Faulty Towers
The good times continue to roll in global speculative-grade credit.

The good times continue to roll in global speculative-grade credit. Yesterday, the triple-C-rated contingent of the Bloomberg Barclays High Yield Index saw its yield-to-worst slip to 7.71%, the lowest in more than six years. That follows a blockbuster November in which the ICE BAML CCC & Lower U.S. High Yield Index logged a 7.47% total return, the best monthly showing since October 2011.  Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, notes in a commentary for LCD that 51 issues, one-sixth of the index, rallied by 20% or more in November, while five bonds saw more than a 100% return for the month. 

It’s more of the same overseas. The Markit iTraxx Europe Crossover Index, which tracks credit protection prices of the most liquid, speculative grade credits, sits at 250 basis points, the least elevated reading since February and well inside its five year average of 300 basis points.  Across the Pacific, J.P. Morgan’s Asia Credit Index sits at an all-time high in terms of price, up a cool 5.7% from a year ago.  

Unsurprisingly, issuers are making hay while the sun shines.  Data from S&P Global show that year-to-date domestic junk bond issuance stood at $405 billion at the end of November, already lapping the prior $345 billion full-year high-water mark set in 2012.

The rally has helped to usher in a trio of notable recent deals: Aiful Corp., a Japanese consumer finance firm, sold JPY 15 billion ($144 million) of 18 month notes at a 1% coupon on Tuesday, marking the lowest yielding junk bond offered globally so far this year, according to Bloomberg.  That follows last week’s move by Australia’s Evolve Education Group Ltd. to sell A$35 million ($26 million) of five year notes priced to yield 7.5%. That’s the first high yield deal from an unrated issuer in Australia for an even 12 months, underwriter FIIG Securities told Bloomberg. 

Stateside, a provocative new offering is coming down the pike as the Financial Times reports today that Blackstone-sponsored Ancestry.com is attempting to “erode a ‘cornerstone’ in the corporate debt market.” Namely, the issuer inserted a contractual 20% voting rights threshold for creditors of its $1.2 billion high-yield offering, rendering some observers bemused. “The market is a game we play,” David Knutson, head of credit research at Schroeder’s, tells the FT. “There are rules we follow to maintain order. One of those rules is one bond, one vote. It’s hard to believe that this is being questioned.” Mr. Market didn’t have too many questions of his own, as the deal was oversubscribed some eight times over according to the FT. For more on the Ancestry offering, and a review of other notable recent specimens, see the Nov. 27 issue of Grant’s.  

While issuers and investors alike celebrate, corporate fundamentals continue to suggest the other shoe may yet drop. 

According to data from Bloomberg Intelligence, 47 dollar-denominated high yield borrowers (nearly 8% of the total category) posted negative Ebitda in the third quarter, up from 24 such Ebitda-negatives in the second quarter and just nine on Dec. 31. More broadly, the average ratio of total debt to Ebitda among high-yield borrowers stood at 5.3 times as of Sept 30., near the record 5.6 times gross leverage established in the second quarter.  Even that improvement, Bloomberg cautions, can be chalked up to a methodology which removes companies generating negative Ebitda from the leverage calculation. 

In Europe, sharp year-over-year declines in corporate insolvencies (nudged lower not only by central bank asset purchases but also aggressive loan deferral programs from area governments) belie the rude state of corporate health. According to the European Central Bank’s most recent Financial Stability Review, corporate vulnerability as measured by an in-house indicator has spiked towards levels commensurate with the global financial crisis, despite the relative lack of outright distress.  Things were hardly copacetic before the bug bit in terms of broad corporate health: French bank Natixis estimates that 21% of euro area companies fell under the zombie (or unable to generate sufficient operating income to cover interest expense) category last year, up from 11% in 2008 and only 3.5% in the early 1990s.  

The yawning gap between ebullient price action and a still-dicey economy has some sounding the alarm. Analysts at Bank of America write today that: “We think 2021 will be a challenging year for fixed rate credit investors as they take credit and COVID-19 risk to earn small positive returns.” 

On Tuesday, Moody’s Investors Service released its 2021 North American Outlook, forecasting a baseline 10.4% peak trailing 12-month default rate in March, followed by a continuation near the current 8.4% rate throughout 2021. Under a pessimistic scenario, defaults could reach 15.2% next year, nearly double the current pace.  

The still-swollen ranks of stressed issues add credence to persistent default worries.  Moody’s B3N and lower list (meaning those rated the equivalent of single-B-minus or lower along with a negative ratings outlook) stood at 25.5% of the total high-yield universe at the end of October, double that of a year ago and not far from the record high 27.5% peak reached in June.  
Those hobbled hordes need the good times to continue. Noting that “open capital markets are critical to support speculative grade company liquidity needs,” the rating agency concludes that “weak structures will delay many days of reckoning.” 

Prospective Ancestry.com creditors, please copy. 

QE Progress Report
No progress this week, as Reserve Bank Credit slipped to $7.18 trillion, down $37 billion from last week’s reading.  That pause did no harm to the recent growth rate of income bearing assets at the Fed, as the three-month annualized pace of growth ticked to 13.5% from 13.4% last week, while year-over-year growth also accelerated slightly, to 79.3% from 79.1%. 
Recap Dec. 3

A late selloff in stocks erased modest gains, though the broad S&P 500 is still up 80 basis points for the week after a flat showing today.  Treasurys enjoyed a rebound, with the 30-year yield falling three basis points to 1.66%, WTI crude rose towards $46 a barrel following news that the OPEC+ cartel reached a new production agreement, and gold managed another rally to $1,844 an ounce.  The VIX finished slightly higher just above 21 for its third straight green finish. 

- Philip Grant

Customer Copy
Modern sovereign borrowing, with European characteristics.

Modern sovereign borrowing, with European characteristics.  On Nov. 19, China sold €4 billion in euro-pay sovereign debt including a five-year tranche priced-to-yield minus 0.152%.  That’s the Middle Kingdom’s first foray into the negative-rate club, according to Dealogic. The deal was covered four-and-a-half times over, according to Deutsche Bank head of China capital markets Samuel Fischer, who helped oversee the sale. 

“People want more exposure to China,” Fischer commented to The Wall Street Journal. “China’s financial markets are opening, but there is still a broad scarcity of the sovereign [debt] among investors. The story of China’s COVID turnaround and the resilience of its economy are also things people like.” 

While that offering went off without a hitch, Chinese debt is slightly less popular in other contexts.  Bloomberg reports today that corporate dollar-pay bond issuance sank to $9.9 billion in November, down 52% on a sequential basis and the lowest monthly total since April.  That slump comes at a potentially inopportune time. According to data from Debtwire, Chinese state-owned enterprises face more than $3 billion in high-yield dollar bond maturities in the first quarter of next year, by far the busiest quarterly maturity schedule through at least 2023. 

One potential explanation for the financing slowdown: A string of recent defaults from those state-owned enterprises across various geographical regions and sectors, including Henan-domiciled Yongcheng Coal and Electricity Holding Group Co. Ltd. and Shenyang-based Brilliance Auto Group Holdings Co (a joint venture partner with BMW). Those defaults helped trigger a selloff dealing creditor losses equivalent to RMB 60 billion ($9 billion), a local broker estimated to Caixin on Nov. 24.  Some 10 SoE’s have defaulted so far this year, representing 40% of total such defaults over the past five years.  

Suddenly skittish investors have tightened their wallets in response, forcing cash-hungry outfits to pay up, with an unnamed Shanxi-based coal miner reportedly paying 5% coupon for ultra-short-term financing. “This might be a historic credit crisis,” one anonymous investor, who held bonds issued by both Yongcheng and Brilliance, told Caixin.  One senior regulator showed limited sympathy regarding those fears, rhetorically asking in response: “When creditors lent so much money to [now-stricken SoEs], did they conduct their risk control properly?” 

One thing’s for sure, state-owned entities have played a starring role in China’s economic miracle. A report today from S&P Global estimates accumulated debt from local and regional government nonfinancial SoE’s at 60% of Chinese GDP (for context, total U.S. corporate debt stood at $10.9 trillion as of the second quarter, equivalent to just over half of last year’s nominal output). The analysts conclude that, as local governments now “have fewer resources to support” those suddenly flailing entities, “higher tolerance for SoE defaults are likely as these governments dig out from COVID.” 

A key feature of the recent credit scare: A Lake Woebegone-type ratings regime, in which virtually all comers are well above average. More than 98% of outstanding bond issuance in China comes from those rated double-A and above according to Wind Data Services, while some 57% of all onshore corporate debt garnered a triple-A-rating as of mid-October per asset manager Invesco Ltd, up from 38% five years earlier.  Indeed, both Brilliance and Yongcheng had enjoyed pristine triple-A ratings from China’s onshore credit rating agencies.  The recent spate of trouble has done little to change that. According to Wind Data Service, only five Chinese companies out of more than 5,000 have been downgraded below the double-A threshold since the Yongcheng and Brilliance defaults.

“China’s rating agencies are even worse than [those] in the U.S.” Andrew Collier, managing director of Orient Capital Management, groused to the Financial Times. “They’re not only beholden to the customer but also [to] the government.” 

Like a home-plate umpire, the Chinese Communist Party is always right. 

Recap Dec. 2

Stocks took a pleasant pause, with the Nasdaq 100, S&P 500 and Russell 2,000 indices each finishing flat or slightly higher to nurse year-to-date gains to 43%, 13.5% and 10%, respectively.  Treasurys settled down a bit from yesterday’s steep selloff but maintained their steepening bias, with the 10- and 30-year yields rising to 0.94% and 1.69%, respectively.  Gold rallied back to $1,834 an ounce, WTI crude rebounded back above $45 a barrel, and the VIX rose to 21.2 after testing the 20 threshold for the first time since February in the pre-market yesterday.

- Philip Grant

Walk Towards the Light

Here’s Fed chair Jerome Powell today, speaking to Congress:

We can see the end — we just have to make sure we get there.

Window Dressing
Notable new developments in the ongoing push-and-pull

Notable new developments in the ongoing push-and-pull between high flying, asset-lite quick-serve restaurant franchisors and their largely put upon franchisee business partners.  Let’s review: 

On Sunday, bankrupt NPC International, Inc., among the largest domestic franchisees, disclosed that it is cancelling a planned auction for its roughly 1,200 Pizza Hut and 400 Wendy’s restaurant locations, leaving an $816 million bid from Flynn Restaurant Group as the sole remaining contender for the assets. 

Flynn was named the stalking horse bidder on Friday.  The privately-owned company, America’s largest restaurant franchisee, offered $816 million for all of NPC’s assets, topping the initial $725 million asking price, though still short of NPC’s $903 million pre-Chapter 11 debt load following a leveraged buyout two years ago. 

Not everyone was pleased. Wendy’s, which had submitted its own plan to buy its locations, objected to the sale in a Nov. 19 court filing, noting that Flynn operates competing fast food brands such as Arby’s and Panera Bread. The parties are currently under negotiation, with Wendy’s potentially willing to drop its opposition in return for “tens of millions of dollars” in store improvement investments, The Wall Street Journal reports today.  

The outcome is generally a positive one however, John Hamburger, president of the Restaurant Finance Monitor, relays to Almost Daily Grant’s via telephone:

Flynn has a very good reputation in the restaurant business.  They are savvy operators known for investing in their stores.

However, some negotiation likely remains between Flynn and Wendy’s regarding remodeling expense and requirements, as well as how many locations Flynn may keep or potentially flip to other franchisees.   

While one franchisee conducts its corporate garage sale, another continues to scuffle.  Carrol’s Restaurant Group, Inc. (TAST on the Nasdaq), the country’s largest Burger King operator and fourth-largest franchisee overall, reported a 3.2% same store sales decline in October. That’s the fourth straight monthly deterioration following a 2.1% year-over-year improvement in July. In addition to tougher comparisons brought on by the August 2019 Impossible Whopper roll-out, CEO Daniel T. Accordino ominously cited “increased competitive pressures in the fast-food segment” for the slowdown.  

The company’s ability to withstand pressure appears limited, as B3/single-B-minus-rated Carrol’s sports net leverage equal to nearly 12 times Ebitda and generated a modest $3.4 million in free cash flow over the 12 months through Sept. 27. TAST appeared to be in big trouble during the harrowing spring sell-off, when its first-lien term loan due 2026 plunged to as low as 71 cents on the dollar for a 1,050 basis point pickup over Treasurys. In February, Carrol’s slashed 2020 capex guidance to a range of $55 million to $65 million, far below a prior projection of $98 million, as the company looked to preserve cash. 

The risk is that currently-flush franchisors, long the recipients of steady royalty income without directly facing a rugged operating environment, end up on the hook for a chunk of franchisees’ growing capital needs. Some of the franchisors have already come under reappraisal: Grant’s pick-not-to-click Restaurant Brands International Inc. (QSR on the NYSE) has seen shares fall 18% inclusive of dividends since the most recent bearish analysis on Sept. 30, 2019, while the S&P 500 has managed a 25% total return.

RBI’s experience, however, has stood as something of an industry outlier. Hamburger tells ADG that “the drive-thru window is everything during the pandemic. The banks want to be in the quick serve restaurant space, the investors want to be there, and p.e. wants to be there. It’s getting crowded.”

Mr. Market continues to smile on that asset-lite cohort, as franchisors continue to command a premium price tag in the face of largely grim operating data. Thus, the S&P Restaurants Index trades at an enterprise value equivalent to 24 times consensus 2020 Ebitda, a 50% valuation premium to the broader S&P 500. For context, the S&P Restaurant Index fetched a 10.5 times EV-to-Ebitda price tag at year-end 2010, compared to 8.9 times for the SPX.   

Meanwhile, industry sales fell by 7.5% from a year ago in October according to data from Black Box Intelligence, representing a modest 60 basis point sequential improvement after far bigger monthly rebounds in August and September. For context, Accordino estimated last year that franchisees required 3% to 4% annual same store sales growth to leverage operating expenses. 

Recap Dec. 1

It’s a new month, but stocks followed a familiar script as the S&P 500 darted higher by 1.1%, setting a fresh record high with a 13.5% year-to-date advance.  Treasurys sold off aggressively in curve-steepening fashion, with the long bond jumping 10 basis points to 1.67%, while gold bounced strongly to $1,819 an ounce and WTI crude slipped back below $45 a barrel.  The VIX rose slightly to near 21.

- Philip Grant

The Debt Sea
The bond market gives thanks.

The bond market gives thanks. Citing data from Refinitiv, The Wall Street Journal reports today that global debt issuance so far this year reached a record $9.7 trillion as of Thursday, surpassing all prior full-year tallies.  That record figure includes $1.4 trillion from U.S. investment grade corporates (up 54% from a year ago) and $337 billion in domestic junk bonds (a 70% year-over-year uptick). 

Of course, surging debt issuance and disappearing yields the world over (see the $17.4 trillion pile of nominal negative yielding debt worldwide), has been little impediment to a rip-snorting, broad-based rally in credit, as the Bloomberg Barclays High Yield Index has generated a 31% return from its March lows and 7.5% from a year ago, while spreads on triple-C-rated corporate bonds have dived to 736 basis points, from 1,815 in March and 970 basis points a year ago. 

That comes despite deteriorating corporate fundamentals at the deeper end of the credit pool. According to data from Deutsche Bank, net leverage among U.S. high yield corporate issuers jumped to more than 8 times adjusted Ebitda in the second quarter from about 5 turns a year prior, while interest coverage collapsed to less than 2.5 times as of June 30 from roughly 3.5 times coverage in mid-2019 and a 4.5 times interest coverage buffer in 2018. Strategist Craig Nicol notes that the issuance spree “flies in the face of what we have typically seen during other periods of stress or recessions when we've seen conditions much more akin to a credit crunch.” 

Seemingly insatiable demand for debt has been the key. “There has been no problem in absorbing the massive debt issuance seen in 2020 due to the combination of central-bank asset purchases and the sharp rise in private savings,” Gene Frieda, global strategist at Pacific Investment Management Co., tells the Journal

A healthy economy is notably absent from that calculus, as global output is set to shrink by 4.4% from a year ago, if estimates from the International Monetary Fund are on the beam. 

Prolonged malaise could spell trouble.  According to a Nov. 18 report from the Institute of International Finance, developed markets lugged debts equivalent to 432% of GDP at the end of the third quarter, up from 380% total debt-to-output at year-end 2019.   The United States is on track to reach $80 trillion in total debt by year end (equal to 370% of nominal 2019 output), up from $71 trillion a year ago.  “There is significant uncertainty about how the global economy can deleverage in the future without significant adverse implications for economic activity,” the IIF concludes. 

Dog Day Afternoon
A mew entrant looms in the publicly-traded food delivery realm.

A new entrant looms in the publicly-traded food delivery realm.  DoorDash, Inc. filed its amended form S-1 today, revealing plans to sell 33 million shares at $75 to $85 each, valuing the company at as much as $32 billion on a fully diluted basis.  That’s up smartly from the $16 billion valuation that DoorDash garnered during its most recent private fundraising round back in June. 

Financial metrics appear to be on the upswing, though consistent profitability remains elusive for the seven year old enterprise. Sales through the first nine months of the year registered at $1.9 billion, more than treble the top line over the same period last year, while net losses narrowed to $149 million compared to $533 million over the first three quarters of 2019.   Nevertheless, persistent red ink appears endemic to the food delivery business, as peer Uber Eats reported adjusted Ebitda of negative $183 million in the third quarter, despite seeing revenues more than double to $1.5 billion (for more on Uber, see the most recent edition of Grant’s Interest Rate Observer). 

For DoorDash, the revelation of extra-legal shenanigans clouds those efforts to push into the black.  Last week, the company paid $2.5 million to settle a lawsuit from Washington D.C. Attorney General Karl Racine alleging that DoorDash helped itself to millions of dollars in driver tips.  In addition to that restitution, the company agreed “to maintain a payment model that ensures all tips go to workers without lowering their base pay, and it will be required to provide clear and easy-to-access information about its policies and payment model to workers and consumers."

The timing of the settlement is ironic. Founder and chief executive Tony Xu, who owns some 42% of all super voting class B shares, wrote in a founder’s letter accompanying the filing that “fighting for the underdog is part of who I am and what we stand for as a company.”

Recap Nov. 30

Stocks took a breather, with the S&P 500 losing 40 basis points and the Russell 2,000 suffering a 1.8% pullback, though those indices logged gaudy 11% and 18% gains for November.  Treasurys went absolutely nowhere, with the long bond holding at 1.57%, while WTI crude remained just above $45 a barrel.  Gold slipped to $1,779 to continue its slump, a marked contrast to “digital gold’ as bitcoin moved to a record high near $19,500.  

- Philip Grant

Solid Rock
Many, many happy returns?

Many, many happy returns?  Peru launched a $4 billion, three-part sovereign debt offering yesterday, including $1 billion worth of 101-year bonds at 3.23%, José Olivares, director-general of the Public Treasury of Peru´s Economy ministry, told Reuters. That marks the lowest yield on an emerging market century bond yet.

The recent history of those ultra-long-term bonds features a wide range in outcomes, as the distant maturity date can allow for huge price swings.  In 2017, Austria issued 100 year bonds at a 2.1% coupon, since been bid to 226 cents on the Euro for a 0.47% yield-to-maturity. On the other end of the spectrum is Argentina, which infamously issued $2.75 billion worth of century bonds that same year, restructuring just over three years later, dealing sovereign creditors haircuts equivalent to nearly half of principal. 

As for Peru, the A3/triple-B-plus-rated South American nation has its investment merits.  “Peru has a strong external position and a low level of indebtedness,” Shamaila Khan, director of emerging market debt at AllianceBernstein, told Bloomberg. “We expect the country to be a solid investment grade credit, despite the political volatility.” 

The economy is on the mend, as a brutal encounter with coronavirus (Peru’s thin mountainous air contributed to one of the globe’s highest mortality rates) and strict lockdowns have given way to a solid snap-back.  GDP jumped by 29.9% sequentially in the third quarter, “by far the strongest gain reported by any major economy to date,” per a Friday Bloomberg dispatch.  A generous government has helped nudge things along, passing a stimulus package equal to 20% of output, in the process pushing public debt to a projected 38% of GDP in 2021 from about 27% last year.

Internal self-assurance remains in abundant supply. “Independent of the political events, there’s a confidence that investors have in the financial institutions of our country,” declared José Olivares today in an interview with Bloomberg.  “When they talk about Peru bonds, they say it’s a risk-free asset.” 

Yet those political events have taken up plenty of bandwidth in Peru of late, which last week saw World Bank alum Francisco Sagasti sworn in as interim President, the third executive in the past two weeks.  Following the Nov. 9 impeachment of predecessor Martin Vizcarra on account of “permanent moral incapacity,” Manuel Merino lasted just six days in the post before resigning thanks to widespread citizen protests and violence.  Yet another new president may be in the offing next year, as general elections are set for April 21. 

Festering problems help explain the recent chaos.  “Ultimately, this is about the collapse of the political parties,” Steven Levitsky, director of the David Rockefeller Center for Latin American Studies, declared to Foreign Policy magazine on Friday. “Twenty years after a return to democracy, Peru’s institutions and social and economic structures are as fragile as ever, and the economy, mired in crony capitalism and mercantilism, stopped shining years ago.” 

The political state of affairs doesn’t look much better over the longer term. Referencing a quintet of government overthrows from 1930 to 1992, Breakingviews columnist Rob Cyran observes on Twitter that “the yield on Peru's new century bond is lower than the number of coups they've had in the past 100 years.” 

The FX market (at least) has taken a dim view of that upheaval, as the Peruvian sol reached a record-low 3.67 to the dollar last week, since rebounding slightly to 3.61.  That compares to a 2.6 sol-to-dollar exchange rate in early 2013, and 3.22 in April 2018.  

Then again, evaporating yields the world over generate their own creditor calculus. “The political backdrop is challenging,” Alberto Ramos, chief economist for Latin America at Goldman Sachs, tells the Financial Times. “On the other hand, we are living in a world with abundant liquidity.” 

Recap Nov. 24

Euphoria is afoot, as the S&P 500 surged 1.6% to a record high, while the Russell 2,000 jumped 1.9% and the price-weighted Dow Jones Industrial Average climbed above the 30,000 mark for the first time.  WTI crude climbed to $45 a barrel for the first time since early March and the VIX finished below 22 to test its post-March lows set in August.  A jubilant Mr. Market continues to want no part of the Money of Kings, as gold slipped to $1,804 an ounce for its worst finish since mid-July.  

- Philip Grant

Almost Daily Grant's will resume Monday 

The Bold and the Beautiful
Credit risk is on the hop in China:

Credit risk is on the hop in China: Yields on double-A-rated corporate bonds, generally considered to be more speculative than similarly-rated western issues, reached 4.38% on Friday, according to Wind Data Service.  That’s up from 3% earlier this year and the highest yield since January 2019. 

The powers-that-be have taken notice. Attributing a recent spate of defaults among state-backed corporations to  “cyclical, institutional and behavioral factors,” (Almost Daily Grant’s, Nov. 17) China’s Financial Stability and Development Committee declared it will “investigate and deal with fraudulent issuance, false information disclosure, malicious transfer of assets,  misappropriation of funds and other illegal activities.”  

Beijing’s hard line comes as China’s largest and most encumbered property developer, China Evergrande Group, which faces a mammoth RMB 836 billion ($125 billion) burden as of the end of June (equivalent to an eye-watering 11 times Ebitda), looks to dig out of a debt-ridden morass.  

Bloomberg reports today that government-linked entities will chip in an RMB 30 billion equity investment for Evergrande’s Hengda Properties Unit, which holds many of the company’s crown jewel mainland assets. In addition, the investor coalition agreed to buy a 7% stake in services division Evergrande Property Services Group Ltd., helping underpin an upcoming Hong Kong-domiciled IPO which will raise a projected HK$15.8 billion ($2 billion) with pricing set for Thursday. Recall the parent company netted $555 million through an equity offering in October, barely half its target sum of $1.1 billion. 

Evergrande scored a crucial victory earlier this fall, when a quorum of investors agreed to hold off on asking for repayment of upwards of RMB 130 billion in funds linked to a scrapped backdoor listing on the mainland Chinese market, equivalent to virtually all of the cash and near-cash on hand as of June 30. The company has since attempted some creative (or desperate) measures to finance itself, including making approaches to offshore and onshore trust companies about issuing debt at coupons above 15%, Reuters reported on Oct. 30 (the investors passed on the deal, owing to “concern over the developer’s high debt level”). 

Instead, Evergrande has all but ceased utilizing the trust market for its financing needs, issuing roughly RMB 3 billion monthly from August through October according to data from industry provider Use Trust. That’s down from about RMB 10 billion per month from January to July. Non-bank financing has figured prominently in the company’s strategy, as trust products accounted for about 40% of total borrowings at year-end 2019 per Use Trust. 

The potential for intensifying regulatory pressure also factors in. Next year, Beijing will roll out the “three red lines” rules for property developers, introducing balance sheet restrictions including debt-to-asset ratios below 70%, net gearing below 100% and short-term debt no greater than cash reserves. Companies which fail these tests (Evergrande reported a net gearing ratio of 199% and cash equal to less than half of short-term maturities as of June 30) will be barred from growing liabilities for one year. 

Use of non-traditional funding sources is likely to come under additional scrutiny, as developers will also need to provide financing information covering not only bank loans and bond issuance, but also less conventional forms of funding like off-balance sheet arrangements and securitization of accounts receivable. 

As Evergrande works to stay afloat, investors face their own problems.  Bloomberg reported on Nov. 10 that bonds issued by companies controlled by billionaire Zhang Jindong have come under severe pressure following his surprise decision to forego early repayment on an RMB 20 billion investment with Evergrande.  

Suning Appliance Group Co.’s privately-traded bonds fell to around 70 cents on the renminbi in recent weeks, while e-commerce platform Suning.com Co. (on which Zhang is the chairman and largest shareholder with a 20% stake), one of China’s largest non-government affiliated retailers, has seen its RMB-pay senior unsecured 5.2% notes maturing next year plunge to 86 cents on the renminbi for a yield-to-worst of 43%. 

There appears to be valid cause for concern, as Suning.com’s interest coverage ratio plunged to 0.76 at the end of June from 1.61 a year prior, per an interim financial report.  “Now you would need to be very bold to lend money to the company,” Shen Chen, partner at Shanghai Maoliang Investment Management LLP, told Bloomberg.

Recap Nov. 23

Another bull day for stocks saw the S&P 500 rise 60 basis points while the small-cap Russell 2000 ripped by nearly 2%, extending to a 9% advance this year to draw closer to the SPX’s 10.7% year-to-date advance. Treasurys came for sale with the long bond rising to 1.56%, WTI crude climbed above $43 a barrel, gold sank to $1,833 an ounce and the VIX dropped 4% to finish below 23.  

- Philip Grant

Faith Healer
Digital gold goes parabolic.

Digital gold goes parabolic. Cryptocurrencies have been on a tear of late, with the price of bitcoin rising above $18,600 this afternoon, good for a 75% advance since October and 280% from its March lows.  The most prominent crypto is now within just 3% of its December 2017 high-water mark. 

Some proponents can hardly curb their enthusiasm. Michael Novogratz, CEO at crypto fund Galaxy Digital, told CNBC Wednesday that bitcoin has “hit escape velocity,” forecasting a cool $60,000 target price by the end of next year.   BlackRock’s chief investment officer of fixed income Rick Rieder declared on the same network today that bitcoin is “a durable mechanism” that “could take the place of gold to a large extent. . .  it’s so much more functional than passing a bar of gold around.” 

Fundamental developments bolster the bullish case. In August, $3.3 trillion asset manager Fidelity announced the launch of its debut Bitcoin mutual fund, featuring a $100,000 minimum investment.  Last week, online payments giant PayPal announced that customers can now buy, hold and sell bitcoin and peers from their existing accounts, making cryptocurrencies “available as a funding source for purchases at [PayPal’s] 26 million merchants worldwide.”  Blockchain investment fund Pantera Capital Management estimates in its November investor letter that PayPal and Square, Inc.’s Cash App peer-to-peer mobile payment platform are together snapping up more than 100% of new bitcoin supply.  

Idiosyncratic factors make their own contributions: Regulators in the Middle Kingdom have ordered banks to freeze accounts associated with cryptos, CoinDesk reported on Monday. As a result, Chinese bitcoin miners, who make up 72% of the blockchain’s computing power, have been unable to sell cryptos for the RMB needed to pay for electricity. “The lack of supply has fed extremely well to the trendiness of this rally, without any of the large sell-downs typical of miner activity in the past,” Singapore-based trading firm QCP Capital commented.  Citing data from research site Flipside Crypto, Bloomberg reported Wednesday that some 95% of the digital ducats are controlled by about 2% of accounts.  

Or, perhaps, we have Jerome Powell, Christine Lagarde et al. to thank.  From today's Financial Times opinion page:

It may be precisely because the Federal Reserve has done such a good job of meeting the world’s need for dollars that investors feel comfortable taking a punt on bitcoin and venturing away from the comparative stability of fiat currency. If so, cryptocurrency advocates have the central bank to thank for their recent success.

Yet another, more nefarious factor may be underpinning the crypto surge:  A helping hand from the oldest and largest so-called stablecoin, tether.  As digital exchanges are mostly unbanked, tether and peers act as a crucial workaround for converting cryptos to something resembling cash and back again without encountering the know-your-customer and anti-money laundering protocols that regulated banks require.

Accordingly, tether is something of a crypto Grand Central Station, with $57 billion in trading volume over the past 24 hours. For context, bitcoin, which boasts a total stock nearly 20 times higher at $343 billion, has seen just $36 billion in trading volume over that period. Aggressive new issuance coincides with this year’s euphoric price action. Tether’s stock of scrip has risen to $18.2 billion from $4.1 billion on Dec. 31, good for a 343% year-to-date increase. 

Persistent legal trouble and pointed operational questions continue to dog the stablecoin, including a class action suit last year accusing Tether and Bitfinex of undertaking “a sophisticated scheme to fraudulently inflate the price of crypto commodities [including] bitcoin.” The class action litigants accuse Tether (the entity) of issuing some $3 billion worth of tokens without any dollar backing, a move which allegedly played a key role in skyrocketing crypto prices during late 2017. 

New York Attorney General Letitia James has come calling, filing an April 2019 lawsuit accusing Tether and closely affiliated crypto exchange Bitfinex of improperly commingling funds under the broad Martin Act, then in September demanding documents related to the disappearance of $850 million in customer funds to Panama-domiciled Crypto Capital. Charles Michael, a lawyer at Steptoe and Johnson LLP representing Tether, responded that it is “literally impossible” to comply with the AG’s request.  

Then, too, a postmortem from the prior crypto breakout in 2017 identified some curious findings, according to a June 2018 paper from University of Texas at Austin professors John Griffin and Amin Shams: 

Overall, our findings provide substantial support for the view that price manipulation may be behind substantial distortive effects in crypto-currencies . . . More generally, our findings support the historical narrative that dubious activities are not just a by-product of price appreciation but can substantially contribute to price distortions and capital misallocation.

Five months before the paper’s publication, Tether fired its auditor, New York-based Friedman, LLP, explaining that: “Given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether, it became clear that an audit would be unattainable in a reasonable time frame.” 

Ignorance is bullish, perhaps. 

Recap Nov. 20

Stocks absorbed their second late-day selloff in the past three sessions, leaving the S&P 500 with an 80 basis point loss for the week to trim year-to-date-gains to 10%.  Treasurys continued their strong recent showing, with the 30-year yield declining to a five week low of 1.52%, while WTI crude climbed over $42 a barrel and gold rebounded to $1,870 an ounce.  The VIX popped back toward 23.5 thanks to that bearish close. 

- Philip Grant

'Trust Fall
A synchronized global crackdown on big tech?

A synchronized global crackdown on big tech? From east to west, governments of all stripes look to agree on one topic: Reining in the corporate kingdoms of Silicon Valley.  Let’s review: 

While China’s last minute, Nov. 3 decision to pull the plug on Ant Group Co.’s gargantuan $37 billion initial public offering drew plenty of attention, subsequent happenings suggest that decision was not made in a vacuum.  Last week, local regulators rolled out new rules designed to curtail monopolistic practices among tech giants, spurring notable selloffs in industry mainstays Alibaba Group Holding, Ltd. and Tencent Holdings, Ltd. 

“Beijing has felt that tactics by ecommerce companies are not leading to healthy development of the retail industry. . . They don’t want three or four companies [dominating], they want 1,000s of companies,” Wong Kok Hoi, chief investment officer at APS Asset Management, told the Financial Times. “This is big, this is a game changer.”

China isn’t the only Asian nation flexing its sovereign muscle, as Reuters reports that Vietnam “has threatened to shut down Facebook, Inc. in the country if it does not bow to government pressure to censor more local political content on its platform.” International political squabbles spur additional headaches: Bloomberg reports that Russian legislators submitted a draft law earlier today which would allow Russia to block Facebook and Alphabet, Inc.’s YouTube in response to those platforms’ apparent censorship of Russian state media outlets. 

Supranational authorities likewise look to tighten their grip on big tech. Last week, the European Commission announced that it had reached a preliminary view that Amazon.com, Inc. has violated EU competition rules.  A second investigation is now underway to determine if the “everything store” has improperly tipped the scales towards its own products and away from unaffiliated marketplace sellers. 

There could be more where that’s coming from. A new report from the European Court of Auditors criticized the E.U.’s antitrust apparatus for overly-narrow interpretations of potential abuses and slow walking investigations, “negatively affect[ing] the effectiveness of the [body’s] decisions.”   That opinion comes ahead of the forthcoming Digital Services Act, which is “likely to require dramatic changes in [industry] business practices and even business models,” Thomas Vinje, a partner at the law firm Clifford Chance, told CNBC on Nov. 5.  

Stateside, bipartisan pressure on the big tech cohort looks set to intensify.  The Washington Post reported yesterday that state and federal authorities are set to bring charges for alleged anticompetitive behavior related to Facebook’s purchases of Instagram and WhatsApp in 2012 and 2014, respectively. The charges, per the Post, will underpin a potential “wide-ranging political salvo. . . ultimately threat[en] to saddle Facebook with its toughest regulatory challenge in its nearly 17-year history.”  The legal bandwagon is filling up, as the Capitol Forum reports that a coalition of at least 30, and potentially up to 40, state attorneys general is set to join the lawsuit. 

Then, too, the Federal Trade Commission (which levied a $5 billion fine on Facebook in July 2019) is reportedly preparing its own antitrust lawsuit centering on the Instagram deal. Alex Kantrowitz, proprietor of the Big Technology Blog, commented on the likely legal ramifications last Thursday:

When you examine previous big tech antitrust cases, the laws the FTC has at its disposal, and the state of Facebook’s business, it becomes evident that Zuckerberg’s crown jewel is under threat. 

Facebook is, of course, not the only one getting the side-eye from Uncle Sam, as Google parent Alphabet’s own U.S. antitrust case will likely commence in December, The Wall Street Journal reported yesterday.  Recall that the Department of Justice sued the behemoth on Oct. 20 for alleged anticompetitive conduct related to its core search engine and advertising businesses.  The lawsuit also alleges that the defendant’s payments to Apple, Inc. to make Google its default search engine contravene U.S. law.  Google remits an estimated $10 billion a year to Apple, equivalent to roughly 15% of the latter’s annual operating income. 

Tangible evidence now suggests that pressure is making an impact.  Apple announced yesterday that it will cut its commissions from app developers producing up to $1 million in annual revenue to 15% from the 30% take rate since the iPhone’s debut in 2008.  The income stream from app developers, described by Bloomberg as “key to Apple’s growing services businesses,” generated $54 billion in revenue during the fiscal year ended Sept. 30, equivalent to just under 20% of the consolidated top-line and about 95% of total net income. 

For more on the implications of this apparent regulatory sea change, including the bull case on an industry giant currently absent from the government’s cross-hairs, see the October 16 edition of Grant’s.  

QE Progress Report
Cooking with gas once more.  Reserve Bank credit jumped $63.5 billion from a week ago to $7.19 trillion, as interest bearing assets at the Fed saw their second largest sequential increase since late May.  That pushed the three-month growth rate to an even 13% from 12.6% a week ago, while year-over-year growth registered at 78.9%, virtually unchanged from last week’s reading. 
Recap Nov. 19

Stocks worked off early losses with the S&P 500 rising 40 basis points to revert to unchanged for the week so far, while Treasurys caught another bid with the long bond falling to a two-week low at 1.56%.  WTI crude remained near $42 a barrel, gold slipped once more to $1,868 an ounce, and the VIX fluttered back to 23. 

- Philip Grant

Brave New World 2
As of yesterday, the global stock of negative-yielding debt

As of yesterday, the global stock of negative yielding debt stood at $17.01 trillion, more than double the $7.5 trillion seen in March and near the peak of $17.04 trillion set in August 2019.  If comments from a senior official at the Bank of England are any indication, the proportion of sub-zero yielding paper, unseen for 4,000 years of financial history prior to this cycle, could soon ratchet higher.  

Andy Haldane, chief economist at the Bank of England, advocated for a move below zero today, telling the London Telegraph that “the potential macro-economic benefits of easing [below] the zero lower bound constraint appear to be significant.” 

Negative rates are, of course, old hat on the Old Continent, as the European Central Bank first drove its benchmark deposit rate below zero in June 2014, extending to minus 50 basis points in September 2019. Seeing no storm clouds on the horizon, Bundesbank president and ECB Governing Council member Jens Weidmann commented in October that the point of diminishing returns is still in the distance: “We haven’t reached the reversal rate and interest rate decreases can still have the intended effect of monetary policy.” 

One thing’s for sure, the “intended effect” of stirring consumer inflation (a development which would presumably occur in tandem with accelerating economic activity) has yet to manifest during this experimental epoch. Instead, eurozone headline CPI inflation has advanced at an average 0.9% annual clip over the past six years, just over half the average 1.6% seen from September 2008 to September 2014.

Other pro-NIRP monetary mandarins opt for different talking points. ECB president Christine Lagarde cited the banking system as the reason for EZ monetary policy in a speech last Friday at the Bank for International Settlements: 

Monetary policy has to continue supporting the banking sector to secure policy transmission and prevent adverse feedback loops from emerging. Firms are still dependent on new flows of credit. And those that have borrowed heavily so far need certainty that refinancing will remain available on attractive terms in order to avoid excessive deleveraging.

Yet negative rates have been little short of catastrophic for the industry, as Europe’s Stoxx Banks Index has absorbed a 52% loss since June 2014, while the U.S. KBW Banks Index has risen 29% over that period.  This year, the European banks, which trade at less than one-half of book value, will generate a 1.8% return on equity if analyst consensus is on the beam.  That’s one-third of the 5.4% RoE estimate for the U.S. lenders, who are quoted at just under one time book value.

A decline in lending spreads explain much of the divergence, as an Oct. 30 commentary from ING reports that net interest margins for European Banks slipped below 1.35% as of June, from 1.55% in late 2014, as the negative rate orthodoxy clashed with business realities:

“Deposit rates have a natural lower bound, [making] them less attractive in a negative rate” world, the ING analysts write. Academic studies have reached a similar conclusion, as a September paper from the San Francisco Fed found that “both bank profitability and bank lending activity erode more the longer such negative policy rates continue.” 

Efforts to shield the banks elicit other problems. Former Bank of England Governor Mervyn King observed to Bloomberg Television last week that negative rates need to be passed along to savers to maintain the health of the banking system, adding that: “Once that happens, I think you should expect to see a long line of customers seeking to take their cash out of the bank and keep it under the mattress. . . I don’t think that’s a politically attractive prospect at all.”  As for the NIRP strategy as a whole, King had this to say to the Grant’s fall conference audience last month:

It’s quite baffling in that, really, the central banks seem to say that negative interest rates are the answer to anything. We stopped well before going to zero during the Financial Crisis [King was governor from 2003 till 2013], precisely because we felt that to go even lower, even towards zero, would be counterproductive because it would compress bank margins and therefore give them a disincentive to lend rather than encourage them to lend.

King has company. Writing in the Telegraph on Oct. 13, international business editor Ambrose Evans-Pritchard minced no words with his assessment of the current monetary upside-down: 

Negative rates do not stimulate lending for useful economic activity. They damage ‘good’ banks by eviscerating their bread and butter business model but help ‘bad’ banks play the casino. They can increase precautionary savings by households and therefore drain money out of the economy. They can stretch public tolerance of overmighty central banks to a near breaking point.

Mr. Market’s tea-leaves suggest that public tolerance will be tested for years to come. The 10-year Euro swap rate is at negative 25 basis points, indicating a general expectation that the six-year-and-counting NIRP regime will remain in place for another decade. Then, too, the key rate looks to be going lower before it goes any higher, as European money markets were pricing in an additional seven points of ECB easing by the end of 2021 as of yesterday. 

Recap Nov. 18

An aggressive late selloff left the S&P 500 nursing losses of 1.2% after the broad index stood unchanged as late as midafternoon, with Treasurys as mere bystanders as the long bond held at 1.6%.  WTI crude continued its modest strength with a push toward $42 a barrel, gold slipped to $1,869 an ounce, and the VIX rose toward 24, finishing 9% north of its intraday low. 

- Philip Grant

We're Gonna Need a Bigger Boat

From CBS News in Sacramento:

A man wanted for his role in an alleged $35 million Ponzi scheme was arrested Monday after evading FBI agents by swimming into California's largest reservoir using an underwater "sea scooter," federal prosecutors said. Matthew Piercey spent about 25 minutes in frigid Lake Shasta using the Yamaha 350Li submersible device before he eventually resurfaced and was handcuffed.

Good times again in the Middle Kingdom?

Good times again in the Middle Kingdom?  China’s National Bureau of Statistics reported yesterday that industrial output jumped 6.9% in October from a year ago, topping the economist consensus for a 6.7% uptick.  That figure, along with a 4.3% increase in retail sales compared to October 2019 (up from a 3.3% annual rise in September) “cements the nation’s status as the only major economy tipped to grow this year” according to Bloomberg.   However, signs of increasingly widespread corporate distress belie those happy figures. Let’s review: 

Last week, state-owned enterprise Yongcheng Coal & Electricity defaulted on an RMB 1 billion ($150 million) in triple-A-rated commercial paper, catching investors off guard. “Due to the market’s insufficient expectations of a default at Yongcheng Coal, panic broke out in the bond market,” broker China International Capital Corp. relayed over the weekend.

Balance sheet strain is apparent across a swath of industries. Thus, Caixin reports that chipmaker Tsinghua Unigroup Co. failed to repay a privately issued RMB 1.3 billion onshore bond with a 5.6% coupon that came due yesterday, validating creditor concerns following the company’s decision to waive the repurchase of a privately-issued RMB 1 billion perpetual bond a month ago. Also yesterday, Brilliance Auto Group Holdings Co. (which is partnering with BMW Group in joint venture) defaulted on RMB 6.5 billion in debt.  

The situation has Beijing’s attention, as Bloomberg reports that China’s State Council has requested risk assessments from relevant government agencies, while the National Development and Reform Commission promised today to intensify its oversight of the bond market.  The Financial Times relays that at least 20 Chinese companies have shelved planned bond sales totaling RMB 15.5 billion over the past week thanks to the tumult. 

It’s hard to say credit markets are overly concerned, as the spread between three-year, double-A-rated corporate debt stood at 114 basis points yesterday over comparable government notes, a six-week high but well below the 163 basis point premium seen in late April. “Credit risk is under-recognized” in Chinese state-owned enterprises, analysts at J.P. Morgan conclude today. “We expect more defaults on SOE bonds or loans.”  As for resolution to the problem, the analysts expect that Beijing will “adopt a gradual approach. . . instead of ‘shock therapy.’”  Investors can expect monetary easing to leave rates “eventually approaching the zero interest rate bound,” risking “Japan-style distress and lost economic growth momentum.” 

The banks have their own problems.  Last week, regulators officially declared embattled Baoshang Bank as insolvent, confirming the lender will not repay a RMB 6.5 billion bond or make accompanying interest payments. Baoshang, which had RMB 576 billion in assets prior to a May 2019 government takeover, declared it is “seriously insolvent and unable to survive” in a filing on Friday, Caixin reports. 

Recall that Baoshang’s default, the first from a Chinese bank since 1998, helped spur a broad credit market seizure, a concerning event considering the bank represents a mere rounding error in terms of its size relative to the Chinese economy (Almost Daily Grant’s, July 16, 2019).

At least five other sizable commercial banks have since been forced to restructure, while other financial institutions have seen bad loans go parabolic. Anxin Trust, one of only two trust companies publicly listed in mainland China, reported in March that nonperforming loans stood at 83% of total loans as of Dec. 31, 2019, compared to 9% a year earlier.  Overall, the 68 Chinese trust companies, including 66 closely held ones, oversaw an aggregate $3 trillion in assets as of March 31. 

More broadly, mushrooming balance sheet distress is especially troubling in that it comes from a distended banking system, as Chinese banking assets footed to $43.8 trillion as of June 30, equaling one-half of 2019 global GDP and three times mainland output last year. Waning economic momentum into the pandemic adds into the mix, as last year’s reported output growth of 6.1% was its lowest since at least 1990.   Logan Wright, head of Rhodium Group’s China markets research, laid out one potential scenario in the July 24 edition of Grant’s:

What will happen is these bank failures will rise to larger and larger banks.  Then we will see this transition moment when we go from bailouts to bail-ins, which is a pretty dramatic moment in terms of overall credit growth. This will also have to be public. This isn’t something that you can just cover up using undeclared funds from the central bank balance sheet. At some point you are going to want to announce that you have a plan or strategy for this.

In the meantime, the slow-motion pileup continues. 

Recap Nov. 16

Stocks saw a moderate pullback with the S&P 500 slipping 50 basis points, though the bulls are unlikely to shed too many tears as the broad index is still up more than 10% from its Oct. 30 closing level.  Treasurys caught a strong bid with the 10- and 30-year yields falling to 0.86% and 1.62%, respectively. Gold pulled back to $1,888 an ounce, WTI crude edged higher to $41.5 a barrel, and the VIX held below 23 for a second straight session.  

- Philip Grant

Trading Places
A blip on the radar, perhaps.

A blip on the radar, perhaps.  Last week saw a notable rotation in the U.S. stock market, with so-called value stocks enjoying a performance snap-back relative to the high-flying (and technology-heavy) “growth” contingent. The Vanguard Value ETF jumped nearly 6% over the five trading day span, while the Vanguard Growth ETF sank by 1% over the same period. 

For the value tribe, there is plenty of ground to make up.  A May paper from Two Centuries Investments founder and CEO Mikhail Samonov analyzed performance data back to 1825, finding that the value factor (or a strategy of going long cheaply valued companies and short richly priced ones) tumbled 59% from its most recent peak through March.  That matches 1904 as the worst drawdown on record in that near-two century span. 

Of course, a certain exogenous event figures prominently in the historic valuation divergence.  “We came into this year after the big capitulation last year thinking that value is going to come good. . . We didn’t foresee a global pandemic,” Michael Barakos, co-chief investment officer for JPMorgan Asset Management’s international equity group, told the Financial Times on Oct. 26. “That’s a pretty extreme curveball that’s been very detrimental for value and very positive for growth.”

Value’s drought is spurring capitulation in some corners. In a Friday interview with the Washington Post, AJO Partners co-founder and principal Ted Aronson explained his rationale in shuttering the $10 billion, value-oriented fund. “Even if we shot the lights out, it would take us five years to get back to showing some decent historical returns.” 

On the other side of the coin, growth-focused managers have flourished thanks in large part to the handful of tech-focused mega-caps which have ascended to an historic share of the indices (Almost Daily Grant’s, October 8).  Bloomberg reports today that, among 200 equity funds benchmarked to the S&P 500, those with at least 20% of assets allocated to Facebook, Amazon, Apple, Microsoft and Alphabet have generated an average 17% year-to-date return, lapping the 2.6% advance for funds which have less than 10% of funds invested in that quintet. 

The blistering run enjoyed by the high-growth tech sector has pushed price tags skyward, as the Nasdaq 100 Index currently trades at 5.05 times enterprise value to projected full-year revenues, up from less than 3 times EV-to-sales in 2016 (over that four-year period, the S&P 500’s EV-to-sales ratio rose to 3.05 from 2.31 times).  Accordingly, a September paper co-written by Research Affiliates chairman Rob Arnott found that “the valuation spread between growth and value is wider than it was at the peak of the tech bubble.” Mark Schmehl, portfolio manager at the Fidelity Canadian Growth Company Fund, summed up the zeitgeist in an interview with the Globe and Mail in late October: “Valuation, I find, is a useless tool. If you base your investment decisions on valuation, you are never going to make money.” 

Some fund managers expect the recent shakeout to abate in short order, with the growth contingent set to reestablish its dominance. “Every call that we’re going to rotate away from growth and toward cyclicals has been wrong for the past eight or nine years. So, I’m not terribly worried this time,” Mitch Rubin, co-chief investment officer at RiverPark Capital Management LLC, tells Bloomberg.  Speaking of tech, Rubin reasoned that: “The strategies of using the internet for commerce or the internet for media and connectivity – we still think those businesses will thrive in an accelerated fashion and we don’t want to trade away from them.” 

Last week’s hiccup aside, growth bulls are sitting pretty. But might a recent turn in conditions in the new issue market presage a wider sea-change in the growth stock regime? Citing data from Dealogic, tech site The Information reports that so far this year, more than 40% of tech sector initial public offerings slipped below their IPO price a week after trading, up from 27% two years ago.  Similarly, the proportion of new offerings trading above their IPO price after six months slipped to 53% last year from 61% in 2018.   The worm can turn on a dime, as Arnott and co. noted that value lagged growth by 4,000 basis points over the 14 years through 2000, before erasing that yawning gap in a mere 13 months. 

Recap Nov. 16

Stocks enjoyed another vigorous bid, as the S&P 500 rose 1.2%, finishing at a session high to extend to a 12.3% year-to-date advance in tandem with the first sub-23 close on the VIX in almost three months.  Treasurys mostly held steady with the 30-year yield inching higher to 1.66%, WTI bounced back above $41 a barrel and gold finished little changed at $1,888 an ounce. 

- Philip Grant

All in the Family
Australia's largest initial public offering of the year

Australia’s largest initial public offering of the year is coming down the pike. Dalrymple Bay Infrastructure Ltd., operator of the Dalrymple Bay Coal Terminal (DBCT), yesterday issued terms to investors for its upcoming debut on the Australian Stock Exchange. The prospectus is likely to be filed with regulators next week, with trading set to begin on Dec. 10.  

DBCT is seeking to raise at least A$656 million ($479 million), which would bestow a A$1.3 billion market cap on the 37-year old facility, reports the Australian Financial Review.   The company’s target A$3.1 billion enterprise value is equivalent to just under 17 times forecast fiscal 2020 Ebitda, with a gaudy 7% implied annual distribution yield. 

Dalrymple, currently owned by Canadian alternative asset behemoth Brookfield Asset Management, operates the world’s largest metallurgical, or coking, coal export terminal, handling some 15% of global export volumes in 2019, according to the company. The post-IPO ownership structure will remain close to home, as Brookfield will maintain a 49% stake while the government-owned Queensland Investment Corporation’s Futures Fund has committed A$128.5 million to purchase a 9.99% position. 

Needless to say, the floatation of a major coal asset comes at a less than ideal time as environmental, social and governance-based investing themes are all the rage currently.  The green zeitgeist is similarly prominent at a national level as several major developed nations, including Germany, Japan and Korea, (the latter pair being major importers of Australian coal) have declared they intend to achieve net-zero carbon emissions by 2050.  Non-ESG factors have also hurt, as China unofficially halted imports on Australian coal in October thanks to an ongoing diplomatic rift between the pair. 

Operational wiggle room looks to be limited, as the company is set to carry pro forma net debt of nearly $A2 billion, equivalent to 10 times consensus 2020 Ebitda.  The virus has, of course, also taken a toll. Volumes over the three months through September came to 12.8 million tons according to the Queensland Port Authority, down 20% from a year ago.  

A bright (projected) future contrasts with those daunting current realities. In an Oct. 28 report, independent investigative journalist Michael West identified a pair of “very aggressive assumptions,” which underpin the deal.  First, Dalrymple’s pro forma financial statements imply that its debt coming due within the next five years will be successfully refinanced into principal-only bullet loans, a prospect which could be difficult considering that the company had to abandon a local bond offering earlier this year.  

The other bullish leap of faith rests on a friendly tweak from the Queensland Competition Authority. Currently regulating the entity as a monopoly, the QCA uses an interest rate-sensitive formula to establish Dalrymple’s revenue rate, a fact which is bad news for shareholders considering this year’s price action in developed-nation sovereign interest rates.  In early June, the QCA extended Dalrymple’s monopoly designation for another 10 years.  

For its part, Brookfield claims that an August draft decision from the QCA raises hope that the regulator may relax its stance and allow the company a more lucrative fee structure (a final ruling is expected in early 2021).  However, West walked through the math related to the repayment of DBCT’s debt load, concluding otherwise: 

Brookfield-generated pro forma financials seen by Michael West Media show that management expects A$98 million in funds from operation (FFO) in 2021. A prudent 60% payout implies that about A$60 million will be available for distribution. 

Many professional investors would adjust financials to incorporate the payment of principal along with interest to estimate a sustainable dividend. If we assume that the debt is amortized over 20 years, distributable cash flow declines 61% to A$38 million. If, a more reasonable proposition, debt is amortized over 15 years, FFO declines 94% to A$5 million, not enough to fund much, [if] any, dividend.

The probability of the QCA making a 180-degree turn and deregulating DBCT seems low. Brookfield’s actions suggest that not even they believe it.

In a follow-up yesterday, West notes that the Queensland pension fund’s large ownership position further muddies the waters: 

How will the QCA make an impartial decision that is best for the market, and the terminal’s owners and users, when a sister branch of government is making a very public bet that it will get a favorable ruling? 

Time will tell, on that score. 

Friday Nov. 13

Friday the 13th was no cursed affair for the bulls, as the S&P 500 rose by nearly 1.5% to reach a fresh all-time high, taking out the prior peak reached on Sept. 2. Treasurys took a rest following some volatile trading earlier this week, as the 30-year yield held at 1.64%. WTI crude pulled back toward $40 a barrel, gold lifted to $1,887 an ounce to continue its climb, and the VIX plunged to a 10-week low near 23. 

- Philip Grant

From Muskogee
Red-ink gusher.

Red-ink gusher. A trio of high-yielding, midstream pipeline energy companies featured as picks-to-click in the Jan. 24 edition of Grant’s.  The timing of that bullish analysis was less than superlative, as the Alerian Midstream Energy Index generated a minus 31% return over the intervening eight-plus months. 

The triptych saw widely disparate results: One, The Williams Companies, Inc., (WMB on the NYSE) has fared relatively well with a 7% decline, inclusive of dividends. Another, Enbridge, Inc. (ENB on the NYSE) has performed slightly better than its peer group with a 25% drop, while the last, Oneok, Inc., (OKE on the big board) has been a disaster with a 55% total return loss.  

Following is a reappraisal of beaten-down Oneok, which now sports a 12% dividend yield and enterprise value equivalent to 9.3 times next year’s Ebitda estimate (down from a 4.9% yield and 13.5 times EV-to-forward Ebitda in January).  As “cheap” has become “much cheaper,” are better days finally ahead?

Tulsa-based Oneok, which was founded in 1906 as the Oklahoma Natural Gas Co., operates natural gas and natural gas liquid (NGL) processing plants, as well as pipelines and storage facilities. Midstream companies, which own and operate interstate oil and gas pipelines, enjoy highly transparent revenues under long-term, fee-based regulated contracts, providing something of a buffer to price fluctuations in the underlying commodity.  

However, the spring demand shock and subsequent supply bulge wreaked havoc on the sector (recall that WTI careened into negative territory in April). OKE was certainly not exempt as revenues over the first six months footed to $3.8 billion, down 27% from the first two quarters of 2019. 

Operational risks further complicate the picture. The company carries substantial exposure to the politically contentious Dakota Access Pipeline (DAPL), which can carry up to 570,000 barrels per day of crude from the Bakken field in North Dakota. In July, a federal judge ordered the pipeline shut for an environmental review after opposition from the local Standing Rock Sioux tribe and other indigenous groups.  The U.S. Court of Appeals for the District of Columbia is expected to render a verdict late this year or early 2021, Bloomberg reported last week. 

The incoming Biden administration poses its own threats for the midstream operators, even if Republicans manage to maintain control of the Senate.  “In the absence of legislation, you’re going to try to do what you can through administrative action,” Christine Tezak, managing director at ClearView Energy Partners, told The Wall Street Journal yesterday of the inbound executive branch. 

Virus-induced stress compelled balance sheet maneuvering, as Baa3/triple-B-rated Oneok sold $1.5 billion in debt (retiring a $1.25 billion term loan due next year) and $954 million in equity during the second quarter, shoring up liquidity but diluting shareholders while driving net debt to $13.9 billion, up $1.1 billion compared to the end of 2019.  With annual dividend costs running at about $1.7 billion (well above the $1.1 billion in operating cash generated in the first nine months of the year), the current payout level may be difficult to maintain. 


On the other hand, Oneok’s Oct. 28 earnings release was not without notable positives: Third quarter adjusted Ebitda came in at $747 million, 11% above the consensus estimate of $673 million, while the company forecast full-year 2021 adjusted Ebitda of $3.1 billion, topping Wall Street consensus of $2.8 billion. 

Pared back spending needs should help: Declaring on the third quarter conference call that most all  “active capital growth projects” are behind them, management pegged the annual capital expenditure run-rate at $300 million to $400 million next year and in 2022.  For comparison, capex footed to $6 billion across 2018 and 2019. 

The Oneok c-suite, characterized by one investor we know as “very, very disciplined,” indicated that Bakken volume growth can continue in the mid-single-digit percentage range even in the event of a DAPL shutdown, as a number of producers in the area have discussed alternative modes of transport such as rail. 

Net leverage stood at 5.2 times Ebitda as of the third quarter, up from 4.5 times in January and far above the company’s long term (and pre-virus) target of 3.5 times.  The bond market isn’t too alarmed, however, as OKE’s senior unsecured 3.1% notes due 2030 last traded at a 234 basis point pickup over Treasurys. That’s not far from the 218 basis point average spread for triple-B-rated midstream issuers calculated by CreditSights at the end of October.

As for balancing the competing goals of maintaining a hefty shareholder payout while simultaneously cleaning up the balance sheet, president and CEO Terry Spencer had this to say Oct. 28: 

With earnings strength expected in the fourth quarter and into 2021, we expect distributable cash flow to cover both the dividend and our 2021 capital expenditures, as we continue on our path to deleverage. As always has been the case, the dividend remains a potential lever we could pull if our deleveraging expectations are not being met.

A businessman’s risk in the Sooner State. 

QE Progress Report
A $16.1 billion weekly increase in Reserve Bank credit pushed the total quantity of interest-bearing assets at the Fed to a fresh record high of $7.126 trillion.  The three-month annualized growth rate rose slightly to 12.6% from 11.8% last week, while year-over-year growth continues to tick lower, to 79% today from 79.9% a week ago. 
Recap Nov. 12

A monster rally in Treasurys erased much of the recent selloff in rates, as the 10- and 30-year yields fell 9 and 10 basis points to 0.88% and 1.64%, respectively.  Stocks came for sale with the S&P 500 falling 1%, as the broad index has now lost 3% from Monday’s euphoric cash open to bring year-to-date gains back below 10%.  WTI crude held near $41 a barrel, gold rose to $1,875 an ounce, and the VIX bounced by 8% after logging its first sub-24 close since August yesterday. 

- Philip Grant

Price Hoppers
"About as bullish as you could want,"

“About as bullish as you could want,” is how Charlie Sernatinger, head of global grain futures at ED&F Man Capital Markets, characterized today’s reading of the USDA’s World Agriculture Supply and Demand Report (WASDE).  Indeed, the report, which forecasts a dry season in international crop mainstay Brazil, helped push soybean prices to their highest level since July 2016, while corn rose to a 15-month high, 37% above its August lows. 

The latest jump in crop prices comes as food inflation has already accelerated across Latin America.  Brazilian consumer price inflation rose at a 0.86% sequential pace last month, its fastest October clip in 18 years, with food and drink prices rising 1.9% from September (following a 2.3% jump from August) as certain staples like rice and tomatoes surged by more than 10% from a year ago.  Brazil’s Selic target interest rate stands at 2%, down from 14.25% in fall 2016. 

In Mexico, October CPI rose 4.1% from a year ago, above the plus-or-minus 1% band on the central bank’s 3% inflation target, as fruit and vegetable prices soared 16.2% year-over-year. That unwelcome development looks set to put the brakes on Banxico’s easing cycle, which has included 11 rate cuts totaling 400 basis points over the past 15 months, leaving the benchmark overnight rate at 4.25%.

Spice of Life
Great quarter, guys?

Great quarter, guys?  Yesterday, SoftBank Group Corp. reported ¥628 billion ($6 billion) in net income for the three months ended Sept. 30, almost double the high analyst estimate of ¥350 billion. The Vision Fund, SoftBank’s in-house v.c. arm, was the star of the show, generating a record ¥784 billion in profit over that period.  

Key portfolio contributors included Chinese property startup KE Holdings, Inc., along with slightly more seasoned public businesses such as Uber Technologies, Inc. (Almost Daily Grant’s, Nov. 3), as the fund managed to turn the page on last year’s outsized losses following the WeWork fiasco. “The Vision Fund’s performance was very encouraging,” said Bloomberg Intelligence analyst Anthea Lai. “They have pulled off a U-turn.” 

As for the widespread media reports that the Vision Fund acted as the “Nasdaq Whale” over the summer, helping to spur an acceleration of the tech-stock rally through aggressive option trades, Vision Fund CEO Rajeev Misra quipped in October that SoftBank “is not even a dolphin, forget being a whale.” SoftBank founder and CEO Masa Son said the options positions account for just 1.2% of total company shareholdings. However, the company acquired some ¥1.7 trillion worth of “highly liquid listed stocks” in the third quarter, including outsize positions in Amazon.com, Inc., Facebook, Inc. and Zoom Video Communications, Inc.  “I can hear people [asking], what’s he doing now investing in public companies?”  Son asked, then answered: “These are investments in the artificial intelligence revolution.”

A different sort of revolution is underway at SoftBank itself. Bloomberg reported Friday that the organizational rise of former Wall Street investment bankers has coincided with SoftBank’s recent pivot “from running technology businesses to an investment-holdings model.” Prominently included in those ranks: A quartet of Deutsche Bank alums, each with “a history of making risky bets that characterized the German lender in the years before the 2008 financial crisis.” 

For his part, Son went with a cooking analogy to explain the strategy shift: “If [long-term investing] is spaghetti, this is the spice.”

A pending logistical decision may add some additional seasoning to the dish. The Financial Times reports that the Vision Fund has “been holding internal discussion over whether to relocate” to Abu Dhabi from the United Kingdom.  The move, which has been under consideration for “several weeks,” would be driven by tax considerations as well as the potential to “put distance” between Vision Fund parent SoftBank Investment Advisers and the U.K. regulatory apparatus.  In undertaking such a move, SoftBank would also seem to be distancing itself from both a deep pool of technology investors and the transparent rule of law. 

Recap Nov. 10

A flat day for stocks (as measured by the S&P 500) featured another notable rotation away from the high-flyers, as the Nasdaq 100 Index tumbled 1.7% while the small-cap Russell 2000 darted higher by 1.8%.  Treasurys came under pressure again, with the long bond rising to 1.74%, within five basis points of its March highs, while WTI crude extended its rally above $41 a barrel, gold bounced to $1,872 an ounce and the VIX ticked below 25. 

- Philip Grant

What's in Your Wallet?

More strange doings in crypto.  Crypto lending service Cred, Inc. filed for chapter 11 bankruptcy over the weekend, with estimated liabilities of between $100 million and $500 million, against assets of $50 million to $100 million. 

That follows an Oct. 28 letter in which Cred announced a two-week suspension of fund inflows and outflows on account of “irregularities” in the administration of “specific” corporate funds from “a perpetrator of fraudulent activity.” 

Also, over the weekend, crypto wallet and trading venue Uphold declared it has “decided to discontinue its relationship with Cred.”  Cointelegraph reported that multiple Uphold users have complained of being locked out of their Cred-linked funds, with one account HODLer unable to access some $140,000 worth of bitcoin and other cryptocurrencies.  Uphold announced on Twitter yesterday that it will seek legal remedies for its customers, owing to alleged “breach of contract, fraud, and other claims.” 

Ketchup Pack
How the turntables have turned.
How the turntables have turned.  This morning’s news of Pfizer, Inc.’s seemingly effective COVID vaccine spurred no small amount of euphoria, as the S&P 500 and Russell 2000 indices shot higher by 3% and 4%, respectively.  It was far from a broad-based rally however, as the Vanguard Value ETF jumped by 4% while the growth-heavy Nasdaq 100 shed more than 2%. 
Of course, one day does not a trend make, and proponents of value-oriented stocks have suffered years of underperformance while watching a handful of high-flyers dominate the market. So far this year, the Nasdaq 100 sits higher by a cool 35%, while the Vanguard Value ETF remains lower by about 5%.  According to Verdad Capital, October marked only the third monthly period in the past two years in which small-cap value outperformed large-cap growth.  
In a commentary today, Dan Rasmussen and Nick Schmitz at Verdad compare the performance figures for those categories over three-, five-, 10- and 50-year time horizon, finding that:
Small-cap value worked about 50% of the time, and when small-cap value worked, the margin of outperformance was significantly larger than the margin of underperformance when it didn’t work. More importantly, the more extreme the bet on small value, the better the performance over the full period, according to our research.
The pair also note that a return to that historical trend could have a major impact on the relative performance of the major indices: 
Most invested dollars in the stock market are currently crowded into the extremely liquid, cap-weighted indexes, which are disproportionately concentrated in large growth stocks
To be sure, it’s been a slog for value-minded investors, as the post-2007 era has been historic in its pro-growth bent.  A paper posted to the Research Affiliates website in August by founder and chairman Rob Arnott, along with Vitali Kalesnik and Campbell R. Harvey of Duke University and Juhani Linnainmaa of Dartmouth College, found that growth stocks trounced value by 55% over the 13.5 years through June 2020. That’s the longest-running period of value underperformance since at least 1963.  Drawing an analogy with the Nasdaq-led bull market rampage of the late 1990’s, the quartet noted that “the valuation spread between growth and value is wider than it was at the peak of the tech bubble.”
That Y2K-era turn is a potentially instructive one, as Arnott noted to Grant’s on Sept. 4 that value had lagged growth to the tune of 4,000 basis points over the 14 years through 2000, necessitating 6,700 basis points of outperformance to break even.  The value contingent subsequently erased all of that gap within 13 months. 
Arnott put it this way in the Sept. 4 issue of Grant’s
I look at today’s markets as a remarkable time to ramp up value exposure to more or less as high a level as an investor can tolerate for a year of disappointment.  I normally say only as far as you can bear two years of back-to-back disappointment. Today I set that aside because it seems like such an extraordinary bubble.
Recap Nov. 9

A Treasury rout accompanied today’s selective rip in stocks, as the 10-year yield jumped to as much as 0.96%, its highest since March.  Gold was hammered by more than 3%, settling at $1,864 an ounce, while WTI soared by 8% to $40 a barrel, its best finish since Oct. 22.  The VIX enjoyed a strong bounce after last week’s outsize decline, rising 4% to finish near 26.  

- Philip Grant

Musical Chair
"Very large" on the way to "very larger?"

“Very large” on the way to “very larger?”  Yesterday’s meeting of the Federal Open Market Committee maintained the status quo, with the funds rate and asset purchase schedule unchanged at a range of 0% to 0.25% and $120 billion per month, respectively.  

While describing the existing monetary stimulus as “very large,” chairman Jerome Powell predicted that “we may reach a view at some point that we need to do more on that front.” 

The chairman went on to prime the rhetorical pump, declaring that: “We understand the ways in which we can adjust the parameters of it to deliver more accommodation if it turns out to be appropriate.” At the same time, Powell continued to bang the drum for another fiscal spending acceleration from Congress: "All of us lived through the years after the global financial crisis, and for a number of those years fiscal policy was very tight. . . Further [economic] support is likely to be needed to avoid further spread of the virus and help individuals who, with the expiration of the CARES Act payments, are seeing their savings dwindle." 

While the Fed urges Congress to turn on the spigots, key legislators instead look for the central bank to help lead the way.  Bloomberg reports that four senators, including minority leader Charles Schumer (D-NY) and Elizabeth Warren (D-MA), sent a letter to Powell and Treasury secretary Steven Mnuchin yesterday urging an expansion of the lending and asset purchase programs enacted during the spring, with the quartet declaring that:  “Absent additional action, these facilities will fail to reach their full potential to support a robust economic recovery.” 

If recent form holds, they won’t have to ask Jerome and Co. twice. 

Damage Assessment
Income evisceration continues apace.

Income, interrupted.  This morning, the global stock of nominally negative-yielding debt rose to $17.05 trillion, surpassing the previous high-water mark established in August 2019 for the once-inconceivable (prior to this cycle anyway) milestone. That stack of subzero debt includes more than a quarter of all worldwide investment-grade debt, Bloomberg reports. 

Evaporating yields in tandem with rollicking risk appetite form a potent cocktail for the most speculative corners of the credit market.  Following an outsized (by the asset class’ standard) 0.52% two-day rally on Wednesday and Thursday, the S&P/LSTA Leveraged Loan Index has now clawed back into the green year-to-date, fully erasing losses of as much as 20% in March. 

On the corporate bond side of the coin, the most speculative junk bonds have likewise enjoyed a face-ripping rally, with spreads on the triple-C component Bloomberg Barclays High Yield Index collapsing to 831 basis points, down from a peak above 1,800 basis points in March and well below the 949 average pickup over the last 20 years.  The triple-C tranche sports a yield-to-worst of 8.95%, the lowest on a nominal basis since the middle of 2018. 

Yet ongoing fundamental danger belies those impressive price recoveries. S&P noted on Monday that LCD’s “weakest links” (encompassing borrowers rated single-B-minus or worse, along with a negative outlook) footed to 22.5% of the leveraged loan universe as of Sept. 30.  That’s down from a June 30 peak of 25% but double the year-end 2019 level, which in turn roughly doubled from the end of 2018. At the bottom of the ratings barrel, some 10% of the index is comprised of credits rated triple-C-plus and below, up from 6% at the end of 2019. S&P also notes that 25% of the 145 weakest links at year-end 2019 had defaulted as of Sept. 30.  The broad loan default rate stood at 4.64% at the end of the third quarter, the highest level since August 2010. 

It’s a similar story in high yield, as Moody’s B3N List, which also measures corporate borrowers rated the equivalent of single-B-minus or lower along with a negative ratings outlook, accounted for 26.1% of the market as of Sept. 30. That’s down from a June peak of 27.5% but still matches the high of the great recession in May 2009.  Then, too, the default picture is shaping up similarly to that at the the financial crisis’ nadir. Moody’s forecasts baseline and bear-case default rate scenarios of 11% and 14.7%, respectively, next year.  That compares to a 13.3% peak in September 2009, itself a post-1983 high. 

While the fundamental picture echoes that of the end of the last financial crisis, the pricing environment is drastically different. Thus, the triple-C portion of the Bloomberg Barclays High Yield Index traded at a 1,460 basis point pickup on May 31, 2009, 75% wider than today’s levels.  

Speaking of the triple-C-contingent back in August, Oleg Melentyev, head of U.S. high-yield credit strategy at Bank of America Corp., presciently told Bloomberg that yield-starved creditors “have no choice. They’re going to have to go there.”  Do they have to stay? 

Recap Nov. 6

A sideways day for stocks allowed the S&P 500 to close out the election week with a monster 7.3% gain, as the broad average closed within 2% of its Sept. 2 high-water mark, while Treasurys came for sale with the 10- and 30-year yields rising six and eight basis points, respectively, to 0.82% and 1.60%. Gold climbed to $1,952 an ounce, WTI retreated to $37 a barrel, and the VIX slipped below 25 for the first time since August. 

- Philip Grant

The Race is On
Reflation, interrupted?

Reflation, interrupted?   As prospects for a Democrat “blue wave” engulfing Congress and catalyzing a massive fiscal response dwindle, long-dated Treasury yields have tumbled while the 10-year TIPS breakeven rate, a market-derived inflation forecast, plunged 10 basis points to 1.65% yesterday.  

Yet, as the Federal Reserve continues to advocate for a consumer price acceleration through so called symmetrical inflation targeting (i.e., allowing measured prices to rise at more than 2% per annum for sustained periods without any policy response), evidence suggests the central bankers may soon get their wish.  A trio of such sightings:

Yesterday, voters in Florida overwhelmingly (some 61% said yay) supported a ballot measure raising the minimum wage by 50% to $15 an hour, becoming the eighth U.S. state to implement that hourly floor.  The decision is notable for a number of reasons, including Florida’s large size, generally right-leaning political bent (President Trump carried the state on Tuesday), and heavy reliance on the generally lower-paying service industry to power the local economy.  Overall, the decisive result “signals to federal lawmakers that this is an issue that they can’t ignore,” David Cooper, senior analyst at the left-of-center Economic Policy Institute, told Yahoo!

Next, higher prices are coming to a highway near you.  The Journal of Commerce reported yesterday that, as excess trucking capacity has tightened to multi-year lows, industry players are forecasting contract rate increases of as much as 15% in 2021.  Driver shortages figure prominently in the equation, as data from the Bureau of Labor Statistics find that long-distance truckload employee headcount fell to 1.45 million in September, down 73,200 from a year ago.  

The virus has also played a role, with some 30,000 drivers still prohibited from returning to work after testing positive. Bob Costello, chief economist for the America Trucking Association, reported last month that some 80% of that cohort “have not even attempted to take the steps they need to return to duty. They’ve thrown in the [towel].”   The shortage is now front-of-mind for industry executives.  “Driver availability is [as] difficult in the present environment as I’ve seen in my 30-plus years in the industry,” commented Mark Rourke, president and CEO of Schneider National, on an Oct. 29 earnings call. 

Then, too, food prices around the globe have legged higher.  According to the United Nations Food and Agricultural Organization’s monthly index, global food prices rose 6% from a year ago in September, returning to their January levels which were themselves near a multi-year high. 

Bloomberg notes that the combination of Covid-induced supply-chain stress and adverse weather, including droughts across much of the U.S., Russia and Brazil, is wreaking havoc with crop supplies and driving prices higher.  The Bloomberg Agriculture Spot Index is up 25% since late June and established a four-plus-year high on Oct. 23.  “The fundamentals have changed dramatically since May,” Don Roose, president of Iowa-based brokerage U.S. Commodities, told Bloomberg. “We have demand chugging in a bull market.”

Might the Federal Reserve and their fellow inflation cheerleaders soon get their wish?   An Oct. 20 commentary from Bianco Research co-founder and eponym Jim Bianco identifies a key variable in the future path of prices:  A mushrooming federal deficit. 

Thanks to federal spending equivalent to 33.5% of output (dwarfing the 24.5% seen at the end of the financial crisis in 2009) Uncle Sam’s fiscal 2020 shortfall stood at more than 15% of GDP. That’s the biggest gap since World War II, and matches only a few instances in U.S. history, including 1864, 1919 and 1943 to 1945. Noting that each of those epochs coincided with or was soon followed by a rapid increase in the price level, Bianco writes that: “Huge deficits mean huge spending. Huge spending bids prices higher, otherwise known as inflation.”   A lasting period of inflation would carry significant consequences.  Bianco concludes:

Think of the Fed as a post and the bond market as a horse tied to that post. The horse will remain in place, tied to that post, unless spooked by inflation. The horse has the ability to rip that post from the ground and run wild. The post cannot stop a scared horse.

We have argued the 0.33% low in 10-year yields on March 9 marked the end of the 39-year bull market. Rates should be moving higher, but they are being suppressed via massive QE. At some point we expect the “horse” to tear the post from the ground and start running with higher yields.

QE Progress Report
Balance sheet growth takes a breather, as Reserve Bank credit (the sum total of interest bearing assets at the Fed) edged lower by $14.6 billion to $7.11 trillion, just off the high-water mark set last week.  The three-month annualized growth rate rose to 11.8% from 10.1% a week ago, while the year-over-year uptick slipped below 80%. 
Recap Nov. 5

Yet another turbocharged rally saw the S&P 500 tack on another 1.9%, to extend its gains for the week so far to a cool 7.4%.  Treasurys consolidated after yesterday’s plunge in yields, with the 30-year bond holding at 1.53%, while the VIX fell below 28 with a 27% week-to-date loss. WTI crude ticked below $39 a barrel, and gold and silver ripped to $1,949 and $25.40 an ounce, respectively, the best close for each since Sept. 18. 

- Philip Grant

Catch 22
The "side hustle" lives.

The “side hustle” lives. Yesterday, California voters passed Proposition 22, delivering a key win for Uber Technologies, Inc. and its gig economy peers, as the companies can continue to classify their drivers as independent contractors rather than costly employees entitled to healthcare and other benefits.  

In reaction to the successful lobbying efforts (on which Uber and friends reportedly spent more than $200 million), shares in Uber and ride-share peer Lyft, Inc.  jumped 15% and 11%, respectively, adding more than $10 billion to their combined market capitalizations. “Two hundred million plus is much cheaper from their perspective than paying the employees these benefits that the legislature has established for them,” William Gould, professor at Stanford Law School and Clinton-era chairman of the National Labor Relations Board, tells Bloomberg. 

While shareholders celebrate their political triumph, fundamental limitations to Uber’s business model remain firmly in place.  Profitability remains a pipe dream for the 11 year-old enterprise, as Uber has generated a combined $18.8 billion in negative adjusted Ebitda and burned through $18.5 billion in cash over the 4 1/2 years through June 30, while even the bulled-up sell-side (consisting of 36 “buy” ratings compared to only four “holds” and a solitary “sell”) expects both cash burn and “adjusted adjusted” red ink to continue in 2021. Tellingly, the pandemic-related collapse in fares has helped the income statement, as Uber’s second quarter operating loss fell to $1.6 billion, compared to $5.5 billion a year ago. 

At the same time, the company commands a premium valuation, with enterprise value equivalent to 4.4 times consensus 2021 revenue.  By comparison, the sometimes-profitable airline industry trades at 1.3 times EV-to-2021 sales. 

Back to your regularly scheduled programming. 

By Hook or By Cook
As the dust settles, some immediate post-election fallout:

As the dust settles, some immediate post-election fallout:  A setback for Illinois municipal credit, as a ballot measure to change the state constitution and allow for a graduated income tax instead of the current flat 4.95% rate was soundly defeated at the polls. The state needed 60% of direct amendment votes or 50% of all ballots voting “yes” to pass the amendment. Instead, roughly 55% of those voting directly on the amendment were in the “no” camp. 

The Chicago Tribune termed the result “a huge setback” for governor J.B. Pritzker, who had made the proposal a “signature campaign issue.” Instead, the revenue collection efforts ran headlong into “voter disdain of any tax-raising issue.” 

Now, unpaid bills are piling up.  The state general fund faced a $7.65 billion payable backlog as of Sept. 21, 42% above its June 30 level.  S&P Global noted that that “the odds of Illinois balancing its budget without additional borrowing or a sizable increase in the bill backlog are looking slimmer.” The rating agency, which grades Illinois triple-B-minus with a negative outlook (the last stop before junk), predicts that the state will enact some spending cuts during the fiscal year, “but these will not likely be timely enough or sufficient to address the entire budget gap.” 

The fiscal state of Illinois’ largest city serves to underscore the scope of the problem. Last week, Moody’s cut its outlook on Ba1-rated Chicago to negative, noting that the Windy City’s “revenue base is shared with other large governments,” a factor which could “constrain the city’s ability to continue addressing budgetary challenges with new revenue, especially as organic revenue growth may be slow in the wake of the pandemic.”

What now?  Another trip to the Federal Reserve’s Municipal Liquidity Fund may be in store for the Land of Lincoln, following a $1.2 billion loan from the Fed’s pandemic-era lending facility in early June after Illinois had failed to raise those funds from the muni bond market. 

Pritzker declared on Oct. 9 that, barring federal help or the enactment of the graduated income tax, the state “would need to go to the MLF borrowing facility, but we would also implement cuts.” The fiscal 2021 budget, passed in June, “allows the state to borrow up to $5 billion from the Federal Reserve that could be repaid with anticipated federal aid,” Bloomberg noted at the time. 

Might the crimped revenue potential resulting from today’s setback mean persistently higher borrowing costs?  Noting that spreads on some Illinois general obligation bonds widened by as much as 50 basis points today, Eric Kazatsky, head of municipal strategy at Bloomberg, tells Grant’s that the tax law “appeared to be the line in the sand for some rating agencies and the market, with spreads widening. . . in anticipation for a spate of downgrades and reduced appetite from funds with inability to hold junk rated paper.” 

Kazatsky continues: “The larger concern for me centers around the access to the Fed’s MLF program and if all raters move to junk, the penalty rate will be much higher than the last time they accessed the program.”

Recap Nov. 4

Stocks enjoyed another yuge rally, with the S&P 500 tacking on another 2.3% to extend its three-day rally to 5.3% and all but erase last week’s steep selloff.  Treasurys likewise enjoyed a screaming rally, with the 30-year yield plunging 14 basis points to 1.54% and squeezing the shorts (Almost Daily Grant’s, Nov. 3).  Gold pulled back to $1,902 an ounce, WTI rebounded to $39 a barrel, and the VIX collapsed by 17% to 29.5.

- Philip Grant

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