Loan and Behold
The good times continue to roll for private equity.

The good times continue to roll for private equity. “This is just an amazing time for our business,” Marc Rowan, CEO of Apollo Global Management, declared last week. Blackstone, Inc. boss Steve Schwartzman likewise termed the recently-completed third quarter “the best results in our 36-year history.”

With the wind at their backs, the p.e. barons have little trouble gathering new assets. Blackstone and peer Carlyle Group are reportedly in the process of raising new flagship funds at near $30 billion each, while fellow operator Advent International is seeking to conjure a new $25 billion fund, Bloomberg relays today. Advent, which currently manages $81 billion, raised a $17.5 billion fund only two years ago. 

That fundraising blitz comes as global merger and acquisition volume reached a record $1.5 trillion in the third quarter per Preqin, while the three-quarter total of $4.3 trillion already tops the prior full-year record of $4.1 trillion established in 2007. 

Naturally, wide-open capital markets and boom times for p.e. go hand in hand.  To that end, some $10.6 billion in domestic leveraged loans came to market last week according to S&P’s LCD unit, with more than half of those proceeds used to finance leveraged buyouts or mergers and acquisitions.  Year-to-date volumes of speculative-grade bank debt stood at $527 billion as of Friday, easily topping the $505 billion, full-year record established in 2017.

Proliferating dividend recapitalizations, or debt-financed payouts for private equity sponsors, further underscore the current state of play. Year-to-date domestic debt issuance volume for that purpose stood at $58.5 billion through last Wednesday, according to data from LCD.  That exceeds the previous full-year record high of $51.1 billion set in 2013, as well as the combined total across 2019 and 2020. 

“The market has been generous for dividend recaps. Negotiations are such that private-equity firms are able to negotiate very friendly agreements, [featuring] attractive pricing alongside very generous terms,” Christina Padgett, head of leveraged finance research at Moody’s, told The Wall Street Journal.  While the p.e. sponsors look out for number one, the corporate borrower deals with the aftermath. “It’s more stress on the company because you have increased interest expense. You might have a trade-off of where you’re going to spend your cash flow, to reinvest or service your debt,” Padgett added. 

From the promoter’s perspective, that spate of dividend recap supply “lays bare private equity firms’ intentions to recoup their investments” after paying up for acquisition targets, analysts at Moody’s wrote in a Sept. 14 report.  The median p.e. buyout took place at a 13.5 enterprise value-to-Ebitda ratio over the first six months of the year according to data from Pitchbook, up from less than 10 times in 2007.  

Higher prices invite more aggressive capital structures:  Median LBO debt to Ebitda ratios reached a record 7.5 times Ebitda year-to-date through June 30, up from 6.1 times Ebitda in 2007. Even that jump in purchase prices and leverage ratios may be understated, thanks to increasingly-common Ebitda add-backs (or credit for hypothetical future cost savings). An analysis from S&P Global last year found that reported net leverage among 2017 vintage deals stood 2.8 turns higher than management had projected by the end of 2018, and 3.3 turns higher as of Dec. 31, 2019. 

At the same time, ever-diminishing legal protections for creditors demonstrate the extent to which borrowers call the shots in the p.e.-dominated leveraged loan market. The share of institutional loans categorized as covenant-light reached 90% in the first half of 2021 according to Debtwire, up from 74% in 2019 and just 50% in 2013.  As Moody’s notes, lenders have permitted leveraged loan borrowers to use 100% of cash on hand for dividends, on average, irrespective of leverage or earnings.  Fixed cash restricted payment baskets, or funds which can be used for dividends without constraint from any financial ratios, averaged 11% of total assets last year, nearly double that seen in 2017. 

Indeed, the LBO machine has contributed to a broad decline in credit quality, as nearly 40% of the domestic speculative-grade universe carries a rating of single-B-minus or below, S&P found in September, more than double the share for that low-rated contingent seen in both 2007 and 1999. Yet, double-B-rated credits (the last stop before investment grade) comprise about 60% of the conventional junk bond market. 

For more on the rising investment risks associated with the p.e. boom, along with a bullish analysis of a public company employing some of the industry’s opportunistic wheeling-and-dealing strategies, see the most recent edition of Grant’s Interest Rate Observer dated Oct. 15. 

Recap Oct. 25

Stocks caught a solid bid to begin the week, with the S&P 500 advancing 50 basis points, while the Treasury curve edged a bit steeper with the two-year yield declining to 44 basis points and the long bond ticking to 2.08%.  Gold logged a fresh six-week high at $1,808 an ounce, WTI crude stayed at $83.50 a barrel and the VIX remained near its virus-era lows at 15. 

- Philip Grant

2020 Vision

“Supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages,” Fed chair Jay Powell predicted today.

On that score, the central bankers can take comfort in a job well done. A headline blast from the not-so-recent past, courtesy of Twitter user @RudyHavenstein: 

All the World's a Stage
Gone in 60 seconds.

Gone in 60 seconds.  Shares in Snapchat parent Snap, Inc. endured a 27% swan-dive today, after the social media outfit predicted fourth quarter revenue growth of 30% from a year ago and adjusted Ebitda of $155 million, using the midpoints of provided ranges, far below the 48% and $299 million respective consensus estimates.  Big picture considerations figure in that shortfall, as supply-chain snafus and cost-side pressures have thrown advertising budgets for a loop, imperiling the platform’s primary revenue source. 

Competitive maneuvering among the big tech cohort presents another aggravating factor, as Apple’s new data collection rules require apps on its iOS 14.5 platform to ask user permission to be tracked. Many users have duly declined the services of digital big brother, leaving advertisers unable to target individuals as effectively, driving up customer acquisition costs and crimping Snapchat’s business model.  “Management almost couldn’t have sounded worse around the effects this is having” RBC Capital Markets analyst Brad Erickson wrote. 

That phenomenon is not confined to Snapchat. Digital ad agency MuteSix relays to The Wall Street Journal that its direct-to-consumer clients have seen ad prices on Facebook, Inc. rise by an average of 25% since Apple enacted that change beginning this spring. Facebook shares sank by 5% today and are up 93% from a bearish analysis in the Aug. 11 pages of Grant’s Interest Rate Observer, trailing the 172% advance for the Nasdaq 100 over that period. 

Mark Zuckerberg’s social media monolith may face problems above and beyond the machinations of its Silicon Valley rival: namely, the veracity of the firm’s self-reported user data.  As documents procured by the financial press from whistleblower Frances Haugen show, an internal study of 5,000 new U.S. users conducted this year found that between 40% and 60% of those accounts duplicate an existing Facebook profile. In addition, company memos from 2018 suggested that encouraging younger users to open multiple accounts would drive engagement, “large growth and sharing increases.”  Market penetration among teenagers stands above 100% in both the U.S. and the U.K., internal documents show. 

“It’s not a revelation that we study duplicate accounts, and this snapshot of information doesn’t tell the full story,” retorts company spokesperson Joe Osborne. “Nothing in this story changes the estimate of duplicate accounts that we disclose in our public filings.” 

Indeed, the prospect of puffed-up user data is far from a new revelation. As then-Pivotal Research analyst Brian Wieser told Grant’s in 2017, Facebook’s self-identified a domestic addressable market of 101 million 18 to 34 year-olds, far above the 76 million Americans within that age bracket identified in the U.S. census.  Then, too, company-reported North American daily active users and monthly users as of January 2019 represented 80% and 105%, respectively, of the 231.2 million total population aged 15-64 in the U.S. and Canada a month earlier (comprising much of Facebook’s target demographic as users must be at least 13 years old), according to the Organization for Economic Co-operation and Development. 

Such estimates of potential market size represent “a starting point of our strategic conversation with our clients,” Darren D’Altorio, head of social media at digital marketing agency Wpomote, tells the Journal. “If your goal as an advertiser is to reach the most number of people at the lowest cost, then there would be a very real impact to that number being wrong.”  Advertising accounted for just over 98% of the company’s $29.1 billion in revenue for the three months through June, and great expectations abound:  Wall Street expects Facebook’s top line to jump to $142.3 billion in calendar 2022 and $167 billion the year after, compared to $105 billion over the year ended June 30. 

To that end, recent trends are unlikely to be to advertisers’ liking.  Daily users aged 18 to 29 fell by 2% over the two years through 2021 according to company data, with a further 4% projected decline penciled in by 2023. That attrition is even more pronounced among teenagers as rival platforms like Tik Tok continue to gain traction: Facebook’s daily active users among the teenage contingent fell by 13% from 2019 to 2021 and are projected to drop by an additional 45% by 2023.

Meanwhile, the prospect of a larger-than-life entrant into the social media realm looms large, as former President Trump prepares to launch his new Trump Social, with the blank-check firm Digital World Acquisition Corp. enjoying parabolic gains since yesterday’s announcement of a merger with the Trump Media & Technology Group. That’s not to say that the lure of traditional industry players has abated, however. Bloomberg reported yesterday that Trump’s lawyers have filed injunctions asking courts to force Facebook and Twitter to temporarily reinstate his blocked accounts, arguing that he is suffering “irreparable harm” from his continued deactivation from those venues. 

Recap Oct. 22

The Treasury curve continues to pancake as the long bond dove six basis points to 2.07% while the two-year yield rose to 0.46%, its highest since early 2020.  Stocks snapped a seven-session winning streak on the S&P 500 as the broad index edged slightly lower and the Nasdaq 100 dropped by nearly 1%, while the VIX rose 3% after logging a fresh virus-era low yesterday.  Gold rallied to $1,794 an ounce, and WTI crude pushed above $84 a barrel for the first time since fall 2014. 

- Philip Grant

We Can Be Heroes
Anchors Aweigh

“Longer-term inflation expectations are anchored, at least for now,” opined Federal Reserve Governor Randal Quarles in a speech yesterday.

A Bloomberg story from this morning notes some dissenting perspectives: 

Market-implied expectations for U.S. inflation for the next half-decade surged to the highest in 15 years on Thursday as investors hedged against the risk that consumer-price pressures fail to abate. 

Ruled by Fiat
Monetary policy diktat:

Monetary policy diktat: The Central Bank of the Republic of Turkey chopped benchmark interest rates to 16% from 18% today, surprising the market as none of the economists surveyed by Reuters expected more than 100 basis points worth of easing. The lira sank by 3% in response to 9.5 per dollar, down 22% year-to-date for the worst showing vs. the greenback of any currency tracked by Bloomberg.  Pervasive price pressures, rarely associated with dramatic monetary easing, put that FX flight into context: Measured headline inflation advanced by 19.6% in September from a year ago, with “core” prices up 17%. 

Some familiar rhetoric accompanied that move, as the CBRT asserted in a statement that “it is assessed that [inflationary pressures] are due to transitory factors.” Paul McNamara, investment director at GAM, termed the decision “either brave or foolhardy” to the Financial Times, adding he “strongly lean[s] to the latter.” 

To be sure, the monetary mandarins are walking a tightrope, with existential financial risks balanced by acute political pressure.  Erdogan last week fired a trio of CBRT deputy governors who were reportedly reluctant to go along with his easy money directives, clearing the path for today’s policy move. Earlier this year, Erdogan replaced governor Naci Agbal with AK Party compatriot Sahap Kavcioglu two days after a 200 basis point rate hike, marking the fourth individual to hold that top post since 2019. 

Heavy-handed remedies for Turkey’s economic woes are not confined to the composition of the CBRT.  On Oct. 13, the Treasury and Finance Ministry announced new rules requiring money changers to log the identity of all clients. Previously, those transacting in sums of less than $3,000 enjoyed anonymity.  Turkish citizens held $233 billion worth of foreign currency deposits as of Oct. 1 per central bank data, up 20% from the beginning of 2020. 

For his part, Erdogan went on a shopping trip to an Istanbul agricultural cooperative earlier this month with media in tow, announcing that he has ordered the construction of 1,000 of those facilities to supply "cheap and high quality goods" and to "balance out markets.” Those assurances left some decidedly underwhelmed. “This is just for show, to give them the impression that there’s a solution,” a local businessman tells Reuters today. “But it’s just a lie. I looked at the prices and they’re not different from other supermarkets.”  Measured food prices rose nearly 29% from a year ago in September. 

That jaundiced view is increasingly representative.  Erdogan’s approval rating tanked to 38% in August according to Metropoll, down a hefty nine percentage points from a month earlier and the second lowest mark logged over the past six-plus years.  Captains of industry are likewise turning on the President. Omer Koc, eponymous chair of industrial conglomerate Koc Holdings, lamented the “extremely saddening” inflation scourge last week, calling for a “fundamental reform agenda” to transform the economy.  The Turkish Industrial and Business Administration chimed in on Tuesday with a call for “central bank independence and cautious monetary and fiscal policy,” in a thinly-veiled dig at the status quo.  

A high-stakes political gambit may underpin today’s head-scratching move.  Phoenix Kalen, emerging markets strategist at Société Générale, tells the FT that today’s aggressive rate cut implies that Erdogan will accelerate the next round of presidential and parliamentary elections, which are currently set for 2023, with easy money ostensibly bolstering his chances of reelection. Otherwise, Kalen added, “this decision is completely nonsensical. You’re going to spur hyperinflation and dollarization. You’re encouraging speculators to go after the currency. You’re going to hurt corporates; with all the foreign currency-denominated debt they still have. From any medium-term perspective, it is really damaging to the monetary policy framework of the country and the financial stability.” 

Damn the torpedoes. 

QE Progress Report
Reserve Bank Credit, or interest-bearing assets on the Fed balance sheet, rose to $8.52 trillion, up $85 billion from last week’s reading.  That maintains a 20% year-over-year growth rate, and 117% from holdings as of October 2019. 
Recap Oct. 21

Treasurys saw some major bear flattening action as the two-year yield jumped to 45 basis points, triple its levels seen in June, while the long bond held steady at 2.14%.  Stocks enjoyed a late ramp to leave the S&P 500 up 30 basis points to log a fresh closing high, while WTI crude pulled back below $83 a barrel and gold held at $1,785 per ounce.  The VIX fell to 15, marking its lowest close since the virus barged in early last year. 

- Philip Grant

The Advice is Free
Facebook is set to change its company name in the coming days,

Facebook is set to change its company name in the coming days, reports tech publication The Verge. The corporate rebranding, which could be unveiled at the company’s annual Connect conference on Oct. 28, will emphasize its focus on the metaverse, with the Facebook app and website assuming a place under the company umbrella alongside other divisions like Instagram and Whatsapp.  

While the social media behemoth shuffles the deck, politicians look to make hay. Washington D.C. Attorney General Karl Racine announced today that he will attempt to hold CEO Mark Zuckerberg personally liable in a lawsuit related to the 2018 Cambridge Analytica consumer data protection scandal. 

Perhaps another name change is called for: how about Mark Defendant? 

Miracle on Ice
Trouble spreads in the wake of China Evergrande Group’s collapse:

Trouble spreads in the wake of China Evergrande Group’s collapse: peer Sinic Holdings Group Co. defaulted on a $250 million note on Monday. The developer, which owes just under $700 million in dollar-denominated bonds according to data from Bloomberg, was rated single-B at S&P until a month ago.  Single-B-rated peer Kaisa Group Holdings Ltd. is likewise on the ropes, with its dollar-pay, senior secured 6.5% notes due Dec. 7 sinking to 60 cents this morning from 77 cents on Friday and near par six weeks ago. Kaisa’s offshore debt load is considerably larger at $11.6 billion.  Nine separate property developers have endured a combined 20 credit rating downgrades since the start of September, Caixin noted yesterday. 

Spreading trouble among that economically vital sector coincides with dispiriting data during the crucial fall selling season. New home sales in major cities declined 33% year-over-year during the National Day holiday spanning the first week of October, according to the China Index Academy.  Sales of existing homes (as opposed to those on the metaverse) collapsed by 63% from a year ago over the first 17 days of October, analysts at Nomura relayed Monday.  

With activity hitting the wall, measured prices have taken on a magenta hue: new home prices across 70 cities edged lower by 0.08% in September per the National Bureau of Statistics, the first year-over-year decline since 2015. “Now the priority is to prevent a state of panic,” Yan Yuejin, research director at the E-house China Research and Development Institute, tells Bloomberg. “The home market has clearly entered a downward cycle.”

As real estate represents as much as 30% of Chinese output, any lasting downshift promises to leave a mark. Fourth quarter GDP will grow by just 3.6% from 2020, Oxford Economics reckons, down from a prior estimate of 5% and a 4.9% print in the third quarter, which was already the weakest reading (excluding the pandemic and lockdown-addled 2020) on record going back to at least 1992. 

“What is the growth driver that will at least set a floor on growth? Nobody knows yet,” commented Leland Miller, chief executive of the China Beige Book, on CNBC yesterday.

Capital Idea
Exxon Mobile Corp. is considering abandoning several large-scale oil and gas projects,

Exxon Mobile Corp. is considering abandoning several large-scale oil and gas projects, The Wall Street Journal reports. As the company undertakes a review of its five-year spending plan ahead of a board vote later this month, some Exxon directors have soured on certain projects in light of their high projected carbon emissions.  Nominees from the environmentally-minded hedge fund, Engine No. 1, which managed to procure three board seats in May despite a meager ownership position of 0.02% of shares outstanding, have helped foment the resistance to those projects, the Journal relays. 

Sharply dwindling exploration and production budgets from global oil majors in the context of a currently-raging energy bull market further color that news. In July, Exxon guided 2021 capital expenditures to around $16 billion, the low end of a previously provided $16 billion to $19 billion range. That compares to $21.4 billion last year and $31 billion in 2019. Rival Chevron expects capex to remain between $14 billion to $16 billion through 2025, down from the $39.8 billion investment in 2014.  More broadly, upstream capex among nine international oil companies tracked by Bloomberg averaged about $100 billion per year across 2015 to 2019, roughly half of the levels seen in the first half of this decade. 

With producers in retreat and prices on a rampage, what’s next for the energy patch?  See the most recent edition of Grant’s Interest Rate Observer dated Oct. 15 for a closer look at the reviled but still-essential asset class. 

Recap Oct. 20

Stocks enjoyed a fourth straight green finish as the S&P 500 advanced by 40 basis points to reach the cusp of fresh new highs, while bitcoin capitalized on that renewed speculative fervor (and yesterday’s debut of the ProShares Bitcoin Strategy ETF) to rise above $66,000 for the first time.  The Treasury curve steepened again thanks in part to a weak 20-year auction, as the long bond yield reached 2.13% to reverse its recent rally, gold rose to $1,782 an ounce and WTI pushed to $83.50 a barrel.  The VIX remained below 16 for a second straight day, the first time that’s happened since August. 

- Philip Grant

Debt Showstopper
New York will advertise its municipal bonds in Broadway show Playbills, if a proposal that underwriter Rice Financial Services suggested last year takes hold.  As Bloomberg relayed Friday, Rice argues that such an approach “would directly target a captive and typically affluent demographic. Playbill is closely scrutinized by theatergoers at the commencement of a performance and during intermission.” 
Kenya Believe It
Clean energy is a relative term.

Clean energy is a relative term.  Let’s review the peculiar case of Ormat Technologies, Inc. (ORA on the NYSE), the 56-year old, Nevada-based firm that manufactures and installs small geothermal power plants.  

As geothermal energy is both far greener than conventional fossil fuels and represents a reliable, baseload power source (unlike intermittent wind and solar energy), the company is a darling of the prospering environmental, social and governance-focused investment movement. Ormat is ranked in the 77th percentile of CSRHub’s ESG ratings aggregate of 25,208 companies compiled by 787 data sources, topping the average rating of its alternative energy peers, while Morningstar bestows a “low” ESG risk rating on the company.  

ORA is likewise the apple of Wall Street’s eye, trading at 50 times consensus estimates of 2021 earnings per share and six times expected full-year revenues. Shares are, however, up just 5% including dividends since Grant’s Interest Rate Observer had its bearish say back on March 6, 2020. Over that time, the S&P 500 has returned 56%. 

The starring role of Kenyan operations in the Ormat story presents a major potential vulnerability. Namely, Kenya delivered 16.4% of revenues through the first six months of 2021, up from 15.7% in the year ago period, and “contributed disproportionately to gross profit and net income,” notes Ormat’s most recent form 10-Q filed in early August. 

Ultra-premium pricing may represent the secret sauce for that windfall. Zachary Truesdell, then managing-partner at Matador Global Management, estimated to Grant’s last year that Ormat was earning around $94 per megawatt hour (MWh) of power provided to local customer Kenya Power & Lighting Co. (KPLC), more than double the $45 MWh rate for state-owned geothermal competitor Kenya Electricity Generating Co.  

That disparity has drawn some unwanted attention. This spring, Kenyan President Uhuru Kenyatta convened a task force to scrutinize all power purchase agreements involving Kenya Power, following the revelation that independent power producers (IPP’s) were enjoying rates far above those charged by the Kenya Electricity Generating Co.  Upon the completion of that review last month, Kenyatta ordered the halt of all power purchase agreements still under negotiation and established a team of auditors to supervise KPLC, while replacing the country’s energy minister.  Energy costs in the country will drop by as much as 33% thanks to those enhanced controls, Kenyatta’s office asserts. 

In its 10-Q filing, Ormat acknowledges receiving a letter from the Kenya National Assembly in July requesting information and materials related to its business practices there.  For its part, Ormat tells Almost Daily Grant’s that it has not been approached by the Kenyan government regarding a renegotiation of its rates, and that its prices are “significantly” lower than those charged by other firms in Kenya.

Operational risks extend beyond the durability of that lucrative Kenya-based revenue stream.  As that 2020 Grant’s analysis pointed out, chairman Isaac Angel served as CEO of Lipman Electronics Engineering Ltd. prior to its 2006 acquisition by Verifone Holdings, Inc. for $793 million in cash and stock.  Thanks in part to financial irregularities at Lipman, Verifone was subsequently forced to fork over $95 million in a class action lawsuit, a setback which led to the resignation of Verifone’s CFO. 

Then, too, current Ormat CEO Doron Blachar previously served as chief financial officer at Israeli construction firm Shikun & Binui, a company that is now under formal police investigation for bribery.  That inquiry is reportedly focused on Kenya and Guatemala, two of Ormat’s most important markets. 

A March 1 analysis by Hindenburg Research alleges that the company routed energy assets through Guatemala via an undisclosed related party, which in turn transferred energy rights to the two senior government officials who approved Ormat’s deal to operate in the country.  While the company website boasts that its geothermal plants are “powered by nature,” Ormat’s “lucrative international contracts appear to be powered by a slew of payments to senior government officials,” Hindenburg writes. 

In March, the company condemned Hindenburg’s report as “inaccurate and filled with innuendo in an attempt to mislead investors about Ormat.”

Apart from those allegations, a report last year from local news service NewsZetu asserted that Kenya Power is “broke,” and “technically insolvent,” as net profits collapsed by 92% over the 12 months through June 30, 2019 compared to the prior year period.  The slow-paying KPLC owed Ormat about $30 million as of the end of July, the 10-Q notes. That’s equivalent to 37% of 2021 consensus net income. 

Anyway, “G” is for governance. 

Recap Oct. 19

Stocks stayed on the front foot with a 75 basis point advance on the S&P 500, while the Treasury curve steepened notably to reverse recent action, as the long bond yield jumped five basis points to 2.08%.  WTI crude rose back above $82 a barrel, gold edged higher to $1,770 an ounce and the VIX slipped below 16. 

- Philip Grant

Place Your Bets
Supply snafus are set to get worse before they get better, reckons trucking leader J.B. Hunt.

Supply snafus are set to get worse before they get better, reckons trucking leader J.B. Hunt.  On Friday’s earnings call, chief commercial officer Shelley Simpson declared that “while peak season is upon us, we believe the bottlenecks on the West Coast . . . [may] even intensify further peak-season capacity needs into November and December.” CEO John Roberts added that “this year, we have reached all-time highs in the need for company drivers in all segments.” The company sees “persistent irregularities in demand patterns substantially resulting from port, labor and inventory challenges with our customers,” he said.

Of course, broken supply chains can be repaired and currently-raging price pressures may abate.  Staff economists at the Federal Reserve predict just such an outcome, penciling in a measured inflation rate of slightly less than 2% in 2022, according to minutes of the September Federal Open Market Committee meeting released last Wednesday. 

“You should take it very seriously,” Claudia Sahm, a former Fed economist and senior fellow at the Jain Family Institute, tells Bloomberg. “It doesn’t mean it’s right, but you have the top forecasters in the world” preparing the numbers. “Looking over time, there is no forecasting shop that can come even close to the board’s analysis of the near-term economy.”

Likewise squinting into the future, investors reach a different conclusion. Gleaning market-derived inflation probabilities from the swaps market, Arbor Research data scientist Ben Breitholz finds today that those investors are pricing in 71% odds of headline CPI in excess of 2.5% over the next 10 years, the hottest reading on record going back to 2010. The perceived odds of a sped-up policy response are likewise on the hop. Alex Manzara, interest rate options trader at R.J. O’Brien, noted in a commentary yesterday that positioning in the Eurodollar market now implies a pair of 25 basis point rate hikes by the end of next year, compared to less than one projected quarter-point rate increase in 2022 as of the June FOMC meeting. 

The Poseidon Venture
SoftBank Group Corp. enjoys “good liquidity at the holding company level”

SoftBank Group Corp. enjoys “good liquidity at the holding company level” and “a highly valuable investment portfolio,” a Friday report from Moody’s Investors Service notes, helping support the firm’s Ba3 corporate family rating.  On the other side of the coin, interest coverage of less than one-to-one helps keep the company three notches below investment grade status, as does SoftBank’s “aggressive financial policy and associated governance concerns.” 

An unusual response followed that routine assessment. The company rifled off a press release this morning noting that, as SoftBank withdrew its request for Moody’s credit ratings on March 25, 2020 (two days after receiving a two-notch downgrade from the rating agency), Moody’s “opinion is based on their subjective assumptions and hypotheses with no reasonable basis for support.”  

Indeed, as SoftBank shares have retreated by 41% from their March highs and languish 60% below the company’s estimated net asset value as of June 30, tempers appear to be running short.  Bloomberg reports today that SoftBank boss Masayoshi Son and chief operating officer Marcelo Claure have been at loggerheads of late, with the latter agitating for a spinoff of the SoftBank Latin America Fund and Son reluctant to undertake such a move.

Conventional professional factors have helped stoke that discord, as Claure “has often pushed for more authority and money,” namely, “he has suggested he deserves as much as $1 billion.” The spat could result in Claure’s departure from the firm, Bloomberg believes. 

Then, too, as tech publication The Information reported on Oct. 6, the firm’s pair of in-house venture capital arms (the $100 billion Vision Fund and its $40 billion sequel) have seen a raft of senior personnel depart in recent months following concerted pressure from Son to increase the number of private startups under its umbrella, a move internally described as a “spray and pray strategy.” That’s despite the fact that the second Vision Fund has consummated deals at an average pace of three per week this year according to Pitchbook and invested some $18 billion over the first six months of the year at terms increasingly advantageous to founders.  

Intensifying competitive pressure within the V.C. industry has crimped the Vision Fund’s dominance. “SoftBank was the focus three years ago, but they don’t get as much attention as before,” Somesh Dash, general partner at competing firm IVP, told The Information. “The market has evolved to where other venture funds replicated their model with faster velocity.” 

See the Sept. 3 edition of Grant’s Interest Rate Observer for an in-depth analysis of the firm that epitomizes the zeitgeist of the current cycle. 

Recap Oct. 18

Happy days are here again for the bulls, as the S&P 500 and Nasdaq 100 each managed another green finish after the back-to-back rallies to wrap up last week, leaving those respective indices within a few percentage points of their respective high-water marks. The Treasury curve continued its marked flattening action, with the two-year yield rising to 0.42% (nearly double that of a month ago) and the long bond dropping to near 2%.  WTI crude held steady above $82 a barrel, gold edged lower to $1,765 an ounce and the VIX gave back an early 10% gain to remain near 16. 

- Philip Grant

Gini Juice

Behold the below pair of headlines from Bloomberg yesterday:

Almost 20% of U.S. Households Lost Entire Savings During Covid

Coach K's Final Game at Duke Sends Tickets Surging Past $50,000

Bench Press
Probably just a coincidence. Firms that do so enjoy a statistically significant improvement in their odds of inclusion in the benchmark index relative to those that do not, concludes a working paper published by the National Bureau of Economic Research on Monday.  Purchases of credit ratings from rival Moody’s impart no such no such benefits, the NBER finds.
Home is Where the Hurt is
Contagion is afoot in China’s lynchpin property sector.

Contagion is afoot in China’s lynchpin property sector.  In the wake of China Evergrande’s implosion under the weight of $300 billion in liabilities, peers try, with varying degrees of success, to keep their own heads above water.  Modern Land (China) Co. requested a three-month extension on a dollar bond due Oct. 25 earlier this week, noting that it hopes to avert “any potential payment default.” U.S.-listed peer Xinyuan Real Estate Co. today completed an exchange offer, swapping $200 million worth of senior debt maturing tomorrow for new senior notes due in 2023, in the process earning a downgrade to single-C from Fitch Ratings and the resignation of accountant Ernst & Young Hua Ming LLP.  That comes on the heels of last week’s default on a $206 million bond by Fantasia Holdings Group Co.  

Beijing, which arguably helped usher in the current tumult by rolling out the so-called three red lines policies limiting balance sheet growth, appears content to let the situation play out rather than ride to the rescue. “The industry is in a period of survival of the fittest and does not require excessive administrative intervention,” Kuang Weida, director of the Center for Urban and Real Estate Research at Renmin University of China, tells Yicai Global.  An unnamed senior official concurs with that assessment, telling Reuters that “property curbs will be painful, but this is the price that must be paid. In the past, we always loosened controls due to economic downturns, but this time round the leadership’s determination looks very firm.” 

Time will tell how durable that determination is: Some $64 billion worth of Chinese property developer dollar-denominated debt currently trades at distressed levels according to data from Bloomberg, equivalent to a hefty 46% share of such global bonds fetching option-adjusted spreads north of 1,000 basis points relative to Treasurys.  The real estate industry’s cross-border bond issuance stood at $232 billion at the end of September according to Fitch, with nearly one-third of that sum set to mature by the end of 2022.  

That may prove problematic, as up to one-third of the 60 real estate firms that have issued dollar-pay debt are currently frozen out of the capital markets, a European bank higher-up estimates to the Financial Times. “International investors are probably used to more aggressive, intervention-style policy,” the publicity-shy banker observed. “They are looking for kung fu but they’re getting tai chi.”   

More broadly, the starring role of real estate in China’s economic miracle (pegged at between 23% and 30% of GDP by various observers) begs the question of what consequences may follow an early autumn freeze. Contracted sales among China’s 100 largest developers plunged by 36% year-over-year in September, one of the most important selling months of the year, according to data provider CRIC.  With activity on the fritz, highly leveraged industry players are obliged cut prices to generate the necessary revenues to service their debts. “Virtually all developers have offered discounts over the past two months,” property agent Huang Jun relays to The Wall Street Journal. “Just like Evergrande, they may be under pressure to sell more flats,” irrespective of price. Indeed, the 21 large developers listed on the Hong Kong stock exchange saw their average interest coverage ratio slip below 1 to 1 as of June 30 according to Refinitiv, compared to nearly 1.5 to 1 at the end of 2020. 

“Fire sales of Evergrande’s land reserves could drive down land prices in many areas of the country, which would be quite frightening,” an anonymous government source tells the FT. “The only viable solution might be to gradually nationalize the whole real estate sector.”

In other words, laissez-faire with Chinese characteristics. 

QE Progress Report
A $16 billion weekly increase in Reserve Bank Credit pushed interest-bearing assets on the Fed balance sheet to $8.43 trillion. That’s up 20% year-over-year and 105% from late February 2020, as financial markets went into meltdown mode. 
Recap Oct. 14

Happy days are here again for the bulls, as stocks stormed higher by 1.7% on the S&P 500 to mark its best one-day showing since the spring, while Treasurys mostly rallied as well with the exception of the two-year, as the curve continues to flatten. A larger than expected weekly crude inventory build didn’t stop WTI crude oil from reaching a fresh post-2014 high at $81.50 a barrel, gold inched higher to $1,798 an ounce to build on yesterday’s rally, and the VIX sank 10% to finish below 17. 

- Philip Grant

Easy Street
Scalding inflation prints and raging price pressures across key economic inputs have inflicted little damage to the European Central Bank’s institutional confidence.

Scalding inflation prints and raging price pressures across key economic inputs have inflicted little damage to the European Central Bank’s institutional confidence.   This morning, ECB Governing Council Member Francois Villeroy de Galhau declared that: “It is clear that the risk remains that we fall short of our inflation target in 2023 rather than exceed it. This calls for a continued accommodative monetary policy.”  ECB chief economist Philip Lane concurs with that assessment, arguing that the current spike in prices “do not imply a trend shift in the path of underlying inflation.” 

Stateside, the monetary mandarins similarly display little alarm. While noting the “eye-popping” recent price pressures in certain categories, San Francisco Fed President Mary Daly concluded in a CBS interview over the weekend that “I don’t see this as a long-term phenomenon.”  Raphael Bostic of the Atlanta Fed offered a measured dissent this morning, stating that “it is becoming increasingly clear that. . . intense and widespread supply-chain disruptions will not be brief. By this definition then, the forces [of inflation] are not transitory. . . These upside risks to the inflation outlook bear watching closely.” Bostic hastened to add, however, that he sees “no signs that this elevated inflation is really doing the kind of harm to the economy that would call the Fed's policy stance into question.” 

The International Monetary Fund provides institutional cover for a stand-pat strategy, predicting in its October World Economic Outlook that “inflation is expected to come down to its pre-pandemic range in 2022, once supply-demand mismatches resolve.” Ongoing slack in the labor market, well-anchored inflation expectations and structural factors like increased automation in the work force will help keep a lid on prices, the IMF believes.  Then again, it hedges, “inflation prospects are highly uncertain. These increases in inflation are occurring even as employment is below pre-pandemic levels in many economies, forcing difficult choices on policymakers.” 

While central bankers and institutional thinkers on either side of the Atlantic patiently await an ebbing of the inflationary tide, businesses strap on their lifejackets. Today’s release of the September National Federation of Independent Business survey finds that the proportion of respondents planning for price increases is at its highest since at least 1998, while planned wage increases stand at their highest since at least 1986.  The public, too, is increasingly attuned to that dynamic.  The New York Fed’s monthly consumer expectations survey for September showed three-year inflation expectations at 4.2%, up from 4% from the previous month and the highest reading in the eight year history of the series. 

That contrast has not escaped Wall Street’s attention. Noting that a durable inflation regime represents something of a consensus among investors, Strategas Research Partners CEO Jason Trennert tells Bloomberg that “what is increasingly worrisome, however, is that more and more of our clients believe that financial policy makers are unable to let long-term interest rates [rise] because it would be too painful for the economy and for investors.” 

While an urge to sustain the current economic rebound and powerful bull market may figure prominently in central bank reluctance to respond to the inflationary dust-up, some believe that other, secular factors may help explain the increasing reliance on easy money across the economic cycle.  Arguing that the pandemic has ushered in an era in which government involvement in all aspects of daily life is not only accepted but expected, Ruffer LLP investment director Alexander Chartres writes in his firm’s 2021 Ruffer Review that the path of least resistance is clear: 

Post-Covid, saying ‘no’ to switching on the printing presses and turning on the spending taps will be far harder. A more inflation-prone fiscal dominance has replaced monetarist orthodoxy. It is here to stay.

Plan accordingly. 

Recap Oct. 12

Treasurys saw some wild action after yesterday’s breather, as the 2-year yield climbed to 0.34% for its highest close since March 2020, while the long bond dove seven basis points to 2.09% to drag the curve notably flatter.  Stocks remained on the back foot with the S&P and Nasdaq 100 each dropping about 30 basis points and finishing near their session lows, gold rose to $1,761 an ounce and WTI crude held at $80.50 a barrel.  The VIX stayed put near 20. 

- Philip Grant

Under the Hood
Robinhood Markets filed an amended form S-1 after the close on Friday,

Robinhood Markets filed an amended form S-1 after the close on Friday, asking the Securities and Exchange Commission to approve an expedited 98 million share sale by early investors previously announced in early August.  If the SEC confers  its blessing, that sales window could open as soon as Wednesday afternoon. 

Employees at the millennial-focused trading app have also demonstrated an eagerness to ring the register.  Ahead of its late July IPO, Robinhood disclosed that insiders would be permitted to sell up to 15% of their holdings immediately upon the start of public trading and another 15% three months later.  That’s a break from a traditional six-month post-IPO lockup period.  

The urge to cash out is understandable. Robinhood shares remain 11% above their IPO price with a $36 billion market capitalization. That compares to an $11.2 billion value garnered from private investors in a series G fundraising round 16 months ago. 

The Producers
Great expectations on Wall Street:

Great expectations on Wall Street: Analysts project S&P 500 components to grow their bottom lines by 28.4% from a year ago according to data from FactSet, building on the second quarter’s 96% expansion from Covid-dented 2020. 

The Street pegs third quarter profit margins at 12.1%, near the 13.1% high-water mark set last quarter and the third highest reading since FactSet data collection began in 2008.  Fourth quarter profits will grow by 20.5% year-over-year, the sell-side reckons. Next year will bring a further fattening of the bottom line, as analysts pencil in an 8.8% per share earnings bump in 2022, outpacing a 6.4% expansion in revenues. 

C-suites are similarly expecting big things.  Bianco Research finds that the ratio of S&P 500 companies offering above-consensus earnings guidance over the past three months stands at its highest since at least 1999, excluding the prior pair of quarters as the virus receded. 

But fraying global supply chains present a clear and present danger to the anticipated profitability boom.  FactSet notes that, as of Friday, 15 of the 21 S&P 500 members that have reported third quarter results cited supply chain disruptions as an adverse factor crimping operations, while 14 of the 21 worried about labor costs and shortages.  Transport and freight costs were points of discussion for 11 members of that cohort, while 10 companies mentioned raw material and commodity cost headwinds in their third quarter earnings call. 

As The Wall Street Journal reports today, big box retailers like Target, Walmart and Costco have resorted to chartering their own small container ships to ferry goods around the globe. While that move will help ensure the arrival of time-sensitive seasonal wares ahead of the year-end holidays, those bespoke solutions will cost a pretty penny: 1,000 container vessels currently charter for $140,000 per day, more than double the pre-pandemic rate. 

“Using small boxships for transoceanic point-to-point sailings is something we’ve never seen before,” Evangelos Marinakis, chairman of Capital Maritime & Trading Corp., tells the Journal.  Necessity is the mother of invention:  Down-market retailer Dollar Tree noted last month that traditional shippers are able to meet only about 60% of their contracted commitments.  Meanwhile, upwards of 60 of those boxships are idling outside ports in Los Angeles and Long Beach, per the Marine Exchange of Southern California, compared to 25 in September.  Thanks to those widespread pileups, Walmart has rerouted some chartered ships to smaller and less active ports.

Businesses without that financial and logistical muscle struggle to keep up. Nebraska-based party supply concern Podzly is coughing up 50% plus premiums for its wares relative to 2019, founder Jeremy Podliska relays to the Journal, while delays have whittled existing inventory to half of its optimum level. That dynamic duly translates to the checkout counter: A 12-pack of sombrero party hats now goes for $52, compared to $32 before the pandemic, a price that is set to rise still further as elevated shipping costs feed through. “My guess is there is some limit to how much you can charge for a sombrero,” quips Podliska. 

Investors wondering about the state of corporate profit margins during the current inflationary dust-up won’t have to wait long for additional information, as the September Consumer Price Index is due on Wednesday, and the Producer Price Index a day later. Economists guesstimate an 8.7% year-over-year leap in the producer component, well above the 5.3% projected advance in CPI.  For more on the implications of that yawning spread, see the Sept. 17 edition of Grant’s Interest Rate Observer

Recap Oct. 11

With the bond market closed for Columbus Day, stocks endured some bearish price action as the indices reversed solid early gains and finished lower by 70 basis points on both the S&P 500 and Nasdaq 100, leaving those indices 4% and 6% below their respective September highs. WTI crude powered to $80.50 a barrel, extending its year-to-date gains to a hefty 67%, while gold stayed at $1,754 an ounce and the VIX climbed to 20, up 6.5% on the day. 

- Philip Grant

Billy Goats Gruff
“If the trolls are right, and Tether is a Ponzi scheme, it would be larger than Bernie Madoff’s.”

“If the trolls are right, and Tether is a Ponzi scheme, it would be larger than Bernie Madoff’s.” Today’s assessment from Bloomberg BusinessWeek underscores a spirited debate over controversial so-called stablecoin tether, which acts as a central thoroughfare for cryptocurrencies, allowing investors to trade in and out of the digital ducts while dodging the know-your-customer and anti-money laundering regulations that govern the regulated banking system. Tether (the entity) had long claimed that the stablecoins were backed one-for-one by U.S. dollars, before broadening that definition in 2019 to include “other assets and loans made by Tether to third parties, which may include affiliated entities.”

Some $69 billion worth of the stablecoins are now outstanding, double the sum of late February when New York Attorney General Letitia James concluded that Tether’s claims of full dollar backing “was a lie” and up nearly five-fold from a year ago, when the price of bitcoin hovered near $11,000 compared to $54,000 today.  That recent supply surge is further colored by reports this summer that the Justice Department is investigating Tether for bank fraud, a development which could discourage institutional investors from allocating capital to tether.  The company is a defendant in a quartet of ongoing legal cases, notes auditor Moore Cayman. 

“It’s not a stablecoin, it’s a high-risk hedge fund,” John Betts, former CEO of Puerto Rico-based lender Noble Bank International, which did business with Tether in 2017 and 2018, tells BusinessWeek.  “Even their own banking partners don’t know the extent of their holdings, or if they exist.”  (See the Sept. 8, 2017 edition of Grant’s Interest Rate Observer for a skeptical early look at the Tether phenomenon).

In a statement, Tether termed the BusinessWeek piece a “one-act play” designed to “fit a pre-packaged and pre-determined narrative,” while general counsel Stuart Hoegner chimed in to brand its critics “jihadists” eager to see Tether implode. The company grandly declared that “Tether, its management and its community are working for a more financially inclusive world. While this may threaten the establishment of traditional financial systems, we will continue to work for the underrepresented.” 

Beneficiaries of that work include the taxpayer.  As part of the February settlement with the New York AG, in which the company forked over an $18.5 million fine while making no admission of wrongdoing, Tether also agreed to provide quarterly breakdowns of the assets underlying its gaggle of stablecoins. 

The legally-mandated quarterly attestations are illuminating:  Traditional reserve assets such as cash and bank deposits footed to just 10% of the total $62.8 billion in reserves as of June 30, while Treasury bills accounted for an additional 24%. Corporate bonds and precious metals, secured loans (none to affiliated entities, the accountant notes), and other investments, including digital tokens, contributed an additional 7.6%, 4% and 3.2%, respectively.

Those funds have helped nurture the digital ecosystem, as Tether has lent substantial sums to such crypto concerns, sometimes using bitcoin itself as collateral. Lending platform Celsius Networks, Ltd., which is facing accusations of offering unregistered securities in Texas, New Jersey and other states, has $1 billion in loans outstanding from Tether at interest rates of roughly 5% to 6% according to founder Alex Mashinsky.  

Meanwhile, commercial paper and certificates of deposit accounted for nearly half of the $62.8 billion in reserves, with a reported $31 billion pile of short-term corporate loans which would make Tether the seventh-largest holder of commercial paper in the world. That’s news to Wall Street, however: “It’s a small market with a lot of people who know each other,” Deborah Cunningham, chief investment officer of global money markets at Federated Hermes, tells BusinessWeek. “If there were a new entrant, it would be usually very obvious.”  Citing competitive considerations, Tether has declined to disclose its investment positions, a departure from standard practice among U.S. money market funds. 

While the June 30 attestation shows that $28 billion of that sum was held in companies garnering a short-term credit rating of at least single-A as of that date, documents obtained by BusinessWeek show that Tether holds “billions” worth of commercial paper issued by Chinese large-cap companies, “something most money-market funds avoid.”  The recent collapse of hyper-levered property behemoth China Evergrande demonstrates the riskiness of such transactions. 

For now, at least, the bull crowd pays these details little mind, as price action continues to reward the believers. “It could be way shakier, and I [still] wouldn’t care,” Dan Matuszewski, co-founder of crypto-focused investment firm CMS Holdings, declared to BusinessWeek. Time will tell. 

QE Progress Report
Reserve Bank Credit fell by $9 billion to mark its second straight decline, leaving the sum of interest bearing assets on the Fed balance sheet at $8.42 trillion.  That’s up 19.9% from a year ago and 115% from early October 2019. 
Recap Oct. 7

Rates came under significant pressure today, with the 10- and 30-year yields each rising by about five basis points to their highest levels since June at 1.58% and 2.13%, respectively, while stocks initially pushed strongly higher before losing steam late in the day to leave the S&P 500 up 80 basis points, back within 3% of its peak.  WTI crude snapped back towards $79 a barrel, gold edged lower to $1,756 an ounce and the VIX declined by 7% to 19.5. 

- Philip Grant

Almost Daily Grant's will resume on Monday

Finite After All

A headline today from Business Insider:

Infinity-pool shortage: Luxury-pool builders are setting minimum prices as high as $500,000 and turning away customers because they can't find enough workers

Strike Too
Operations at all six of Kellogg Co.’s U.S. cereal plants ground to a halt yesterday

Operations at all six of Kellogg Co.’s U.S. cereal plants ground to a halt yesterday as some 1,400 employees walked off the job.  Kellogg and the Bakery, Confectionery, Tobacco Workers, and Grain Millers’ Union have been at loggerheads for more than a year over pay and benefits, a union higher-up told the Associated Press.  While the company contends that its compensation packages “are among the industry’s best” and that it has offered employees pay increases on top of the average 2020 unionized worker earnings of $120,000, Memphis-based union vice president Kevin Bradshaw countered to Bloomberg that extensive pandemic-driven overtime helped explain that figure, as base pay at that facility foots to just $58,000 annually.  “We worked seven days a week, 12 to 16 hours a day” last year, Bradshaw said.  

With the work stoppage now persisting into a second day, unpleasant implications loom. “The concern here is about the potential for supply chain issues to be amplified if the company is unable to maintain production levels,” observes Bloomberg analyst Jennifer Bartashus.  

Some businesses are turning to an all hands on deck approach to combat their own production “issues.” Baton Rouge-based Raising Cane’s Chicken Fingers is dispatching white collar employees at the corporate office to restaurant duty, as the fast food chain grapples with severe staffing shortages. Raising Cane’s, which spans 530 restaurants, is aiming to hire 10,000 restaurant staff in the next 50 days.

Reading the tea leaves, Bank of America announced today that minimum wages will increase to $21 per hour from $20.  That’s only the beginning: BofA targets a $25 hourly floor by 2025, up 120% from 2010 and 47% from 2019. That comes a day after Target upped its hourly ante by $2 for peak days this holiday season in stores and service centers. The big-box retailer bumped its minimum wage to $15 per hour from $13 last July, six months earlier than previously projected.  Those incentives may help Target get the jump on its peers, as all but 2% of respondents to a September survey of 176 retailers by consulting firm Korn Ferry reported that securing sufficient staff was a problem. Though the federal minimum wage remains just $7.25 per hour, fewer than 20% of all U.S. workers now earn less than $15 per hour per the Economic Policy Institute, compared to upwards of 30% at the start of 2021.

Similar dynamics are at play across the Atlantic.  The U.K.’s Low-Pay Commission is reportedly set to recommend bumping the hourly minimum by 5.7% to £9.42 ($12.81) next year, following a 2.2% hike to £8.91 per hour in April, with Prime Minister Boris Johnson stating yesterday that he will accept the committee’s suggestion.  That comes as measured inflation reached a nine-year high at 3.2% year-over-year in August, while market-derived interest rate expectations, as measured by the 10-year breakeven rate, jumped to 4.08% today for the highest reading since 2008.  The public concurs, as consumers expect inflation to settle at a 4.1% clip over the next 12 months, a YouGov survey from last week finds. 

The implications of an unhappy labor force may soon be felt on the European continent. Some 900,000 German construction workers threatened a nationwide strike today if their demands for a 5.3% wage hike, along with enhanced travel compensation, are not met. “Without the employers really giving in, there will be no agreement with us this time,” Robert Feiger, head of the IG Bau labor union, told Sueddeutsche Zietung newspaper today. “And believe me: We know how to strike.”  That comes two days before negotiations are set to commence between Germany’s 15 federal states and public employee unions representing 2.3 million workers, who are asking for a 5% hike in their earnings. 

German wage inflation footed to 5.5% on an annual basis in the second quarter, according to data from the Federal Statistics Office, while headline CPI jumped 4.1% year-over-year in September for its hottest reading since shortly after the Berlin Wall came down. 

“Definitely for the time being we cling to the hope that the current inflation spike will be transitory,” ECB Governing Council member Robert Holzmann illuminatingly stated today.  Indeed, the bedrock of near-zero interest rates and accompanying edifice of sky-scraping asset prices arguably depends on just that. 

Recap Oct. 6

It was a good day for the bulls, as stocks erased an early 1.3% loss on the S&P 500 to eke back into the green by day’s end, while long-dated Treasurys also finished a bit stronger with the 30-year yield ticking lower to 2.08%.  WTI crude pulled back to $77 a barrel following a larger-than-expected weekly inventory build, gold edged higher to $1,764 an ounce and the VIX gave back early gains to finish at 21.  

- Philip Grant

Climate Change is Covered Though

Here’s ECB President Christine Lagarde in a speech today:

We should not overreact to supply shortages or rising energy prices, as our monetary policy cannot directly affect those phenomena. 

Facial Recognition
Into the financial metaverse:

Into the financial metaverse: While Sunday’s 60 Minutes segment focusing on the corporate practices of Facebook, Inc. (FB on the Nasdaq) stole headlines, a potentially far more impactful set of allegations are now firmly in the public domain. 

Former Facebook product manager Frances Haugen, who resigned from the Menlo Park-based social network this spring, declared in a series of eight complaints to the Securities and Exchange Commission that Facebook has violated securities laws by repeatedly misrepresenting key user metrics to advertisers and investors.  Namely, the firm buried unflattering data showing sharp declines in usage and content production from the crucial teenage and young-adult segments, as well as the true total of recipients served by its advertising platform.  

Daily active users reached 1.91 billion as of June 30 according to the company, up 7% from a year ago, while per-user ad revenues ballooned by 47% in the second quarter from the same period in 2020. Yet internal data found that daily active users among the teenage cohort fell by 13% from 2019 to 2021 and are projected to drop by an additional 45% by 2023; young adult daily users fell by 2% over the two years through 2021 with a further 4% projected decline penciled in by 2023 (Boston’s not a big college town anyway – ed.).  The company failed to disclose those measured contractions and starkly negative projections with investors. 

Facebook “hides behind walls that keep the eyes of researchers and regulators from understanding the true dynamics of the system,” Haugen asserted in prepared testimony before the Senate today. “We have to just trust what Facebook says is true – and they have repeatedly proved that they do not deserve our blind faith.” 

No mere blind faith has conferred a monster $940 billion market cap on the social network, equivalent to a 4% weighting on the Nasdaq 100. Rather, a stellar income statement plays a featured role in Facebook’s exalted status among investors. The company generated $105 billion in revenues, $53.5 billion in adjusted Ebitda and $32 billion in free cash flow over the 12 months through June 30, figures which are each expected to roughly double by calendar 2024 if sell-side estimates are on point. The balance sheet is likewise shipshape, with $12.5 billion in net debt supported by a $64 billion cash pile. FB shares have powered higher by 98% from a bearish analysis in the Aug. 11, 2017 edition of Grant’s Interest Rate Observer, though that’s well shy of the 162% return for the Nasdaq 100 Index over that same period.

Unsurprisingly, Wall Street remains firmly on Mark Zuckerberg’s bandwagon, with 49 of the 60 sell-side firms surveyed by Bloomberg conferring a “buy” rating on FB.  Analysts at Barclays, who count themselves among that bull contingent, expect daily active users to grow to 2.01 billion in 2023, with advertising revenue per daily active user increasing to $16.87 by 2023 from $8.73 last year.  

Of course, the idea that Facebook might be engaging in fuzzy math on its lynchpin, self-reported user metrics might be breaking news only to the passive index investors at Vanguard, BlackRock and State Street (the trio hold 18% of shares outstanding). As then-Pivotal Research analyst Brian Wieser told Grant’s in September 2017, and highlighted in the Jan. 30, 2019 edition of ADG, the company identified an addressable U.S. market of 41 million 18-24 year-olds and 60 million 25-34 year-olds.  The only problem: 2016 U.S. Census population figures showed 31 million 18-24 year-olds, and 45 million 25-34 year-olds.  

Meanwhile, as the Cambridge Analytica data-selling scandal reverberated in 2018, a study from Pew Research found that 42% of respondents took a multi-week break from the platform and 26% deleted the app outright.  Yet Facebook reported North American daily active users at 185 million across the first, second and third quarters of 2018. 

“If advertisers were aware of the discrepancies, they would spend less on ads, leading to lower advertising revenue and lower profits,” the whistleblower complaint argues. What’s more, “some investors simply will not want to invest in a company that does not have the growth (e.g., daily and monthly active users) that is represented and then engages in misstatements and omissions on this topic.” 

To be sure, few have paid the veracity of Facebook’s self-reported data any mind during its rise to corporate dominance.  Will that happy state of affairs persist?

Recap Oct. 5

Seesaw price action continues, as stocks caught a strong bid to mark the fourth straight session with at least a 1% daily move on the S&P 500, leaving the broad index 4.2% south of its early September highs.  Rates came under renewed pressure with the benchmark 10-year yield climbing five basis points to 1.53%, while WTI pushed higher by another 2% to $79 a barrel and gold pulled back to $1,760 an ounce.  The VIX fell 7% to finish near 21.  

- Philip Grant

All Together Now

Shifting winds in the financial markets:  Sharpe Ratios across major asset classes condensed to their tightest range since at least 1990 in the just-completed fiscal third quarter, Arbor Research finds, as returns on a risk-adjusted basis coalesced in historic fashion. 

That phenomenon is unlikely to persist. “History shows dispersion has always increased after ultra-tight risk-adjusted returns,” Arbor Research data scientist Ben Breitholtz notes. “In other words, do not expect a repeat of the ‘everything trade’ of either the risk-on or off variety.”

Grande Central Terminal
Trading in China Evergrande Group was halted on Hong Kong’s stock exchange today,

Trading in China Evergrande Group was halted on Hong Kong’s stock exchange today, as the stricken mega-developer continues to unload a hodgepodge of assets. Indeed, financial news service Cailian reports that Evergrande will sell a 51% stake in majority-owned Evergrande Property Services Group Ltd. to Hopson Development Holdings Ltd. for HKD $40 billion ($5.2 billion), or 28% below its public market value.  As that hefty discount suggests, desperate days have arrived for Asia’s largest junk bond issuer, which sports upwards of $300 billion in total liabilities and failed to make an $83.5 million interest payment on an offshore bond in late September. 

That Hopson transaction comes as investors try to determine the scope of Beijing’s response to the unfolding crisis in the lynchpin property sector, which accounts for some 29% of Chinese output per an estimate from Harvard economics professor Kenneth Rogoff.  “We think policymakers and Evergrande will ultimately agree to a debt restructuring plan,” Jing Sima, China investment strategist at BCA Research, wrote last Wednesday. “Evergrande could transfer some of its hard assets to state-owned banks or enterprises and the banks could either extend or restructure Evergrande’s existing loans to help finish and deliver the company’s housing projects.” That company had 132 million square meters worth of projects under construction as of year-end, The Wall Street Journal notes.  For context, the Empire State Building spans 257,000 square meters of total floor area.

Yet the prospect of a vicious cycle looms, as government efforts to contain any fallout could crimp Evergrande’s operations, in turn further imperiling its debt repayment capacity. The South China Morning Post reports that authorities in Guangzhou have ordered Evergrande’s local sales office to place all local property sales proceeds in escrow under government purview, “to protect the interests of homebuyers and ensure the completion” of a large-scale project there.  Evergrande is currently undertaking 146 shanty town reconstruction projects across the Chinese mainland, with an order book pegged at RMB 100 billion ($15.5 billion) by analysts at Kaiyuan Securities. 

“The first obligation is going to be to make sure that homeowners who bought those homes take delivery and are made whole,” Bruce Richards, CEO of Marathon Asset Management (which recently began accumulating Evergrande debt at distressed levels), tells Bloomberg. “At the very end of the pecking order are offshore bondholders.”

Even a well-managed wind-down could widely reverberate across the increasingly shaky real estate sector. The aggregate interest coverage ratio of 21 big Hong Kong-listed Chinese real estate developers fell to 0.94:1 as of June 30 according to data from Refinitiv, down from 1.47:1 six months earlier.  At the same time, recent activity has hit a wall: developer land purchases from Chinese local governments through the first 12 days of September imploded by 90% from their year-ago levels. “If Evergrande has to revalue its property holdings downwards, investors may conclude that other highly leveraged Chinese developers will face similar difficulties too in offloading their properties,” DBS macro strategist Chang Wei Liang wrote last week. 

Those concerns are increasingly front-of-mind.  Peer Fantasia Holdings Group Co. Ltd. saw its senior unsecured, 6.95% dollar-pay notes due Dec. 17 collapse to 38.2 cents from 67 on Friday, according to data from Bloomberg, following downgrades from each of the three primary credit rating agencies.  Thanks to an 18% downdraft since late June, the Hang Seng Index now sits near a 52-week low.  The credit markets are conveying outright alarm, as a Bloomberg gauge of Chinese dollar-pay high-yield credit has blown out to a 1,500 basis point spread over Treasurys (a 1,000 basis point pickup typically indicates distress).  That’s up from less than 800 basis points in early June and a 10-year average of 660 basis points.  

What second-order consequences might follow a derailing of the debt-driven Chinese economic miracle?  See the most recent issue of Grant’s Interest Rate Observer dated Oct. 1 for a comprehensive analysis of the wide-ranging implications of Evergrande’s travails.

Recap Oct. 4

Stocks were hit hard with the S&P 500 and Nasdaq 100 sinking 1.3% and 2.2%, respectively, to finish at their lowest levels since mid-July and late-June, while Treasurys also finished in the red with the 10-year yield rising to 1.48%. An announced 400,000 barrel-per-day output hike from OPEC beginning in November didn’t prevent WTI crude from jumping to near $78 a barrel for its best finish since 2014, gold rose half a percent to $1,769 an ounce and the VIX rose 9% to 23. 

- Philip Grant

Carbon Copy
“The long-term story is clear,” Philipp Hildebrand,

“The long-term story is clear,” Philipp Hildebrand, former head of the Swiss National Bank turned vice chairman of BlackRock, told Bloomberg Television this morning. “We’re going to continue to see a vast reallocation of capital towards sustainable products.” 

That mass migration is well underway.  Assets under the environmental, social and governance umbrella reached $35.3 trillion globally as of the beginning of last year according to the Global Sustainable Investment Review for 2020, up 15% from the start of 2018 and representing 36% of all professionally managed funds.  BlackRock will do its part to make sure that figure grows larger. “Our job as an asset manager is to increase the scope of our product offering, ensure that it’s transparent and continue to innovate together with the index providers to make sure we can offer more choices,” Hildebrand added.

To that, big investors say, keep those green investment products coming. California State Teachers' Retirement System chief investment officer Christopher Ailman declared at a conference Wednesday that climate change “is a mega-trend that if you take advantage of it, and get ahead of it, it’s going to be an alpha generator for the next 30 or 40 years.” Conversely, “if you don’t pay attention to it, it’s going to be a negative alpha and you’re going to be stuck with a low-beta return.”  Those sentiments are widely shared. Summarizing the results of a global survey of 24,000 investors, Sarah Bratton Hughes, head of sustainability for Schroders North America, termed 2020 an “inflection point” for ESG strategies. “It is now less about risk and more about return.” 

Mushrooming assets under the ESG purview and ambitious investor expectations lead some to wonder just how financially sustainable the phenomenon really is.  Thus, the Bank for International Settlements issued a stark warning in its most recent quarterly review published Sept. 20: “Historical lessons from the investment volume and price dynamics in rapidly growing asset classes could be relevant for ESG securities. Assets related to fundamental economic and social changes tend to undergo large price corrections after an initial investment boom.” Railroad stocks in the mid-19th century, dot com stocks at the late 1990s and mortgage-backed securities during the mid-aughts housing boom all fit the bill as historical analogies, the central bank of central banks ominously writes.  "You could have too much, too quickly of a good thing," BIS monetary and economic department head Claudio Borio told Reuters. "We know valuations are rather rich." 

Indeed, new evidence suggests that the ESG boom and the grand bull market are inextricably linked. An August paper from EDHEC-Risk Institute analyzing portfolio construction across green-focused exchange traded funds in Europe from 2011 to 2020 found that in climate focused strategies, only 12% of a given stock’s weighting was determined by its climate score.  Market capitalization accounted for the other 88%.  

What’s more, firms that failed to do their part for Mother Earth often saw little in the way of consequence:  35% of companies with deteriorating environmental scores over that 10 year period managed to grow their ESG portfolio weightings anyway.  Finally, the EDHEC researchers find that ETF promoters chronically underweight economically critical but high emission sectors like energy and utilities in their portfolios, burnishing those managers’ green bona fides but depriving the firms with the most room to enact environmental improvements of the capital to do so. 

With fossil fuel prices now going vertical around the globe, the limitations of that strategy are abundantly clear. “The generators of innovations to address environmental issues must have an incentive” to do so, Will Thomson, managing partner at Massif Capital, writes today. “Such environmental innovation is most likely to arise from firms that create environmental problems or firms in industries with environmental problems. In our minds, this is common sense.”

For more from Thomson on this essential topic, join us in person at the Plaza or tune in for the webinar of the Grant’s Fall Conference on Oct. 19 (advt.)

Recap Oct. 1

Stocks enjoyed a strong bounce, with the S&P 500 advancing by 1.2% to erase yesterday’s losses and narrow its decline for the week to 2.2%, while Treasurys built on yesterday’s rally with the 10- and 30-year yields falling to 1.46% and 2.03%, respectively.  Gold edged higher to $1,760 an ounce, the VIX fell 9% to 21 after logging a relatively weak move during yesterday’s selloff and WTI crude pushed to near $76 a barrel, its best finish since fall 2018. 

- Philip Grant

A Tree Grows in Washington
Breaking the buck, 2021 edition.  Dollar Tree, Inc. announced yesterday that it will begin selling items at up to $1.50 at all its stores, comprehensively bucking the eponymous pricing strategy in place since its founding in 1986.  “We recognize the need to make adjustments in the current economic environment,” CEO Michael Witynski told The Wall Street Journal, pointing to “the pressure all of us are seeing on wages, freight and on our suppliers and cost increases.”
Climate Change on the Planet of the Apes
Retail investors allocated just 43% of their options volume towards buying calls

Retail investors allocated just 43% of their options volume towards buying calls in anticipation of higher prices, data from Sundial Capital show, down from a peak of 55% in February and marking the lowest level of 2021 so far.  As ever, markets make opinions. “Deterioration under the surface [of the major indices] has dented investors’ optimism, and many of the indicators we follow have moved back into neutral, or even slightly pessimistic territory,” Sundial’s chief research officer Jason Goepfert wrote Tuesday.  The recent volatility spasm “has led the smallest of traders to pull back significantly on their bullish bets.” 

Such cooling bullish sentiment is an unwelcome development for millennial-focused trading platform Robinhood Markets, Inc. (HOOD on the Nasdaq).  Citing data from Apptopia, analysts from JPMorgan relayed yesterday that downloads of the Robinhood app in the third quarter collapsed by 78% from the prior period, exceeding the 50% sequential decline in downloads for crypto-focused favorites such as Coinbase and Binance and 15% for stock-trading rival Charles Schwab.  

Similarly, Robinhood’s daily active users slipped by 40% this quarter relative to the three months ended June 30, outpacing declines of about 25% for the crypto exchanges and 30% for Schwab. Those declines are particularly eye-catching in the context of ambitious growth expectations, as the sell-side pencils in $3.7 billion in revenue for Robinhood in 2023 from $2 billion this year.  Following a 2.5% decline today, HOOD shares sit 11% above their $38 per share late July IPO price, with a $36 billion market capitalization towering over the $11.2 billion value obtained from a series G fundraising round in June of last year. 

That share-price resilience could be tested. The JPM analysts also note that, with insider lockups set to expire in the coming months, Robinhood’s currently tiny floatation could soon dramatically expand. Thus, as many as 567 million shares could be made available to trade by Dec. 1 if insiders opt to sell en masse. For context, a mere 59 million shares were floated at the time of the IPO while up to 160 million shares are currently in the public domain, a small fraction of the 855 million total shares outstanding as of Aug. 16.  Recall that, prior to its public debut, Robinhood permitted employees to sell up to 15% of their holdings immediately upon the listing and another 15% three months later, instead of a more typical six-month lockup period for insiders. That flood of supply will, in JPMorgan’s estimate, yield “a stock more likely to trade on fundamentals rather than sentiment.” 

Meanwhile, new details come to light regarding the January meme “stonk” kerfuffle, in which Robinhood limited the ability of individual investors to purchase the likes of GameStop and AMC as those equities embarked on epic rallies fueled by frenzied activity from the retail cohort.  Earlier this week, Citadel Securities issued a statement denying that it strong-armed Robinhood into restricting activity in those meme stocks to position closing transactions only, a move which spurred a 44% swan-dive in GameStop on Jan. 28. That follows a class-action lawsuit filed last week accusing the pair of working in cahoots to drive those high-flyers back to earth, dealing substantial losses to the retail crowd in the process.  This afternoon, Citadel tweeted out a screenshot of an electronic messaging exchange in support of its position:

The lawsuit, which alleges that Citadel “applied pressure on Robinhood” to put the brakes on the meme stonk rally, cites an internal message from HOOD chief operating officer James Swartwout on Jan. 27 telling a colleague that “you wouldn’t believe the convo we had with Citadel, total mess.”  Later that day, Swartwout allegedly declared that “I am beyond disappointed in how this went down. It’s difficult to have a partnership when these kinds of things go down this way.” One thing’s for sure, the high-frequency trading firm enjoys plenty of negotiating leverage: payments from Citadel for its order flow amounted to 21% of Robinhood’s total revenues over the first six months of the year and 34% across 2020.  

The Robinhood c-suite’s personal financial interests further color this unusual tale.  As the complaint shows, Swartwout advised his colleagues in an internal chat on Jan. 26 that “I sold my AMC today.”  Perhaps referring to an imminent increase in margin requirements, the Robinhood executive added: “FYI – tomorrow morning we are moving GME to 100% -- so you are aware.”  Charles Gasparino of Fox Business reports this afternoon that Swartwout’s transactions are now being “scrutinized” by the Securities and Exchange Commission’s Division of Enforcement.

QE Progress Report
Reserve Bank Credit, or interest-bearing assets at the Fed, fell to $8.43 trillion.  That’s down $13 billion from last week’s reading but up 19.7% year-over-year and 116.5% from late September 2019. 
Recap Sept. 30

A stable showing in the Treasury complex didn’t help stocks, as the S&P 500 slid another 1.2% to wrap up September with a 4.8% decline to all but erase its gains for the third quarter.  Gold took full advantage of a slight USD pullback by jumping 2% to $1,758 an ounce, WTI edged back above $75 a barrel and the VIX rose a modest 2.5% to 23. 

- Philip Grant

The Joker

From CBS News:

A Danish artist was given $84,000 by a museum to use in a work of art. When he delivered the piece he was supposed to make, it was not as promised. Instead, the artist, Jens Haaning, gave the Kunsten Museum of Modern Art in Aalborg, Denmark two blank canvases and said they were titled "Take the Money and Run."

Maybe the museum can mint a commemorative NFT to recoup their stolen funds. 

Foreign Affairs
A September chill ripples through financial markets:

A September chill ripples through financial markets: Bloomberg relays that traditional 60% equity and 40% bond portfolios absorbed a near 1% decline across the first 23 days of the month for their worst showing since last fall, even before the continued bearish action over the past two days.  That 60/40 allocation had previously enjoyed seven consecutive months of positive performance prior to the September stumble. 

A vicious cycle may be taking shape, some caution.  The move higher in rates following last week’s Fed meeting “should provide support for spread widening pressure on investment grade credit debt portfolios,” Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings, told Bloomberg.  “This in turn should have an adverse effect on 60/40 portfolio[s]. . . which could also have a negative effect on equity markets in the near-term.” Stock jockeys should hope the strategist has no crystal ball: Di Galoma predicts that the 10-year yield will rise to 2% to 2.25% by year-end, from the current 1.55%. 

With the S&P 500 sporting a sticker shock-inducing 38 times Shiller price-to-earnings multiple (surpassed only by the late 1990s tech bubble), a lasting disruption to the lower-for-longer rates regime could certainly sting.  Accordingly, the prospect of shifting financial winds invites a second look at one of the core trends of the post-crisis bull market.  

A paper this month from Research Affiliates founder Rob Arnott analyzes the yawning valuation gap between growth and value stocks utilizing the price-to-book valuation methodology advanced by economists Eugene Fama and Kenneth French. Research Affiliates finds that value stocks endured a 34% drawdown relative to growth stocks from December 2006 through August of last year, bringing value’s comparative valuation from the most expensive quartile to the cheapest percentile on record going back to 1963.  Even with a subsequent bounce relative to growth, Arnott finds that “value stocks remain priced at very attractive valuations. . . discounts are not only in the cheapest decile in history, they are in the bottom half of the cheapest decile!” 

A less-than-rosy profile for future returns colors the bull case for the oft-overlooked corner of the stock market:

The bottom line is that even after value’s recent partial rebound, the strategy in most regional markets is still priced at very attractive valuations. In the U.S. and developed markets, value discounts have only been cheaper at the very height of the tech bubble and during the summer of 2020. When most other liquid asset classes are priced to generate negative or near-zero real returns, only equity value strategies are priced to generate long-term real returns higher than 5%. 

While Arnott posits that value stocks domiciled in the third world are poised to deliver the highest real returns, at nearly 10% per annum over the next decade, value plays in developed markets such as mainland Europe, the U.K. and Japan “are priced to generate an anticipated real return of 6% to 8% a year over the next 10 years, likely with less risk compared to emerging markets.” 

Indeed, a flood of capital into U.S. equities during the post-crisis era has perhaps opened the door to opportunities outside the 50 states for value-seeking contrarians. To wit: the MSCI USA Index sports a $40.4 trillion market cap, compared to $19.2 trillion for the MSCI World ex-USA Index, which tracks other developed markets across the globe. That 67.8% market share for the United States is up from less than 50% in 2010. 

Where might those opportunities be found? See the issues of Grant’s Interest Rate Observer dated May 28, April 30, Feb. 5 and Jan. 22 of this year, along with Nov. 27, 2020 for bullish analyses on a raft of companies far afield from the S&P 500.  

Recap Sept. 28

It was a sea of red today with the S&P 500 finishing near session lows with a 2% decline to extend to a 4.1% drawdown from early September, while rates lurched higher again with the 10- and 30-year yields finishing at 1.55% and 2.1% respectively, each at its highest since June.  A strong bid for the dollar helped pressure gold to $1,732 an ounce and WTI crude back below $75 a barrel, and the VIX jumped 24% to 23.3. 

- Philip Grant

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