Stocks finished unchanged to consolidate recent gains, as the S&P wrapped up the week 2.5% in the green to remain roughly 1.5% from its February high-water mark. Treasurys came under modest pressure with the 10- and 30-year yields rising to 0.56% and 1.23%, respectively. Gold pulled back to $2,043 an ounce, WTI crude held at $41.5, and the VIX fell to near 22 to mark another post-February low.
- Philip Grant
Almost Daily Grant's will resume Monday, Aug. 24
Monetize this. The Treasury Department announced Monday that it projects $947 billion in debt issuance over the next three months, up 40% from a $677 billion forecast issued in May. The fourth quarter should see still more supply, with estimated marketable debt issuance of $1.216 trillion, or a further sequential increase of 28%.
Depending on the outcome of the congressional stimulus negotiations currently underway in Washington, those figures could increase further. The Congressional Budget Office pencils in a $3.5 trillion budget deficit in the 12 months through Sept. 30, compared to just under $1 trillion in fiscal 2019.
Of course, all that debt will need to find a home, and the Federal Reserve has pulled back from its feverish buying during the height of the pandemic. Between March 4 and June 10, the Fed bought roughly $1.6 trillion in Treasury debt, equal to more than half of the net $2.5 trillion increase in total government debt outstanding over that period. From the March peak of $75 billion a day in Treasury purchases, the Fed has since scaled back its buying pace to about $80 billion per month.
The composition of future supply is shifting, as Treasury announced yesterday that the increased issuance will be concentrated at the back end of the curve. Thus, while two-, three- and five-year note auctions will each rise by $2 billion through October, the 10- and 30-year auctions will increase by $6 billion and $4 billion, respectively.
That shift toward longer-dated issuance will surely attract notice within the Eccles Building. “The Treasury is increasing pressure on the Fed to extend the duration of their purchases,” Priya Misra, global head of rates strategy at TD Securities, tells the Financial Times. “It is almost a necessity now. Without that, we could have a messy Treasury market both in terms of functioning and auctions.”
Jon Hill, rates strategist at BMO Capital Markets, noted the central bank’s shifting goals from the height of the financial panic earlier this year. “Back in March and April the Fed was focused on market functioning. Now things have calmed dramatically but we still need quantitative easing to compress long rates and lower borrowing costs.”
In his June testimony on Capitol Hill, Fed chair Jerome Powell declared that the Fed’s government bond purchase program “wasn’t in any way about, you know, meeting Treasury’s supply. . . we really don’t think about that.”
That proclamation may be soon put to the test. The Treasury’s Borrowing Advisory Committee noted in May that roughly 30% of outstanding Treasury debt would mature within the next 12 months.
Trouble flows uphill in 2020. The pandemic and lockdown are taking a severe toll on the retail realm, as Moody’s predicts that operating income across the sector will plunge by 25% to 30% from a year ago.
Bloomberg reports today that pandemic-related pain among brick and mortar retailers is now taking a wider toll. With at least 25 retailers filing for bankruptcy so far this year and many others forced into survival mode, a number of outlets including J. Crew Group, Inc., Neiman Marcus Group, Inc. and Men’s Wearhouse parent Tailored Brands, Inc. have opted to file for Chapter 11 instead of renegotiating with their landlords. Data from Trepp show that 16% of retail property loans packaged into commercial mortgage backed securities were delinquent at the end of July, compared to 3.8% in January.
“This is now black-letter law – a debtor can cram down a landlord,” said Melanie Cyganowski, partner at law firm Otterbourg P.C. and a former bankruptcy judge, told Bloomberg. “If this becomes a tsunami of retailers rejecting their leases, it’s going to trigger another part of the sea change – the mortgages held by the landlords.”
Fallout is already visible. Retail carnage was front and center in the second quarter for commercial real estate giant and Grant’s pick-to-not-click (see the Nov. 29, 2019 issue) Brookfield Property Partners, Inc. (BPY on the Nasdaq). Brookfield reported a net loss of $1.51 billion for the second quarter, compared to a $23 million profit in the same period a year ago. Perhaps most alarmingly, the company disclosed that retail rent collections stood at just 34% in the second quarter. Recall that last week, the company struck a deal with its lenders to relax certain covenants governing leverage limits and fixed charge coverage ratios, in exchange for a higher interest rate and limitations on restricted payments, including dividends.
New highs look to be in the offing, as another top-heavy advance pushed the S&P 500 to 3,350, within 150 basis points of its Feb. 19 high-water mark. Treasurys were modestly bid with the 10-year yield slipping back to 54 basis points, while WTI rallied to near $42 a barrel and gold jumped to $2,074 an ounce. The VIX closed below 23 for the first time since Feb. 21.
- Philip Grant
The Turkish lira’s offshore borrowing rate went skyward overnight, soaring 1,200 percentage points (not basis points) to a cool 1,050%. Proximate cause, according to Bloomberg: “Dollar sales executed by state banks, designed to prop up the lira, began to settle after a public holiday.”
The overnight surge will likely do little to attract foreign investors, who have been effectively barred from dealing with local banks and now face those prohibitive costs when transacting in lira. According to the Central Bank of the Republic of Turkey, foreign investors withdrew a record net $7 billion from local debt markets in the first half of the year, while a further $4 billion in equity outflows pushed the ratio of foreign investors in the Turkish market below 50% for the first time in 16 years.
For more on the dicey state of affairs in the Gateway to Asia, see the July 14 edition of Almost Daily Grant’s.
Avert your eyes, environmental, social and governance-driven investors: Last Thursday Altria Group, Inc. (MO on the NYSE) reported second quarter figures. Let’s review the state of play for the U.S. tobacco giant and international peer Phillip Morris, Inc. (PM on the NYSE), which featured in Grant’s last fall.
The pair have been slow out of the gate. Since a bullish analysis in the Oct. 4, 2019 issue, shares in Altria and Phillip Morris have returned 6% and 3% inclusive of dividends, respectively, trailing the S&P 500’s 13% total return over that period.
As always in the tobacco realm, worries over health concern-related revenue attrition loom large. Altria announced last week that it now expects U.S. industry volume declines of 2% to 3.5% this year, up from a prior estimate of minus 4% to minus 6%.
Then, too, efforts to diversify into the formerly fast-growing vaping trend have come a cropper. In December 2018, Altria coughed up $12.8 billion for a 35% stake in e-cigarette company Juul Labs, Inc., an unfortunate allocation of capital as the company has subsequently written off two-thirds of its investment. Regulatory and P.R. woes have been front and center, with last fall’s spate of vaping-related lung illnesses dimming the company’s prospects. On last week’s conference call, Altria management noted that total vaping volumes fell 14% from a year ago during the second quarter.
However, a major catalyst looms on the e-cigarette front. Juul announced last Thursday that is has filed an application with the Food and Drug Administration to continue selling its tobacco and menthol-flavored vape pods in the U.S. ahead of a Sept. 9 deadline for hopeful e-cigarette vendors, with the company including more than 110 studies in its petition including research documenting the health effects of the products. Safeguards to keep underage would-be vapers away will be crucial to the lobbying effort. “Juul Labs has committed all necessary resources to deliver the best possible premarket tobacco product application based on rigorous scientific research and data-driven measures to address underage use,” commented Chief Regulatory Officer Joe Murillo.
As the former growth area of e-cigarettes now resides in regulatory limbo, would-be tobacco investors confront the key question: Can industry pricing power offset the seemingly inexorable decline in legacy unit sales? In formulating a bullish stance on the pair last fall, Grant’s answered in the affirmative. Encouraging signs are visible on that score, as an 8.8% decline in volumes translated to more modest 3.8% revenue decline from a year ago. In addition, earnings per share rose by 0.9% from last-year excluding one-off expenses, and the company reinstated full-year earnings guidance calling for EPS of $4.21 to $4.38, figures which range from unchanged to up 4% relative to a year ago
The vaping crackdown has spurred some smokers to switch back to the real McCoy. “That consumer was faced with choices,” Altria CEO Billy Gifford said on last week’s earnings call. “It benefited the entire cigarette category.” Current circumstances have provided an unexpected lift, as well. “Fewer social engagements allow for more tobacco-use occasions,” Gifford added.
Altria and Phillip Morris trade at roughly 10 times and 15 times consensus 2020 earnings per share, respectively, undaunting valuations compared with other ESG rejects such as Anheuser-Busch and Raytheon Corp. valued at 29 times and 21 times full-year estimates, as well as casino operator Las Vegas Sands Corp. with shares quoted at 21 times calendar 2021 consensus EPS.
Balance sheets are in decent shape, with each carrying net debt equivalent to roughly two times consensus 2020 Ebitda, while Altria can further reduce leverage if it opts to sell its 10% stake in Anheuser Busch at the expiration of a five-year lock-up period in October 2021. In addition, A3/triple-B-rated Altria and single-A-rated Phillip Morris sport dividend yields of 8.3% and 6.1%, respectively. For context, the single-B component of the Bloomberg Barclays U.S. High Yield Index trades at a yield-to-worst of just 5.3%.
A margin of safety in the producers of demonstrably unsafe cigarettes?
More of the same today, as stocks caught another bid with the S&P 500 closing above the 3,300 mark for the first time since Feb. 21 and within 3% of its all-time highs. Treasury yields continue to shrink, with the 2-, 10- and 30-year yields sinking to 11, 51 and 118 basis points, respectively. Gold continued its aggressive rally with a 2% gain to $2,033 an ounce, WTI approached $42 a barrel and the VIX dropped below 24.
- Philip Grant
In the wee hours Friday the overnight 10-year Treasury yield fell to 0.52%, its lowest ever beyond an intraday spell during whipsaw trading on March 9. Deutsche Bank research strategist Jim Reid put it this way:
The U.S. has been through depressions, deflations, wars, restrictive gold standard regimes, market crashes and many other major events and never before have we seen yields so low back to when the Founding Fathers formed the country.
The belly of the curve has likewise plumbed new depths, with the five-year Treasury yield finishing Friday at just 21 basis points, comfortably within the upper end of the overnight Fed Funds policy rate range of 0 to 0.25%.
Those diving nominal interest rates are even more notable because inflation expectations, as measured by the 10-year breakeven rate, have swiftly retraced most of their March collapse. On Friday, the real 10-year yield (the nominal 10-year yield less the inflation rate implied by 10-year breakevens) fell to negative 1%, down from minus 68 basis points on July 1 and the lowest since at least 1995.
10-year TIPS breakeven rate. Source: The Bloomberg
Real rates may move still deeper into negative territory, if our monetary mandarins have their way. The Wall Street Journal reports today that the Fed “is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.” Last year, Fed chair Jerome Powell declared that a too-low rate of inflation was “one of the major challenges of our time.”
On the other side of the equation, some high-profile Fed alums bang the drum for more overt price controls. On May 27, New York Fed president John Williams declared that the central bank was “thinking very hard” about rolling out yield curve control, in which the Fed would pledge to buy unlimited quantities of certain Treasury maturities to ensure that rates did not exceed target levels. On July 17, former chairs Ben Bernanke and Janet Yellen penned a blog post for the Brookings Institution expressing their approval of the even-lower-for-even-longer rate regime:
We expect low rates will spur spending in sectors like housing as the economy reopens. And the Fed may well do more in coming months as re-opening proceeds and as the outlook for inflation, jobs, and growth becomes somewhat clearer.
In particular, to maintain downward pressure on longer-term interest rates, the Federal Open Market Committee likely will provide forward guidance about the economic conditions it would need to see before it considers raising its overnight target rate.
Artificially low borrowing costs are boon (or lifeline) to Uncle Sam as well as to Mr. Market. On Friday evening Fitch Ratings cut its outlook on U.S. sovereign debt to “negative” from “stable,” citing “the ongoing deterioration in the U.S. public finances and the absence of a credible fiscal consolidation plan.” The rating agency pencils in a deficit equating to 20% of GDP in fiscal 2020 (ending Sept. 30), followed by an additional 11% GDP shortfall next year. That’s despite a decline in the effective interest rate on the government debt stock to 1.75% in June, down 75 basis points from a year prior.
The gaping shortfalls are likely to be chronic, as Fitch calculates that even with real growth rates rising back to 2%, stabilized deficits would remain at 3% to 4% of GDP by 2024. For context, the federal deficit equaled 5.1% of output in fiscal 2019, up from 3.5% two years earlier and the highest since World War II outside of the 2008-era financial crisis. By Fitch’s reckoning, a 1% rise in the effective interest rate would add an extra 1.2% worth of GDP to the annual bill.
The May 1 edition of Grant’s summarized this peculiar moment in monetary history:
The financial risks attached to the still more radical policies of the Powell Fed are twofold. The first is the risk that the policies prove inadequate to support either the stock market or the economy. In which case, as the Fed itself has pledged, there would be more of them.
The second risk is that the policies succeed—both the economy and the financial markets emerge hale and hearty from the government- ordered lockdown. What, then, could stay the hand of the next central banker in the face of even a garden-variety downturn? The precedent would be in the books. One’s first response, it would say, is to throw the kitchen sink.
Implicit in the world’s Covid-19 policy response is that inflation (besides posing a less consequential risk than death by a novel virus) is not merely dormant but kaput. Count us in the dormant camp. The post-lockdown world—may it soon arrive! —will be one of reduced trade, stunted productivity growth and, if current trends hold, super-abundant monetary growth. And all of that in the context of the lowest interest rates in 4,000 years.
In other words: Yield curve, controlled. For now.
The rise in June pending home sales data mentioned in Thursday’s edition of Almost Daily Grant’s was on a sequential basis, rather than year-over-year as characterized.
Another strong day for stocks left the S&P 500 at its best close since Feb. 21, up 2% for the year and 47% from its March 23 nadir. Treasurys came under some modest pressure with the long bond yield rising to 1.23%, while gold rose to $1,990 an ounce and WTI reversed early losses to finish near $41 a barrel. The VIX held at 24.5, far above its closing level of 17 when the S&P 500 was last seen at these levels on Feb. 21.
- Philip Grant
“CLOs Are About to Get Easier for the Robinhood Crowd to Buy,” blares a Bloomberg headline this morning. Indeed, asset manager Janus Henderson is planning to roll out a U.S.-listed exchange traded fund focused on collateralized loan obligations (CLOs), or packaged and securitized collections of leveraged loans. The ETF, which will be exposed to the highest quality end of the credit spectrum, would be the first such vehicle dedicated to CLOs, an asset class which has enjoyed brisk growth in tandem with the post-crisis expansion in the leveraged loan market.
While the idea of retail investors wading into the choppy waters of securitized debt may be less than appealing to some, relative credit quality of the offering allays some concern. “In the case of triple-A CLOs, it’s a safe and low-risk asset class,” comments David Schawel, chief investment officer at Family Management Corp. “Yields are fairly low on triple-A CLOs in the first place, but if investors can earn 150 to 175 basis points of spread on a short duration asset, it can be attractive.”
As Janus Henderson looks to bring the triple-A cordon of CLOs to Main Street, another yield-starved constituency has loaded up on the contraptions. Insurance industry holdings of CLO debt stood at $158 billion at year-end 2019 according to data from Barclays, up 22% from a year ago and nearly double that of 2016. That figure represents nearly one quarter of the total market. A June report from the National Association of Insurance Commissioners warned that under a severe recession scenario, cascading losses from CLO defaults could overwhelm the capital and surplus of four (unnamed) insurers.
Insurers including American Equity Investment Life Insurance Co. and Apollo management’s Athene Holding Ltd. have CLO holdings of more than 75% of total adjusted capital, according to Fitch Ratings. Credit quality is far from pristine, as the NAIC found that roughly 55% and 40%, respectively, of the pair’s CLO holdings are rated triple-B. For context on the market’s view of the relative risk profile, triple-B-rated CLOs currently yield roughly 5% according to data from Palmer Square, more than double the 2.34% yield for the Bloomberg Barclays U.S. Aggregate Baa Index.
That discrepancy is telling. “To say triple-B is all money good is unrealistically optimistic and puts a lot of trust in CLO managers’ ability to de-risk their weakened portfolios in a timely manner,” Jason Merrill, structured product specialist at Penn Mutual Asset Management, told Bloomberg. “There are likely to be weaker triple-B’s that will take some amount of principal loss.”
Pandemic and lockdown-related corporate downgrades will test the health of the CLO market. Moody’s Investors Service reports that a record 102 U.S. nonfinancial companies are now in the “crossover zone,” meaning the boundary between investment grade and high yield. Of the 41 companies that joined the list in the second quarter, all but three are potential “fallen angels” (investment grade credits demoted to junk), while the ratio of fallen angels to rising stars (or those promoted to IG) now stands at 5.8:1, compared to less than 2:1 at year-end. According to S&P’s LCD unit, the rolling three-month ratio of downgrades to upgrades in June for the underlying leveraged loans stood at 18.4-to-1, more than double the financial crisis-era peak.
That raft of downgrades is causing a pile-up at the lower credit reaches, as analysts from Barclays forecast that the ratio of triple-C-rated loans will approach 12% by year-end. That is potentially significant as CLO managers are typically limited to a 7.5% portfolio cap on triple-C-rated issues. Exceeding that threshold, a manager would need either to sell quickly out of those positions or face restrictions on investor payouts and unfavorable mark-to-market rules on the excess triple-C-rated assets.
Of course, further fundamental deterioration from triple-C credits can often spell default. With covenant protections largely hollowed out over this cycle, managers and investors could be in for a surprise. “CLO ratings and the risk of a loss on CLO tranches rely on the loss assumptions of the underlying risky leveraged loans,” writes UBS credit strategist Stephen Caprio, referring to historical loan recovery rates of 70 to 80 cents on the dollar. “Recovery rates [in this cycle] are already problematic. What should be crystal clear is that leveraged loan recovery rates are going to be lower than historical levels.”
Disappointment averted, as a late rally pushed the S&P 500 higher by nearly 1% at the close after sluggish trading for most of the day followed strong results from a quartet of tech giants overnight. Treasurys enjoyed yet another green showing with the 5-year yield falling to 0.21%, well below the 0.25% top end of the range for the Fed’s overnight Funds rate. Gold broke to another fresh high of $1,972 an ounce, WTI crude held near $40.5 a barrel, and the VIX closed below 24 for the first time since Feb. 21.
- Philip Grant
Will the last person to leave New York City turn out the lights? According to the Manhattan Chamber of Commerce, overall foot traffic across the Big Apple is down 46% from its pre-pandemic levels. As of last week, only 8% of employees at downtown office buildings managed by CBRE Group had physically returned to work.
Instead of pounding the NYC pavement or hunkering down, residents are skipping town in droves. Pending home sales leapt higher by 54.4% in the Northeast in June sequentially, compared to roughly 12% across the West, Midwest and South. Meanwhile, the median home price in the Hamptons jumped to $1.08 million in the second quarter according to the July Elliman report, up 27% from a year ago.
On the West Coast, one-bedroom rental prices in formerly red-hot tech mecca San Francisco sank by 11.8% in June from a year ago, accelerating from a 9.2% decline in the 12 months through May.
While urban migration reshapes the residential housing market, the commercial side of things has gone into deep freeze. According to data from Real Capital Analytics, nationwide commercial real estate transactions fell 68% in the second quarter compared to a year ago.
“The buyer and seller expectations are not aligned,” Simon Mallinson, an executive managing director at RCA, told Bloomberg last week. “Sellers aren’t being forced to the market because there’s no realized distress and buyers are sitting on the sidelines thinking there’s going to be distress.”
With the pandemic and lockdowns continuing to ripple, signs of stress are plentiful.
The Real Deal reported Wednesday that a consortium of Chinese investors under the EB-5 immigrant visa program (which allows foreigners who invest at least $900,000 in a U.S. business a path to a green card) sent a letter to the CEO of New York-based real estate developer and landlord Related Companies demanding an onsite inspection of Related’s financial records, after the company had halted payments on its Hudson Yards project (one of the largest in the city) to those EB-5 creditors in June. As the contract fine print indicates those payments are discretionary, “the investors fear that you have tricked them into a perpetual state of nonpayment,” Douglas Litowitz, the group’s lawyer, wrote to Related.
That follows a July 14 dispatch from the New York Post relaying that developer Harry Macklowe had stopped paying the $200,000 monthly rent for his company headquarters at the GM building on 5th Avenue as the coronavirus swept through the city in March.
Things are looking particularly grim on the retail front, as a July 21 report from S&P Global predicted that retail landlords cannot expect a return to pre-virus credit metrics until 2022. An April 28 analysis from Green Street Research concluded that “more than half of all mall-based department stores will close by the end of 2021.”
“It’s becoming clearer, especially with the resurgence in [virus] cases across the country, that a three-month forbearance is not really going to satisfy the situation,” Lisa Pendergast, executive director of the CRE Finance Council, told Bloomberg last week. “So there are other things that can be done. A lot of that has to do with loan modifications.”
Retail landlord Brookfield Property REIT (BPYU on the Nasdaq), which, along with parent company Brookfield Property Partners, L.P. (BPY on the Nasdaq), was the subject of a bearish analysis in the Nov. 29, 2019 edition of Grant’s, exemplifies the trend.
In August 2018, BPY dove headlong into the now-fraught shopping mall realm, snapping up the remaining two-thirds stake it didn’t already own in mall-based real estate investment trust GGP, Inc. for $15 billion. Those assets now constitute the entire BPYU portfolio.
Yesterday, Brookfield REIT disclosed that it had agreed on amended terms with its lenders in roughly $2 billion worth of term loans related to that deal, including eased covenant restrictions governing total debt levels through June 30 of 2021 and a reduced fixed charge coverage ratio. In return for those lender concessions, Brookfield will pay a higher interest rate (300 basis points above Libor, compared to 225 basis points before), and will face restrictions on incurring additional debt, the use of proceeds under a revolving credit facility and on making restricted payments.
Importantly, that final stipulation appears to include dividends, which would be capped at the company’s cumulative net income as well as realized gains. That change is potentially significant as the pair (which trade in near lockstep and are fungible, despite differing asset bases) offer dividend yields of more than 11%.
Then, too, on July 2 Brookfield REIT announced a tender offer for $110 million worth of common stock at $12 a share, news which spurred a sharp rally and has since helped shares climb to near that offer price. Might the more restrictive legal language imperil those shareholder-friendly uses of cash?
Reserve Bank credit (i.e. the sum total of interest-bearing assets at the Fed) edged higher to $6.92 trillion, $4 billion above last week’s reading. With that modest increase, the three-month annualized growth rate has slowed to 44%, from 72% last week and 217% three weeks ago.
This morning, the Bureau of Economic Analysis announced that second quarter GDP fell to an annualized $19.4 trillion from $21.6 trillion in the first quarter. That diminished denominator increases the ratio of Reserve Bank credit to 36% of GDP, while total public debt outstanding now foots to 137% of output.
A modest pullback in stocks left the S&P up a bit less than 1% for the week so far, while Treasurys rallied across the board to leave the 2- and 30-year yields at 0.12% and 1.2%, respectively. Gold ticked lower to $1,945 an ounce, WTI crude slipped to near $40 a barrel, and the VIX rose to 25.
- Philip Grant
This one is worth a Polaroid. Legacy photography concern Eastman Kodak Co. (KODK on the NYSE) enjoyed a second straight parabolic rise today following Tuesday’s news that the federal government will advance the company a $765 million loan under the Defense Production Act for the manufacture of generic drug ingredients. As shares finished north of $33 today from $2.62 a share at Monday’s close, that loan announcement was good enough to bump KODK’s market cap to $1.5 billion from $114 million on Monday.
The news represents a corporate lifeline for Eastman Kodak, which filed for bankruptcy in 2012 and has posted negative free cash flow in each year since, but plenty of work (and uncertainty) remains. David Sherman, founder and president at Cohanzick Management, notes to Grant’s that the company has merely signed a letter of intent for the loan, and will need to build capacity, scale operations and secure necessary government approvals to successfully complete the pivot.
All that is tomorrow’s problem for the horde of retail investors now on the scene. According to RobinTrack.net, nearly 114,000 Robin Hood accounts held KODK shares as of the close, up from 34,000 yesterday and 9,300 at Monday’s close. That surge lifts Kodak to the 63rd most widely held name on RobinTrack, one spot ahead of the iShares SPDR S&P 500 ETF Trust (ticker: SPY), which has a market cap of $291 billion.
This morning the Central Bank of the Republic of Turkey acknowledged rising price pressures in the world’s 19th-largest economy. Consumer prices are on track to rise by 8.9% this year according to the central bank, up from a prior estimate of 7.4%.
In tandem with that announcement, the CBRT suggested that its recent easing cycle, which featured a reduction in benchmark rates to 8.25% from 24% over nine separate cuts, has reached its conclusion. “Our current monetary-policy stance is in line with the inflation outlook,” asserts CBRT governor Murat Uysal, perhaps recalling that his predecessor was fired for monetary policy that President Recep Erdogan deemed to be too tight. With a realized inflation rate of 12.6% in the 12 months through June, Turkey’s real policy interest rate of minus 4.35% is by far the lowest in the world, according to data from Bloomberg. “We see Turkey’s monetary policy as historically ineffective at managing inflation” commented S&P Global Ratings last week.
The inflationary outbreak is especially unwelcome considering the sorry state of the global economy. The Culture and Tourism Ministry disclosed last Friday that foreign tourist arrivals in June fell by 96% from a year ago, bringing the total six-month decline to 75%. Overall, a survey of 42 economists polled by Reuters pencil in a 12.2% GDP contraction in the second quarter and a 4.3% drop in output for full-year 2020.
As the government attempts to keep the economy afloat, fiscal deficits have jumped as the six-month shortfall of TRY 109.5 billion ($15.6 billion) is equivalent to 2% of last year’s GDP and nearly matches the full-year 2019 deficit of TRY 123.7 billion. Timothy Ash, emerging market sovereign strategist at BlueBay Asset Management, summarized the government’s haphazard strategy to The Wall Street Journal Friday: “It’s stop-go economics with these guys: They love growth, they love credit, they want to create new jobs, but [policies are] never balanced.”
Foreign investors are hitting the bricks. Data from the CBRT show that nonresident fund managers withdrew more than $7 billion from lira-denominated bonds in the first six months of the year, the largest outflow on record. In turn, foreigners disposed of a net $4 billion in Turkish equities, sending their share of the market below 50% for the first time in 16 years.
That combo is taking a toll in the currency market. Following notable weakness on Monday and Tuesday, the Turkish lira has now fallen by 14% against the (itself retreating) dollar this year and remains near its all-time weakest 7.2 to 1 exchange rate set in May. Bloomberg reports that the CBRT stepped into the market to combat the currency move by selling some $2.5 billion against the lira over those two days.
That follows other recent countermeasures taken by Erdogan’s government. On July 18 the CBRT announced that it will hike foreign currency reserve requirements for local banks by 300 basis points to help bolster its dwindling cache of reserves, while Turkish state-owned banks have doubled their short foreign-currency positions by more than $9 billion over the past seven weeks to help defend the lira. That’s the largest such intervention in the last four years.
These developments have done little to slow a concerning pace of capital flight, as gross reserves have slipped below $50 billion, a 15-year low and down from $82 billion at year end. CreditSights wrote last week that those figures are flattered by the use of currency swaps, noting that “The CBRT is a net borrower of foreign currencies to an amount that is more than its stock of gross foreign currency reserves (excluding gold) as of the end of May.”
Add it all up, and trouble could well be on the horizon. The Turkish economy is “only one shock away from crisis,” Maya Senussi, senior economist at Oxford Economics, tells the New York Times. Recent outflows aside, such an ordeal could still make a wider impact: Turkish debt is the fifth-largest component of the iShares J.P. Morgan USD Emerging Markets Bond ETF, which has $15.7 billion in assets under management.
Stocks celebrated the stand-pat Fed meeting followed by dovish press-conference commentary from chair Jerome Powell, as the S&P 500 rose more than 1% to swing back into positive territory for the year and approach its post-February highs set on July 22.
The Treasury curve steeped in response, with the 2- and 5-year yields slipping to 13 and 25 basis points, respectively, while the long bond rose to 1.24%. Gold ascended to $1,961 an ounce, WTI remained near $41 a barrel and the VIX fell to 24.10, its lowest close of the pandemic.
- Philip Grant
Penalty flag on the field. Athletic apparel producer Under Armour, Inc. (class A shares: UAA on the NYSE) disclosed in a filing yesterday that founder Kevin Plank, chief financial officer David Bergman and the company itself received Wells Notices from the Securities and Exchange Commission indicating that the regulator may soon file a civil suit regarding the company’s revenue recognition policies in 2015 and 2016. The notices referenced allegations that the company pulled forward future sales to bolster quarterly results in the years in question.
By way of response, a UAA press release contended that its accounting was “appropriate” and that it would “engage in a dialogue with the SEC staff to work toward a resolution of this matter.”
The announcement follows an admission last fall that the company was under investigation. “Not every Wells Notice leads to an enforcement action,” former Department of Justice prosecutor Eric Beste tells the Baltimore Sun. “Having said that. . . it’s a significant event and escalation in the process.”
Not every UAA bull is concerned. Predicting that the probe will lead to a fine and restatement of those years-old financials, analysts at Jefferies conclude that the “SEC inquiry matters, but it doesn’t matter.” Then again, the investigation colors the tail end of an extraordinary run for the company, which included 26 straight quarters of annual revenue growth of at least 20% through the third quarter of 2016. With the SEC now on his company’s case, Plank may regret the following quip from the April 2016 first-quarter earnings call, referring to two-time NBA most valuable player, Davidson College man and Under Armour pitchman Stephen Curry:
Our first-quarter revenues grew 30%, with the growth coming from every facet of our business. And to be clear, that 30% number was no accident. When Stephen Curry decided to average 30 points this season to take the scoring title while wearing the number 30, we thought that putting up 30% growth on our end was the best way for us to demonstrate our pride and support of Stephen and the Warriors.
Since then, operating problems have been front and center (as has heavy turnover in the c-suite), with $5 billion in revenues and $477 million in Ebitda over the 12 months through March 31 compared to $4.8 billion and $587 million, respectively, in calendar 2016. Shares are down 73% from an initial bearish analysis in the June 12, 2015 issue of Grant’s.
That jarring price correction hasn’t yielded a cheap multiple, as UAA shares trade at more than 100 times consensus 2021 earnings per share, with an enterprise value quoted at 20 times next year’s Ebitda estimate.
By way of response, the company has undertaken a series of cost-saving initiatives, including ending a series of high-profile collegiate sponsorships and a lacrosse equipment licensing deal, as well as a timely February announcement that it would forego a planned flagship store in New York City. Analysts at BTIG, who rate UA shares “sell” with a $5 price target (compared to just over $11 currently), wrote last week:
UAA appears to be making deep, across-the-board cuts to its business, cuts that our industry contacts suggest are now starting to hit bone. . . While some might view these actions as an attempt to improve profitability and shore up its cash position, we view them as a sign of a company in distress.
The failure to adequately monetize past investments exacerbated by a weak product engine and diminishing brand value among its core consumer has resulted in a shrinking business with no discernable strategy to return it to sustained top-line growth. We have seen too many companies attempt to cut their way to prosperity only to fail and accelerate the decline of its sales base.
The bond market is starting to show some concern, as the Under Armour’s double-B-rated senior unsecured 3 ¼% notes due 2026 change hands below 93 cents on the dollar, for a 463 basis point spread over Treasurys. For context, the double-B-rated portion of the Bloomberg Barclays High Yield Index trades at a 347 basis point pickup.
Risk aversion reigned as stocks came under late selling pressure to push the S&P 500 back into negative territory for the year, while Treasurys caught a strong bid with the 30-year yield falling to its lowest since April at 1.22%. Gold shook off early weakness to set a fresh closing high at $1,952 an ounce, WTI crude held near $41 a barrel and the VIX ticked back above 25.
- Philip Grant
Prognosis negative in 2021? With the Federal Open Market Committee set to begin a two-day meeting tomorrow, analysts and Fed watchers expect more of the same this week. Interest rate futures are pricing in more than 90% odds of no change to the current 0 to 0.25% Fed Funds rate, while James Knightley, chief international economist at ING, predicts that the central bank will maintain last month’s press-release language stating that its QE program will continue “at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions”.
Bigger changes will be coming later, if Mr. Market’s hunch proves correct. Fed funds futures contracts currently imply a sub-zero Funds rate beginning next summer and extending until early 2023, defying a steady drumbeat of commentary from Fed officials downplaying that possibility. “We’re sitting here with real economic turmoil and what the market is saying is that the risks could be bad enough that the Federal Reserve could be forced to take rates negative,” comments Stan Shipley, fixed income strategist at Evercore ISI.
Price action in the bond market supports that view. On Friday, real yields (as measured by the gap between the nominal and inflation protected 10-year Treasury yields) reached a record low going back to at least 1995, while the five-year Treasury yield of 0.27% is barely above the upper end of the Fed’s administered overnight rate range. Worldwide, some $14.7 trillion in debt is priced to yield less than nothing. That’s equivalent to nearly 20% of the global debt stack, while fully 60% of global debt is priced to yield less than 1%, according to ICE Data Services.
While nominal sub-zero rates have caught on in Europe and Japan (who rolled out the practice in 2014 and 2016, respectively), some prominent figures are less than impressed with the results. Writing in the Financial Times last Monday, former International Monetary Fund managing director and Bank of France governor Jacques de Larosière argued that debt restructurings, rather than ultra-low rates and central bank asset purchases, are the best way to address excess leverage in the system. Negative rates:
Encourage companies to take on cheap debt to pay for share buybacks instead of investment; allow zombie companies to survive, lower overall productivity; encouraging asset bubbles; obliterating the distinction between profitable and unprofitable activities; and making little or no distinction between good or poor quality debtors.
Everyone knows how excessive debt can lead to crisis. We have paid the price of this causality for decades. And yet negative interest rates open the credit floodgates to both governments and the private sector. They are a source of financial instability and help to create asset bubbles.
Indeed, the low-rates era has coincided with a transformation of the corporate sector. According to the Bank for International Settlements, the proportion of so-called zombie firms (i.e., those who are unable to generate sufficient operating income to service their debts for three years running) reached 19% of U.S.-listed companies at the start of the pandemic, up from less than 5% in 2007.
Then, too, disappearing income streams from ever-more diminutive interest rates introduces their own peculiar investor calculus. Amin Rajan, chief executive of U.K.-based CREATE-Research, summarized the state of play in the FT on July 9: “Fixed income is turning into fixed expense for those investors seeking haven assets for capital conservation or balance sheet management.”
Noting data from European pension consultancy Mercer showing that 64% of European pension plans were cash flow negative last year and 91% were obliged to dip into their capital base to help offset the cash drain, Rajan concludes that for pension funds, the lower-for-longer rates regime “bears a worrying resemblance to a Ponzi scheme.”
Meanwhile, supply of government scrip continues to flow. The Organization for Economic Co-operation and Development reports that global sovereign debt issuance across its 37 country member bloc is projected to foot to a record $28.8 trillion this year, pushing OECD marketable government debt loads to 86% of GDP from less than 73% a year ago.
Another round of selling pressure hit the greenback, as the Dollar Index fell to a two-year low this morning. Asset prices mostly rose in reaction, with the S&P 500 advancing nearly 1% to push back into the green year-to-date as the broad index continues to consolidate near the unchanged line. Gold jumped again to $1,932 an ounce, WTI rose back above $41 a barrel and Treasury yields ticked slightly higher across the curve. The VIX fell below 25.
- Philip Grant
Traditional folklore, with a modern twist. Bloomberg reports that the state of Washington U.S. Attorney’s office recently charged executive Mukund Mohan with fraudulently procuring $5.5 million under the Payroll Protection Program. Mohan, an Amazon and Microsoft alum who is currently chief technology officer at BuildDirect.com Technologies, Inc., claimed that one of his companies had paid out $2.3 million in payroll last year, yet the concern actually had no employees and Mohan had only just taken ownership in May.
Instead of paying employees, the entrepreneur had another use of funds in mind. Prosecutors claim that Robinhood Markets, Inc. has records showing that Mohan transferred $231,000 of the stimulus money to the stock-trading app.
This morning the five-year Treasury yield sank to an all-time low 0.255%, hardly above the Federal Reserve’s overnight funds rate of between zero and 0.25%. At the same time, the nominal 10-year yield of 58 basis points is again approaching the record low of 49 bps set in early March, while the real yield (the nominal 10-year yield less the yield on 10-year Treasury Inflation Protected Securities) has fallen to negative 92 bps, the lowest on record going back to 1996.
“Low real yields represent a barometer for liquidity being injected into the market,” Jim Caron, senior portfolio manager at Morgan Stanley Investment Management, told the Financial Times yesterday. “It is no doubt supportive for financial assets and supportive for growth.”
Rhetoric from the monetary mandarins certainly supports that view. In June, Fed chair Jerome Powell declared that the Fed “is not even thinking about thinking about raising rates.”
Economists at Deutsche Bank led by Matthew Luzzetti estimate that in using asset purchases to attempt to stimulate the economy (rather than taking rates as low as minus 5%), the Fed would need to hoover up an additional $12 trillion in assets. For context, total assets at the Fed currently stand at $6.96 trillion, up from $4.2 trillion as the pandemic began wreaking havoc in March, while Luzzetti estimates it would take eight years of QE at the current run-rate to hit his target.
As an alternative, perhaps Jay Powell et al. could further broaden their purchase criteria?
“For most of these big [distressed] funds, there is no longer credit investing, there is just creditor-on-creditor violence,” declared Adam Cohen, managing partner at Caspian Capital, in an interview with Bloomberg. “It’s just people hiring enough lawyers to figure out a way to steal value from another creditor.”
Triple-C-plus-rated Community Health Systems, Inc. (featured in the Feb. 7 edition of Grant’s) is one example of a potential bondholder scrum in the making. The hospital operator, which is the ninth-largest holding in the iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG), carries long-term debt of more than $13 billion including some distressed issues such as the senior unsecured 6 7/8% notes due 2028, which last changed hands at 36.5 cents on the dollar for a yield-to-worst of 26.6%. Other CYH bonds, such as the first-lien 6.25% notes due 2023, remain above par.
Covenant Review analyst Ross Hallock warns that Community Health’s credit documents allows the company to shift assets into subsidiaries that are out of creditors’ reach in the case of a debt restructuring. “Investors have to read the underlying documents to find out how,” Hallock told Bloomberg Wednesday.
Meanwhile, potential future battlegrounds continue to emerge. U.K.-based hospitality company Stonegate Pub Co. came to market today with a £950 million ($1.2 billion) junk offering, the largest sub-investment grade sterling denominated bond deal since 2013.
Would-be creditors would be well served to review the fine print. CreditSights analysts note that the assets guaranteeing the new debt do not cover those of a subsidiary, which represents almost 40% of the group’s holdings and 30% of the combined earnings. Indeed, those assets “will be out of reach of bondholders.”
A second straight selloff in stocks left the S&P 500 modestly lower for the week and pushed the broad index back into the red for 2020, while Treasurys gave back early gains to finish mostly flat. Gold topped $1,900 an ounce intraday before settling at $1,898, while WTI crude continued to consolidate near $41 a barrel. The VIX fell below 26.
- Philip Grant
Front runners rejoice. There’s hardly been a better time to live at the top of the public company food chain, as evidenced by the rampaging performance of the behemoths of the S&P 500. Shares in Microsoft Corp., Apple, Inc., Amazon.com, Inc., Facebook, Inc. and Alphabet, Inc. have enjoyed gains ranging from 13% to 63% so far this year.
The quintet now commands some 23% of the S&P 500’s index weighting according to Goldman Sachs, the highest proportion in the post-Bretton Woods era. The top dog, Microsoft, itself accounts for 5.9% of the S&P, approaching the record 6.4% weighting established by International Business Machines Corp. (IBM on the NYSE) in 1985.
Of course, trees don’t grow to the sky, and the law of gravity asserts itself sooner or later. The Feb. 21 edition of Grant’s noted the thoroughly mixed investment record of companies that had ascended to that rarified air of index composition.
Scale has its diseconomies as well as economies. At some invisible inflection point, the colossus loses more in dexterity than it gains in power and loses more in political vulnerability than it gains in commercial prestige. And at some other unmarked bend in the road, the once admirable founder of a great business may undergo the not unfamiliar personality transformation from entrepreneur to lord of creation.
What better example than IBM itself? Since reaching that exalted status, the mainframe computer-turned-corporate consulting behemoth managed compound annual revenue and net income growth of 1.3% and 1.1%, respectively, in the 34 years through 2019, well below the average annual 2.6% rise in the CPI. Since that Feb. 21 bearish analysis, shares are down by 14% inclusive of dividends (trailing the 2% decline in the S&P 500), and now represent just 0.4% of the broad U.S. stock index.
On Monday, Big Blue reported second quarter revenues of $18.12 billion, topping consensus estimates of $17.6 billion but 5.4% below the year-ago figure. The company trumpeted 30% sales growth among its cloud computing units, helped by the July 2019 acquisition of Red Hat for $34 billion. The newcomer made a strong first impression, as Red Hat managed 17% revenue growth compared to the second quarter of 2019.
The Street cheered the report, with a host of brokerage houses raising price targets. Analysts at Argus Research upgraded IBM shares to “buy,” declaring: “We believe IBM has turned an important corner.” The valuation seemingly leaves plenty of room for improvement, as shares fetch less than 12 times full-year earnings per share estimates.
Then again, that undemanding multiple reflects the fact that IBM’s non-cloud businesses are in chronic decline, as the global business and technology service units (which account for more than half of total revenues) saw their top lines shrink by 7% and 8%, respectively. Excluding the $900 million contribution from Red Hat, total revenues of $17.2 billion would have declined more than 10% from last year. As the deal was completed last July, IBM will now face tougher, apples-to-apples comparisons in coming quarters.
Grim growth prospects color a now less-than-pristine balance sheet. Thanks to that Red Hat deal (for which IBM paid 10 times revenues, 53 times Ebitda and a 63% premium to the target’s pre-bid closing price), single-A-rated IBM’s net leverage has risen to 3.3 times trailing Ebitda from the 1.5 times Ebitda prior to the deal announcement. While the company suspended share buybacks last year, management has signaled it expects to continue paying its $1.63 per share quarterly dividend, which equates to a relatively chunky 5.1% indicated yield. The $1.45 billion in dividend payouts amounted to roughly half of free cash flow generated during the quarter.
Indeed, IBM’s post-1985 travails should serve as a cautionary tale for the modern-day high fliers. Bloomberg reports this afternoon that a House antitrust panel is set to meet July 27 with an eye towards scrutinizing Amazon, Facebook and Google, while Italian antitrust authorities announced their own investigation into Apple and Amazon yesterday. In addition, Axios relays that a coalition of state attorneys general “are investigating Apple for potentially deceiving consumers.”
Risk aversion was the name of the game, as stocks came under pressure with the S&P 500 slipping by 1% to finish back near the unchanged mark year-to-date, while a strong rally in long dated Treasurys pushed the 10-year yield below 0.58%. Gold continued its aggressive rally with a move to $1,881 an ounce, WTI crude remained at $41 a barrel, and the VIX rose 7% to 26.
- Philip Grant
Chart of the day, courtesy of Liz Ann Sonders, chief investment strategist at Charles Schwab:
Bloomberg reports that Epicor Software Corp. is set to sell $2.75 billion worth of leveraged loans. Proceeds from the sale will include a $560 million dividend for its private-equity owner KKR & Co. The loans, which are indicatively priced at a 425-basis point premium to Libor for the first-lien tranche and between 775 and 800 basis points over Libor for the second-lien, will increase Epicor’s leverage to 8.6 times last year’s Ebitda from the current 6.9 times.
The deal looks like a success, as investors have already placed orders in excess of the offering size. “This opens the door for other opportunistic deals,” Ron Launsbach, senior portfolio manager at Columbia Threadneedle Investments, tells Bloomberg. “There’s demand for loans and limited supply in the near term.”
Indeed, loan issuance has remained in the dumps, with just $8.4 billion in new supply month-to-date, compared to $44.6 billion in July of last year. By comparison, the high-yield market has seen $15.2 billion in primary supply so far in July, roughly equal to its monthly pace a year ago. That’s something of a reversal, as the loan market grew at a 10.2% compound annual rate from 2010 to 2019, nearly triple that of junk bonds. The mushrooming loan growth has served as a key cog in the private equity boom (which included a record $361 billion in fundraising last year for buyout funds), as p.e.-sponsored companies account for nearly 60% of leveraged loan issuance since 2005.
Of course, the coronavirus fallout promises to lay bare all sorts of corporate vulnerabilities, and the loan market is no exception. Thus, the trailing 12-month default rate on leveraged loans rose to 3.7% in June from 2.02% in March, while Wells Fargo & Co. forecasts that such defaults will climb to 12% by the end of 2020. In addition, more than one-third of the loan market has received a rating downgrade this year according to S&P’s LCD unit, while the rolling three-month ratio of downgrades to upgrades in June stood at 18.4-to-1, more than double the financial crisis-era peak.
That spreading corporate contagion underscores the princely prices paid by p.e. in the run-up to the current recession. Bain and Co.’s 2020 Global Private Equity Report finds that deals last year featured a median purchase multiple of 11.5 times Ebitda, well above the 9.9 times seen in 2007. To pay those fancier prices, p.e. titans added an extra dollop of debt: Bain reports that nearly 75% of buyout deals last year featured net debt in excess of six times reported Ebitda, up from about 60% in 2007. When adjusted for so-called add-backs (the now-prevalent use of credit for hypothetical future cost savings), those leverage figures are likely higher still.
Might operational improvements under p.e. ownership help offset those daunting valuations and aggressive capital structures? Not likely. From the Bain report:
When we analyzed 65 fully realized buyout deals invested in 2009 through 2015, the average margin was well below the deal model forecast, and the majority failed to meet their projected margin expansion. Even more worrisome: For the deals where margin improvement was a critical factor in the value-creation plan, more than three-quarters did not meet the margin target.
Then, too, the proliferation of so-called covenant-lite legal structures (now accounting for roughly 80% of the loan market compared to 17% in 2007) is another prominent risk within the leveraged loans that have facilitated the p.e. boom.
Those loosey-goosey vintages are now being tested, as a new report from Moody’s notes a “surge” in covenant-relief amendments, indicating that “borrowers are exhausting significant covenant cushions and are worried about breaching their maintenance covenants.” The rating agency also reports that revolving credit lenders “are demanding increased compensation, minimum liquidity requirements and enhanced covenant packages in exchange for financial covenant relief.”
Pushback from some corners of the market is perhaps helping to spur p.e. operators into other creative maneuvers. A recent survey from the Institutional Limited Partners Association found that 71% of LP respondents reported that general partners have altered or eliminated contractual fiduciary responsibilities in the past year, representing more than 50% of the funds in which the LPs were invested.
“That language is not there to ensure the GP does the right thing when things are going well,” an anonymity-seeking LP told industry publication Buyouts Insider last week. “Rather, that language is there to protect LPs when a fund goes south [and] maybe even reaches zombie status. At that point the LP/GP dynamic can often become a zero-sum game, and it is at that point when an investor would take comfort in the protections of the agreement. So yes, it is a concern.”
For more on p.e., including a pair of ways to potentially profit from a change in industry conditions, see the May 29 and July 10 editions of Grant’s.
A sharp selloff in the greenback pushed the broad Dollar Index to its lowest close since early March, spurring another rally in the precious metals with gold moving out to $1,844 an ounce and silver to $21.6 an ounce. Stocks gave back their early gains to leave the S&P 500 modestly higher, while Treasurys remained well bid, with the 2-year-yield falling below 0.15% and the 10-year slipping under 0.6% intraday. The VIX rose to just below 25.
- Philip Grant
We’re number one. The Fed appears to be tapping the brakes after its spring splurge, with Reserve Bank credit waning for five straight weeks to push the three-month annualized growth rate to a mere 124% last week from 726% in early June.
Still, that now-paused asset shopping spree was enough to materially change the composition of the Treasury market. As Greg Blaha of Bianco Research noted Friday, the Fed’s holdings of U.S. government debt reached $4.18 trillion as of July 15, topping the $4.11 trillion aggregate holdings of foreign central banks. For context, the Fed’s Treasury holdings footed to less than $2.2 trillion last fall, while foreign holdings have remained mostly steady for the last six years.
A well-earned breather in the primary debt markets, as nary an investment-grade corporate bond offering came to market today. Bloomberg notes that the blank issuance calendar is “an odd circumstance as Mondays are generally busy.”
As the formerly jam-packed issuance schedule takes a pause (fresh I.G. supply of $150 billion is already well above the $135 billion seen all of last year), risk appetite in the bond market currently appears to be insatiable. This morning, the yield on the Bloomberg Barclays Investment Grade Index fell to 1.98%; the first time on record that the yield on that gauge has dropped below 2%. Last week, high-grade corporate bond mutual funds enjoyed inflows equivalent to 0.53% of assets under management, according to research from ING, bringing year-to-date inflows to 16.9% of AUM.
Of course, euphoria-type conditions don’t usually last forever. Analysts at Bloomberg Intelligence write today that “sustaining the disconnect from fundamentals will require the Federal Reserve to stand at the ready.”
The Central Bank of the Republic of Turkey announced Saturday that it was hiking foreign currency reserve requirements for local banks by 300 basis points. That move, which partially reversed pandemic-related stimulus measures in March, will serve to bolster the country’s flagging foreign exchange reserves, which have fallen to $51.3 billion from $82 billion at year-end and remain stuck near 15-year lows.
Then, too, the financial system has seemingly been mobilized to conduct the FX battle. According to a Reuters report from last Thursday, Turkish state-owned banks have doubled their short foreign-currency positions to a net $8.3 billion over the past six weeks to help defend the lira. That’s the largest such intervention in the last four years.
“I suspect state banks are giving a helping hand as the central bank’s reserves are pretty much all used up,” an anonymity-seeking Turkish banker told Reuters. The extent to which the banks can further assist may be limited, as the unnamed source estimates that the short currency positions now foot to more than 25% of the Turkish bank’s total reserves. Meanwhile, Turkey faces some $165 billion in external debt obligations over the next 12 months, while the lira remains near lifetime lows against the dollar, down by more than 50% since the failed coup attempt against President Recep Erdogan in the summer of 2016.
A top-heavy day for the stock market saw the S&P 500 advance by nearly 1% to break back into the green year-to-date, though only 125 index components finished higher on the day. Treasurys remained range bound with the 10-year yield settling at 0.62%. Silver jumped above $20 an ounce intraday for the first time since September 2016 while gold finished near the top of its recent range at $1,818 an ounce. WTI crude held just below $41 a barrel, and the VIX closed below 25 for the first time in six weeks.
- Philip Grant
“We should consider forgiving all small loans,” Treasury Secretary Steve Mnuchin tells reporters today on the government’s next move under the Paycheck Protection Program.
Uncle Sam has thus far doled out $518 billion under the PPP, equivalent to 11% of the federal budget for fiscal 2021 that the Trump administration released in the pre-pandemic days of early February.
Here’s Oksana Aronov, head of market strategy for absolute return fixed income at J.P. Morgan Asset Management, on Bloomberg Television today:
Market valuations are entirely fabricated – or synthetically generated – by all the central bank liquidity and do not reflect fundamentals of the securities that they represent.
[Mr. Market remains] locked in this collective hallucination. . . Central banks continue to run the show and investors need to be really cautious here.
Authorities including the Federal Bureau of Investigation have opened probes into the Wednesday hack of social media platform Twitter, which compromised more than 100 high profile accounts.
The hack targeted figures such as Joe Biden, Elon Musk and Bill Gates, who posted similarly worded Tweets promising followers a two-for-one return on any bitcoin deposited into a specific “wallet.” In addition to disrupting service for so-called verified Twitter users, the scam netted its masterminds some $120,000 worth of bitcoin, according to media reports.
Some industry members believe that Twitter will receive the brunt of bad press and regulatory backlash over the incident, rather than bitcoin. Kristin Smith, executive director of the Blockchain Association, tells Coindesk:
I would say 99% of policymakers are not thinking about blockchain or cryptocurrency [as a culprit]. And so anytime that you have national headlines that deal with a hack of this size and magnitude, and bitcoin is sort of involved in the process, for the uneducated it’s a bad association because they then think that bitcoin is sort of a preferred tool of criminals. Those of us that work in the industry and know it, study it, the policymakers who spent the time to learn about it, know that that’s not the case.
There is some dissent from that view. Regarding the hack, an account affiliated with digital currency research firm OXT Research concluded via tweet: “This is peak crypto.”
While political and legal fallout from the hack unfolds, mounting legal and regulatory pressures on a key cog in the crypto food chain known as stablecoins (i.e., digital scrip that is supposedly backed by hard currency), and particularly tether, which has long claimed to be backed on a one-for-one basis with U.S. dollars, could prove far more impactful.
As the oldest and largest of such stablecoins, tether is the straw that stirs the crypto drink. Most exchanges do not perform know-your-customer and anti-money-laundering checks (KYC and AML, respectively) and thus can’t get access to bank accounts.
Accordingly, the stablecoins serve as a crucial conduit for turning fiat dollars into bitcoin (or its peers) and back again: In the last 24 hours, tether has seen trading volume of $17.2 billion, equivalent to nearly double its total capitalization of $9.2 billion. Bitcoin, which is worth $169 billion in total, has seen just $14 billion in trading volume over that period.
Regulators are taking notice. On July 7, international watchdog The Financial Action Task Force released a report for G-20 finance ministers calling for global regulation of tether and other stablecoins, to ensure compliance with KYC and AML laws. Under the proposed rules, stablecoins would be compelled to establish processes for transaction monitoring and investigations, among other requirements.
In addition, tether itself has attracted unwanted interest from the law. Last spring, New York State Attorney General Letitia James accused iFinex, Inc., which operates both Tether and Bitfinex, of “engaging in a cover-up to hide the apparent loss of $850 million of co-mingled and corporate funds.”
On July 9, the New York Supreme Court’s Appellate Division declared that the A.G. can move forward with previously announced investigations into Tether and the closely affiliated crypto exchange Bitfinex. The ruling is significant as the A.G.’s investigation is taking place under the wide-ranging Martin Act. Attorneys from BakerHostetler wrote in an analysis yesterday on JD Supra that the case will reverberate:
Given this decision, the New York A.G. now may be emboldened to use these powers to more actively police the emerging industry by seeking asset freezes and other preliminary injunctive relief against potential bad actors outside of the Empire State.
Even insiders appear to be hedging their bets. In an interview with Bloomberg last Friday, Tether(the company) co-founder Brock Pierce declared that his stablecoin “is, I think, one of the most important innovations in currency, but it also seemed like one of the higher risk businesses.”
The entrepreneur has himself moved on to greener pastures. On July 4, Pierce, who played the role of young Gordon Bombay in the 1992 Disney film “The Mighty Ducks,” announced he is running for President. Why not?
Stocks finished slightly higher, as the S&P 500 continues to tread water near the unchanged mark so far this year, while modest steepening in the Treasury curve pushed the long-bond yield to near 1.33%. Gold rose back to the top end of its recent range at $1,812 an ounce, WTI crude held just below $41 a barrel, and the VIX fell below 26.
- Philip Grant
Trading platform Charles Schwab reports today that new retail brokerage accounts skyrocketed to 1.65 million in the second quarter, far above the consensus 1.08 million and more than four times last year’s 386,000 figure. CEO Walt Bettinger noted that overall daily trading activity in the second quarter rose a cool 126% from a year ago.
In addition, Matthew Klein of Barron’s posted the following screenshot from the Schwab website on Twitter this afternoon:
Who needs sports to gamble on anyway?
Earlier today China’s National Bureau of Statistics reported that second quarter GDP grew 3.2% from a year ago, topping Bloomberg’s consensus figure of 2.4% and helping the Middle Kingdom skirt a technical recession following the 6.8% year-over-year decline in first quarter output. NBS spokesperson Liu Aihua described the rebound as “restorative growth.”
The only problem, according to Trivium’s China Tip Sheet:
We hate to rain on the parade, but we are just going to say it. There is NO WAY this economy grew 3.2% y/y last quarter.
By way of rationale, the publication cites measured weakness in the consumer realm (retail sales fell by 2.8% and 1.8% in May and June, respectively) and notes that businesses were operating at 85% to 90% of capacity throughout April and May. In addition, the Ministry of Transportation’s passenger traffic data showed a roughly 50% contraction from a year ago across those two months.
The Tip Sheet concludes thus: “After buying good will by coming clean on the extent of first quarter economic weakness, authorities are at risk of undercutting their credibility.”
The worst is over for corporate credit? Evidence of healing continues apace in the bond market, as investment grade and high-yield spreads have retraced most of their March widening. Primary markets remain wide open as issuance continues to blow past that of a year ago, with the $1.2 trillion in fresh investment grade supply year-to-date already topping 2019’s full-year figure while junk issuance is up 42% from this time last year, according to CreditSights.
More than a few investors are looking askance at that issuance spree, as 62% of respondents in the July BAML fund manager survey indicated they want CEOs to prioritize balance sheet improvements, while 27% preferred increased capital expenditures and only 9% asked for shareholder-centric maneuvers like increased dividends and stock buybacks. Even prior to the pandemic, there was plenty of room for improvement. According to data from CreditSights, corporate liabilities stood near a record-high 135% of GDP as the calendar turned to 2020, compared to 105% in 2007.
Edward Altman, professor emeritus of finance at the NYU Stern School of Business (and guest on the May 27 edition of the Grant’s Current Yield podcast) expressed confusion to Bloomberg yesterday over the issuance deluge: “I thought the market would gain some much needed deleveraging with the Covid-19 crisis. [Instead], it seems like companies again are exploiting what seems to be a crazy rebound.” Altman predicts that more than 60 U.S. companies with liabilities above $1 billion will file for bankruptcy by year-end.
Recent fundamental developments suggest that those concerns are well founded. In a report today, Moody’s Investors Service relays that its so-called B3N list (meaning those rated single-B-minus with a negative outlook and below) rose to 414 companies at the end of June, double that of a year ago. That means that 27.5% of the high-yield universe is now concentrated within that vulnerable ratings category, topping the financial crisis-era peak of 26.1%. The rating agency’s default forecast for that B3N cohort now stands at 34%, down from a recent peak of 43% but up from 22% last year.
Stocks saw a modest pullback with the S&P 500 trimming its gain for the week so far to 1%, while Treasurys were bid with the 10- and 30-year yields dropping to 0.62% and 1.31%, respectively. Commodities came under pressure with gold falling to $1,795 an ounce and WTI crude slipping to $40.5 a barrel, and the VIX finished at 28.
- Philip Grant
The Canada Pension Plan Investment Board (CPPIB) plans to allocate up to 17% of its total portfolio to China by 2025, Suyi Kim, senior managing director and head of Asia Pacific for CPPIB, reveals today in an interview with Caixin. That’s up from 13% currently and from less than 5% in 2016. The fund reported C$410 billion ($303 billion) in assets under management at the end of March.
That growing investment focus in the Middle Kingdom may cause some awkward situations in the halls of power. Canada-focused website iPolitics reported on July 5 that the House of Commons cybersecurity team emailed a warning to Parliament members and their staff not to use messaging app WeChat on account of “potential cybersecurity risks.”
The email noted that “messages continue to reside on servers even after users have deleted them, with information pertaining to users’ locations saved as well” and, as WeChat’s servers are located outside of Canada, “rigorous protections of user data cannot be assured.” WeChat is a subsidiary of Shenzhen based, Hong-King listed Tencent Holdings Ltd. (ticker: 700), which is the CPPIB’s largest portfolio holding at C$3.05 billion as of March 31.
Then, too, Canada’s 2018 detention of Huawei Technologies Co’s chief financial officer, Meng Wanzhou, on a U.S. arrest warrant further complicates the matter. The Meng case has spurred Chinese retaliation, including restrictions on canola imports and the imprisonment of Canadians on patently trumped-up charges. On the official government website, Ottawa warns Canadians in China to “exercise a high degree of caution due to the risk of arbitrary enforcement of local laws.”
The debate over yield curve control (i.e. de facto caps on selected government bond maturities) continues at the Federal Reserve, with a pair of senior officials offering contrasting views yesterday. “There may come a time when [YCC] is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve” declared Fed governor Lael Brainard.
Speaking to The Economic Club of New York, St. Louis Fed president James Bullard dissented: “I don’t see [YCC] as being terribly necessary at this point because expectations are already low as for the outlook for interest rates.”
While Brainard, unlike Bullard, is currently a voting member of the Federal Open Market Committee, the minutes of the FOMC’s most recent meeting indicated broad skepticism over yield curve control: “Nearly all participants indicated they had many questions regarding the costs and benefits of such an approach.” Investors seem to agree, for now at least, as Bank of America’s Fund Manager Survey for June found that 54% of respondents predict that the Fed will not take the YCC plunge at its September meeting.
What might we expect if and when the Fed decides to throw its weight around in the Treasury pit? One such clue resides Down Under, where the Reserve Bank of Australia in March implemented a 25-basis point cap on the 3-year government bond and those under the thumb of YCC attempt to profit from the price-administration regime. “Yield-Curve Control Turning Australia into Carry-Trade Haven,” a Bloomberg headline today declares.
As the RBA targets only the short end of the curve, the 2- vs. 10-year spread sits at a princely 61 basis points, the steepest such spread among major economies (10-year U.S. Treasurys currently command a 49 basis point premium over twos). With short-term rates seemingly locked in, investors have piled into trades in which they borrow at the short end then invest the proceeds into the longer dated, higher-yielding securities. The so-called “carry and roll” strategy, designed for a relatively inert curve, is particularly popular, Bloomberg notes.
By contrast, the Bank of Japan’s yield curve control policy, which extends out to a 0% target on the 10-year JGB, has left the Japanese 2- vs. 10-year spread at a meager 17 basis points and sent Japanese investors Down Under in search of return. “Investing in a bond market where the curve is steep like Australia generally turns out to be a winning bet,” Akira Takei, fund manager at Tokyo-based Asset Management One, tells Bloomberg.
Just the right amount of control, in other words.
Almost back to the promised land, as another near-1% gain on the S&P 500 pushed the broad index to the cusp of unchanged for the year, and less than 5% below the all-time highs set in February. Gold closed at $1,814 an ounce on the August contract for another post-2011 high, WTI crude rose to near $41 a barrel, and the VIX tumbled below 28.
- Philip Grant
Turkey’s Capital Markets Board announced today it will fine seven brokerages and 18 individual investors a total of TRY 16.7 million ($2.4 million) for violating short-selling bans instituted on Feb. 25.
Those restrictions, which also included stock-loan prohibitions and limits on currency speculation, illustrate President Recep Erdogan’s desire to bring financial forces under heel. In spring 2019, Erdogan responded to weakness in the lira by accusing speculators of “full blown economic sabotage” and vowed that “whatever we did to the terrorists threatening our borders, we will do the same” to those financial saboteurs.
Perhaps getting the message, foreign investors have pulled roughly $4 billion from Turkish equity markets in the year-to-date, pushing non-local equity ownership below the 50% threshold for the first time since 2004. At the same time, Turkey’s weighting in the MSCI Emerging Markets Index has fallen to less than 0.5% from more than 2% in 2013.
Local investors have more than taken up the slack. The number of domestic equity market accounts has jumped to 1.61 million according to the Central Securities Depository, up 33% for the year. Overall trading volume is up five-fold from a year ago.
Some investors are spotting value within the hyperactivity. Haydar Acun, managing partner at Marmara Capital Management, tells Grant’s via email that while pockets of bubble-type conditions are visible, “the general state of the market is still cheap, as the Istanbul 100 Index remains lower by 10% this year in dollar terms. However, one has to be selective.” Acun advises Grant’s that he has been rotating from a handful of small-cap winners into the larger banks, which have lagged.
Yet a further acceleration in foreign capital flight, perhaps resulting from the Erdogan’s heavy-handed approach, represents a clear and present risk for Turkey bulls. On June 23, the indexation giant MSCI announced it was considering a reclassification of Turkey to frontier-market or standalone-market status from its current emerging-market designation, if the “already deteriorating accessibility level of the Turkish equity market were to worsen.” The index provider warned that the short-selling and stock-lending bans “severely risk the ability of institutional investors to express active investment views and hedge portfolio risk.”
Such a move from MSCI would lead to further equity outflows of between $4 billion and $5 billion, Emre Akcakmak, portfolio manager at East Capital, estimated to Bloomberg. “It does pose a serious question on what the government is trying to achieve with these [short sale and stock loan] bans,” commented Anastasia Levashova, fund manager at Blackfriars Asset Management.
It’s not just the stock market which has fallen under the government’s heavy hand. In May, Erdogan banned citizens from engaging in FX trades with foreign banks including Citigroup, BNP Paribas and UBS, a move which allowed local lenders to have a freer hand in establishing exchange rates which the strongman might approve.
Political control over the banks has its advantages. Thus, new home sales for June topped 190,000, a record figure and more than triple that of a year ago. As Bloomberg notes today, “authorities have leaned on banks” to extend mortgages and other loans, while Turkey’s three-largest state-owned institutions dutifully offered credit “at below-inflation interest rates in June.”
Finance minister Berat Albayrak (the President’s son-in-law) has overseen aggressive monetary easing, cutting the benchmark interest rate to 8.75% from 24% last summer. Inflation – which had been in retreat for most of 2019 – has recently revived, with Turkish CPI rising by 12.6% year-over-year in June. That’s up from 8.6% last October.
Steady declines in FX reserves indicate still-more constrictive policies could be on the way, with gross foreign reserves down to $51.3 billion from $82 billion at year-end, and just off the lowest reading since 2005. In its June Global Financial Stability Report, the International Monetary Fund reported that Turkey’s ratio of reserves to short-term liabilities stood at about 80%, well below the recommended floor of 100%. Meanwhile, the lira sits precariously near its worst ever levels against the dollar, now fetching 6.87 per greenback compared to 7.2 in early May. At the time of the failed coup attempt against Erdogan in the summer 2016, the exchange rate was near 3 to 1.
“Good luck with convincing the world capital controls are off the table now,” Paul McNamara, investment director at the asset manager GAM, summed things up to emerging markets news service bne IntelliNews in May.
Stocks shook off early weakness, as the S&P 500 logged gains of more than 1% to close back to within 6% of its February high-water mark, while Treasurys finished little changed. WTI crude popped back above $40 a barrel, gold finished little changed at $1,811 an ounce, and the VIX reversed early gains to slip back below 30.
- Philip Grant
A sign-of-the-times three-pack:
Yesterday, health care concern MultiPlan, Inc. announced it will go public via an $11 billion billion merger with Churchill Capital Corp. III, a so-called special purpose acquisition company (SPAC) managed by former Citigroup executive Michael Klein. The private-equity owned MultiPlan has enjoyed a steadily rising valuation over the years, attracting a $1 billion price tag from the Carlyle Group in 2006, followed by a $3 billion sale to BC Partners and Silver Lake Partners in 2010. In 2016, Hellman & Friedman paid $7.5 billion for the business.
That’s not the only dedicated acquisition vehicle coming down the pike. Bill Ackman’s Pershing Square Capital Management announced today that it will upsize its offering for a “blank check” SPAC to $4 billion from a previously planned $3 billion. The acquisition vehicle hasn’t identified a particular sector of interest, but rather noted in the filing that it will target “mature unicorns” for a potential deal.
The appeal of public markets is understandable, considering recent price action in speculative names. An intraday jump of as much as 14% pushed Tesla shares to a cool 329% year to date, while CEO Elon Musk’s net worth rocketed to an estimated $70.5 billion, up $43 billion for the year according to data from Bloomberg. That’s good for the seventh richest on planet Earth (the Mars billionaires list has yet to debut), ahead of Warren Buffett at $69 billion. The Oracle of Omaha has seen his wealth fall by $20 billion this year.
The Senate Banking Committee announced Friday that it will hold a July 21 vote on the nominations for a pair of candidates to the Federal Reserve’s seven-member board of directors.
While one of the hopefuls, Christopher Waller, boasts a conventional resume including head of research at the Federal Reserve Bank of St. Louis, the candidacy of economist and former Trump campaign advisor Judy Shelton has proved far more controversial inside the Beltway. Shelton had previously advocated for a return to a gold-based monetary system, among other transgressions against contemporary orthodoxy.
On Friday, a coalition of the 12 Democrats on the committee sent chairman Mike Crapo (R-ID) a letter requesting a second hearing, as the group is “deeply concerned that the situation we are in today would have been worse if Dr. Shelton were already sitting on the board of governors.”
While Republicans hold a one vote majority and can approve Shelton along a party-lines vote, political skepticism is bipartisan. Sen. Richard Shelby (R-AL) noted in February that “I don’t think she’s a mainstream economist,” a perhaps unintended compliment to which Shelton readily agreed. “Nobody wants anybody on the Federal Reserve that has a fatal attraction to nutty ideas,” declared Sen. John Kennedy (R-LA) at the same hearing.
What sort of nutty ideas? Let’s hear from the candidate herself:
I keep going back to the fact that the power to regulate the value of U.S. money was granted by our Constitution to Congress. It’s in Article 1, Section 8. And in the very same sentence Congress is given the power to define the official weights and measures for our country, because money was meant to be a measure, to be a standard of value. I think that money has to work the same for everyone in the economy, and it’s important that it serve that purpose as a reliable measure, so that people can plan their lives.
I don’t see how you can have a free market economy if people can’t rely on the most vital tool that makes markets work. It’s through money that we transmit market signals. And you need clarity of those signals or supply and demand can’t figure out what’s the optimal solution. So ... at the Federal Reserve is a responsibility to remember that money has to work for everyone and that in a sense it’s a moral contract between the government and the citizens.
Meanwhile, the Fed has turned on the jets in hopes of supporting the economy and asset prices through the pandemic, including a 63% jump in balance sheet assets since early March.
In addition, M2 money supply grew by $1.02 trillion from late April to early June, more than the $921 billion expansion across all of 2019. In April, Fed vice president Richard Clarida declared in a television interview that: “I think we have the tools to keep the economy out of deflation.”
Discussing Shelton’s candidacy, the Feb. 21 edition of Grant’s summarized the current mainstream monetary platform:
It’s the body of beliefs that upholds the authority of the central bank to treat the value of money and the rate of interest as instruments of public policy. Members of the mainstream deprecate price discovery, warm to price administration, especially in the matter of interest rates. They are dismissive of moral hazard and clinically indifferent to the great fundamental monetary question: What’s money, and who says so?
Nutty ideas, indeed.
A sharp late selloff left the S&P 500 1% in the red, erasing gains of as much as 1.5% which would have completed the broad index’s journey back into positive territory for the year. Treasurys were mostly bid with the 10- and 30-year yields falling to 0.62% and 1.32%, respectively. Gold edged higher to $1,805 an ounce, WTI crude pulled back below $40 a barrel, and the VIX jumped above 32, up 18% on the day.
- Philip Grant