 1.7% from 2.1% in October.
The long-running Canadian housing boom is likewise encountering icebergs, as home sales in Toronto and Vancouver plunged last year by 16% and 32%, respectively, from 2017. The Teranet-National Bank House Price Index remains in positive territory but near the lowest growth rate of the post-2008 cycle. Meanwhile, the credit-engine which propelled the housing bull run looks set to stall, as Canadian Imperial Bank of Commerce CEO Victor Dodig forecast a flat to low single-digit growth rate in mortgages for the “foreseeable future” at a Toronto conference in early January (for more on CIBC and mortgage growth, see the Feb. 9, 2018 edition of Grant’s).
Teranet-National Bank Canadian Home Price Index. Source: The Bloomberg
That housing downshift carries particularly acute risk for encumbered Canada, where the household debt-to-disposable income ratio registered at 175% at the end of the third quarter according to data from Bloomberg, well above the U.S. peak of 137% reached in 2007. A December survey from MNP Ltd. showed that 46% of respondents are avoiding insolvency by less than $200 per month, up from 40% in September. “Many [Canadians] have so little wiggle room that any increase in living costs or interest payments can tip them over the edge,” MNP president Grant Bazian commented.
Inconveniently for the Bank of Canada, inflation is also on the rise. Last Friday brought a surprisingly hot CPI report for December, with the headline figure rising 2% year-over-year against the consensus of 1.7%, with the services sector reaching its highest since 2008 with a 3.5% year-over-year jump. Overall, headline CPI averaged 2.3% year-over-year in 2018, up from 1.6% and 1.4% in the prior two years.
Much like the Fed, the BoC has been in a tightening cycle, raising rates five times since July 2017 to 1.75%. Following a stand-pat meeting on Jan. 9, BoC president Stephen Poloz highlighted the positives, observing: “The economy has been operating essentially at full capacity for about 18 months now, and inflation has been running on target. The labor market has been performing well . . . and unemployment is as low as we’ve ever seen it.” The market, however, isn’t so sure. Interest rate futures now price just 15% odds of another rate hike at the April 24 meeting; that’s down from 88% two months ago.
But would a turn toward easier money or even “QE”-like monetary stimulus provide much help for what ails Canada? Grant’s put the question to Hilliard MacBeth, portfolio manager at Richardson GMP Ltd. and author of “When the Bubble Bursts: Surviving the Canadian Real Estate Crash.”MacBeth predicts that while the BoC will indeed be forced into a dovish pivot, the central bank may not be able to accomplish much beyond currency devaluation:
The BoC displayed a readiness to change course very quickly in 2015 when rates were cut after the energy sector was hit hard.
However, with household debt higher than almost any other country at 100% of GDP, the traditional interest rate stimulus through housing is not going to work this time. The housing sector is too large and this downturn will be very deep once credit growth slows below GDP growth. Mortgage growth has already slowed sharply.
When Canada enters a recession and if the U.S. continues to grow, the BOC will face a very difficult time. Interest rate cuts, while unlikely to work on housing, will have the effect of pushing the Canadian dollar below 70 cents per U.S. dollar [from the current 75 cents and a five year average of 80 cents].
The BoC would be willing to let this happen, hoping for an export-led rebound. But it's likely that fiscal stimulus will be required when monetary policies fail to work.
Recap Jan. 22
Stocks endured a sharp pullback, with the S&P 500 falling nearly 1.5% for its biggest selloff since Jan. 3, narrowing the year-to-date gains to 5% for this young 2019. Commodities were likewise hit hard, with WTI crude dropping 2% to $53 a barrel, and Treasury yields fell moderately across the curve. The VIX closed above 20 for the first time in two weeks.
- Philip Grant
Friday, January 18, 2019
Hope springs eternal
Great Wall of worry
Good times are here again.
Good times are here again.
Dancing in the dark
Recap Jan. 18
Hope springs eternal
This afternoon, MarketWatch reports that acting director of the Federal Housing Finance Agency Joseph Otting told staff “that the regulators will announce a plan within weeks to take the government-sponsored enterprises out of conservatorship.” That was music to the ears of long-suffering Fannie and Freddie investors, as the pair’s common shares jumped by 34% and 32%, respectively while the most-actively traded preferreds gained 9% and 5%. Fannie and Freddie common shares now each trade at a slight premium to their average close since Donald Trump’s election in November 2016, while the preferreds each trade about 50% higher than their Trump-era average.
For more details on the contentious debate over the government-sponsored entities, see the Jan.8 edition of Almost Daily Grant’s.
Great Wall of worry
Good times are here again. The emphatic rebound in the stock market since late last year has pushed the S&P 500 higher by 6.5% year-to-date, erasing more than half of the fall 2018 selloff. Bottom-catchers in popular technology stocks have been even more richly rewarded, as the 10-stock NYSE FANG+ Index has surged by nearly 11% year-to-date, shaking off some major setbacks along the way. Investor darling Netflix, Inc., surprised the Street yesterday evening with weaker than expected fourth quarter results and guidance, but saw its shares decline only 4% to remain a whopping 45% above their Dec. 24 close. Even Apple, Inc., which fell 30% in the fourth quarter and another 9% on Jan. 3 after issuing its own profit warning, has seen its shares enjoy a 10% snapback over the past 11 sessions.
But for these lynchpins of the post-2009 bull market, cracks in the edifice continue to surface. A quartet of new developments concerning FANG+ Index components today:
Tesla, Inc. announced it would lay off 7% of its work force to cut costs, sending shares careening lower by 13%. Nikkei Asian Review reports that Apple supplier Foxconn Technology Co. Ltd. dismissed 50,000 temporary workers from the iPhone factory in Zhengzhou beginning in October, “significantly earlier” than recent years. The Washington Post relays news that the Federal Trade Commission is expected to levy “a record setting” fine against Facebook, Inc. for its disregard of privacy laws. Bloomberg reports that Alibaba Group Holding Ltd. is delaying new hires and imposing new travel restrictions on its employees, including “restricting business class airfares on a unit-by-unit basis, with staff only able to select a premium cabin on every fifth round trip that takes more than 20 hours.”
The question before the house: Does the powerful upside reversal signal a renewed bull market, or just a simple bear market bounce? A new white paper from Grantham, Mayo, Van Otterloo & Co. finds that U.S. equities entered bubble territory in early 2017, and that the bubble began to deflate in the fourth quarter. Author Martin Tarlie concludes: “Our advice, consistent with our portfolio positions, is to own as little U.S. equity as career risk allows.”
Dancing in the dark
The gyrating stock market seems to be itself influencing the future direction of the U.S. economy, if interest rate futures are any indication. On Oct. 2, with the S&P 500 near its highs, Fed Fund futures implied a 98% chance of at least one rate hike this year. On Dec. 28 with stocks in freefall, those odds collapsed to 8%, and have since risen back to 29%.
The policymakers are likewise keeping their options open. John Williams, president of the New York Fed, summarized his views in a speech today:
The approach we need is one of prudence, patience, and good judgement. The motto of ‘data dependence’ is more relevant than ever.
If growth continues to come in well above sustainable levels, somewhat higher interest rates may be called for at some point. However, if conditions turn out to be less robust, then I will adjust my policy views accordingly.
A reasonable viewpoint, to be sure. The only problem: The Census Bureau and Bureau of Economic Analysis remain closed thanks to the ongoing (and going) government shutdown, depriving the policymakers of key growth indicators such as gross domestic product, durable goods and retail sales.
Williams’ boss, Fed chair Jerome Powell, has likewise vacillated back and forth. A sampling of Powell’s recent comments, as tabulated by Jim Bianco of Bianco Research:
October – The funds’ rate is a long way from neutral (hawkish)
November – The funds’ rate is just below the range of estimates (dovish)
December – Balance sheet reductions are on “automatic pilot” (hawkish)
Jan. 4 – The Fed can be patient and flexible (dovish)
Jan. 10 – The balance sheet will be ‘substantially smaller’ (hawkish)
Recap Jan. 18
Another strong rally left the S&P 500 higher by 1.3% and the Dow Transports up by more than 4%, to leave each of those indices at their best closing levels since early December. WTI crude likewise made a fresh six week high near $54 a barrel, while the VIX closed below 18 for the first time since, you guessed it, early December. Treasury yields jumped across the curve, with more pronounced weakness at the short end leaving the two-year yield at 2.61%, up from 2.38% on Jan. 3.
- Philip Grant
Thursday, January 17, 2019
The man who really knew
Yesterday, John C. Bogle, founder of The Vanguard Group and the “Thomas A. Edison of indexation” (Grant’s, April 17, 2015), died at home in Pennsylvania at the age of 89. Bogle, who founded Vanguard near the S&P 500’s cyclical low ebb in 1975, spent the rest of his life advocating for his revelatory concept of tracking the overall market on the cheap. In a 1999 New York Times opinion piece, Bogle dished out a dose of reality to the frenzied bull market masses, writing: “The market is simply a gambling casino. . . beating the market is a zero-sum game, but only before costs are deducted. In the stock market casino, it is the croupiers who win.”
In 2012, Bogle explained to the Times: “My ideas are very simple; in investing, you get what you don’t pay for. Costs matter.” Three years later, Bogle looked at the big picture in making his case for passive investing at the Grant’s 2015 spring conference in New York:
The cost of investing, shared by active managers at a high cost, is roughly 2% per year. The cost of investing, shared by index investors at a low cost, is 0.05% per year. Therefore, low-cost investors, collectively, must earn higher net returns. So it is demonstrated – Q.E.D.
And that’s why indexing is now so dominant, because people are getting the message.
Indeed, Bogle lived to see his creation and its close cousin, exchange traded funds (though about that cousin, he had mixed feelings), grow into a dominant financial force. As noted Tuesday by the Financial Times, data from consulting firm ETFGI shows global ETF assets at $4.6 trillion, up from less than $100 billion in 2000 for a compound annual growth rate of 22.3%. Vanguard itself now owns 5% or more of 491 stocks in the S&P 500.
Welcome to the 'Rock
Bogle’s big idea hasn’t just served Vanguard well. Yesterday, BlackRock, Inc. (BLK on the NYSE) reported fourth quarter results, featuring a record $81 billion inflow into its iShares division of exchange-traded funds. Kyle Sanders of Edward D. Jones & Co. was impressed, telling Bloomberg: “To put up for more than $80 billion in iShares flows in a really, really tough market shows [that] they’re differentiated, and ETFs have a pretty good runway for growth.”
What’s more, the influx into ETFs continued apace as the market tumbled late in the year, with the company reporting record monthly inflows in both November and December. The stampede into ETFs has hardly abated in this young 2019: BlackRock CEO Laurence D. Fink noted that January has seen a net $13 billion inflow thus far.
Those impressive figures from iShares were enough to send BLK shares higher by more than 5% in reaction, outweighing weaker-than-expected headline earnings per share, a 9% year-over-year drop in revenues, 5% pullback in assets under management and a 320 basis point decline in operating margin, to 36.3%. BLK shares are up by 14% since Grant’s offered a bearish analysis on Sept. 30, 2016, trailing the S&P 500s 23% advance over that period. Of his star performer iShares unit, Fink had this to say on the conference call:
More and more clients are choosing ETFs as the preferred investment vehicles because of their superior structure relative to the mutual fund industry, including liquidity and, most importantly, tax efficiency.
In a follow-up interview on CNBC, Fink further explained the financial paradigm shift, and his own firm’s prominent role therein:
What I think is really differentiating us [and] changing the whole composition of the markets; we’re seeing . . . investors move away from stock picking, moving away from buying a product to working on models and really now portfolio composition.
Might the long post-2009 asset price levitation, bountifully assisted by the world’s central banks through zero or negative interest rates and various forms of QE, play a more prominent role in the ascent of ETFs, iShares and BlackRock itself? Kevin Duffy, principal at Bearing Asset Management and confirmed BLK bear, writes in to Grant’s to pose a rhetorical question:
If client inflows were strong, especially in equities, how is it that “sentiment shifted from cautious to negative [as stated by the CEO on the conference call]?” It’s almost as if Fink is saying Q4 was a stress test and the BLK model passed with flying colors. Has he dialed in the possibility of a bear market alongside fee compression and outflows?
If a prolonged bear market is headed our way, I suspect we’ll find out if the passive perpetual motion machine is designed to go in reverse.
QT Progress report
The Fed’s portfolio of securities held outright stands at $3.855 trillion this week, down $6.6 billion from a week ago. Mortgage-backed securities accounted for two-thirds of the run-off, with Treasurys supplying the balance.
Compared to the trailing four-week average, today’s figures represent a decline of $18.6 billion. Since the onset of “QT” on Oct. 1, 2017, the Fed’s total balance sheet assets are down by 9.1%.
Recap Jan. 17
Another day, another rise in the stock market, as an afternoon report that the Trump administration is considering lifting tariffs on China (since denied) helped the S&P 500 rise for a third straight day. The broad index now sits higher by 5% year-to-date, erasing exactly half of the peak-to-trough swoon in the fourth quarter on an absolute basis.
Treasury yields ticked higher with the exception of the 30-year long bond to leave the curve flatter, and commodities finished little changed. The VIX closed below 20 for a seventh straight session, matching the longest streak since the market remained near its highs in early October.
But the bulls can perhaps expect a bumpier ride tomorrow, as Netflix, Inc. reported light fourth quarter revenues and weaker-than-expected guidance for the first quarter on both the top and bottom line. NFLX shares fell as much as 5% in early reaction.
- Philip Grant
Wednesday, January 16, 2019
Gotta serve somebody
From this morning’s edition of The Wall Street Journal:
From this morning’s edition of The Wall Street Journal:
More money – more good?
According to data released on Monday from China’s General Administration of Customs,
According to data released on Monday from China’s General Administration of Customs,
Recap Jan. 16
Gotta serve somebody
From this morning’s edition of The Wall Street Journal:
For more than two months after employees at International Business Machines Corp. moved into a Manhattan building managed by office-space giant WeWork Cos., frequent elevator problems forced workers to climb the stairs of the 11-story building and prompted complaints to the company.
One of the landlords behind the building was no ordinary owner: It was Adam Neumann, WeWork’s chief executive, who leased the property to WeWork after buying it, according to people familiar with the situation.
Mr. Neumann has made millions of dollars by leasing multiple properties in which he has an ownership stake back to WeWork, one of the country’s most valuable startups. Multiple investors of the privately held company said the arrangement concerned them as a potential conflict of interest in which the CEO could benefit on rents or other terms with the company.
This afternoon, WeWork responded to the Journal’s reporting, stating: “Those transactions are reviewed and approved by the board, and they are disclosed to investors.”
More money – more good?
According to data released on Monday from China’s General Administration of Customs, December imports sank by 7.6% year-over-year while exports dropped by 4.4%. Those figures compare to consensus year-over-year growth expectations of 4.5% and 2%, respectively, and represent the biggest annual declines in a given month for each since late 2016.
Poor December aside, 2018 was a strong year for Chinese trade, as exports and imports jumped by 10% and 16% over the full-year period. But as noted by the South China Morning Post, front-loading of trading activity ahead of U.S. tariffs was largely responsible for the brisk year-over-year growth, while the most recent figures “give the first indication of the full impact of the U.S.-China trade war.”
Whether or not the direct result of trade tensions, evidence of economic trouble in the Middle Kingdom is increasingly hard to ignore. Last Friday, Reuters reported that China has lowered its GDP target for 2019 to a range of 6% to 6.5%. That’s below the 6.6% reported output gain widely expected last year, which would already be the weakest figure since 1990. With a towering leverage profile featuring banking assets of $39.1 trillion as of Sept. 30, nearly half of the $80.7 trillion 2017 world GDP as measured by the World Bank, waning economic growth could spell big trouble for both China and beyond.
For its part, the People’s Bank of China is taking action. Today, it injected a net RMB 560 billion ($83 billion) into the financial system, by far the highest one-day liquidity addition on record. While seasonal factors, including the Lunar New Year and annual tax collections played their part, the figure was more than double the RMB 270 billion influx from the People’s Bank of China a year ago. That follows last week’s cut of the reserve ratio requirement for Chinese banks by the PBOC, the fifth such rate reduction in the past year.
The central bank’s ministrations have had some positive effects. Bloomberg notes today data from ChinaBond showing that the spread of three-year triple-A-rated local government funding vehicles (which finance infrastructure and other state-directed projects) has fallen to 119 basis points over Chinese sovereign bonds, the narrowest spread in two years and down from nearly 250 basis points last fall. Perceived sovereign credit risk is likewise abating, with Chinese five-year credit default swaps dropping below 61 basis points today. That’s down from 73 basis points in late November and the most sanguine reading since early October.
Credit may be generally on the uptick, but growth in Chinese money supply continues to evaporate (Almost Daily Grant’s, Jan. 7). The December figures, which were released yesterday, show that while the broader M2 metric improved off multi-decade lows with an 8.1% year-over-year reading, M1 (which measures the most liquid forms of money) grew just 1.5% from a year ago, below the 1.6% consensus and ahead of only January 2014 as the weakest monthly reading going back to 1996. For context, M1 grew 11.7% year-over-year in December 2017 and has averaged 13.5% since March 2009.
China M1 money supply, year-over-year growth rate. Source: The Bloomberg
Ming Ming, head of fixed-income research at Citic Securities Co., aptly summarizes Grant’s long-held viewpoint in a research note yesterday: “The structure of China’s credit system is not in a good shape.”
Recap Jan. 16
Another up day for stocks left the S&P 500 at its highest close in more than a month, while narrowing the broad index’s decline from the Sept. 20 highs to less than 11%. Financials continued to carry the day as a raft of larger institutions reported fourth quarter results, with the KBW Banks Index up nearly 5% over the first three days of the week.
Rates were generally higher across the curve with the exception of the long bond to leave the curve flatter after some notable recent steepening, while commodities and the dollar both traded slightly higher. The VIX finished little changed to close below the 20 mark for a sixth straight session.
- Philip Grant
Tuesday, January 15, 2019
A reason to move
Rampant fuel theft in Mexico has attracted the attention of President Andrés Manuel López Obrador (AMLO for short). On Dec. 27, AMLO announced plans to defend the country’s oil installations from the so-called “huachicoleros” with military personnel and transport more fuel across the country in tanker trucks instead of vulnerable pipelines. Yesterday, the Mexican President suggested the government may transport gasoline via train, and called on energy companies to increase fuel imports.
The theft problem is a significant one as $3 billion of black gold was stolen last year according to government data, while state-owned oil company Petróleos Mexicanos, or Pemex, reports that illegal pipeline taps rose 45% year-over-year in the first 10 months of 2018. Then, too, the newly installed President (he took office on Dec. 1) enjoys broad public support for his initiative: According to a poll by El Financiero released yesterday, 89% of respondents agreed with the President’s theft crackdown, while 64% of approved of the pipeline closures.
The drive to combat fuel theft has yielded some results, as attorney general Alejandro Gertz Manero told reporters yesterday that three “top” (but unidentified) Pemex executives in charge of pipeline management will face prosecution for siphoning fuel, while Mexican authorities have opened some 1,700 individual cases related to the matter. But criminal justice aside, AMLO’s moves have taken a toll in the form of fuel shortages, rationing and long lines at gas stations. Regional authorities complained about the abrupt implementation of the plan. Yesterday, Reuters reported:
Officials in three affected states [said] they were not warned in advance about the supply cuts.
“There was zero coordination,” said Alejandro Guzman, head of economic development in the government of Jalisco, home to the country’s second-biggest city, Guadalajara. “We started to notice when the gas stations started closing.”
AMLO’s energy initiatives are not limited to combatting theft. Last week, Pemex announced that the government will provide $1.25 billion in capital this year, as the state-owned energy concern looks to “improve cash flow and investment through an optimized financial engineering.” Pemex carries $83 billion in outstanding bonds, faces $5.4 billion in maturities this year, and has operated in the red on a free cash flow basis in each year since at least 2008.
Baa3/triple-B-plus-rated Pemex, the eighth-largest oil producer in the world, has absorbed a precipitous fall in both output and reserves in recent years, an ominous development for such a highly leveraged enterprise. Last Wednesday, senior executives trekked up to the Big Apple to meet with investors. It didn’t seem to go particularly well, as analysts at Nomura wrote following the powwow that “we believe Pemex managers were not able to present a credible explanation,” for the company’s struggles, while Jefferies analysts said they were “disappointed by lack of a cohesive strategy.”
The buy side was even more scathing. James Craige, co-chief investment officer at Stone Harbor Investment Partners, told Bloomberg: “The CFO had no handle on the company and was not impressive at all. . . he has to go.” Craige went on to lament a “lack of clarity in the financing program, lack of clarity on how they reach production goals and lack of clarity on future concession auctions” before concluding: “If this guy is the conduit to the rating agencies, we can expect downgrades.” The bond market has been likewise unimpressed, as the Pemex senior unsecured 4 7/8 dollar-pay notes of 2024 have fallen to 94 cents on the dollar for a 375 basis point spread over Treasurys. That’s down from 101 and a 199 basis point spread in March.
The March 23, 2018 edition of Grant’s featured a bearish analysis of Pemex, suggesting that the state-owned enterprise might one day become the direct obligation of the Mexican government, since, in the words of IPD Latin America’s John Padilla: “Pemex, in any private sector context would absolutely be considered bankrupt.” A November follow-up, written after those notes had retreated to the current price of 94, concluded: “Grant’s remains bearish – emphatically.”
Recap Jan. 15
Stocks rose again, with a 1% advance pushing the S&P 500 back above 2,600 at the close for the first time in a month, while the KBW Bank Index has managed an impressive 2.2% advance over the past two days despite seemingly poor results from Citigroup, Inc. and J.P. Morgan Chase & Co. The Dow Transports were noticeable laggards, falling by nearly 1%, but after the bell, United Continental Holdings, Inc. reported far better than expected fourth quarter profitability figures, sending shares higher by more than 5% in initial reaction.
Elsewhere, another round of steepening in the Treasury curve pushed the 5-year/30-year spread above 54 basis points, approaching a 52-week high and up from less than 20 basis points in July. Commodities caught a bid with WTI crude rising back above $52 a barrel, and the VIX finished below 20 for a fifth straight session.
- Philip Grant
Monday, January 14, 2019
A negative art
This morning, San Francisco-based PG&E Corp.
This morning, San Francisco-based PG&E Corp.
Gold fingers
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc.
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc.
Recap Jan. 14
A negative art
This morning, San Francisco-based PG&E Corp. (PCG on the NYSE) announced it will file for bankruptcy by Jan. 29. The devastating wildfires that afflicted California last fall left Chapter 11 reorganization as “ultimately the only viable option to restore PG&E’s financial stability to fund ongoing operations and provide safe service to customers,” according to the form 8-K the company filed today. The company is facing more than $30 billion in liabilities stemming from the disaster, swamping the approximately $1.5 billion in cash and cash equivalents available as of Friday.
It’s been a steep decent for PCG, which has seen its shares plummet to $8.50 from $25 on Jan. 4 (they fell 52% today), while the senior unsecured 6.05% notes of 2034 have fallen below 84 cents on the dollar, compared to 94 ten days ago. The progression of PG&E’s credit ratings have been similarly abrupt, as Moody’s downgraded PG&E’s long-term issuer rating to B2 on Thursday from investment-grade Baa3, a five-notch demotion, while S&P also cut PG&E five notches to single-B from triple-B-minus last Monday. Each firm had downgraded PG&E by one notch in mid-November as the so-called Camp Fire, which killed more than 100 people, raged.
“Since the chief emphasis must be placed on avoidance of loss,” wrote Benjamin Graham and David Dodd in their mighty volume, “Security Analysis,” “bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.” Cautionary words to mark, to be sure, though it is asking a lot of any investment committee to anticipate a plague of forest fires. Business risk is a more frequent, and usually more costly, source of surprise.
Thus, as recently as April, the senior subordinated 10 1/4 notes of American Tire Distributors, Inc. traded above par, before Goodyear Tire & Rubber Co. announced it would end its distribution ties to American, sending those bonds careening to 43 cents on the dollar a week later (American Tire filed for Chapter 11 in October). The Toys “R” Us Inc.’s senior unsecured 8 3/4 notes of 2021 likewise changed hands above par as recently as August 2017, plummeting to 12 a month later as the retailer filed for bankruptcy. “Hence,” Graham and Dodd completed their thought, “broadly speaking, there is no such thing as being unduly captious or exacting in the purchase of fixed-value investments.” Especially, one might add, in an age of suppressed interest rates.
Gold fingers
Today, Newmont Mining Corp. (NEM on the NYSE) announced its intention to buy peer Goldcorp, Inc. in a $10 billion stock-and-cash deal. At an aggregate eight million ounces of production using 2017 figures, the combined company will become the world’s largest gold miner by market cap, production and reserves. This proposed deal follows the September merger announcement between Barrick Gold Corp. and Rangold Resources Ltd.
Josh Wolfson, analyst at Desjardins Securities, writes today that Newmont got itself a deal: “Goldcorp is on the cusp of delivering material production growth and free cash flow, the shares have come under pressure [down by 49% over the past five years compared to a 12% gain for the S&P/TSX Global Gold Total Return Index] and valuation is attractive.”
The pair of high-profile mergers may precede further consolidation in the gold miners, as Barrick CEO and former Rangold boss Mark Bristow hinted in an interview with Bloomberg on Jan. 2: “Without a doubt, this industry needs transformation. We believe we have started that. We’re going to end up with a blue-chip business and on the way we’re not going to be sitting on our hands should there be other opportunities.”
When the interviewer noted that the Barrick/Rangold enterprise controls five of the top 10 gold mines in the world and asked how many more he wanted to own, Bristow quipped: “All of them,” arguing that the “industry, if it had carried on the way it was, was going to become irrelevant, [with] too few assets with too many management teams and it needs reorganization.”
Bristow’s sentiments have long been shared by John Hathaway, co-manager of the Tocqueville Gold Fund. Speaking at the Grant’s spring conference in April, Hathaway detailed the predicament faced by miners, as the price of gold remains stuck below $1,300 an ounce after having reached $1,900 in 2011:
Mine lives at multi-decade lows. Discoveries are almost non-existent. Because of the downward pressure on [mining-company] share prices, the industry has been unable to finance and therefore has cut off exploration. So we’re almost guaranteed a long period where, even with rising gold prices, there will not be a supply response.
The investment opportunity to propose here is that the large companies, which have big market caps and relatively good valuations, will be forced, in my mind, to make a number of acquisitions.
Hathaway went on to identify three smaller miners as attractive potential acquisition targets. For more details on his picks-to-click, see the April 20, 2018 edition of Grant’s.
Recap Jan. 14
Stocks absorbed a moderate loss, with the S&P 500 pulling back by 0.5% as intraday volatility continues to cool: Since the onset of 2019, the broad index has either risen or dropped by more than 1% on only two of nine trading sessions. In December, the S&P closed higher or lower by more than 1% on 10 of 19 trading days.
Elsewhere, the Treasury curve steepened a bit as the long bond came under pressure to leave the 30-year yield at 3.05%, while commodities and the dollar both finished slightly lower. The VIX gave back the bulk of its early gains to finish just below 19 for a second straight day, the calmest such stretch since early December.
- Philip Grant
Friday, January 11, 2019
The show must go on
From the Hollywood Reporter
From the Hollywood Reporter
Hair of the dog
It went down smooth.
It went down smooth.
Recap Jan. 11
The show must go on
From the Hollywood Reporter:
Creators, innovators and entrepreneurs were celebrated at the 2nd Annual WeWork Creator Awards Global Finals, which were held at the Microsoft Theater on Wednesday night.
The theater was packed with WeWork employees and before the competition started CEO Adam Neumann spoke to a vision for his company that was larger than just making a profit.
“The world was made for all of us to be all that we can be. And when we started this company with a simple concept, it was called WeWork and we wanted to create a world where people could make a life and not just a living ... because making a life means to enjoy the struggle," he said.
The contestants competed in a shark-tank style “pitch-off” in front of a panel of four judges, which included longtime tech investor Ashton Kutcher, rapper and business mogul Diddy, Gary Vaynerchuk, the CEO of VaynerX, and venture capitalist Kirsten Green.
After the confetti cannons exploded there was a surprise performance by the Red Hot Chili Peppers, who played an hourlong set that included classic hits such as "Californication," "Can’t Stop" and "Scar Tissue."
Hair of the dog
It went down smooth. Yesterday, Anheuser-Busch InBev S.A./N.V. (ABI on the Belgian Stock Exchange and BUD on the NYSE) rang in the New Year for corporate bond issuance in style, pricing a mammoth $15.5 billion offering in, appropriately enough, a six-pack of maturities ranging from 2025 to 2059. Baa1/single-A-minus-rated Anheuser Busch will use the funds to help retire $16.5 billion in shorter-term obligations, largely stemming from the company’s 2016 acquisition of SAB Miller plc., but will pay up for the privilege of doing so: The 10- and 30-year tranches were priced at respective 205 and 250 basis point spreads over Treasurys. That compares to 120 and 150 basis point premiums for the same 10- and 30-year maturities during a prior offering last April.
Wider spreads aside, encouraging signs were readily apparent from the deal. Bidding interest was robust, with the order book reaching as high as $41 billion before settling at $39 billion, leaving the issue 2.7 times oversubscribed. Pricing was also solid, with Bloomberg describing the 26 basis point concessions from secondary market prices as “reasonable” considering the beer maker was able to upsize the offering from an original $10 billion.
The bond market’s warm reception was a much needed win for highly-leveraged ABI, which saw shares spike this morning on a report that it is considering an initial public offering of its Asian operations. Positive recent developments aside, it’s been tough sledding for the beer giant, which has seen its shares slide by 31% since February, thanks to largely disappointing operating results that led to the brewer slashing its dividend in half in October to improve a flagging balance sheet. Nevertheless, on Dec. 10 Moody’s downgraded ABI’s credit rating to Baa1 (three notches above junk) from A3, while S&P has kept Anheuser-Busch debt on watch “negative” since early 2017. For good reason, as ABI’s $116 billion in net debt equates to more than five times consensus 2019 adjusted EBITDA, double the leverage ratio of Baa1/triple-B-plus-rated peer Heineken N.V.
Meanwhile, ABI’s massive $65 billion acquisition of SAB Miller (at a fancy price of 18 times the target’s trailing 12-month EBITDA) has yet to lead to much tangible benefit: Free cash flow is expected to register at just under $12 billion this year, not much changed from the $10 billion generated in 2012, when the company carried a net debt load of $35 billion, less than a third of its current burden.
ABI management still has its work cut out for it, particularly if credit spreads see another bout of widening similar to that seen last fall. A bearish analysis of ABI in the Feb. 9, 2018 edition of Grant’s made special mention of the brewing giant’s heavy near-term debt obligations and subsequent refinancing risk, as the company last year faced $46 billion in maturities through 2023 at an average coupon of just 2.8%. By way of conclusion, a metaphor:
Artificially suppressed interest rates produce a feeling familiar to drinkers – weekend drinkers only, mind you – of more than a little fine craft beer. It’s rapturous at first, and so it remains for a time. But finally you go home and go to bed, and then it’s Monday morning. Monday is dawning for mispriced corporate credit.
Recap Jan. 11
Stocks recovered from early losses to leave the S&P 500 flat by day’s end, as the broad index now sits higher by 3.5% in this young 2019, with the small cap Russell 2000 and tech-heavy NYSE FANG+ Index sporting year-to-date gains of 7.5% and 9%, respectively. Treasurys were bid across the curve with the 10-year yield finishing just under 2.7%, while commodities came under some pressure as the dollar caught a bid. The VIX finished just above 18, its lowest weekly close since the end of November.
Fourth quarter earnings season gets underway next week, with results from Citigroup, Inc. due on Monday, J.P. Morgan Chase & Co. on Tuesday and Alcoa Corp. on Wednesday, among others.
- Philip Grant
Thursday, January 10, 2019
The money of bond kings
He said it. Yesterday at the Barron’s and Grant’s co-hosted “Art and Interest Rates” event at the world famous Albright-Knox Art Gallery in Buffalo, N.Y., Jeffrey Gundlach, CEO of DoubleLine Capital and steward of $121 billion in assets, had a surprising prediction for the rapt audience: Bitcoin is on its way back to $5,000. While noting that such a call is highly speculative, Gundlach described a long bitcoin trade as “the easiest 25% gain available in the market right now.” Thanks to a 9% drop today to $3,674, a return to $5,000 from here equates to a 36% advance.
Later that evening, an attendee remarked with surprise that a particular investment topic had gone unmentioned during the wide-ranging afternoon discussion between Gundlach and James Grant: Gold. The DoubleLine boss revealed that, indeed, one of his top recommended long ideas for 2019 is the VanEck Vectors Gold Miners ETF (GDX on the NYSE ARCA).
Thanks to everyone who joined us, particularly the many who traveled great distances to attend. It was a terrific success!
QT progress report
No significant change this week, as the Fed’s portfolio of securities held outright stands at $3.862 trillion, down a mere $105 million from last week’s reading. It’s the first status-quo week since Dec. 12, with declines of $4.7 billion, $11.5 billion and $18.2 billion registered over the past three weeks.
Since the Fed began its QT balance-sheet runoff on Oct. 1, 2017, total balance sheet assets are down by 8.96%, a simple annualized pace of 7.04%.
Recap Jan. 10
The bull march continues, as stocks erased early losses to leave the S&P 500 higher by about 50 basis points, the fifth straight green finish that pushes the broad index 10.5% above its closing level on Dec. 24. A stronger dollar put a lid on commodities, but WTI crude oil managed a flat performance to finish above $52 a barrel, while the formerly-designated “waste places” were able to continue their rebound with the iShares MSCI Emerging Market ETF reaching its best close in more than a month.
Treasury yields rose across the curve, with the long end catching the worst of the selling as this afternoon’s 30-year auction saw weak pricing and soft demand; the long bond now yields 3.06%, up from 2.9% a week ago.
- Philip Grant
Tuesday, January 8, 2019
Freddie Murky-re
Yesterday, the Trump administration installed Comptroller of the Currency Joseph Otting as acting head of the Federal Housing Finance Agency, overseer of mortgage guarantors -turned wards of the state Fannie Mae and Freddie Mac. Otting replaces former Democratic congressman Mel Watt on a temporary basis, while nominee Mark Calabria awaits confirmation hearings in the Senate.
The market approves, as Fannie and Freddie common equity each jumped by 31% over the past two sessions while the most actively traded preferred shares gained 5% and 3%, respectively. Hopes that the acting boss will swiftly implement the Trump administration’s agenda help explain the bullish response, as Charles Gabriel of Capital Alpha Partners writes that Otting is: “freed to make any early moves that he, [the] Treasury or the Trump White House may have been itching to make during the cautious [Watt’s] tenure.” Isaac Boltansky of Compass Point Research & Trading agrees that Otting “has clear authority to act. . . while also providing Mark Calabria with procedural momentum when he takes the post later this year.”
What sort of actions might the Trump administration pursue with regards to Fannie and Freddie, famously nationalized by the Bush administration during the fall 2008 panic? Treasury secretary Steve Mnuchin hinted at a potential endgame for the government-sponsored enterprises in a December interview with Bloomberg Television, stating “I would like to get them out of conservatorship” and adding that “there are changes we will be able to make with a new director at the FHFA.” For his part, Calabria commented back in the fall of 2017 that the Trump administration was “committed” to that outcome, but cautioned that “if it were easy to get the GSEs out of conservatorship, it would have been done already.”
For investors in Fannie and Freddie, the proximate goal would be a return to the private ownership model which predated the 2008 bailout, an event which still rankles some observers. Back in September, Ron Haynie, vice president of mortgage finance policy for the Independent Community Bankers of America, noted in National Mortgage News the significant changes made to the original agreement in 2012:
All Fannie and Freddy earnings will be sent to the Treasury in perpetuity. After receiving $187 billion in aid from the U.S. Treasury, from 2008 to 2012, returning to profitability and stabilizing the broader mortgage market, they have cumulatively repaid more than $280 billion and counting. As one architect of the 2012 modification said, “they can never escape.”
Gary Hindes, chairman of the Delaware Bay Co. and shareholder in Fannie and Freddie, argued in the Washington Post on Sunday that the crisis-era government rescue of the GSEs was both illegitimate and unnecessary, as evidenced by their prolific earnings generation in the post-crisis years: “[Fannie and Freddie] did not ‘collapse;’ what was billed as a ‘bailout’ was actually a stick up.” In a Nov. 26 commentary, Hindes disputes the notion that the two were on death’s door upon entering conservatorship in September 2008, pointing out that Fannie and Freddie had managed to raise $6 billion in unsecured debt just three days before Uncle Sam took over, in an offering that was oversubscribed.
After spending nearly 10 years stuck in post-crisis financial purgatory, holders of Fannie and Freddie common equity and preferred shares finally have a shot at earning outsize returns through privatization. However, Chris Whalen, publisher of the Institutional Risk Analyst, thinks they should be careful what they wish for:
If you take the GSEs out of conservatorship, you’ll have to go raise money. That's what the law says. So you can put them through receivership, same way they come out as they were at inception, and then you'd have to go raise “private capital." The only thing that matters to bond investors is the federal wrapper. From a credit perspective, that is all that matters. You are "AAA" or not. Most private mortgage banks are "B" credits.
The idea of "privatizing" the GSEs is likewise fanciful. A GSE without full faith and credit is maybe a low investment grade credit with attendant funding costs. The last thing we need right now is more capacity in mortgage finance. We could get rid of 25 percent of total capacity in lending right now and it would be helpful, but not sufficient to fix the industry's pricing problem. Seriously, almost nobody is making money in mortgage lending in 2019.
GSE equity holders fundamentally misunderstand return of capital versus return on capital. Return of capital has to happen all at once. If you want to pay us back, okay, and redeem the warrants, great. Then these GSEs go back into the nether world of being not quite full faith and credit. And unlike the old days where everybody waves to one another and Fed officials would wink at central bankers and say, oh, it's okay, Fannie and Freddie really are full faith and credit. Well, no, they're not.
The bottom line is that, in order for the GSEs to function as they do today and issue debt at the spreads they do today, they have to have a federal guarantee. So when the hedge funds complain about the return of capital, they are wrong. The sweep of all GSE profits to the U.S. Treasury is payment for the use of the full faith and credit of the United States every day. Right? So to the hedge funds that own GSE common or, better yet, preferreds, I say you go right ahead, exercise the warrant, repay the Treasury and go on your merry way as a non-bank mortgage finance company, the supreme ghetto among financials. Good luck.
Recap Jan. 8
The bulls are back in town. Stocks absorbed a mid-morning selloff before pushing higher once more this afternoon to finish 1% in the green on the S&P 500, leaving the broad index nearly 10% above its Dec. 24 interim low. The Dow Transports have enjoyed a similar bounce, while the small-cap Russell 2000 and tech heavy NYSE FANG+ Index are 13% and 15% above their recent respective lows.
Elsewhere, Treasury yields rose again with the short end seeing the biggest movement, as the two-year yield finished the day at 2.58%, up 20 basis points from Thursday’s close. Commodities caught another bid despite a stronger dollar with WTI crude approaching $50 a barrel, and the VIX closed at 20.41, the lowest finish in over a month.
- Philip Grant
Monday, January 7, 2019
Supply side
Is a winter thaw forthcoming in the Sino-American trade spat? Commerce secretary Wilbur Ross raised the possibility of rapprochement in an interview with CNBC this morning, saying there is a “very good chance” of a “reasonable” agreement between the two world powers. Adding fuel to the optimism, Bloomberg reports that Chinese vice premier Liu He unexpectedly attended trade talks in Beijing today, which had been designated to take place at the “vice-ministerial” level. The clock is ticking, as the three-month trade truce agreed to by president’s Xi and Trump at the G20 meeting last fall is scheduled to expire at the end of February.
Hopes for a breakthrough aside, the Chinese are turning back on the public-spending spigots. Today, the Financial Times reports that the National Development and Reform Commission has given the green light on eight separate urban rail projects with a total value of RMB 860 billion ($125 billion) over the last month.
Financial easing is also back on the agenda, as the People’s Bank of China last Friday cut banks’ reserve ratio requirement by 100 basis points to 14.5% and 12.5% for large and small institutions, respectively, the fifth such reduction in a year. Also over the weekend, Hong Kong financial secretary Paul Chan Mo-Po wrote in a blog post that he is looking into measures to help would-be homeowners afford down payments, spurring a broad rally in property developer shares.
Regardless, some developers are scaling back their ambitions. Earlier today, China Evergrande Group announced in a filing that it is targeting a 9% growth rate in contracted sales this year. That’s down from more than 20% in 2018 and 120% two years ago (for more on Evergrande, see the June 2, 2017 edition of Grant’s). The powers that be are likewise de-emphasizing real estate. Last week, a commentary in the Communist Party People’s Daily instructed Chinese regional economies to lower their reliance on real estate-related activities to generate growth.
As Beijing looks to kickstart the Chinese growth engine, signs of trouble are increasingly apparent. Caixin’s manufacturing PMI reading fell into contraction territory in December, the first sub-50 reading for the series since 2016. Meanwhile, M2 money supply growth continues to wane, falling to 8% year-over-year in November to match the lowest annual growth rate in at least 23 years.
China M2 money supply, year-over-year growth rate. Source: The Bloomberg
As output depends on the availability of money and credit, the sharp slowdown in M2 growth indicates nothing bullish for growth. Anne Stevenson-Yang of J Capital Research writes in a commentary today:
From 2008, when the PBOC started reporting on monetary growth, through February of this year, either M1 or M2, or both, grew consistently in the teens or twenties, much higher than GDP. Since an economy’s money supply should run roughly in tandem with GDP growth, the portion of money growth in excess of economic growth should be viewed as fundamentally worthless.
And we know that China’s GDP growth is not only intentionally overstated by statisticians but systematically overstated as a consequence of unwillingness of banks to write down worthless assets.
What does it all mean? Stevenson-Yang explains:
No country has seen its “questionable” offshore assets grow at the pace of China’s. A significant portion of that money represents capital flight and straight-up theft, and very little of it is being taxed or reinvested in China. The problem will persist as long as the world is happy to buy renminbi for less than 7 to the dollar.
A weaker redback may be the long-term answer, but progress on that front has been halting. Since falling to 6.97 per dollar on Oct. 31, the renminbi has recently strengthened to less than 6.85 to the buck.
Recap Jan. 7
Another solid bid for stocks pushed the S&P 500 to its highest close since Dec. 19 and more than 8% above the Christmas Eve nadir, as outsize dollar weakness also put a bid under the commodity complex with WTI crude rising to near $49 a barrel. Treasury yields ticked higher across the board with the short end underperforming to leave the curve flatter, and the VIX finished unchanged to settle near 21.
- Philip Grant
Friday, January 4, 2019
Herding behavior
Contrarianism has its benefits.
Contrarianism has its benefits.
Apples and oranges
According to a report from Bloomberg on Wednesday,
According to a report from Bloomberg on Wednesday,
Recap Jan. 4
Herding behavior
Contrarianism has its benefits. From the New York Post:
New Yorkers trying to make good on “eat healthy” resolutions are mobbing salad joints — leaving many on long lines cursing their radicchio-strewn diets.
“You guys can go f–k yourselves!” one very hangry businessman in a Patagonia puffer vest was overheard telling his colleagues at lunchtime on Thursday, as he ditched the 100-plus-long line at Chopt on West 51st Street, between Sixth and Seventh avenues.
Meanwhile, at Sweetgreen on East 55th Street, Julie Pastor, 30, had to wait in a line of 50 people to get her guacamole-and-greens bowl.
“The line was outside the door and wrapping around the sidewalk,” she said.
“It’s a psycho line,” agreed another customer.
Diet starts next week.
Apples and oranges
According to a report from Bloomberg on Wednesday, not a single new high-yield issue debuted in December. Overall, $190 billion in speculative-grade corporate debt came to market last year, down from $330 billion in 2017 and the lightest year for new high yield supply since the annulis horribilis of 2008.
Then, too, overall inventory is on the wane. Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, reports yesterday in S&P’s LCD publication that total face value of the ICE BAML U.S. High Yield Index finished 2018 at $1.231 trillion, down for an “unprecedented” third consecutive year and 8.2% south of 2015’s high water mark of $1.341 billion.
That supply contraction may be good news for credit bulls, but still didn’t help much in the fourth quarter as the Bloomberg Barclays U.S. Corporate High Yield Index sank by 4.5%. That’s the second worst three-month showing of the past five years and ahead only of the 8% November 2015-February 2016 swoon, when numerous distressed energy credits followed the collapse in oil prices.
While the high-yield market shrinks, leveraged loans enjoy their day in the sun. The loan market overtook high yield in total size last year for the first time. Loans are senior to bonds and typically offer floating-rate coupons, a tempting feature for investors in a rising-rate environment. Then, too, loans’ commendable complete-cycle performance during the late-aughts financial crisis have helped burnish the bulls’ confidence.
But the year-end rout likewise took its toll on loans, as the S&P/LSTA Leveraged Loan Index fell a steep 2.5% in December, its worst one-month performance since August 2011, to all but wipe out what had been an excellent performance for the year (the index finished 2018 higher by 0.44%). The index didn’t trade higher in a single session from Nov. 1 to New Year’s Eve.
Leveraged loans and high yield may have sold off in relative tandem at the end of 2018, but it’s the former category that has caught the cautious analytical eye of Grant’s. A July 13 analysis detailed concerning features of the loan boom, including steadily eroding covenant protection, management incentive to call the loans when spreads decline, and, perhaps most importantly, so-called EBITDA add backs. One particularly aggressive example, from longtime Grant’s foil Bausch Health Cos, Inc., formerly known as Valeant Pharmaceuticals International, Inc.:
In calculating EBITDA, our old friend adds back “pro forma ‘run rate’ cost savings” – the money that the company expects to save through its hallmark dexterous management. So Valeant’s EBITDA is actually EBITDAH: earnings before interest, taxes, depreciation, amortization and a hunch.
EBITDA add-backs are particularly prevalent in private equity-sponsored merger and acquisition loan deals. According to LCD, the percentage of loans with a flattering EBITDA adjustment reached 53.5% of all M&A loans in the first half of last year, nearly double the 2005 pre-crisis peak. Nearly 22% of those adjustments amounted to 50% or more of the issuers total EBITDA, also about double the prior high-water mark in 2005.
Recap Jan. 4
An impressively strong December payrolls report featuring robust jobs creation and the largest year-over-year uptick in average hourly earnings since April 2009 helped put some spring in the step of beleaguered bond bears, as yields rocketed higher across the curve with the 10-year rising 11 basis points to 2.66%. Stocks likewise enjoyed a frenzied 3.4% rally on the S&P 500, erasing yesterday’s downdraft with room to spare to leave the broad index green by nearly 2% for the week.
Commodities enjoyed a surge of more than 1% in the broad CRB Index with WTI crude rising above $48 a barrel to continue its rebound, but gold bucked the bullish trend by falling back to $1,285 an ounce. The VIX finished at 21.3, the lowest weekly close since the end of November.
- Philip Grant
Thursday, January 3, 2019
Carried out
Strange doings afoot.
Strange doings afoot.
Shelter from the storm
QT Progress report
Recap Jan. 3
Carried out
Strange doings afoot. Yesterday evening’s revenue warning from Apple, Inc. not only sent shares in the Cupertino-based juggernaut lower by 10% and helped knock the broad market back into retreat (E-mini S&P 500 Futures slid by more than 50 basis points in the minutes following the announcement) but appeared to spur sharp reactions across any number of seemingly unrelated financial products. In the moment’s following the bombshell, 10-year Treasury futures ticked notably higher, with the yield dropping four basis points to 2.61%.
The currency market logged even wilder, and less intuitive, gyrations. The Japanese yen briefly surged as much as 3.8% against the U.S. dollar, 7% against the Australian dollar and nearly 9% against the Turkish lira in a straight line before swiftly retracing the bulk of those gains.
What spurred that ferocious yen bid? In a postmortem today, Bloomberg cites the Apple news as a potential factor, along with thin liquidity during the gap between U.S. and Asian trading sessions, as well as a crowded yen position. The Commodity Futures Trading Commission reported noncommercial futures positions at net short 102,271 yen contracts as of the most recent update on Dec. 18, near the most bearish positioning level of 2018. The Japanese market was also closed today, exacerbating the lack of liquidity.
But perhaps the underlying cause of those outsize currency swings is the ultra-repressive monetary policy of the Bank of Japan. The June 1 edition of Grant’s noted that Japanese savers, laboring for income under the thumb of the BoJ’s “qualitative and quantitative easing with yield curve control” regime, have looked overseas for income, particularly to Turkey.
Japanese yield-hunters had pulled back following the rout in Turkish assets over the spring and summer, but have recently returned as conditions steadied in the land of Erdogan. As of Dec. 18, the Tokyo Financial Exchange reports that open interest in lira/yen (long the former, short the latter) contracts rose to 290,164, up nearly 50% from the lows seen in late August.
Shelter from the storm
This (Big) Apple isn’t doing so well either. The Manhattan housing market continues to struggle, as the median apartment sales price registered $999,000 in the fourth quarter, down 5.8% year-over-year, with closed sales declining 3.3% according to appraiser Miller Samuel and brokerage firm Douglas Elliman’s fourth quarter market report. That’s the first sub-$1 million median sales price in three years, and marks the fifth straight quarterly year-over-year drop in transactions.
Other metrics lend further color to the slowdown. In the face of a 14% decline in full-year transactions to 10,229, inventory of active listings rose to 6,092 units, up 11.8% year-over-year. That pushed the average months to sell to 7.5, up from 6.5 months a year ago, with the listing discount from last offer price rising to 6.2% from 5.4% in the fourth quarter of 2017. It’s not all bad news, as the median price for luxury units rose 10.3% to $6.3 million, with active listing inventory declining 6.3% to 1,345 units at the upper end.
It might be tough sledding in Gotham, but things could be worse.
The formerly red-hot Hong Kong housing market fell into a deep freeze at the end of 2018, with the South China Morning Post reporting that December property sales plummeted by 58% from a year ago for the quietest December in 28 years. Meanwhile, Hong Kong-based brokerage Ricacorp Properties estimates that an additional 17,000 units will come online this year in Hong Kong, outpacing the firm’s expected apartment sales figure of 15,800 units this year. Median prices are down by 7.2% since July.
In Vancouver, December activity continued its recent swan dive (Almost Daily Grant’s, Dec. 20), declining by 46.3% from last year and the lowest level since 2000, bringing the full-year 2018 sales total to 25% below its 10-year average. The benchmark price index, which had managed to remain higher through the first 10 months of 2018 before turning negative by 1.4% year-over-year in November, sank by 2.7% from a year ago last month.
A near-term reprieve for sellers looks unlikely. Phil Moore, president of the Real Estate Board of Greater Vancouver, comments, “We’ve had record building activity in recent years and many projects will complete soon. This will provide additional housing options for home buyers across the region.”
QT Progress report
Jay Powell isn’t backing down yet. The Fed’s portfolio of securities held outright registered at $3.862 trillion, down a meaty $18 billion from a week ago (Treasurys supplied all of this week’s run-off) and down $29 billion from the trailing four-week average.
Since the Oct. 1, 2017 commencement of QT, total balance sheet assets at the Fed are down by just under 9%.
Recap Jan. 3
Stocks were pummeled, with the S&P 500 falling 2.3% to sink back within 4.5% of the Dec. 24 interim lows, as Delta Air Lines, Inc., joined Apple in cutting its profit outlook, sending the Dow Transports Index lower by 3.5%. Yield curve-flattening continued apace, with the 10-year yield settling at a 16 basis point premium to the three-month Treasury bill, while interest rate futures now point to 54% odds of a Fed rate cut by year-end with 0% odds of a hike. Less than a month ago, futures suggested 94% odds of a hike by December and 0% chance of a cut (Almost Daily Grant’s, Dec. 4).
One bullish development was commodity resilience, as the broad CRB index finished well in the green thanks to a weak dollar, with WTI crude rising back above $47 a barrel and gold approaching $1,300 an ounce.
- Philip Grant
Wednesday, January 2, 2019
Pancake breakfast
In with the new.
In with the new.
To greener pastures
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois
Recap Jan. 2
Pancake breakfast
In with the new. The turn of the calendar comes not a moment too soon, as a 13.5% plunge in the fourth quarter swung the S&P 500 to a 4.38% loss last year. It wasn’t just equities, as Treasurys, corporate bonds and commodities were down 0.38%, 2.11% and 10.66% as measured by the Bloomberg Barclays Global Treasury Index, the Barclays Credit Index and the Reuters/Jefferies CRB Index, respectively.
Is the December selloff just a “glitch”, as claimed by President Trump today, or an augury? Manufacturing indices from the Dallas and Richmond Fed’s showed sharp and unexpected contractions in December, falling to minus eight and minus 5.1 respectively, compared to expectations of 15 and 15. More broadly, today’s release of the Markit U.S. Manufacturing PMI for December saw the headline figure slow to 53.8, south of the 53.9 estimate and the lightest reading since September 2017.
The rates market is also swiftly repricing for weaker economic growth on the horizon. The yield curve continues to flatten at a rapid pace, with the differential between the three-month Treasury bill and 10-year note dwindling to as low as 19 basis points this morning. That’s down from a one-year average spread of 94 basis points and the narrowest since fall 2007.
Yield spread between the 10-year note and three-month bill. Source: The Bloomberg
As the yield premium on long dated Treasurys evaporates, risks to economic growth intensify. The Cleveland Federal Reserve reported in a Dec. 14 paper (published when the aforementioned spread stood at a relatively towering 47 basis points) that their in-house model based on the slope of the yield curve suggested 24% odds of a recession in the next 12 months, up from 16.6% in October. In a strategy note this morning, Ian Lyngen of BMO Capital Markets writes that if recent history is any guide, this phenomenon suggests that the Fed may be forced to backpedal from its planned rate hikes sooner than later.
When the [3 month/10 year] spread crossed below 20 basis points in February 1989, the Fed stopped hiking at the March meeting to begin cutting policy rates in June – only four months later. In the 90s, 3 m/10s crossed this psychological line in the sand several times, and in each instance, within three months we either saw a rate cut or pause in tightening to eventually give way to cuts.
In early January 2006, after 3m/10s crossed 20 basis points for the first time, the Committee was only able to continue tightening until the August meeting (four additional hikes) where they left the target unchanged before ultimately cutting [from 5.5% to virtually zero by the end of 2008] roughly one year later.
Indeed, while Fed chairman Jerome Powell projected a pair of additional rate hikes this year following the Dec. 19 meeting, the market is now calling his bluff. Interest rate futures currently forecast a funds rate of 2.39% at year-end, down from 2.69% at the end of November and below the current 2.40% effective rate. The odds of at least one rate hike this year, which topped 90% as recently as November, currently stand at just over 10%.
The big question: If economic data and financial markets continue to deteriorate, how long before non-traditional monetary policy (a.k.a. QE4) is back on the table?
To greener pastures
The new U.S. Census Bureau population survey for the 12-months ended July 1 finds that Illinois lost more than 45,000 residents last year, or 0.35% of the total. How it misplaced them was unreported. Anyway, that’s the fifth straight annual decline in the Land of Lincoln, which is the only state in the Midwest to see a net population outflow last year.
As citizens hit the bricks, Illinois’ budget woes continue to mount. According to a report from the Illinois Commission on Government Forecasting and Accountability, the combined shortfall of five state-run pensions rose $4.1 billion year-over-year to $133.5 billion on June 30, despite a strong market and increased taxpayer infusions. Those improvements were swamped by the ongoing explosive growth in benefit liabilities, as local business news site WirePoints reports that state worker pension payouts have ballooned 1,061% between 1987 and 2016. That compares to personal income growth of 236% and state revenue growth of 176% over that period.
Jim Bianco, founder and eponym of Bianco Research, reports today that Illinois municipal debt yields an average of more than 0.50% premium spread over the S&P Municipal Bond Index, by far the highest of the 50 states but a relatively narrow premium compared to what might be fetched by, say, a distressed corporate issue (triple-B-minus-rated Illinois narrowly avoided a downgrade to junk last summer, which would have been a first for a U.S. state in the modern era).
Recent experience informs those prices, as Bianco finds that debt from Illinois and similarly-strapped New Jersey (Grant’s, April 7, 2017) have averaged total returns above 10% and 9%, respectively, since December 2016. Those figures far outpace gains in more prudently-run states like North Carolina and New Mexico, up roughly 6% and 5% respectively over that period. Bianco notes:
These high yields are why states that are run irresponsibly can continue to be that way for a long time. Illinois and New Jersey will come to market with high tax-free yields and institutional investors will jump over each other to buy.
Investors in high-flying munis like Illinois and New Jersey are essentially making a bet that the “gradual” phase of bankruptcy will continue long enough to enjoy higher returns. This works until the “suddenly” phase of bankruptcy hits, which often comes when investors least expect it.
Recap Jan. 2
The bulls started the new year in solid fashion as stocks erased pre-market losses of more than 2% on the S&P 500 to finish unchanged, while commodities caught a bid with WTI crude settling near $46.50 a barrel despite a stronger dollar. Treasury yields ticked mostly lower, with the 10-year finishing at 2.65%, and the VIX fell to 23.3, its lowest close since Dec. 14.
But after the bell, Apple, Inc. dropped a bombshell by projecting first quarter revenues of $84 billion, far below the street’s $91 billion expectation and down roughly 5% year-over-year. CEO Tim Cook cited weakness in emerging markets for the anticipated shortfall, “particularly in greater China.” AAPL shares dropped by 6% in immediate reaction.
- Philip Grant
Friday, December 21, 2018
Over a barrel
Timing is everything.
Timing is everything.
Loan shark
Let’s do a status check on the leveraged loan market,
Let’s do a status check on the leveraged loan market,
Recap Dec. 21
Over a barrel
Timing is everything. Yesterday, industrial packaging concern Greif, Inc., (GEF on the NYSE) announced it had entered a binding agreement with private equity firm H.I.G Capital LLC to purchase Caraustar Industries, Inc., a Georgia-based paperboard manufacturer, for $1.8 billion in cash.
The deal, which is expected to close in the first quarter of 2019, will be immediately accretive to gross margins and earnings per share according to the acquirer, who has identified “at least” $45 million a year in cost synergies within 36 months, on top of Caraustar’s trailing 12-month run rate EBITDA of $220 million. As for the balance sheet, Greif asserts in the press release that “strong pro-forma free cash flow is expected to drive rapid deleveraging.”
The rating agencies were unimpressed by Greif’s promise of swift debt repayment, as both Moody’s and S&P placed GEF debt on review for downgrade. S&P notes that they expect the entire $1.8 billion price tag to be financed with new borrowings, while Moody’s estimates a pro-forma leverage ratio of 4.5 times following deal completion, an aggressive structure considering GEF’s “inherent cyclicality and weak margins.” Investors were in no mood to wait for more clarity, instead dumping Greif shares to the tune of 19% yesterday, extending the stock’s losses to 41% in the last 15 months.
For a thorough, and thoroughly bearish, look at GEF, see the Sept. 22, 2017 edition of Grant’s.
Loan shark
Let’s do a status check on the leveraged loan market, which has enjoyed aggressive growth this cycle prior to the recent turn and has been the subject of a number of cautionary analyses in Grant’s (“Tomorrow’s debt hearings,” on July 13, for one). The ongoing dislocation in credit has not spared the loan realm, which was formerly the apple of investors’ eye thanks to its floating-rate structure in what had been an agreeable, rising rate environment. Yesterday’s close of 94.5 on the S&P/LSTA Leveraged Loan Price Index left that gauge at its lowest since September 2016, while bringing the year-to-date total return to less than 1%.
Index-level pain aside, the typical leveraged lender is hanging in there just fine, so far. According to data provided by S&P Global Intelligence’s LCD unit on Twitter, the percentage of S&P/LSTA issuers whose loans are trading at 80 cents on the dollar or below stands at 2.27%, far below the 12% reached in the February 2016 risk spasm, to say nothing of the mind-boggling 81% of index components that saw their loans sink south of 80 during the 2008 crucible.
In a commentary today, LCD reported that a recent survey finds that loan investors do expect defaults to rise to 2.16% by the end of next year, up from 1.63% currently but well below the 3.1% historical average.
Nevertheless, the odds suggest that more issuers will find themselves in difficulty sooner than later, if recent history is any guide. That S&P/LSTA index has dropped below 95 on four other occasions since 1998, each time then proceeding to fall below 90 (and far lower in 2008) before recovering.
S&P/LSTA Price Index, 30-year view. Source: The Bloomberg
Correlation is not causation, but recent experience implies that flagging loan performance also precedes an economic turn. On Dec. 7, Fabiano Santin of this staff spoke with Marty Fridson, chief investment officer of Lehman, Livian, Fridson Advisors LLC, and “the dean of high yield,” for historical observations about the likely path of corporate defaults following a drop in the LSTA loan index toward these mid-90s price levels. Fridson offered the following observations:
[On Dec. 6, the S&P/LSTA index closed] at 96.39. It was below that level in October 1998. According to Moody’s, the speculative-grade default rate rose from 3.03% in 1998 to 5.36% in 1999, but did not reach the cyclical peak of 9.63% until 2001.
In July 2007, the index fell to 95.70 from 99.77 the previous month. The default rate rose from 0.95% in 2007 to 5.43% in 2008 and peaked at 12.11% in 2009.
So the sample size is quite small, but a single-factor model would say that a drop in the S&P/LSTA Index to the present level has historically been a signal that default rates are about to come off the cyclical low.
So this doesn’t spell imminent catastrophe, but high yield bond returns tend to be lower during the up leg of the default rate cycle than during the down leg.
Meanwhile, the recent tumble has attracted not only attention but action from investors. LCD cites data from Lipper to report that domestic loan funds saw a record $3.29 billion of outflows for the week ended Dec. 19, outpacing the prior week’s $2.53 billion drain and the previous record outflow of $2.12 billion in August 2011, which took place in the teeth of the E.U. sovereign debt crisis and S&P’s downgrade of the U.S. government
The aggressive fund withdrawals are spurring notably broad based moves. John Wright, managing director at Bain Capital Credit, observes: “The latest price correction has been a lot faster than what we were seeing in 2015, rather than being concentrated in a select few industries.”
Recap Dec. 21
Santa was apparently too busy making toys to help the bulls this week, as yet another sharp selloff left the S&P 500 down more than 7% over this five-day stretch, extending the year-to-date loss to nearly 10% and pushing the broad index below its simple three-year average price.
Elsewhere, a solid rally in Treasurys pushed the 10-year yield to 2.78%, four basis points below yesterday’s fixing of three-month Libor. A dollar rebound pressured commodities with WTI crude sinking back to near $45 a barrel, and the VIX popped above 30 at the close for the first time since February.
Almost Daily Grant’s will resume on Jan. 2. Happy New Year!
- Philip Grant
Thursday, December 20, 2018
A turn in the tide
James Grant writes
James Grant writes
Northern exposure
QT Progress report
Recap Dec. 20
A turn in the tide
James Grant writes:
Thursday’s Wall Street Journal editorial condemning Wednesday’s rate hike ran out under the headline, “Powell to Markets: Take That.” It reminded us of a Journal editorial from Oct. 25, 1929, whose headline we reprint above.
The stock market had already crashed when William Peter Hamilton, the Coolidge-era editorialist, started typing. He wrote to observe that the Dow Jones Railroad Average had fallen to confirm a prior decline in the Industrials, thus, under Charles Dow’s technical theory, signaling a bear market.
The final two paragraphs of Hamilton’s comment seem particularly timely reading today. Thus:
There are people trading in Wall Street and many from all over the country who have never seen a real bear market, as for instance, that which began in October, 1919, and lasted for two years, or that from 1912 to 1914 which predicted the Great War if the world had then been able to interpret the signs. What is more material is that the stock market does forecast the general business of the country. The big bull market was confirmed by six years of prosperity and if the stock market takes the other direction there will be contraction in business later, although on present indications only in moderate volume.
Some time ago it was said in a Wall Street Journal editorial that if the stock market was compelled to deflate, as politicians seemed so earnestly to wish, they would shortly after experience a deflation elsewhere which would be much less to their liking.
Hamilton was not forecasting a great depression; nor, certainly, are we. Neither are we equipped to read the tea leaves of stock-price action. What we do mark is that the Powell Fed, professedly “data-dependent,” yesterday chose to continue to tighten in the face of the real-time data of falling share prices, widening credit spreads, a plunging oil price and a flattening yield curve.
In a CNBC panel discussion following the Powell press conference, a commentator insisted that there had been no “policy error,” adverse market reaction notwithstanding—it was obvious, he said. But if policy errors were obvious at the time they were perpetrated, our policy-makers would never err.
A decade’s worth of interest-rate suppression has led to an outpouring of new credit. Arguably, given the artificially low borrowing costs in place, much of this debt was mispriced at inception. Perhaps the message of the markets is that Corporate America is dependent on negligible real interest rates only and is ill-equipped to deal with substantially higher ones. If so, 2019 may feature a U-turn in monetary policy and a, perhaps, long overdue reappraisal of the judgment and operating methods of our omnipresent central bank.
Northern exposure
Is a course reversal underway in the Great White North? On Monday, The Canadian Real Estate Association reported that existing home sales dropped 12.6% year-over-year in November, while the average home price of C$488,000 represented a 2.9% decline from November 2017.
The epicenters of the long-running Canadian housing bull market have likewise seen their fortunes turn, as existing home sales in Toronto slumped by 15.2% year-over-year, outpacing the broad decline, while such transactions in Vancouver cratered by 42.3% from a year ago.
Then, too, the sharp recent decline in energy prices is making an impact on Canada’s economic picture. November CPI showed a 4.8% sequential and 1.3% decline in the energy component, helping to push headline price growth to 1.7% year-over-year, below the 1.8% consensus and down from 2.4% in October. Pain in the Canadian energy patch is severe enough that the energy and trade ministries announced a C$1.5 billion loan package for the oil and gas sector, with a bulk of those funds earmarked for exporters with “working capital needs.”
While the housing market sputters and the oil industry struggles, Canadians remain in hock. Last Friday, Statistics Canada reported that the ratio of household debt to disposable income rose to 173.8% for the third quarter, up 60 basis points sequentially and near 2017’s record 174.4%. By comparison, that figure stood at 109% in the United States last year and topped out at 144% during the prior cycle in 2007.
The heavy debt load is taking a toll, as the Office of the Superintendent of Bankruptcy reports that consumer insolvencies jumped 9.2% year-over-year in October, the biggest jump since the 2016 oil-bust aftermath. Ted Michalos, licensed insolvency trustee at Hoyes, Michalos & Associates, Inc., tells Bloomberg that: “The tide has turned, and the water’s starting to rise. Now it’s just a question of how quickly does it rise.”
Ominous economic developments and inflation downtick aside, Bank of Canada governor Stephen Poloz stayed on message in a recent interview with CTV news, stating that “The Canadian economy begins the new year in solid shape. Our fundamentals are quite solid.”
Of the BoC’s 1.75% overnight rate, Poloz indicated that he sees a target range of 2.5% to 3.5%, but gave himself plenty of rhetorical wiggle room: “Getting there, it’s a journey and we expect over time to get there. But it can be interrupted or it can be sped up, depending on how the economic data evolve.”
Talk aside, investors are increasingly certain that the BoC will back off after five rate hikes in the past 18 months, followed by a status quo result at the Dec. 5 meeting. According to interest rate futures data provided by Bloomberg, the odds of a rate hike at the Jan. 9 meeting have collapsed to 2.5%, down from 70% a month ago.
Whether BoC follows the Fed higher or follows the newly dovish route now expected by the markets, the Canadian dollar looks vulnerable. Continued tightening by Poloz and Co. would add additional strain to an economy whose dual pillars of housing and energy are both under duress, while a more dovish approach would likewise be negative for the Loonie thanks to the widening yield differential with the U.S.
Canadian dollar/U.S. dollar cross, three-year view. Source: The Bloomberg
Meanwhile, the accelerated carnage in asset prices after yesterday’s Fed funds-rate hike has led some investors to rethink the recently unthinkable. Futures currently price 1.5% odds of a U.S. rate cut by the Dec. 11, 2019 meeting, up from 0.0% one week ago.
QT Progress report
A $5 billion sequential downtick left the Fed’s portfolio of securities held outright at $3.892 trillion this week, with Treasury securities comprising about 57% of the remaining portfolio. Compared to the trailing four-week average, today’s figure is down by $13 billion, split evenly between Treasurys and mortgage-backed securities.
Since the start of QT on Oct. 1, 2017, the Fed’s total balance sheet is down by 8.34%.
Recap Dec. 20
A 1.5% drop in the S&P 500 left the broad index about 16% off its September high water mark, while the Russell 2000 and Dow Transports fell by a similar percentage. The NYSE FANG+ Index lost 3.5%, and is now negative year-to-date.
But perhaps the wilder action was in the bond market, where we saw three-month Libor briefly exceed the 10-year Treasury yield this morning, while the 30-year long bond rallied to push the yield as low as 2.96% before a late reversal left yields higher across the curve. Speculative grade corporate debt was hammered, with the iShares iBoxx High Yield Bond ETF falling to its lowest since that 2016 winter of discontent, while the Invesco Senior Loan ETF finished the day at a 1.3% discount to its net asset value, the biggest since at least 2011.
- Philip Grant
Wednesday, December 19, 2018
Recap Dec. 19
YouWork
Yesterday, Japanese telecom concern SoftBank Corp. (code 9434)
Yesterday, Japanese telecom concern SoftBank Corp. (code 9434)
Diploma see
Yesterday, Bloomberg reported that Georgetown University,
Yesterday, Bloomberg reported that Georgetown University,
Recap Dec. 19
The “dovish rate hike” turned out to be just a rate hike, as Fed chairman Jerome Powell implied in his press conference that “QT” asset sales will continue apace, setting off another sharp sell-off in equities. The S&P 500 dropped more than 1% and is now 14% below its Sept. 20 highs, while the small cap Russell 2000, Dow Transports and NYSE FANG+ Index have all entered bear market territory, down more than 20% from their own respective high water marks.
Treasury yields darted lower on the long end of the curve, pushing the 10-year to 2.76% (the lowest since May) while short rates ticked higher to pull the spread between the 2- and 30-year yields to 35 basis points, its lowest since 2007 and down from a 242 basis point average since 2010. Commodities caught a bounce after yesterday’s liquidation with WTI crude inching back above $47 a barrel, while the VIX held steady near 25.
YouWork
Japanese telecom concern SoftBank Corp. (code 9434) made its debut today as a publicly traded company on the Tokyo stock exchange. It didn’t go very well, as shares gapped lower at the open and continued to falter, eventually losing 14.5% and closing at the lows of the session. Nevertheless, one could argue the deal could have performed far worse, considering the roughly 60% valuation premium to peers NTT DoCoMo, Inc., and KDDI Corp. at the initial offering price (Grant’s, Nov. 30).
The inauspicious debut coincides with a potentially more ominous development for Masayoshi Son’s tech empire. Today, The Wall Street Journal reports that key investors in Son’s mammoth $100 billion Vision Fund are getting nervous about a cornerstone portfolio company, forcing the SoftBank boss to potentially buy them out the position:
Key investors in SoftBank’s giant tech fund have balked at a planned $16 billion investment in co-working startup WeWork Cos., leaving SoftBank chief executive Masayoshi Son to find an alternative as his ambitions hit up against the limits of his financial firepower.
The new investment would value WeWork at around $36 billion, the people said [down from a prior valuation of $45 billion one month ago], and would bring SoftBank and its affiliates’ total investment in the company to more than $24 billion.
Under the deal being discussed, SoftBank would buy out existing investors at a valuation of around $22 billion, subject to a shareholder vote.
If SoftBank is indeed “the epitome of the cycle”, as contended in the Dec. 15, 2017 edition of Grant’s, Jay Powell and friends might be rethinking their planned 2019 rate hikes sooner rather than later.
Diploma see
Yesterday, Bloomberg reported that Georgetown University, founded in 1789 and the oldest Catholic college in the U.S., will offer $305 million worth of taxable century bonds maturing in 2118.
Investors inclined to wade into the 100-year debt pool may find A2-rated Georgetown a more attractive issuer than, say, Argentina, which has defaulted time and time again (Almost Daily Grant’s, June 19, 2017), or Austria, which pays a meager 2.1% coupon, below the current measured rate of inflation (Almost Daily Grant’s, Sept. 13, 2017). Scott Richman, chief investment officer of Whitehaven Asset Management, told Bloomberg that: “We strongly believe the very selective schools will definitely be around 100 years from now.”
However, while the venerable D.C. based institution has the track record, recent financial performance is another matter: Georgetown finished $19.2 million in the red in fiscal 2018, its second straight year of operating losses. In addition, operating cash flow margins slumped to 6.4% in fiscal 2018, down from more than 10% three years earlier and well below the 14.7% median for private universities in 2017. In a Dec. 13 report, Moody’s lays bare Georgetown’s difficulties:
Below average operating margins, along with the large proportion of restricted net assets, limits the university’s buffer against uncertainty. Georgetown’s total wealth relative to operating expenses are more in line with Baa-rated private universities, and are well below those medians when measured against spendable cash and investments.
We anticipate the university will remain challenged to materially improve balance sheet flexibility, absent outsized increase in major unrestricted gifts, given the time required to fully implement cost saving initiatives.
As for the now-confirmed plan to issue century bonds, the rating agency commented last week that the issue “materially backloads the debt structure and notably increases debt service demands beginning in 2025.” Creditors aren’t worried: The Georgetown 5.06%s of 2044, issued in 2014 at par, currently trade at 102.43 cents on the dollar for a yield-to-worst of 4.49%.
Solid performance of its credit aside, are Georgetown’s financial struggles emblematic of wider pain in higher education? One thing’s for sure; the generally poor performance of endowment funds isn’t helping. A recent paper co-written by Georgetown's’ Sandeep Dahiya and David Yermack of NYU finds that from 2009 to 2016, a sample of 28,000 university endowments trailed a simple 60/40 portfolio mix of U.S. equity and Treasury allocations by 5.53% annually, with a statistically significant “alpha” [meaning excess return relative to a benchmark] of negative 1.01% per-year.
- Philip Grant
Tuesday, December 18, 2018
Polly want a virtual assistant
Status quotient
No one puts Baby in a corner.
No one puts Baby in a corner.
Recap Dec. 18
Polly want a virtual assistant
From last Friday’s edition of The Times of London:
When Rocco the parrot is peckish, he knows who to turn to — Alexa.
The African grey parrot has become so adept at giving orders to Amazon’s smart speaker system while his owner is out that he uses it to play songs, tell him jokes and even order treats.
It’s not the first time that Rocco has talked his way into trouble. He was removed from a National Animal Welfare Trust sanctuary at Great Shefford, Berkshire, for swearing too much.
And from Bloomberg on Monday:
Several of [Amazon.com, Inc.’s] online stores in North America and Europe showed various models of the Alexa-powered line of gadgets temporarily out of stock on Monday, with shipment delayed to January or beyond in some places.
Coincidence? Probably.
Status quotient
No one puts Baby in a corner. Today, Chinese president Xi Jinping stood his ground in a Beijing speech commemorating the 40 year anniversary of Deng Xiaoping’s liberal reforms, telling the assembled that “no one is in a position to dictate to the Chinese people what should and should not be done.” Bloomberg describes the ruler-for-life’s remarks as “outlin[ing] no new economic policies that might assuage investor concerns about market access or the slowing economy.”
Xi’s rhetoric aside, major changes are afoot in the bond market. As of this morning, the Chinese one-year government bond yields 2.5%, well below the 2.63% on offer in 12-month Treasury bills. The yield premium in U.S. debt runs counter to credit rating profiles, where the U.S. enjoys triple-A and double-A-plus ratings at Moody’s and S&P, respectively, four and three notches above the A1 and single-A-plus designations for the Middle Kingdom. Recent history has also been turned upside down: Over the past five years, the Chinese one-year yield has averaged 2.96%, a more-than 200 basis point premium to the 0.88% five-year average for 12-month Treasury bills.
Beijing’s borrowing costs are low (the 10-year yield of 3.38% likewise sits below its five-year average of 3.55%), but the relentless output expansion often dubbed the “Chinese economic miracle” appears to be on the wane. Headline GDP is now expected to grow at 6.2% next year according to the International Monetary Fund, downgraded from a 6.4% guesstimate in October. That's well below the 6.9% in full-year 2017 and 7.1% average growth rate over the last five years. Meanwhile, the National Bureau of Statistics reports that industrial profits grew by 3.6% year-over-year in October, the sixth consecutive monthly decline and down from 21.9% year-over-year in April.
With slowing growth comes increased difficulty for the corporate sector; record local bond defaults in 2018 are followed by a maturity wall of RMB 3.5 trillion ($507 billion) from Chinese non-financial companies next year, according to Bloomberg. Cindy Huang of S&P Global Ratings comments: “As credit lending and property sales are slowing down, private firms will face increasing liquidity pressures if their ability to make a profit worsens. Supportive measures since the third quarter did not reverse the rising default trend in November.”
China’s suddenly-cool property market is reflected by an interesting divergence. In a Dec. 10 commentary, Anne Stevenson-Yang of J Capital Research notes that while land sales are flat to down this year across China (including a 10% decline in so-called Tier 1 cities), most Hong Kong-listed developers have continued to see sales growth this year. However, “these numbers are not necessarily signs of health: Developers in China tend to sell in high volume only when they cannot access working capital loans. . . This is borne out by the pre-sale numbers. Developers are selling more of their inventory before the housing is built. This suggests a strain on cash flow.”
How will heavily-leveraged China (banking assets represent 285% of trailing four-quarter nominal GDP as of Sept. 30) respond to the weakening growth picture? Through the suppression of information by government dictum, of course. Yesterday, the South China Morning Post reported that Beijing “has ordered authorities in the country’s export hub, Guangdong province, to stop producing a regional purchasing managers’ index for the manufacturing sector as it seeks to control the flow of sensitive economic data.”
Recap Dec. 18
Stocks gave back an early rally to leave the S&P 500 little changed at the close, leaving the broad index down about 4.5% for the year with eight trading sessions remaining in 2018. Momentum outperformed slightly, with a 1% gain in the NYSE FANG+ Index, leaving that gauge 6% in the green year-to-date.
While equities managed that sideways finish, bearish price action again reigned elsewhere: Commodities were hammered once more, with the CRB Index falling 2% to its lowest since summer 2017 and WTI crude plummeting to $46 a barrel, and Treasury yields dropped again with the 10-year settling at 2.83%, two basis points above yesterday’s fixing of three-month Libor. The VIX rose back above 25, and global shipping giant FedEx Corp. surprised the market by offering weaker-than-expected EPS guidance for fiscal 2019 after the bell, sending FDX shares lower by 4% in immediate reaction.
- Philip Grant
Monday, December 17, 2018
Liquid gold
The spigots are off. On Wednesday, the Federal Reserve will conduct its final policy meeting of 2018, with a 25 basis point hike to the overnight funds rate the likely outcome; interest rate futures currently price 74% odds of policy tightening, down slightly from 78% two weeks ago. One interested observer is happy to provide chairman Jerome Powell with some free advice. This morning, Donald Trump shared his thoughts on Twitter:
It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!
It’s not just leveraged real estate-speculators turned commander-in-chief who are advocating a cessation of policy tightening, which is taking place not only through rate hikes (eight and counting since December 2015) but also the ongoing “QT” asset sales. In today’s edition of The Wall Street Journal, former Fed governor Kevin Warsh and Duquesne Family Office LLC chairman Stanley Druckenmiller argue that the Fed needs to pump the brakes, particularly on QT:
The Fed’s balance sheet is where the money is. Yet it has provided little additional clarity on its balance-sheet plans since Chair Janet Yellen’s tenure. At a time of global quantitative tightening and uncertain economic prospects, the Fed’s silence on its asset holdings is contributing to the tumult. We were assured by policy makers that QE provided large benefits to the real economy. If so, won’t its reversal in the form of QT come with a cost? It can’t all be rainbows and unicorns.
Protestations by the executive branch, former colleagues and Wall Street luminaries aside, the Fed forges ahead. Although securities held outright held steady last week at $3.896 trillion, $20 billion below the trailing four-week average, total balance sheet assets are down by 8.2% since the Fed began to run off its balance sheet in October 2017.
The pace has been quickening. Thus, while Federal Reserve bank credit has declined by 7.9% over the past 12 months using the trailing four-week average, the contraction has accelerated to a 11.1% annualized rate over the past three months. Broad M2 money supply has grown by 3.9% over the past 12 months, but just 3.1% annualized since September.
Consequences of the liquidity drain are increasingly apparent, as the Druckenmiller/Warsh pair cites sharp recent drops in the banks (BKX Index is down 21% since late September and 14% in the last two weeks) and commodities (the CRB Index is down 11.6% since early October). In credit, the most speculative issues have been hammered, with the option-adjusted spread on the Bloomberg Barclays CCC and Below Index jumping to 934 basis points today from 619 basis points in early October. Today, the Financial Times reports that “not a single company has borrowed money through the $1.2 trillion U.S. high-yield corporate bond market this month.” It would be the first time since November 2008 without any new high-yield supply.
The un-bullish turn has likewise put a dent in the leveraged loan category, with the FT reporting that two deals were scratched last week after major banks including Barclays and Wells Fargo were unable to locate buyers. Those failures were no outliers. Bloomberg reports today that issuance of collateralized loan obligations (collections of loans that have been packaged and securitized) fell 25% year-over-year in the first half of December, accelerating from a 10% decline last month (for more on CLO’s, see the Sept. 7 edition of Grant’s).
S&P/LSTA Leveraged Loan Index, five-year view. Source: The Bloomberg
The broad reversal of financial conditions can indeed be laid at the feet of the Fed, according to David Rosenberg of Gluskin Sheff + Associates, Inc. At the spring 2018 Grant’s conference, Rosenberg told the audience that as the post-2008 bull run can be largely chalked up to the ultra-dovish policies of past Fed chairs Ben Bernanke and Janet Yellen, and investors should gird themselves for the opposite dynamic as monetary stimulus is withdrawn.
We’ve never had a cycle where the stock market has done what it did in the context of such weak economic growth. If I took the ratios of what the stock market does benchmarked against what the economy does in nominal and real terms, this bull market and the S&P 500 would have stopped out at 1800, not 2800. The excess is central bank liquidity. The central banks added 1000 points. Not fundamentals. Central bank liquidity.
Now people say to me: No cycle ever dies of old age. I get that. But, they die at the hands of the central bank. The Fed. Each cycle has died at the hands of the Fed. Every bear market ended by the Fed. Every recession ended by the Fed. By the same token every bull market / expansion, the Fed has its thumb prints over every expansion. There is nothing more important, not fiscal policy, not trade policy. Nothing is more important for what we do than Fed liquidity.
Slowly but surely, the pool is draining.
Recap Dec. 17
It was another ugly day, as the S&P 500 shed more than 2.5% to finish at its lowest since October 2017, while momentum stocks were strafed with the NYSE FANG+ Index losing nearly 5%. Another leg down in energy prices pushed WTI crude below $50 a barrel at the close for the first time this year, and Treasurys enjoyed a solid rally with the 10-year yield finishing at 2.86%. While government yields decline, interbank lending rates continue to jaunt higher, as three-month LIBOR rose to near 2.81% as of Friday, nearly converging with that 10-year Treasury yield.
- Philip Grant
Tuesday, December 11, 2018
Markets make opinions; central banker edition
Help wanted: Project manager
Recap Dec. 11
Markets make opinions; central banker edition
From Reuters, June 27, 2017, with the VIX at 11:
U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash.
“You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” she said.
And from CNBC this morning, with the VIX at 22:
There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.
The former Fed chair, now a scholar at the Brookings Institute, said there remains an agenda of unfinished regulation. “I’m not sure we’re working on those things in the way we should, and then there remain holes, and then there’s regulatory pushback. So I do worry that we could have another financial crisis.″
Help wanted: Project manager
The recent economic protests by the “Yellow Vests” have ground France to a halt and turned up the heat on President Emmanuel Macron, a steadfast E.U. proponent who is stuck at an abysmal 23% approval rating according to a Les Echos poll. The embattled president responded in a speech yesterday evening, announcing a series of measures aimed at placating the citizenry including a minimum wage hike and ending taxes on overtime and pensions below €2,000 a month.
While Macron’s remedies may or may not be enough to quell the decentralized protests (Bloomberg reports that Yellow Vests plan to continue blocking roads near major cities including Strasbourg and Lyon), the impact on France’s fiscal position is clearer. This morning, budget minister Gérald Darmanin told the French senate that the 2019 budget deficit is now projected at 3.4% of GDP after accounting for a one-time 0.9% tax credit, up from 2.9% before the protestor concessions.
Energy minister François de Rugy shared his priorities during an interview on Radio Classique: “We aren’t saying that long term the debt isn’t a problem. But the first priority isn’t to discuss this with Brussels, but with the French people.” In response, Valdis Dombrovskis of the E.U. demurred: “We are monitoring closely the potential new measures being announced, but we cannot comment before they are properly announced and detailed.”
Of course, Italy is watching these developments with particular interest. In September, the coalition government led by the populist Five-Star and the League parties announced the projected budgets for the next three years will target deficits equating to 2.4% of GDP. After a series of failed negotiations, that proposed budget was rejected by the E.U. a month later, with Dombrovskis mincing no words: “Unfortunately the clarifications were not convincing to change our earlier conclusions of particularly serious non-compliance. . . It is tempting to cure debt with more debt, but at some point the debt weighs too heavy."
Sovereign credit markets also continue to give France the benefit of the doubt. The spread between double-A-rated French and triple-A German 10-year yields sits at 48 basis points, slightly above the five-year average spread of 37 basis points. Meanwhile, triple-B-rated Italy’s 10-year yield of 3.12% represents a 289 basis point spread over Germany, up from a 113 basis point gap in April and a five-year average spread of 159.
Add inflation into the mix, and holders of French 10-year sovereign debt are facing a real yield of negative 1.5%, as CPI grew 2.2% year-over-year in October. Thanks to a 2.3% CPI uptick, German 10-year debt currently sports a real yield of negative 2%. Italy, with CPI of 1.7% offers a 10-year real yield of 1.4% but with the credit risk implied by the near-junk rating.
Meanwhile, the Thursday meeting of the European Central Bank is widely expected to mark the end of the asset purchase program which has been in place since 2015 (Almost Daily Grant’s, Dec. 3). Mario Draghi, who famously told investors in 2012 he would do “whatever it takes” to preserve the euro, is set to retire next September. An increasingly unpredictable political situation coinciding with the planned withdrawal of monetary stimulus ensures that his successor will have his or her work cut out.
Recap Dec. 11
Stocks drifted sideways for a second straight day, leaving the S&P 500 at the low end of its fall range, but weakness in the Dow Transports, small-cap Russell 2000 and KBW Bank Index brought each of those gauges to respective multi-month lows. Treasury yields again jumped higher across the short end and belly, while the 10- and 30-year bonds outperformed to pull spreads tighter. Commodities held steady as the Dollar Index briefly matched its 52-week high intraday.
Almost Daily Grant’s will resume next week.
- Philip Grant
Monday, December 10, 2018
Job openings at Bloomberg
From the New York Times:
More than 18 months ago, the Manhattan district attorney’s office opened yet another investigation into fraud in the city’s $62 billion construction industry, this one involving Bloomberg L.P., the financial information and media company owned by former Mayor Michael Bloomberg, who is considering running for president in 2020.
On Tuesday, the District Attorney’s Office and the state police are expected to arrest more than a dozen executives, including senior executives in New York of Bloomberg’s global construction and facilities department, on fraud, theft and bribery charges, according to one executive briefed on the investigation and defense attorneys.
Subcontractors and vendors are accused of paying bribes and kickbacks in various forms over nearly four years to executives at Bloomberg and to two executives at Turner Construction, a general contractor that oversaw work at Bloomberg.
Phone home
Today, SoftBank Group Corp. announced the terms for the initial public offering of a 37% stake in its domestic telecom unit, SoftBank Corp., which will price at ¥1,500 ($13.3) a share and generate proceeds of ¥2.65 trillion as brisk demand triggered an overallotment option.That figure approaches the 2014 New York Stock Exchange debut of SoftBank portfolio company Alibaba, Inc., as the largest IPO in history. Shares are set to begin trading on the Tokyo Stock Exchange (code 9434) on Dec. 19.
Instead of an indicated price range that typically precedes an IPO and allows for fluctuations in investor demand, SoftBank and its CEO Masayoshi Son opted to post a single offering price, a first in the Japanese stock market. Retail shareholders accounted for about 90% of the offering’s buyers according to the Financial Times, a cohort that the company and its investment bankers courted through television commercials and door-to-door sales pitches. The FT relays another sales tactic that fits the modern investment zeitgeist:
Brokers have also told retail investors that the stock is likely to be supported by the large influx of passive money that can be expected as the newly listed company is added to various indices tracked by funds.
The unusual details don’t end there. Back in September, Bloomberg reported that the consortium of investment bankers working on the deal were required to provide roughly $9 billion in loans to SoftBank’s majority-owned, in-house venture capital arm, the Vision Fund. Stakes in five unnamed Vision Fund portfolio companies will serve as loan collateral, per Bloomberg.
The Vision Fund is certainly flush with cash. According to a regulatory filing made over the weekend, the fund has seen its assets under management grow to $98.58 billion, approaching the $100 billion target size. Not one to be accused of complacency, Son declared at a Tokyo conference in May that “Vision Fund 2 will definitely come, it’s just a matter of when.” Chief operating officer Marcelo Claure was more circumspect, stating in October that “there was no certainty” of a Vision Fund sequel.
On Friday, Reuters’ Breakingviews discussed the so-called SoftBank effect, by which a company that takes an investment from the flush fund “has the means to grind their rivals into dust, but with the pressure that comes from having to justify a generous valuation.” High-profile Vision Fund portfolio companies such as Uber Technologies, Inc. (which on Friday filed its own IPO paperwork) and WeWork Cos. are two examples of that phenomenon. New York City real estate firm Compass is another.
In September, Compass raised $400 million in a series F round led by the Vision Fund and Qatar Investment Authority, valuing the start-up at $4.4 billion. That’s double the valuation fetched at the prior round in December 2017. Consistent with financial backer Masa Son, Compass CEO Robert Reffkin is thinking big. In June, Reffkin told Bloomberg: “What books were for Amazon, the brokerage model is for us.”
Compass, which began the year with 30 offices, will finish the year with 150 and reach 300 locations by the end of next year, according to chief growth officer Rob Lehman. On Nov. 29, The Real Deal reported that Compass is launching a company-branded credit card for its real estate agents, who can pay back their charges on their “own timelines,” according to Lehman. In October, The Real Deal reported on another generous perk for agents: a company stock option program which provides for a 30% bonus for every dollar invested back in Compass. The company reported last month that more than 1,000 agents have invested some or all of their commissions back into the unicorn, a development that CEO Reffkin described thusly:
It’s not something we needed to do to raise capital. It’s purely an offering to respond to an agent’s desire to have ownership in Compass’ future success.
Three weeks ago, Compass hired Carlyle Group veteran Kristen Ankerbrandt as chief financial officer to help oversee what Reffkin termed the company’s “next stage of hypergrowth.” Ankerbrandt replaces Craig Anderson, who was on the job for just seven months.
For a detailed analysis of SoftBank, see the Nov. 30 edition of Grant’s.
Recap Dec. 10
Stocks staged a late rally, with the S&P 500 erasing near-2% intraday declines to finish modestly in the green, helped by a 1.2% gain in the NYSE FANG+ Index. Commodities were hammered as the Dollar Index approached 52-week highs, and WTI crude slumped back below $51 a barrel. Treasury yields mostly ticked higher, with the 10-year and 30-year outperforming to leave the curve flatter. The VIX gave back solid gains to finish just below 23.
- Philip Grant
Friday, December 7, 2018
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short)
Recap Dec. 7
Cancun swoon
Last Saturday, left-wing populist Andrés Manuel López Obrador (AMLO for short) was officially inaugurated as Mexico’s 58th president, replacing establishment predecessor Enrique Peña Nieto. AMLO wasted no time in establishing his anti-elitist bona fides, opening the opulent presidential mansion Los Pinos to the public while maintaining his own, more modest residence in the south side of Mexico City. The new president also dispatched the presidential plane, a Boeing 787 Dreamliner that cost more than $200 million, back to California where it will await a new buyer.
Changes under AMLO go well beyond the symbolic. In October, the then-president elect announced the cancellation of a partially-completed $13 billion airport expansion outside of Mexico City after a mini-referendum showed 70% of respondents opposed the project (Almost Daily Grant’s, Oct. 29). While El Universal polls show a 9% decline in AMLO's approval ratings since August, a majority of Mexicans (55.6%) still give their new president a thumbs up as of Nov. 26. Investors are another matter.
Last week, the Mexican government launched a tender offer for $1.8 billion of the $6 billion in airport bonds outstanding at prices ranging from 90 cents on the dollar to par, in return for looser covenants and a change in the revenue stream servicing the remaining debt.
News of the offer has lifted those bonds to 83 cents on the dollar from 75 prior to the announcement, but the experience has done little to build good will with creditors. Michael Leithead of EFG Asset Management tells the Financial Times that Wall Street “will be cognizant of the unpredictability of the new government. Despite the market-friendly outcome.” Sebastian Salvay, analyst at TPCG brokerage in Argentina, suggests some specific improvements to Bloomberg: “The main problem with this offer is that it doesn’t give you anything in exchange with what you give. . . you need a guarantee, collateral from government.” On Tuesday, a group of creditors claiming to own more than half of the bonds outstanding rejected the government’s proposal.
The uncertainty of the airport bond situation is one example of political risk south of the border. AMLO’s energy policy is another. During his inauguration speech, the new president declared: “Neoliberal economic policies have been a disaster,” referring to the market-friendly energy reforms put in place by his predecessor. Indeed, AMLO promised on the campaign trail to halt crude exports by 2022, while The Wall Street Journal reported in August that the then-president elect “will hold off auctioning any new oil blocks for at least two years and plans to modify laws to bolster the dominant role of state oil company Petróleos Mexicanos [a.k.a. Pemex]”.
The March 23, 2018 edition of Grant’s featured a skeptical analysis of Pemex, which was founded in 1938 with the seized assets of foreign oil companies. The bear case rests on the fact that Pemex is a debt-heavy ($103 billion in net borrowings, and a leverage ratio of nearly eight times debt to EBITDA when factoring in pension liabilities) and chronically money-losing enterprise (net income and free cash flow have both remained in the red since 2013) beset by chronic production declines.
The triple-B-plus-rated oil behemoth managed to place senior unsecured 2027 dollar bonds at a 6.5% coupon in February, an issue that traded well above par as recently as July. It’s been a different story since, with those bonds last fetching just under 94 cents on the dollar, for a yield-to-worst of 7.52%. Pemex five-year credit default swaps have likewise jumped to 333 basis points from 185 in March, while the price of Mexican sovereign credit protection has also risen, to 148 basis points from 116 at publication time.
In July, AMLO tapped Octavio Romero Oropeza, a long-time political ally with no energy experience, to lead Pemex as general manager. The company’s creditors are getting a little nervous. We suspect they will become more than a little nervous.
Recap Dec. 7
Stocks were clubbed again, with the S&P 500 wrapping up the short week nursing a near-5% loss to sink back toward the low end of its fall trading range, while the small-cap Russell 2000 broke to its lowest since September 2017, down 3% year-to-date. Treasury yields darted lower across the short end and belly, while the long bond underperformed to push the 5- and 30-year spread toward the upper end of its 2018 range, and commodities were well bid as an OPEC production cut agreement helped WTI crude rise to $52.50 a barrel while gold finished at $1,248 an ounce, just above its five-year average.
This morning’s release of November non-farm payrolls featured a 3.1% year-over-year rise in average hourly earnings, matching last month’s for the strongest reading in the series since 2009.
- Philip Grant
Thursday, December 6, 2018
Board games
This bellwether got rung. Yesterday, industrial packaging producer Greif, Inc. reported fiscal fourth quarter results that fell short of estimates, with net sales of $988 million and adjusted EPS of $1.08 trailing the Street’s consensus expectation of $1.02 billion and $1.19, respectively. That sent shares lower by 10% as investors were clearly in no mood for disappointment. CEO Peter Watson tried to put a happy face on the results, while acknowledging problems on both the cost and the demand sides of the equation:
Greif delivered a strong financial performance in fiscal 2018, despite being impacted by significant cost inflation in most areas of the business . . . at the end of fiscal 2018 we began to see signs of market softness in discrete areas of our global portfolio.
On this morning’s conference call, Watson expanded a bit on the geographic demand dispersion. While North America “is experiencing very healthy volumes,” it’s a different story elsewhere, with the CEO noting “soft” demand in China and Western Europe. Mother Nature apparently played a role in the latter development, as the company cited the “continued impact of weaker European conical drum demand due to weather.” That marks the 5th straight quarter in which GEF cited weather-related issues in its review of operations (see the Aug. 30 edition of Almost Daily Grant’s for a rundown of Greif’s prior meteorology mishaps).
Weather excuses aside, investors of all stripes should be paying attention, as the Sept. 22, 2017 edition of Grant’s termed Greif “a kind of one-company Purchasing Managers Index.” The rationale for that designation:
There’s not much technology in a 55-gallon steel drum, not much intellectual property in the soft-sided luggage called an aggregates bag. So, as industrial production goes, so goes Greif. It’s the very stock not to own, and the very dividend yield on which not to depend, on the eve of a recession.
Beyond acute cyclical exposure and a fancy valuation (29 times trailing GAAP earnings at publication time, an important distinction as 19.6% of cumulative pretax income since 2003 had taken the form of “one-time” restructuring charges), a few other factors colored Grant’s bearish assessment of Greif.
One potential stumbling block: The company had seemingly been underinvesting in its business, as GEF spent $103.5 million in capital expenditures over the prior 12 quarters, well below the $121.3 million in depreciation and amortization expense. Sure enough, CFO Lawrence Hilsheimer noted a reversal during today’s earnings call:
Compared with the prior year quarter, fourth quarter free cash flow was lower by $19 million, partially due to our conscious decision to increase our CapEx spend. . . Relative to the guidance we published at our third quarter call, fourth quarter free cash flow was impacted by higher than anticipated CapEx, cash taxes and cash restructuring.
Higher capital expenditures weren’t the only factor hindering GEF’s cash generation. Asked about a $24 million dollar hit to working capital as a result of unfavorable foreign exchange moves, Hilsheimer explained:
Currency rates have been really volatile. And when we did our guidance for cash flow for the fourth quarter, we went through our processes. And so when we saw the end results of our cash flow, I asked the team to really do a deep dive into every factor because it just did not make any sense to me.
What ultimately we found out was that the currency impacts on working capital when you get down to an account by account level of the various elements of it and some other current accounts end up being a $24 million hit in the fourth quarter. So the drag that was something that had nothing to do with mismanagement, it had everything to do just with the currency impacts to our working capital.
Then there are the so-called headline risks. In 2017, the Milwaukee Journal Sentinel published a series of stories exposing illegal dumping by GEF subsidiary Container Life Cycle Management that potentially jeopardized the health of workers, local residents and safety inspectors. Indeed, two examiners from the Environmental Protection Agency were sickened during the subsequent investigation of a CLCM facility. In January, the Journal Sentinel reported that the EPA is prepared to sue Greif if settlement negotiations break down.
Months passed, too quietly for some. In early August, Senator Tammy Baldwin of Wisconsin sent a letter to acting EPA secretary Andrew Wheeler asking for an update, stating: “I am deeply concerned the EPA has not taken swift, substantial action to protect residents by addressing the company's negligence."
Five weeks later the EPA replied to Baldwin, noting that while a soil sample at the St. Francis facility indicated no “immediate threat to human health . . . the three CLCM facilities in, and around Milwaukee, Wisconsin are already the subject of notices of violation issued by the EPA in November 2017” and that the investigation was proceeding apace, while declining to comment further. Since publication last September, GEF shares are down by 23%, lagging the 8% gain in the S&P 500 over that period.
QT progress report
The Fed’s portfolio of securities held outright fell to $3.896 trillion this week, down $12.5 billion from last week’s reading and $31.5 billion below the trailing four-week average. Treasurys accounted for this drop after mortgage-backed securities ran off the balance sheet last week.
Since the Oct. 1, 2017 commencement of QT, total assets on the Fed’s total balance sheet are down by 8.3%.
Recap Dec. 6
Stocks staged a feverish late rally, all but erasing a near-3% intraday decline on the S&P 500 after The Wall Street Journal reported that the Federal Reserve is having second thoughts about hiking the Funds rate at the Dec. 19 meeting (Fed Fund Futures now price a 69% chance of a rate increase according to Bloomberg, down from 78% on Nov. 30).
Treasury yields finished lower across the curve but well off their best levels of the day, as the 10-year yield jumped 5 basis points in the afternoon to finish around 2.88%. The CRB Commodity Index lost more than 1% despite a weaker dollar, but gold managed to inch into the green, finishing at $1,238 per ounce.
- Philip Grant
Wednesday, December 5, 2018
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat.
Creative destruction, by government fiat.
Franchise player
The beef wars are raging.
The beef wars are raging.
Schumpeter-ism, with Chinese characteristics
Creative destruction, by government fiat. From Caixin Global:
China wants to kill off — or possibly revive — its lurching horde of “zombie” companies by 2020.
The central government has given local governments and state-owned asset management departments three months to submit a list of money-losing companies and has required that they be restructured or disposed of by the deadline.
The deadline shows that the issue of China’s immense corporate debt, especially at state-owned enterprises (SOEs), remains on the government’s agenda. According to the latest Ministry of Finance data, China’s SOEs had 113.9 trillion yuan ($16.5 trillion) in total debt as of the end of October, up 7.7% for the year.
Franchise player
The beef wars are raging. Yesterday, CNBC reported that Burger King has debuted a promotion of once-cent Whoppers through Dec. 12, when ordered through the company app in close proximity (within 600 feet) of rival McDonald’s Corp. (MCD on the NYSE) restaurant locations. The app will then lead McDonald’s customers-turned-deserters to the nearest Burger King to claim their penny-prize.
Such aggressive promotions are one indication of a tough operating environment in fast food. Inflation in wages and commodities is another. Bloomberg reported yesterday that rising prices have narrowed the discount on fast-food hamburgers compared to more upscale concepts like Shake Shack, Inc. to 8% this year from nearly 30% in 2012, as restaurants struggle to adapt to higher labor costs while maintaining their competitive position.
During the October earnings call, McDonald’s CEO Steve Easterbrook described the environment in zero-sum terms: “I think it’s a market share fight. I don’t see many people, many out there in our sector, who are actually growing traffic at all.”
Indeed, the restaurant industry as a whole grew same-store sales by 0.8% year-over-year in October according to industry research firm TDn2K, down from 1.2% in September and 1.8% in August and well below the most recent readings of CPI inflation (2.5% year-over-year in October) or nominal GDP growth (5.5% year-over-year in the third quarter). As top-line growth has floundered, strains between asset-light franchisors and capital-intensive franchisees have intensified.
Yesterday, the National Jack in the Box Franchisee Association filed a lawsuit against its corporate parent in Los Angeles Superior Court, alleging breach of contract and seeking an audit of the company-managed marketing fund, including a “full accounting” of the fund’s activity since 2016. That follows last week’s incorporation by MCD franchisees of their own National Owners Association, a notable development considering McDonald's is the largest, most profitable and arguably best-run fast food company in the world.
Then there’s Restaurant Brands International, Inc. (QSR on the NYSE), parent company of the Burger King, Popeye’s Louisiana Kitchen and Tim Hortons brands and Grant’s pick-to-not-click on June 2, 2017, which has been locked in a contentious dispute with Tim Hortons’ franchisee group the Great White North Franchise Association.
Back in September, Restaurant Brands seized the four Tim Hortons locations owned by David Hughes, president of the GWNFA, commenting that the “franchisee agreement clearly states it is not allowable for any restaurant owner to share confidential company information with the media; disparage the company or the Tim Hortons brand in the media or with community partners and vendors; or ultimately harm the Tim Hortons brand in any way.” For his part, Hughes accused the company of retaliating against him for “shin[ing] a light on many practices and policies that are detrimental to the individual franchisees and the chain as a whole.”
Unsurprisingly, economic difficulties are driving the widening rift between the companies and store operators, with Allan Hickok of the Boston Consulting Group explaining to Restaurant Finance Monitor: “I think we’re going to have a come-to-Jesus moment about exactly what bang for the buck franchisees are getting, especially in asset-light systems.”
John Hamburger, founder and president of the Franchise Times, predicted a similar outcome to attendees of the Grant’s spring 2018 Conference back in April:
On one side you have a franchisor with no capital expenditures and no day-to-day street-level exposure collecting royalties and rents by the bushel basket, trading at double-digit multiples, all the while levering up to pump out cash out to shareholders like there’s no tomorrow. On the other side, [you have] a franchisee, one that’s actually in the trenches running these restaurants and finding out it’s not a very friendly operating environment right now.
I’m here to tell you this Shangri-La doesn’t go on forever. You can’t have one side of the franchise contract getting fabulously rich while the other side faces these headwinds alone. The concept of a moat around the franchisor is a myth. That somehow a brand can separate itself from the unit-level economics of its franchisees is not grounded in reality.
In my view, it can only mean one thing, and that’s a lid on value for asset-light franchisors, especially the ones not growing. The fact that rates are rising may force a multiple compression sooner rather than later.
U.S. markets were closed today in observance of the memorial service for President George H.W. Bush.
- Philip Grant
Tuesday, December 4, 2018
So much for the honeymoon
From Reuters:
From Reuters:
Curve sketching
Big doings in the government bond market.
Big doings in the government bond market.
Recap Dec. 4
So much for the honeymoon
From Reuters:
Brazil’s Supreme Court said on Tuesday it had authorized a federal investigation into allegations that the incoming chief of staff for far-right President-elect Jair Bolsonaro had taken illegal campaign donations.
The investigation is the second graft allegation made against a top member of Bolsonaro’s incoming government, a thorny issues as the leader was elected on a law-and-order platform a vow to end widespread political corruption exposed by the sprawling “Car Wash” investigation and other probes.
Bolsonaro’s presidential inauguration is scheduled for Jan. 1, 2019.
Curve sketching
Big doings in the government bond market. Today, the spread between the 2- and 10-year Treasury yields briefly fell below 10 basis points, the narrowest since 2007. That follows the first partial inversion of the Treasury curve since that same pre-crisis era yesterday, as the 2- and 3-year yields both topped the five year. While the long end has contributed to the latest round of curve compression, the 2.92% 10-year still sits higher by almost 50 basis points year-to-date. Instead, a sharp leg higher in short maturity yields has accomplished most of the heavy lifting.
ZIRP no more. Three month Treasury bill yield. Source: The Bloomberg
What gives? By most metrics, the economy seems to be humming along just fine. GDP grew by an annualized 3.5% in the third quarter and has averaged a 3.1% real growth clip over the last four quarters, while the November Manufacturing PMI printed at a brisk 59.3, the 23rd consecutive monthly reading north of 55 (a reading above 50 denotes expansion).
Although just a partial inversion thus far, the rise in short rates above those of longer maturity is a significant development: Each of the past seven recessions have been preceded by a fully (meaning the three-month yield outpaces the 10-year for 10 consecutive days) upside down yield curve, with an average lag time of 311 days, according to Jim Bianco, founder and eponym of Bianco Research.
But as the current inversion is just a partial one, recent history implies we can expect the real McCoy soon enough. Bianco notes that going back to 1970, each time the 2-year vs 5-year curve inverted, the 3-month vs 10-year differential (which Bianco dubs “the economist curve” due to its frequent use in academic studies) soon followed suit, concluding: “It may take a while, but once one curve inverts, they eventually all invert.”
Bianco has a theory about what’s driving the flip: An aggressive Fed tightening cycle contrasting with an uncertain inflation outlook:
Assuming inflation actually returns, all is well. The Fed is correctly leaning against the markets. However, this is not always the case. . . By our count, the Fed has engaged in nine rate hike campaigns. Since 1980, inflation has been in a downtrend. PCE has rarely exceeded 2% since 1997. Each time it has, the Fed aggressively hikes, the curve inverts and a recession ensues about a year later.
The move in the curve has got the attention of at least some in the Fed, as Dallas Federal Reserve president Robert Kaplan said in a Texas speech Monday that the prospect of curve inversion “tells me that it’s wise to be patient here,” seemingly hinting at a more dovish tilt from the non-voting member (he regains his vote in 2020).
Kaplan’s concerns have yet to be priced into the market, however. Interest rate futures currently assign 79% odds of a rate hike of a 25 basis points or more at the Dec. 19 meeting, up slightly from a 75% probability a month ago.
At the same time, there is no allowance for surprise: As far out as December 2019, futures currently assign 0.0% odds of a rate cut. We’d be so bold as to suggest that figure should be a little bit higher.
Recap Dec. 4
The recent rally ended in abrupt fashion, as stocks were splattered to the tune of a 3.2% drop in the S&P 500, with the industrials and financials groups each losing more than 4% while the NYSE FANG+ Index sank by 3.9%. Treasurys were bid across the curve with the yield on the 30-year long bond sinking nearly 9 basis points to 3.17%, its lowest since mid-September, while the VIX enjoyed a mid-day surge to close back above the 20 mark.
One relative bright spot was in commodities, as energy prices managed a flat finish with WTI crude settling just under $52 a barrel. Gold enjoyed another solid bid, closing at $1,238 an ounce, its best level since mid-July.
Both the stock market and the bond market are closed tomorrow in observance of the national day of mourning for President George H. W. Bush.
- Philip Grant
Monday, December 3, 2018
The end of the beginning
The training wheels are coming off. Next week, the European Central Bank will conduct its final meeting of 2018, and is widely expected to announce the cessation of its QE asset purchase program. The ECB began buying sovereign bonds in 2015 and added corporate debt to the mix a year later. ECB president Mario Draghi, who piloted the program, will soon be riding off into the sunset, as his term ends on Oct. 31, 2019.
As the ECB’s balance sheet has grown to €4.65 trillion, up 117% since early 2015 to equal 30% of full-year 2017 European GDP (the Fed’s balance sheet represents 21% of 2017 U.S. output by comparison), both sovereign and corporate credit spreads collapsed as investors basked in the warm glow of a non-economic buyer of first, middle and last resort.
The European Central Bank asset purchase program, visualized (sovereign bonds in blue, corporate in yellow, asset-backed securities in green and covered bonds in red). Source: ECB website
At the sovereign level, there is ample evidence that Super Mario’s exertions have thus far produced their desired effect. For instance, five-year Portuguese credit default swaps are quoted at 94 basis points and trade at an 80 basis point-premium to triple-A-rated Germany; that compares to 362 basis points and a 335 basis point spread over German CDS in early 2016. Triple-B-minus rated Portugal’s 10-year yield stands at 1.8%, down from north of 4% in early 2016.
But thanks in large part to the recent risk spasm, the pancake-like corporate spreads stemming from the ECB’s benevolent stewardship have widened. As Bloomberg notes this morning, the Bloomberg Barclays European Investment Grade Corporate spread has widened to nearly 150 basis points, up from just 73 basis points earlier this year to return to its levels seen at the commencement of corporate-bond purchases in early 2016.
The selloff in corporate bonds has erased what was one of the most noteworthy securities prices of the modern era. The Dec. 15, 2017 edition of Grant’s shined a spotlight on double-B-plus-rated Telecom Italia S.p.A., which last year achieved the seemingly impossible as its 3.25 notes of 2023 rose above 111 cents on the euro, sending the yield to a double-take inducing 0.95%. As that TI note carries not only the credit risk inherent in a sub-investment grade rating but also offered a virtually zero real yield when accounting for inflation (Italian CPI rose 0.9% year-over-year in December 2017), Grant’s termed the sub-1% yielding TI issue a kind of “inverse museum piece,” referencing the description for particularly attractive fixed income securities that have been rendered cyclically defunct.
Sure enough, the recent re-rating of corporate credit has put an end to that anomaly (or abomination), as the 3.25s of 2023 have declined to 101.5 cents on the euro, for a yield-to-worst of 2.78% and 320 basis point spread over the benchmark. In mid-November, the company fired CEO Amos Genish, the third time that TI has changed its top executive in the past two years.
What sort of unintended consequences might stem from Draghi’s monetary adventures? The March 25, 2016 edition of Grant’s featured commentary from a publicity-shy London correspondent, who had some observations and some questions about the ECB’s mission to lower borrowing costs to bottom-scraping levels:
While Draghi’s latest trick may be notched up as another success by the technocrats of Brussels and Frankfurt, one wonders if Mario should be quite so eager to please the markets. After all, at some point this debt will need to be refinanced.
Will the ECB still be expanding its balance sheet in 2020, to help peripheral issuers fund at near the same interest cost as their German counterparts? And if so, will the same accommodation be tendered for the next maturity and for the one after that? Even the universe, we are told, cannot expand forever.
The ECB may give it a go, to judge from past communiques. Shortly after the commencement of QE, ECB governing council member Vitas Vasiliauskas displayed no lack of confidence in the abilities of his fellow central bankers. In a May 2016 interview with Bloomberg, Vasiliauskas remarked:
People say the ECB is done, their box is empty. But we are magic people. Each time we take something and give it to the markets – a rabbit out of the hat.
Recap Dec. 3
Stocks ripped higher once again following a seemingly-successful round of U.S./China trade discussions over the weekend, as the S&P 500 rode a 1% rally to close within 5% of its September highs while the NYSE FANG+ Index jumped nearly 3% to narrow its post-June losses to less than 16%. Commodities were also well bid, with WTI crude ripping above $53 a barrel for its best single-day showing since June while gold gained nearly 1% to settle at $1,230 an ounce.
While the equity and commodity markets partied, the Treasury curve continues to flatten as the 2- and 5-year yields have virtually converged at 2.83% (they briefly inverted during the today’s session), while the 2- and 10-year spread cratered by 5 basis points to just 15, the narrowest since 2007.
- Philip Grant
Friday, November 30, 2018
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation,
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline.
Recap Nov. 30
Mobile command
Will Uncle Sam sign off on the proposed merger between T Mobile U.S., Inc. and Sprint Corporation, the nation’s third- and fourth-largest wireless operators?
On Wednesday, an association of 14 organizations including the American Antitrust Institute, Common Cause, Consumer Reports and the Rural Wireless Association sent a letter to incoming House Judiciary and Energy & Commerce ranking members Jerry Nadler and Frank Pallone to express concerns and urge new hearings on the pending deal. The consortium asks the congressmen to ensure “stronger antitrust enforcement, protecting consumers, promoting competition, and standing up for American workers.”
Meanwhile, the Capitol Forum reported on Nov. 15 that the Department of Justice has been investigating allegations that T Mobile was “retaliating against regional carriers critical of the company’s proposed acquisition of Sprint. . . [by refusing] to discuss roaming and other agreements that would allow the carriers’ mostly rural customers to use the T-Mobile wireless network when they travel, the sources said.”
For more on Sprint and its majority owner, SoftBank Group Corp., see the freshly-published Nov. 30 edition of Grant’s.
Game of Monopoly
“There are now more indexes than stocks,” blared a May 2017 Bloomberg headline. Yesterday, John C. Bogle, Wall Street legend and founder of passive investing mainstay the Vanguard Group, blew the whistle on his wildly-successful creation. Bogle penned an opinion piece in The Wall Street Journal calling attention to the rapid growth of the passive investment industry, one he pioneered by introducing the Vanguard 500 Index Fund in 1976.
As Bogle recounts, that initial offering was an epic flop, as the targeted $250 million initial public offering instead raised $11.3 million, “falling a mere 95% short of its goal.” Forty-two years and a couple investment cycles later, and it’s a different story indeed: The Vanguard 500 Index has seen assets under management swell to $431.5 billion as of Oct. 31, while the low-cost investment “exposure” offered by passive and general underperformance of active management strategies have helped foster an industry sea change. The Vanguard founder explains:
Equity index fund assets now total some $4.6 trillion, while total index fund assets have surpassed $6 trillion. Of this total, about 70% is invested in broad market index funds modeled on the original Vanguard fund.
Yes, U.S. index mutual funds have grown to huge size, with their holdings doubling from 4.5% of total U.S. stock market value in 2002 to 9% in 2009, and then almost doubling again to more than 17% in 2018.
If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and [must] consider its impact on the financial markets, corporate governance, and regulation. These will be major issues in the coming era.
Bogle’s warning is perhaps the starkest yet, considering his unique role in ushering in the modern era of indexation.The question before the house: Is a change in government policy needed to curtail the passive behemoth, or might investors unwind the logjam themselves? Kevin Duffy, principal at Bearing Asset Management, is of the latter belief. Duffy tells Grant’s:
After 10 years of everything going in the same direction, extrapolation is the order of the day. But market forces work to prevent trees from growing to the sky.
While passive investing has a cost advantage over active investing, the indexation movement is still subject to the general laws and flaws of the investment business. Perhaps most importantly: its customers tend to act in herds and make poor decisions at major turning points. Some 257 ETFs own Apple, more than any other stock. Passive investors have heavy exposure to the winners, notably large cap technology.
At the beginning of the bull market, the FAANG companies spent $6 billion on annual R&D. Today that figure is $94 billion, or 20% of all private R&D spending. These companies have mostly picked the low hanging fruit, have their fortunes tied more to the economy (increasingly, they are the economy) and are competitively bumping into each other. These stocks went from 3% of the S&P 500 to 12% at their peak a couple of months ago, a significant driver of outperformance. After AMZN and AAPL reached $1 trillion valuations, how can these stocks not underperform over the next decade? That is what will likely derail the passive bubble: its own success.
Just as faith in market forces is lost, those forces seem to come out of nowhere and exert themselves. It wasn’t long ago that the antitrust police thought Microsoft would rule the world. . . yet Google came out of nowhere. Similarly, people wired for intervention feared Japan Inc. during the late 1980s (Donald Trump being one of them, see the March 1990 Playboy interview) and felt that drastic measures should be taken. No surprise then, that Japan has been replaced by the new economic bogeyman, China.
Recap Nov. 30
Stocks rose again, capping a terrific week for the bulls as the S&P 500 jumped nearly 5% to reach the midpoint of its fall trading range. Treasury yields dropped again, with the 10-year closing just above 3%, while a rally toward fresh 52-week highs in the Dollar Index helped push WTI crude back below $51 a barrel.
- Philip Grant
Thursday, November 29, 2018
Just a billion
From the South China Morning Post:
From the South China Morning Post:
Plumber's crack
QT Progress report
Recap Nov. 29
Just a billion
From the South China Morning Post:
The founder of Shenzhen-based Gionee, a Chinese smartphone brand on the verge of bankruptcy, has admitted he may have used company assets to gamble at a Hong Kong-listed casino in Saipan, but denied a reported loss of 10 billion yuan ($1.4 billion), saying it was only a fraction of this amount.
“I did participate in gambling in Saipan, but how could I possibly lose that much? If it is true, shares of Imperial Pacific [the casino owner] should have surged,” Liu Lirong, Gionee’s chairman and chief executive, said in an interview with Securities Times in Hong Kong at the weekend, responding to recent reports that his gambling loss of 10 billion yuan had resulted in the collapse of Gionee.
When asked how much he lost gambling, Liu told the Securities Times reporter, “a bit more than 1 billion yuan.”
Who makes dumb phones?
Plumber's crack
A strong bounce in the bond market. Since logging an interim high of 3.23% on Nov. 8, the 10-year Treasury yield has declined in 12 of the past 14 sessions, ticking below 3% today for the first time since mid-September. Dovish language from the Fed chairman Jerome Powell hinting that interest rate hikes could wrap up sooner than later catalyzed the latest move in rates.
But while the benchmark Treasury yield flutters lower, interbank borrowing costs continue to jam higher. Three-month Libor jumped by more than 3 basis points this morning, the second-largest move of the year, to 2.738%. That’s up from 1.7% at year-end and 0.7% in summer 2016, when the 10-year yield made its cyclical low of 1.36%.
Cartoon From the April 20, 2018 edition of Grant’s
What’s driving the sharp increase in bank-to-bank lending rates? As noted by Alexandra Harris of Bloomberg, the Fed’s ongoing balance sheet runoff (see below) may be playing a role. Excess banking reserves footed to $1.66 trillion as of last week, well off the $2.67 trillion peak reached during the QE-era.
U.S. excess banking reserves. Source: The Bloomberg
The burden of tightening monetary conditions is not one equally shared, as foreign banks have accounted for about half of the drop in reserves. Non-domestic banks are using commercial paper borrowings to help fill the dollar funding gap. Foreign financial commercial paper outstanding currently stands at $308 billion, just off the record $314 billion seen at the end of October and well above the five-year average of $256 billion.
Bloomberg’s Harris concludes: “Should overseas banks continue to bear the brunt of the decline in reserves, they will have to seek out alternative sources for short-term financing.”
One bank is certainly paying up for funds. Today, Italy’s UniCredit S.p.A. sold $3 billion in five year senior non-preferred dollar bonds, with Robert Smith of the Financial Times reporting that Pimco LLC bought the entire offering at a yield of 7.83%. That’s a 493 basis point premium over Treasurys and 420 basis points over the so-called mid-swap benchmark reference rate.
In January, triple-B-minus rated UniCredit issued €1.5 billion in euro-denominated five year notes at a 1% coupon and just 70 basis points over mid-swaps. Those 1% notes, issued at just under par, have since declined to 91 cents on the euro for a yield-to-worst of 3.27%, dealing investors a quick 8% (€120 million) unrealized loss after factoring in accrued interest.
While UniCredit faces its own particular problems, including an outsize portfolio of non-performing loans (a sale of dubious debt to Pimco and Fortress earlier this year took its NPLs below 20% of total loan book according to the bank), and the sharp recent rise in Italian sovereign yields, other European banks should pay heed.
For his part, UniCredit CEO Jean Pierre Mustier struck a victorious tone, telling the Financial Times: “We wanted to show we had access to the market in large size. And by doing such a large transaction with a single investor, it also conserves the capacity for new transactions.”
New transactions at what price?
QT Progress report
The Fed’s portfolio of securities held outright dropped by $8 billion this week to $3.91 trillion, following a $26 billion decline during the holiday-shortened prior week, as Treasurys and mortgage-backed securities each comprised about half of the aggregate $34 billion decline over the past two weeks.
Since QT got underway on Oct. 1, 2017, total assets on the Fed’s balance sheet have declined by 8.1%.
Recap Nov. 29
Stocks drifted sideways, with the S&P 500 maintaining a 4% gain for the week that has narrowed the recent drawdown to 6.5% off the broad index’s Sept. 20 highs. Treasury yields were bid across the curve, with the 10-year outperforming as the two- and 10-year spread narrowed 21.5 basis points, less than three basis points from the flattest of the post-crisis era in August.
Commodities caught a modest bid while the Dollar Index finished unchanged, and the VIX held near 19.
- Philip Grant
Tuesday, November 27, 2018
Door busters
It’s a buyers’ market in the Big Apple. A reader alerts Grant’s to a broker email:
I have 32 apartments left to sell at 550 Vanderbilt. On this Sunday (December 2nd) we will have a 1-day, 20% OFF SALE from 11am – 4pm.
We will be doing previews by appointment only from Wednesday – Friday.
Big River
Power up. On Nov. 16, the Republic of Tajikistan debuted its prize $3.9 billion Rogun hydroelectric power plant on the Vakhsh River in the southern end of the country, as the first of six turbines went online. Upon completion at the dam’s projected 335 meter height, it will become the world’s tallest. Agence France-Presse reports that the fully-functioning power plant will double Tajikistan’s energy output, “alleviating a long-lasting, debilitating national energy deficit.”
The dam may be partially up and running, but the tiny central Asian nation (2017 GDP per capita: $801, per the World Bank) faces an uphill climb toward realizing its goals. Construction on the Rogun dam initially began in Soviet-era 1976 before being abandoned. Rogun is also being built “in a highly seismic area, and several geologic studies have warned about the risks of building such a large dam in this setting,” Dr. Filippo Menga, lecturer in human geography at the U.K’s University of Reading, told the AFP.
It’s not just the geography that’s potentially unstable. In December 2016, the Tajik government was obliged to borrow $490 million (more than 20% of that year’s state budget according to Reuters) from the local central bank to bail out the country’s four largest banks, which had seen bad loans balloon to 58.7% of their total book as of Sept. 30, 2016. Three months later, EurasiaNet, citing Tajikistan’s Radio Ozodi, reported that local prosecutors were investigating lending practices at the institutions, with an unnamed source explaining that “some banks have been known to accept doors, windows, cows and other livestock as collateral for credit, immaterial of whether the customer was ever likely to be able to repay the debt.”
Production and financial red flags aside, intrepid investors were all too eager to fund the ambitious project. Last September, single-B-minus (“adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments on the obligation”) rated Tajikistan sold $500 million in senior unsecured 10-year dollar bonds, at a yield of 7.125% and 506 basis point spread over Treasurys. That yield was down from an initial projection of 8%, as a $4 billion order book left the deal oversubscribed by eight times, according to the Financial Times.
Just over one year later, those bonds have declined in price to 88 cents on the dollar, for a par yield of 9.36% while the spread over Treasurys has widened to 639 basis points.
Tajikistan is not the only recently issued speculative-grade sovereign bond to suffer swift unrealized losses. The single-B-rated Republic of Ghana’s 8.63% senior unsecured dollar bonds of 2049, sold in May at a 550 basis point spread over Treasurys, last changed hands at under 85 cents on the dollar for a 10.25% yield-to-maturity and a 693 basis point spread. The single-B-plus rated Republic of Kenya issued senior unsecured 7.25% dollar bonds due in 2028 in February at a 434 basis point spread; that issue has retreated to 87 cents on the dollar, priced to yield 9.33% and a 637 basis point spread.
While frontier-market debt represents one kind of overt risk, a different sort of investment hazard lies closer to home. In September 2017, the double-A-plus-rated Republic of Austria sold 2.1% bonds maturing in 2117 at a 23 basis point premium over French soverigns due in 2066. Those century bonds have since been bid to 112 cents on the euro, now priced to yield 1.84% and a 2.4 basis point premium over the French issue maturing nearly 50 years earlier. Meanwhile, Austrian CPI rose by 2.2% year-over-year in October, bestowing upon bondholders a real yield of negative 36 basis points.
With 99 years left until maturity, Austria’s ultra-patient creditors are soon facing the loss of a price-insensitive ally: The European Central Bank is widely expected to announce a taper of its QE bond buying regime at its Dec. 13 meeting, with ECB president Mario Draghi again hinting as much during a speech in Brussels on Monday.
Recap Nov. 27
A relatively stable day for asset prices saw the S&P 500 reverse early losses to finish slightly in the green, extending yesterday’s bounce from the interim lows reached Friday. Treasury yields ticked slightly higher, while WTI crude managed to inch toward $52 a barrel despite strength in the greenback, as the Dollar Index approaches its 52-week high.
While stocks and bonds largely treaded water, interbank borrowing costs made another lurch higher as three-month LIBOR finished the day just under 2.71%; that’s up from 2.32% in September and 1.7% at year-end 2017.
- Philip Grant
Monday, November 26, 2018
China chalet
Two ships in the night. As investor attention turns toward the highly anticipated meeting between Donald Trump and Xi Jinping later this week at the G20 meeting in Argentina, a sea change in borrowing costs has taken place: For the first time since at least 2000, the yield on the one-year Treasury bill (2.58%) now exceeds its Chinese equivalent (2.5%). As recently as June, Chinese one-year sovereign debt out-yielded the U.S. by more than 100 basis points, at 3.37% compared to 2.32% stateside. In a research note last week, Bank of Montreal strategist Jon Hill wrote that the declining Chinese yields “should put further depreciation pressure on the renminbi, which would serve as a disinflation force domestically.”
Sovereign rates may be coming down in the Middle Kingdom, but that’s been no help to the encumbered property developers. Last Monday, Times China Holding Ltd. issued two-year dollar bonds at a 10.95% coupon; just 10 months ago, the same company was able to pay only 6.25% on three-year notes. Peer Agile Group Holdings Ltd. was obliged to pay a 9.5% coupon on two-year dollar denominated notes on Nov. 15, up from 8.5% for three-year paper issued in July. China Evergrande Group, featured in the June 2, 2017 edition of Grant’s, was forced to pay 11% for two-year dollar bonds last week. That compares to an 8.75% yield on eight-year bonds issued in June (those notes have fallen to 80.25 cents on the dollar for a yield-to-worst of 13.35%). Overall, Bloomberg highlights that the property developer-heavy ICE BAML Asian dollar China corporate Index now carries a near 12% yield, the highest since 2015.
The pain is not confined to the developers. Formerly acquisitive conglomerate HNA Group Co. Ltd., which went on a $40 billion corporate shopping spree between 2015 and 2017, has recently been forced to turn tail and sell assets in hopes of remaining solvent. Last Tuesday, FinanceAsia Daily made note of an instructive recent transaction:
One recent sale highlight’s HNA’s desperation. On Nov. 19, BrightSphere Investment Group, an asset management firm listed on the New York Stock Exchange, announced that Paulson & Co., a hedge fund controlled by U.S. investor John Paulson, had agreed to buy HNA’s 24.95% stake in the group.
BrightSphere said that the stake would be sold for around $371 million. Given that HNA paid $446 million for its stake in the asset management firm only 18 months ago, this equates to a loss of roughly $75 million for HNA.
In a possible swipe at the Chinese conglomerate, BrightSphere chairman James Ritchie said: “The transfer of shares to a respected institutional investor such as John Paulson will bring the clarity of ownership which is positive for all our constituencies.”
FinanceAsia Daily goes on to note that while HNA has managed to so-far trim its debt load by 10.7% in the six months ending in June, the company still sports a towering leverage ratio of more than 21 times total debt to EBITDA as of June 30.
With cash hard to come by, some of HNA’s subsidiaries are getting creative. On Nov. 14, Bloomberg reported that Qianhai Air & Shipping Exchange “is offering tickets from [fellow HNA units] Hainan Airlines or Grand China Air to repay what it owes. . . the flights can be for both domestic and international travel and are valid for five years.”
Recap Nov. 26
A strong bounce in stocks left the S&P 500 higher by 1.6% at day’s end, recouping a chunk of last week’s ugly 3.7% decline, while the NYSE FANG+ Index gained nearly 4% but still remains in bear market territory, 21% south of its June peak. The Dollar Index reversed early losses to finish in the green, but energy managed to catch a bid anyway with WTI crude ticking back to $51.50 a barrel.
Treasury yields finished higher across the board, with the 10-year settling at 3.06%. The VIX sank by more than 12% to finish below 19, its second-lowest close in more than two weeks.
- Philip Grant
Wednesday, November 21, 2018
Sturm und Drang
It’s no breaking news that Denmark’s largest financial institution, Danske Bank A/S, is mired in disrepute after being caught up in money laundering scandal involving some €200 billion flowing through its Estonian subsidiary. More topical is the allegation, levelled yesterday by whistleblower Howard Wilkinson in Danish Parliament, that Germany’s largest lender Deutsche Bank A.G. had served as correspondent for Danske Bank, helping to process as much as €150 billion in dubious payments.
On this side of the pond, Bloomberg reports today that Deutsche Bank’s efforts to mitigate risk and improve performance via the creation of a so-called central risk book for its positions have instead led to some $60 million in losses. Culprits for the misadventures include “issues with the CRB’s technology. . . the CRB may also have become too big to manage properly.”
Then, too, brisk management turnover continues apace at DB, with co-head of structured credit Armin Rothauser leaving the bank two weeks ago to “pursue other opportunities,” according to an internal staff memo cited by Bloomberg. Back in April, CEO John Cryan was dismissed “followed months of conflict on the management board and indecision on the supervisory board over whether to replace him,” per The Wall Street Journal. Chief operating officer Kim Hammonds departed soon after.
The drumbeat of dour news is taking a toll, as the New York-listed DB shares yesterday finished at an all-time low of $9.23 a share (they were listed in 2001). That’s down from $20 in December of last year and $45 in early 2014. European money center bank peers have likewise been weak, but not to the same extent; shares of Credit Suisse Group A.G., BNP Paribas S.A. and Barclays PLC are all hovering at or near their lowest levels since mid-2016.
But the alarming erosion in Deutsche Bank’s equity value has yet to make much of an impression on the rest of the A3/triple-B-plus rated bank’s capital structure. The senior unsecured 1.5% notes of 2022 last traded at just over 99 cents on the euro, while five-year DB credit default swaps currently fetch about 173 basis points, down from the interim highs of 184 basis points seen in July.
That relative resilience extends to the debt securities toward the bottom of the capital structure; i.e. junior unsecured contingent convertibles, or CoCo bonds. These regulator-approved securities (they are considered Tier 1, or “core” capital) glean their name from their convertibility to equity at the bank’s discretion, rather than investor's, as would be the case in a conventional convertible. The Bank for International Settlements describes the merits in a 2013 paper:
CoCos are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Then debt is reduced and bank capitalization gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements.
The DB 6% perpetual CoCo bonds, issued in 2014, currently trade just under 90 cents on the euro for a yield-to-call of 9.59%. That’s not so far off their five-year average price of 94.3, slightly above the early July provisional lows and well north of the February 2016 nadir of 71.
DB 6% CoCos in white, vs. DB share price in orange. Source: The Bloomberg
Does the divergence between Deutsche Bank’s slumping equity value and still-presentable credit performance signify bullish opportunity, or ominous indicator of trouble ahead? Investors and regulators alike should bear in mind that the convertibility feature embedded in the CoCo bonds may serve as a source of something other than stability and market confidence, were they to be exercised. The July 11, 2014 edition of Grant’s noted that:
Conversions or write-downs, when they’re finally forced, won’t take place under wraps. The news will start a highly focused reassessment of the creditworthiness of the stricken CoCo issuer or issuers. Providers of short-dated liabilities – certificates of deposit, uninsured deposits, commercial paper – are likely to arrive at the same conclusion more or less simultaneously.
Deutsche Bank is currently leveraged at about 22 times equity capital as of Sept. 30, north of Credit Suisse’s 18 times but below BNP’s ratio of 24 times assets to capital. DB’s return on equity footed to negative 3% in the last quarter, by far the worst of those four major European banks. The derivatives book, with a notional value of €48.3 trillion according to the 2017 annual report, is four times last year’s Eurozone GDP of