®
Vol. 33, No. 16
Two Wall Street, New York, New York 10005 • www.grantspub.com
AUGUST 7, 2015
Fault lines in credit In writing off all but tag ends of its Nokia acquisition of little more than a year ago, ago, Microsoft Microsoft produced produced a $7.5 billion demonstration of the evanescence of modern business value. Creative destruction may be salutary—it is salutary. Still and all, destruction costs money. Credit—the promise to pay money—is the subject of this unfolding narrative. Junk bonds are in the foreground, money is in the background. No further need to reach for a certain kind of yield, we are about to contend; higher speculative-grade yields are coming to you. In advance, we are prepared to assign a cause to the downturn that hasn’t fully materialized yet. Six carefree years of Fed-engineered zeropercent funding costs will prove the fundamental reason for the next gust of defaults. The prospective rise in the federal funds rate will turn out to be a causative footnote. The credit cycle is a mass migration of the mind. It begins with the collective fear of losing money, point A. It ends with the collective fear of not making money, point B. Point A finds lenders and borrowers nursing the wounds of the bust that followed the boom. The penitents resolve to be more careful if only the market will give them another chance. They do not disavow leverage—it is, after all, the raison d’etre of speculative-grade finance. They rather pledge to employ it more prudently. They will henceforth lend at rates that are sensibly aligned with the evident risks of the corresponding borrower. No more updating their Facebook status when they ought to be reading prospectuses, either. The passing years leach away memories of the bust. Bankruptcy filings
become rarities as prosperity spreads its blessings. The return of the itch to speculate means that, for the professional investor, generating gains takes precedence over avoiding losses. Leverage creeps (at length, it gallops) back into the market, and pricing comes to favor the seekers of funds, rather than the providers of funds. Point B is the apex of optimism. Point A of the present cycle we may pinpoint as March 2009, the nadir of stocks and credit. Point B, we shall guess, has just passed. The crystallization of boom-time optimism occurred on July 16. The oversubscribed sale of more than $1 billion of debt by the Ba-1-rated City of Chicago was the red letter event. A two-line quotation in the Chicago Tribune before before the sale took place could speak for broad swaths of American speculative-grade finance.
Grant’ss on vacation Grant’ Grant’s Interest Rate Observer , taking its
summer vacation, will resume publication with the issue dated Sept. 4, 2015.
“It sounds like we don’t have much of a choice,” said Alderman Nicholas Sposato, concerning the feasibility of the then prospective issuance. “This is a way to at least put our finger in the hole in the dike for now.” The fingers in the dike, duly inserted, belong to America’s fiduciaries. For many a moon, the prices of junk bonds failed to register bad news. That has begun to change. Thus, the Bon-Ton Stores 8s of June 2021, issued at par in May 2013, were quoted at 84 as recently as mid-May of this year; they change hands today at 75, a price to yield 14%. “One might reasonably argue that the prospects for U.S. consumer spending should be pretty good, given rising employment, growing wages and falling energy prices,” colleague David Peligal observes. “The Bon-Ton clientele is not high end, so its demographic should benefit more on the margin. The fact that the bonds are sinking is perhaps telling you something about changing perceptions of credit risk.” A July 30 report on the junk market by Michael Contopoulos et al. at Bank of America/Merrill Lynch makes a persuasive case that, if the top in the junk market is not in, it is likely not far off. “The future is what it used to be” is the promising title. Plainly, the authors—who include Neha Khoda and Rachna Ramachandran—are alert to the cyclical facts of life. Reversion to the mean is the foremost cyclical fact. Trees don’t grow to the sky; the cure for high prices is high prices, and the cure for low prices is low prices. The junk market, though it has suffered a rocky couple of weeks— thereby trimming returns in the year (Continued on page 2)
2 GRANT’S / AUGUST 7, 2015 (Continued from page 1)
15%
e t a r t l u a f e d
Too quiet out there
15%
Moody’s trailing 12-month issuer default rate for global speculative-grade debt
12
12
9
9
6
6
3
3
0
1/70
1/75
1/80
1/85
1/90
1/95
1/00
1/05
1/10
d e f a u l t r a t e
0
6/30/15
source: Moody’s
to date to little more than 1%—has by no means corrected the manifold excesses that are so much in need of correcting, the authors assert. Not only is the market not out of the woods, Contopoulos et al. insist, it is “not even in the woods yet.” Well, the market is in the woods of debt. Over the past several years, speculative-grade companies have releveraged, “somewhat of an anomaly during periods of decent growth, low default rates and strong equity markets,” the report observes. The authors relate that they have looked at leverage in its many different facets: “We have run the numbers using unadjusted EBITDA, adjusted EBITDA including and excluding energy, metals and mining, and materials. . . .” The conclusion is the same, no matter how the data are sliced, they find: “[C]ompanies have re-levered to an extent not seen since the late 1990s.” Apocalyptic, the BofA/Merrill team is not, bearish it is: “In our view, commodity, rate, liquidity and, most importantly, fundamental pressures have yet to fully affect the market, and when they do, we expect further price loss across a broader set of companies.” Naturally, all cycles are different. Radical monetary experimentation is the standout characteristic of this one. Zero-percent funding costs have pulled forward consumption and pushed back distress. They have reduced the returns to skepticism, securities analysis and due diligence. They have
prolonged the commercial lives of marginal businesses that, were they forced to finance themselves at normal interest rates, might be pushing up daisies in some reorganization proceeding. At the spring 2014 Grant’s Conference, Martin Fridson, now chief investment officer at Lehmann Livian Fridson Advisors, imagined the next wave of speculative-grade defaults. It would begin in 2016, he projected—that is, it would likely begin in 2016 if past were prologue. The wrinkle was that, in this day of monetary activism, the past may not be prologue. Thus, in 2009, 13.3% of the speculative-grade issuer universe defaulted. It was far and away a record for any year in the 45 years since the data were first collected. Yet—remarkably—in 2010 the default rate subsided to 3.3%, slightly below the long-term average of 4.6%. “I would submit that is physically impossible,” said Fridson, still amazed at this occurrence a halfdecade after it happened. “But it did actually happen, and I think that the only conceivable explanation is the Fed’s extraordinary intervention.” Contopoulos et al. compare 2015 to 1998, a year best remembered, if at all, for the flameout of Long-Term Capital Management. The year 1998, like 2015, saw plunging oil prices, swings in quarterly GDP readings of as much as four percentage points, apprehension over a Fed tightening cycle and flattish junk-bond returns. Front and center, too, was the concentrated issuance of speculative-grade debt in a certain
favored industry. The fair-haired segment of 1998 was telecommunications, that of the present is, or rather was, commodities. “High yield typically overbuilds in one industry before realizing stress in that sector,” the BAML report observes. We would amend that statement. Credit markets tend broadly to overbuild. They tend especially to overbuild when tempted by governmentally suppressed interest rates. Junk bond yields beginning with the number “five” and sovereign debt yields beginning with the number “one-half of one” have proven temptations impossible to resist. Intimations of trouble in telecom did not, at first, trouble the broad junk market. Investors wrote it off as a speculative outlier. Only gradually did they lose faith in industries and companies that they had previously assumed to be safe. Skepticism proved contagious once it set in. “It is this heightened skepticism that ultimately feeds into capital markets, creating a re-pricing of risk and ultimately a lack of desire to fund risky companies,” the authors say, and they add: “We’re seeing similar behavior today. A year ago, weakness was isolated to metals and mining and pockets of retail. This ‘idiosyncratic’ weakness bled into energy in the fall, and now is beginning to affect wireline, technology and financial companies.” Advanced Micro Devices is an example of a speculative-grade issuer to which the market has belatedly given the fish-eye. Incorporated in 1969 and public since 1972, AMD is a Silicon Valley senior citizen. It designs and markets semiconductors for use in personal computers. As recently as 2012, the company’s PC-centered business designated “computing and graphics” generated revenue of $4.7 billion and operating income of $129 million. That was as good as it got. In the first six months of 2015, AMD logged revenue of just $911 million and operating income of minus $222 million. A second AMD division, the “enterprise, embedded and semi-custom” unit, is both profitable and growing, though it is not so profitable, nor so fast growing as to lift the corporate whole. Companywide revenue and earnings per share both peaked in 2011. EPS turned negative in 2012 and has not returned to the black. Second-quarter 2015 results featured dwindling sales,
Copyright ©2015 by Grant’s Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.
GRANT’S / AUGUST 7, 2015
declining cash and rising inventories. Revenue declined by 35% vs. the previous 12 months, a plunge that included a 54% drop-off in the legacy PC segment. Not only is PC demand falling, but AMD is also taking a smaller share of what remains. “So it’s quite possible,” Peligal points out, “that AMD only generates total 2015 revenue of slightly more than $4 billion. If true, it would be down by a little more than 25% from 2014. The closest debt maturity is March 2019, which, at this rate, may be closer than it seems.” It falls to management to keep up a brave face—if not management, who?—and AMD’s chief financial officer, Devinder Kumar, tried to put the minds of dialers-in at ease on the second-quarter conference call. “As far as the financing is concerned. . . ,” he said, “I monitor the capital markets pretty closely and if the need arises, obviously, we’ll access the capital market. . . . If you think about it, with the cash that we have, we also have ABL [asset-backed revolving credit accommodation] availability that we put in place in the late part of 2013 and that’s not all fully tapped out.” In his expressed optimism concerning the hospitality of the credit markets, Kumar recalled the words of Chicago’s Alderman Sposato. Willing fingers plugging leaky dikes is all very well in the bullish portion of the credit cycle. The gentlemen will find that the fingers are hard to come by in the bearish portion. It seems to us—to repeat—that we’re in it. It’s no news at all that the PC business is in long-term decline. What is new is the bond market’s recognition of that fact. The stock market has long been fully briefed. AMD common is heavily shorted and hugely expensive to borrow (a trader we know was offered 25,000 shares at a cost of 16 ½% of the share price per annum). It trades at around $2 a piece, lurching higher in response to periodic recalls of borrowed shares. Altogether, some 24% of the company’s 633 million-share float is sold short. On July 28, Moody’s slashed the rating on four issues of senior unsecured AMD notes to Caa2 from Caa1, the new rating being four notches from C, which means finis . “As a result of projected operating losses,” said the agency, “credit metrics will be very weak, with negative EBITDA relative
NEW this conference: Webcasting the full day’s events! Go to grantspub.com/conferences
®
Fall 2015 Conference Tuesday, Oct. 20, 2015
The Plaza, Manhattan
Martin Wolf, Financial Times economics columnist,
debates
James Grant: “Resolved: Monetary experimentation has gone dangerously far.” Speakers include:
Wences Casares, Xapo
Jim Chanos, Kynikos Associates, LP
Stanley Druckenmiller, Duquesne Family Office, LLC
Thomas S. Gayner, Markel Corporation
John Hathaway, Tocqueville Asset Management
James Litinsky, JHL Capital Group
Michelle Leder, Footnoted.com
Avoid disappointment! Register online now. In person: $2,150, includes breakfast, lunch and cocktail reception. Webcast: $1,750 gets you the complete virtual experience, including the ability to participate in a live Q&A. For information, call 212-809-7994, during business hours.
Register or download a form at www.grantspub.com/conferences
3
4 GRANT’S / AUGUST 7, 2015
$50
e r a h s r e p e c i r p
Bonds tag along
$50
AMD stock price
40
40
30
30
August 4, 2015: $2.13
20
20
10
p r i c e p e r s h a r e
10
0
0
1/95
1/97
1/99
1/01
1/03
1/05
1/07
1/09
1/11
1/13
1/15
source: The Bloomberg
to $2.5 billion of adjusted debt, and negative free cash flow.” The senior unsecured AMD 7s of 2024, which had changed hands at 85, a price to yield 9.5%, as recently as July 2, are quoted at 68 today, a price to yield 13%. The problems that have lately come to light were not previously in the dark—certainly, not when the 7s came to market in June 2014. As those securities flew out the window and into the hands of yield-famished investors at 100 cents on the dollar, the AMD share price was quoted at just $4. Here was a broad hint that something was wrong. Whatever the bull case on the stock might have been—something to do with intellectual property assets? With a hoped-for upturn in the PC market? A potential takeover—the bull case on the bonds was as modest as the bull case for a corporate debt security has ever been. To wit: “If all goes well, you’ll recover your principal at maturity while earning the coupon in the interim. The upside is par. The downside is default with uncertain recovery.” At least, that was the pre-ZIRP value proposition. Radical monetary policy transformed the arithmetic. A 7% yield to a 10-year maturity is a king’s ransom compared to the Treasury’s 2%-and-something 10-year paper. Then, too, the argument goes—or went—the Fed would lift the funds rate most deliberately, if at all. Creditors have reached for yield as long as there have been yields to reach for. The reaching has been more ac-
robatic this time around because the need has been greater. The need must explain Chicago’s otherwise inexplicable success last month in placing $743 million of 7.55% taxable general obligation bonds due 2042 and $346 million of 5.5% general obligation tax-exempt bonds due 2039. The creditworthiness of the issuer in no way accounts for it. Our friend Michael Lewitt, proprietor of the monthly Credit Strategist , points out that a July 24 court decision by the Cook County Circuit Court scuttles plans of Mayor Rahm Emanuel to restructure the city’s pension funds in such a way as to postpone
105
their inevitable insolvency. If, as the court held, benefits once promised but now unpayable cannot be renegotiated, bondholders may be out in the cold. “The negative outlook,” said Moody’s in May when downgrading America’s third-largest city to junk, “also reflects our expectation that Chicago’s credit quality will weaken as unfunded liabilities of the municipal, laborer, police and fire pension plans grow and exert increased pressure on the city’s operating budget.” Lewitt: “Why any responsible manager would think that an 8% taxable yield on a 27-year bond or a 5.7% taxexempt yield on a 24-year bond is sufficient compensation for the risk of owning Chicago’s debt is a total mystery, particularly in view of the recent experience of those who rushed to buy Puerto Rico’s 8% Series A general obligation bonds due 2035 in March 2014. Those bonds are guaranteed tickets to the boneyard.” Something is changing, as the BAML analysts observe. Caa spreads widened in the first four months of the year, even as the broad junk market rallied. Not that such cracks have yet defaced much of the surface area of the speculative-grade market—“as recently as a week ago, the ex-commodity portion of high yield was still yielding less than 6%.” Team BAML adds that the evident complacency is no bullish sign but a worrying one, “just a delay of the inevitable and an indication that there is room to move lower in price.” They
Junkland gets the memo
105
AMD 7s of July 1, 2024
95
95
85
85
e c i r p d n o b
75
75
65
65
55
9/11/14 source: The Bloomberg
12/15
3/11/15
6/11
55
7/30
b o n d p r i c e
GRANT’S / AUGUST 7, 2015
point a finger of blame to where, in this publication’s estimate, it ought to be pointed: “By inducing reach-for-yield behavior, the Fed may have incentivized the market to overlook fundamentals, creating sensitivity to those metrics when macro liquidity begins to dry up. Given the near doubling in the size of the market since 2008, we think crowded trades are likely to unwind, meaning both high yield as an asset class as well as crowded sectors.” As the market has grown larger, failure has become rarer. Over the past 12 months, according to Moody’s, just 2.3% of the market, measured as a percent of all speculative-grade issuers, has defaulted, one of the lowest rates since the start of record keeping in 1970. The narrative just presented would suggest that the default rate is headed much higher—that if it were a stock, you would want to own it. Invited to freshen up his forecast that the next default cycle is right around the corner, Fridson replies that he stands by it. Next year—some time next year—he expects “a multi-year period in which the default rate is at or above the long-term average of 4.6%” to get underway. “I still think it is possible,” Fridson tells Grant’s. “The market right now is saying—by my interpretation— that the default rate will run about 3% over the next 12 months. That gets you into the first half of 2016. . . . The Fed may be able to stave that off through continuing Herculean efforts, but then again, maybe not. Wi th everything they are doing, maybe we will still see some natural, cyclical economic forces play out.” It happened in Vietnam last year, according to a July 20 dispatch in The New York Times, when, in the wake of a debt crisis, 78% of registered companies in Ho Chi Minh City went broke. “But the creation of new companies has since gathered pace,” the paper said; “so far, 26% more new companies have been formed this year than in the same period last year.” “‘Weak companies will fail; that’s normal,’ said Tran Anh Tuan, the acting president of the Ho Chi Minh City Institute for Development Studies, a government planning agency. ‘They can learn from failure. That’s a good way to develop.’” Over to you, Janet Yellen.
•
Dueling indices How, demands Fred Kalkstein, broker at Janney Montgomery Scott, could the government’s Employment Cost Index for the second quarter have registered the smallest sequential gain in three decades, up by a mere 0.2%. How was it possible in the sixth year of a business expansion during which 12.2 million jobs were created? How can the ECI have risen by just 0.2% when, in the first quarter of the plague year 2009, that very index registered a gain of 0.3%? How is it possible? The Fed seems not to wonder. To explain the ECI-derived data, the mandarins have developed the theory of “pent-up wage cuts.” Employers, so the thinking goes, are loath to reduce compensation in a slump. Maybe they’re too tenderhearted. But they don’t forget. The cuts they didn’t implement stack up like traffic on the Long Island Expressway. “[T]he accumulated stockpile of pent-up wage cuts remain and must be worked off to put the labor market back in balance,” contend Mary C. Daly and Bart Hobijn of the Federal Reserve Bank of San Francisco. “In response, businesses hold back wage increases and wait for inflation and productivity growth to bring wages closer to their desired level. Since it takes some time to fully exhaust the pool of wage cuts, wage growth remains low even as the economy expands and the unemploy-
$34 33
5
ment rate declines.” Janet Yellen has cited the Daly and Hobijn doctrine in her speeches. From here on, it’s Kalkstein who deserves the plug. The data are the trouble, as he persuasively shows. The Employment Cost Index is a less informative measure of wage and benefit pressures than an alternative government index called the Employer Costs for Employee Compensation (ECEC). The ECI treats the landscape of the labor market as if it were frozen in place. The ECEC treats that landscape as if it were ever changing. The ECEC, which takes more time to calculate than does the ECI, has been rising faster than the ECI. It would seem to deserve at least as much attention as the ECI. Built into the ECI is the assumption that the structure of markets has remained as it was in 2013. The ECEC measures the current cost of employee compensation to reflect how, and in what form, the labor market might have evolved. Suppose that recent employment growth happens solely in better paying jobs. The ECEC, picking up on the change, will show a rise in average compensation. The ECI will not because it will capture no such movement toward high-quality work. In the same vein, the ECEC is more likely than the ECI to reflect a migration to lower-paying jobs. Businesses, like the people who work for them, live and breathe and adapt. The second-quarter ECEC is slated for publication on Sept. 10. In the first (Continued on page 8)
Whom do you believe?
135
Employer Costs for Employee Compensation (left scale) vs. Employment Cost Index (right scale)
130
ECEC r u o h r e p s r a l l o d n i n o i t a s n e p m o c
32
125
31
120 ECI
30
115
29
110
28
105
27
100
26
95
25
90
3/05
3/07
source: Bureau of Labor Statistics
3/09
3/11
3/13
6/15
E C I i n d e x l e v e l
6 GRANT’S / AUGUST 7, 2015
CREDIT CREATION 10%
There they go again U.S. mortgage rates (left scale) v
9
F������ R������ B������ S���� (in millions of dollars)
8
July 29, 2015
July 22, 2015
July 30, 2014
$4,239,745 0
$4,244,822 0
$4,137,038 0
201
192
245
216,668
216,053
226,498
$4,456,614
$4,461,067
$4,363,781
% n i e t a r e g a g t r o m
The Fed buys and sells securities…
Securities held outright Held under repurchase agreements and lends… and expands or contracts its other assets…
Maiden Lane, float and other assets The grand total of all its assets is: FEDERAL R ESERVE B ANK CREDIT Foreign central banks also buy, or monetize, governments:
4 Bankrate.com U.S. 30-year fixed 3
$3,327,998
$3,340,353
(in millions of euros) July 31, 2015
June 26, 2015
July 25, 2014
Gold
€ 364,458
€ 383,966
€ 334,431
Cash and securities
1,400,206
1,279,223
959,215
Loans
543,636
555,596
507,819
Other assets
228,292
233,162
242,847
€ 2,536,592
€ 2,451,947
€ 2,044,312
*totals may not add due to rounding
MOVEMENT OF THE YIELD CURVE 4.0%
4.0%
3.5
3.5 3.0
8/4/15 5/6/15 8/4/14
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
3 month
6 month
source: The Bloomberg
1/02
1/04
1/06
1
Try this
$3,309,299
E������� C������ B��� B������ S����*
Total
1/00
source: The Bloomberg
Foreign central bank holdings of Treasurys and agencies
s d l e i y
6
5
Borrowings—net
3.0
7
2 year
5 year
10 year
30 year
0.0
y i e l d s
Low, low mortgage rates are a double blessing, at least to the would-be house buyer. The first reason is obvious: They make a house more affordable. The second, as paid-up subscriber Michael Harkins is wont to observe, is less intuitive. The borrower builds equity faster by paying a low rate than he does a high one. A $100,000, 30-year mortgage will serve as a financial test dummy. At a 4% rate of interest, the mortgagor’s first year payment comes to $5,729, of which $1,761 is devoted to principal amortization. Compare and contrast a 10% mortgage rate. One’s first-year payment comes to $10,531, of which just $556 is earmarked for principal amortization. Harkins performs this interest-rate parlor trick for his financially sophisticated dinner guests. Most refuse to believe him (check the math). ZIRP- and QE-powered real-estate bull markets are once again interrupting the sleep patterns of conscientious central bankers. The functionaries slash interest rates to induce the kind of inflation they prefer. What they get instead is the kind of inflation that the asset-owning portion of the community prefers. Thus, the central banks of Sweden and Norway have reduced policy rates to minus 0.35% and 1%, the central banks of Denmark and Switzerland to an identical negative 0.75%. For one reason or
GRANT’S / AUGUST 7, 2015
7
C AUSE & EFFECT 230
. house prices (right scale)
A��������� R���� �� G�����
210 S&P/Case-Shiller Composite-20 Home Price Index
(latest data, weekly or monthly, in percent) 190
170
150
3 months i n d e x l e v e l
130
110 Home Mortgage national avg
/08
1/10
1/12
1/14
90
7/15
at home
Federal Reserve Bank credit Foreign central bank holdings of gov’ts. European Central Bank Commercial and industrial loans (June) Commercial bank credit (June) Asset-backed commercial paper Currency M-1 M-2 Money zero maturity
6 months
0.5% 7.0 31.2 10.9 6.6 13.1 3.0 4.4 5.1 6.4
12 months
-0.5% 4.0 35.4 13.0 8.2 9.7 5.6 8.4 6.5 7.0
2.3% 1.3 22.7 12.4 7.7 -14.5 6.6 6.4 5.7 6.4
R��������/D�������� W����
another, real estate prices have shot higher. Swedish house prices showed a 13% spike in the 12 months to May. Norwegian house prices climbed 6.6% in the 12 months to June. Copenhagen apartment prices have soared by 25% in a year. Swiss home prices, according to the UBS Swiss Real Estate Bubble Index, are the toppiest since 1991. What, then, should a central bank governor do? Do not— not —raise interest rates: “[R]ough calculations show that the size of rate increase needed to do so might also boost unemployment and push down inflation,” a trio of economists prescribe in a new Federal Reserve Bank of San Francisco Economic Letter. “Thus, using this type of policy tool may cause the central bank to de viate significantly from its goals of full employment and price stability.” The Fed would seem to prefer the certainty of job losses after a bubble burst than the possibility of job losses before a bubble becomes inflated. “[W]hile monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation—namely that it gets in all of the cracks,” former Fed governor Jeremy C. Stein cracked at a St. Louis Fed research symposium in February 2013.
•
FTSE Xinhua 600 Banks Index Moody’s Industrial Metals Index Silver Oil Soybeans Rogers Int’l Commodity Index Gold (London p.m. fix) CRB raw industrial spot index ECRI Future Inflation Gauge Factory capacity utilization rate CUSIP requests Fed’s reverse repo facility (billions) Grant’s Story Stock Index* *Index=100 as of 7/31/2013 Grant’s Never-Never Index** **Index=100 as of 1/4/2013
Latest week
Prior week
Year ago
13,020.43 1,500.86 $14.75 $47.12 $9.81
14,023.91 1,507.66 $14.49 $48.14 $9.91
8,879.56 2,043.31 $20.41 $98.17 $12.25
2,434.59 $1,098.40 448.52 (June) 100.5 (June) 78.4 (July) 1,741 132.0 103.6
2,478.52 $1,080.80 447.20 (May) 101.3 (May) 78.1 (June) 1,564 79.4 103.9
3,565.94 $1,285.25 531.50 (June) 104.8 (June) 79.1 (July) 1,873 101.0 116.1
180.7
187.6
196.9
EFFECTIVENESS OF THE MONETARY POLICY
M-2 and the monetary base (left scale) vs. the money multiplier (right scale) $16
s n o i l l i r t
o n
12
8 e y
8
6 u
4
4 l i
m
$ n i
10x m
0
6/04
6/06 M-2
6/08 monetary base
6/10 6/12 money multiplier
2
6/14 6/15
l t i p e r
8 GRANT’S / AUGUST 7, 2015 (Continued from page 5)
quarter, the ECEC showed sequential growth of 1.1%; the ECI registered a rise of 0.7%. In the fourth quarter of 2014, the ECEC showed a sequential gain of 2.9%; the ECI registered a rise of 0.5%. Wait till the FOMC finds out. If the ECEC is the better barometer of wage and benefit compensation, there are changes afoot in the labor market. Either they will take the form of rising wages (and perhaps of rising prices) or of lower business operating margins. You can pick your poison.
rather on the investment opportunities that angry headlines usually surface. Five discrete investments—two pairs of unloved “emerging” stocks and a Brazilian corporate bond—are featured below. Each is cheap, each has merit—each had merit even before its price was sawed in half in sympathy with the goings-on in Turkey, Greece, Brazil, Russia, South Africa, Argentina, Colombia, China, etc. (India, one of the former so-called BRICs, is a bullish breed apart). The sawing suffices to show how macroeconomic problems can overwhelm business fundamentals. It turned out that in 2007-08, the only relevant American “fundamental” was the broad mispricing of credit. In 2014, the defining Russian fundamental was the looming bear market in oil (would that we had seen it coming; see, for instance, Grant’s, Aug. 8, 2014). Perhaps, in 2015, it’s the long-delayed consequences of the suppression of moneymarket interest rates that will set markets on their ear. Still, cheap business value is a rare commodity. It warrants a certain tolerance for macroeconomic dislocation. If it weren’t for the dislocation, the value wouldn’t be there for the plucking in such profusion. In Monday’s Financial Times, the CEO of a Brazilian truck manufacturer was quoted as saying, “In my professional life, I’ve already passed through 17 [economic] crises.” He must have been grateful for so many buying opportunities—and for so many reciprocal selling opportunities— even if he didn’t think to mention it.
•
Global verbiage glut From time to time, Ben S. Bernanke, central banker turned blogger and capital-introduction professional, vouchsafes his latest thoughts on a concept of his own devising, the “global savings glut.” By the former chairman’s telling, an excess of savings in emerging markets is the cause of ultra-low interest rates the world over (it isn’t the Fed’s doing). Could that be true? Yes—or perhaps no. As with the nonstop talk about secular stagnation or a commodity super cycle or the drawdown in international monetary reserves, you start to wonder what the words signify. “Not much,” is the thesis of the essay now in progress. Buying low and selling high is rather the point. So saying, we don’t mean to deny that the emerging world is in a jam or that the difficulties are not traceable to macroeconomic causes. Our focus is
12%
What goes up...
12%
emerging market forex reserves as percent of world GDP 10
10
8
8
P D G 6 d l r o w
6
4
4
2
2
0
0
1/95
1/97
source: IMF
1/99
1/01
1/03
1/05
1/07
1/09
1/11
1/13
4/15
w o r l d G D P
What pulled the rug out from under the emerging markets is still a topic of learned macroeconomic debate. Commodity prices have broken as the dollar has rallied. EM stocks and currencies have plunged. The burden of servicing dollar-denominated debt outside the 50 states is becoming more onerous. These are the symptoms of the problem. What is the cause? Recalling that booms not only precede busts but also cause them, one turns to the People’s Republic. On the upswing, China suppressed the renminbi-dollar exchange by buying dollars. It printed the renminbi with which to do the buying. In consequence, in China, moneysupply growth accelerated, interest rates declined, official dollar holdings soared and factory chimneys smoked. Now, the processes are reversing. Official dollar holdings are dwindling, economic growth is decelerating, capital is fleeing. Well, capital appears to be fleeing the People’s Republic. To explain the ambiguity on this point requires a short, instructive detour. The IMF reports that foreign currency reserves held by emerging economies plunged by $533 billion to $7.5 trillion in the 10 months till April. Nothing like it has ever been seen before. It was far and away the steepest decline since the start of record keeping in 1995. One is worried, of course. The data must signify something, they’re so big. And they do signify something. What they signify is how little anyone really knows about the cross-border flows of hot money. That $533 billion is a raw, unprocessed datum. It requires adjustment for the changing value of the dollar, against which other currencies are valued, and it requires adjustment for variations in the composition of international reserves. It happens that the IMF has hard information on the makeup of only one-third of international currency reserves. The other two-thirds it must guess about. The uncertainties reduce the careful analyst to expressing the size of reserve flows not as a single point but as a range of possibilities. In this case, the range may be expressed as between $533 billion on the high side and $44 billion on the low side. As you could drive a truck through the difference, you hesitate before saying much more than the not altogether informative, “emerging market currency reserves have declined.” Irresolution similarly set the tone of a report in Monday’s Financial Times
GRANT’S / AUGUST 7, 2015
on supposed capital flight from China: “Analysts broadly agree that China has experienced capital outflows on an unprecedented scale. But they disagreed about their size, causes and risk to the economy.” Note well: other than “size, causes and risk.” No sense, then, on too great insistence on quantitative macroeconomic diagnosis. Some policy errors have created a deflationary undertow, others an inflationary over lift. The dollar surges, EM currencies buckle. Country-specific, heterogeneous problems have yielded uniform, homogeneous outcomes of one particular kind: Bear markets dot the EM landscape. Records are beginning to fall. Thus, for instance, the Malaysian ringgit and Indonesian rupee have fallen by 16.9% and 12.7% against the dollar in the past year to levels not seen since the end of the Asian financial crisis in 1998. Turbulence mixes badly with leverage. It is not farfetched to expect some thunderclap of a bankruptcy in the EM world. With regard to China, a Hong Kong-based friend of this publication, asking not to be named, advises colleague Evan Lorenz that China’s fast-growing, $30.5 trillion asset banking system is at risk. “Deposit growth is very weak right now,” our source relates. “Maintaining that growth requires you to take more liability risk.” On form, muses Russell Napier, an independent strategist and co-founder of Electronic Research Exchange, downturns in emerging markets tend not to stop until there’s a major default. Observe, says Napier, how very much like Mahathir Mohamad, prime minister of Malaysia during the Asian financial crisis, the president of Turkey, Recep Tayyip Erdogan, is beginning to sound with his railing against the “interest rate lobby” and his accusations of “treason against this nation.” “If Turkey imposed exchange controls, that is a de facto default,” Napier says. “Turkey is one of the biggest components of the emerging markets debt index. I think it would be tantamount to the BNP Paribas closing those three mortgage-backed securities funds in 2007. People would realize the lack of liquidity and the higher credit risk and things would come to a halt very quickly. We’ve lent money to emerging markets before, but we’ve never lent it to them in this form of bonds, which are theoretically liquid through open-ended funds. It is the holding of them through open-end-
75
Not in the plan ruble exchange rate (left scale) vs. price of oil (right scale)
$120
70
110
65
r a l l o d r e p s e l b u r
100
rubles per dollar
60
90
55
80
50
70
45
60 price of Brent crude per barrel
40 35
9
8/1/14
10/3
12/5
2/6/15
4/3
6/5
p r i c e p e r b a r r e l
50
8/3
40
source: The Bloomberg
ed funds which is dangerous if someone does impose capital controls or if someone defaults.” So there’s no guarantee that what’s cheap may not become cheaper. If the point needed proving, the gold-mining stocks would nail it down. They have wasted away to the point that we at Grant’s, their close and loyal friends, hardly recognize them by sight on our brokerage house statement (note for the file: Buy more at the bottom). Then, too, American equity values remain Uberized. A sell-off in New York would likely not be seen as a bull market catalyst in Bogota, Sao Paulo or Moscow. Herewith our picks to click (or, in the case of the Russians, to re-click) at some indeterminate date : Avianca Holdings SA, the Colombian airline (AVH is the ticker for the New York-listed American Depository Receipt); Grupo Nutresa SA, a top Colombia-based food distributor, processor and marketer (the peso-denominated common shares are listed in Bogota); the senior debt of General Shopping Brasil S.A., a financially leveraged owner and operator of Brazilian shopping malls; and a pair of Russian equities that may be familiar—perhaps all too familiar—to constant readers. They are Sberbank (SBER on the Moscow and London exchange; SBRCY is the American Depository Receipt); and Moscow Exchange (MOEX, listed on itself). One year ago, these pages prophesied that “as tensions subside, so will Russian equities come in for what the comrades used to call ‘rehabilitation.’” Tensions
have not subsided, the oil price has not rallied and the ruble has not recovered. In the past 12 months, Sberbank, Russia’s largest bank, has declined by 41% in dollar terms (it is up 2% in rubles); Moscow Exchange has fallen by 31% in dollar terms (it has rallied by 21% in rubles). Each company remains profitable. Each remains value-laden, and each remains a kind of call option on normalcy. We remain bullish (to declare an interest, your editor owns Sberbank). In picking Russia, this publication failed to pick a winner. Real Russian GDP is on track to sink by 3.4% this year as the rate of inflation tops 15%, according to a forecast by the IMF. Sberbank is a mirror to those circumstances: It has reported sharply lower net income (down 58% in the first quarter; second-quarter results are due on Aug. 27), higher loanloss provisioning, rising non-performers (now 3.9% of total loans, up from 3.2% a year ago) and contracting net interest margins in consequence of a central bank rate that jumped to 17% in December from 8% four months earlier; 11% is the current rate. Still and all, the bank remains profitable. In the first quarter, it earned 12.5% on equity, down from the 20%-plus returns generated in 2013 and 2012 but more than respectable in the comparative light of, for instance, J.P. Morgan Chase & Co., which earned 10.2% on equity in the first quarter. Sberbank common is priced at 75% of book value and 6.2 times trailing earnings; the (shrunken) dividend delivers a yield of 0.6%. Sberbank pre-
10 GRANT’S / AUGUST 7, 2015
$120
Perpetuity on sale
$120
price of General Shopping 10% senior unsecured perpetuals
e c i r p d n o b
110
110
100
100
90
90
80
80
70
70
60
60
50
50
40
b o n d p r i c e
40
11/10
11/11
11/12
11/13
11/14
8/4/15
source: The Bloomberg
ferred, which confers no voting rights but holds an identical economic interest to that of the common, is priced at 53% of book value and 4.5 times earnings. It yields 0.9%. “Throughout its post-Soviet history,” observes Boris Zhilin, co-founder and principal of Armor Capital, “Sberbank has weathered at least two severe storms—in 1998 when Russia defaulted on its sovereign debt following the Asian crisis, and in 2009 as a result of the Great Recession. Despite that, its book value per share in U.S. dollar terms posted a compound annual growth rate of 17% from 1997 through the end of 2014 (the ruble lost about 90% of its value vs. the U.S. dollar throughout this period). In other words, painful upheavals notwithstanding, those who held shares of Sberbank did very well, provided a sufficiently long-term investment horizon.” For the grandson, then. Even faster than the ruble exchange rate has fallen, the earnings of Moscow Exchange have risen. They leapt by 124% in the first quarter (secondquarter results are due on Aug. 5, the day after we go to press). On the firstquarter call, MOEX’s management laid out a five-year plan to boost growth through initiatives in commodities trading, over-the-counter derivatives clearing, risk management and collateral management. Moscow Exchange is priced at 9.8 times trailing net income; the 3.87 rubleper-share payout delivers a 5.5% dividend yield. J.P. Morgan analyst Alex Kantarov-
ich is projecting a boost in the payout to 6.10 rubles per share in fiscal 2016. Dilma Rousseff’s Brazil is perhaps a more inviting place than Vladimir Putin’s Russia, but that speaks chiefly to the weather. With respect to inflation, the immediate economic outlook and currency depreciation, the two countries are very nearly peas in a pod. Which brings us to the perpetual, 10%, dollardenominated debt of General Shopping. Quoted at 48 cents on the dollar, the securities yield 20%; at par value, $250 million are outstanding. We come by the General Shopping story through our value-seeking friends $20
at Explorador Horizon Fund L.P., which manages $300 million and is based in Sao Paulo. General Shopping owns and operates 16 shopping malls in southeast Brazil, mostly in the state of Sao Paulo; the founding family, the Veronezis, own 60% of the stock. The rest trades on the Brazilian public market. General Shopping is an example of a good business chained to a bad currency. Taking in reals, it must pay out a certain number of dollars. The local currency’s plunge in depreciation stresses the balance sheet and introduces the apprehension that partly explains the bargain price of the bonds (sky high Brazilian interest rates explain the rest). “General Shopping’s B1 senior unsecured debt and corporate family ratings reflect the good quality of its portfolio with solid margins and high occupancy rate as well as the management team’s experience and successful track record in development,” judges Moody’s in a June bulletin. The other side of the ratings coin concerns that sinking currency and the interestrate problems that go with it. The bull story on the General Shopping 10s harps first on operations, second on asset coverage. At year-end 2014, CBRE appraised the value of the assets at $880 million. “If we take all liabilities,” Daniel Delabio, Explorador portfolio manager, tells Grant’s, “we’re talking about total debt of $570 million. So still you have $200 million-plus of value in excess of liabilities. The market value of the debt is less than half the value of
Monetary turbulence Avianca share price (left scale) vs. Colombian peso (right scale)
18
3.100
2,900 pesos per dollar
16
e c i r p e r a h s
2,700
14
2,500
12
2,300
10
2,100 Avianca Holdings
8
1,900
6
1,700
11/8/13
5/9/14
source: The Bloomberg
11/7/14
5/8/15
8/4/15
p e s o s p e r U . S . d o l l a r
GRANT’S / AUGUST 7, 2015
the total properties. It’s good value even in a distressed scenario. That is point one. Point two is that we don’t think it is going to restructure or needs to go that route. They are not against the wall to do anything, because cash liquidity is very high. Today, their cash position is 1.5 times earnings before interest, taxes, depreciation and amortization. And that should be enough to pay interest. Even if they don’t get any new funding, or any new bank loans for the next two years, they should be able to pay principal and interest. “We’re talking about the senior debt,” Delabio goes on. “But they also have subordinated bonds, where they can pay coupons in kind. So we’re talking about a company that has enough EBITDA today to pay its cash interest payments but also has the optionality to defer coupons on the subordinated debt, which would be in favor of the senior bonds. So a bond at 48 cents with those dynamics, there is asset coverage, there is liquidity, there is seniority to the subordinated bonds, and you should be able to collect your coupons. With time, this should re-rate, and the bond should move up in price.” Acronym is the lingua franca of the EM world. First came the BRICs. They were succeeded in 2013 by the Fragile Five. And now, through the offices of BNP Paribas, come the “PICTS,” signifying Peru, Indonesia, Colombia, Turkey and South Africa. As BNP sees the situation, they are a kind of United Nations of financial risk. The intrepid team at Explorador dissents from that top-down fatwa. As of June, 18.5% of their fund was apportioned to Peru, 13.8% to Colombia. As for the latter, much of what could go wrong already has. Before its price collapsed, oil generated more than half of Colombian export sales. In the past 12 months, the Colombian peso has depreciated by 36%, the third worst performance among the 150 currencies that Bloomberg tracks (Ukraine and Russia edged out Colombia in the monetary race to the bottom). The Colombian stock market has fallen by 59% in dollar terms from its November 2010 peak. Five years ago, the MSCI Latin American index traded at 15 times the average of 10 years trailing net income. It trades at 9.6 times that 10-year trailing average today. Avianca Holdings S.A., the foremost Colombian airline, owns regional airlines in South and Central America. It has subsidiaries in Ecuador, El Salvador, Costa
Rica, Peru, Nicaragua and Honduras. Its on-time performance stacks up well against U.S. carriers, indifferently against neighboring ones. Standard & Poor’s rates its debt B-plus for higher-quality junk; in the 12 months to March 31, operating income covered interest expense by a slim 1.5 times. The shares are quoted at 4.5 times earnings. Avianca is a sum-of-the-parts story, too. On July 13 came word that management had sold 30% of its LifeMiles B.V. subsidiary, a six million member consumer loyalty program, for $343.7 million to Advent International, a private-equity investor. The purchase price valued the whole at more than $1 billion. “So,” says Delabio, referencing Avianca’s overall $1 billion equity market cap, “you’re almost getting the stand-alone airline for free.” Yes, he adds, the oil price implosion has damaged Colombian GDP. It has simultaneously raised up Avianca. “One-third of Avianca’s costs are tied to oil,” Delabio goes on. “And lower [consumer] demand will be offset by lower oil-related expenses. So we see margins actually extending from 6% last year to 7.5% this year, and this is below company guidance. The company is guiding to 8% to 10% margins for the year, so we’re being conservative.” Grupo Nutresa SA, our final EM submission, is a prosperous, conservatively financed, $4.1 billion market-cap food distributor and processor. “The Nestle of Colombia,” a bull might call it. It is an exotic stock: to buy it, an American high net worth individual must execute a local share swap with his or her broker. Read on anyway. Nutresa crystallizes the problem of the good business yoked to a bad currency (and to a problematical macroeconomy). Nutresa processes and distributes cold cuts, biscuits, chocolate, coffee, tea, juice, ice cream and pasta. It is Starbucks’ Colombian coffee vendor. It operates ice cream parlors and hamburger casual restaurants. It employs 39,000. As Explorador does the arithmetic, Nutresa’s food business changes hands at 17.6 times next year’s likely earnings and at 1.5 times book. John Haskell, Explorador’s head of research, reckons that Nutresa trades at a 37% discount to comparable worldwide food companies. Says Haskell: “They have a 61% market share in Colombia. Their market share comes about because they have been advertising for decades in Colombia. Their brand equity provides an in-
11
tangible asset that provides a barrier to entry. They also have an incredibly dense distribution network. They have 100,000 individual partners with over one million points of sale. They’re not only in Colombia; they’re also across Latin America. . . . If I were Nestle and looking to enter Colombia or expand my market share, I would think seriously about what it would take to replicate what Nutresa has built up over decades.” On Tuesday, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, rattled the world when he uttered the not altogether novel words that the Fed may raise the funds rate. When the monetary dust finally does settle, Nutresa and its ilk will still be standing—they might be even cheaper.
•
®
James Grant, Editor Ruth Hlavacek, Copy Editor Evan Lorenz, CFA, Analyst David Peligal, Analyst Harrison Waddill, Analyst Hank Blaustein, Illustrator John McCarthy, Art Director Eric I. Whitehead, Controller
Delzoria Coleman, Circulation Manager John D’Alberto, Sales & Marketing Grant’s is published every other Friday, 24 times a year, by Grant’s Financial Publishing Inc. Offices at Two Wall Street, New York, N.Y. 10005. Telephone: (212) 809-7994; Fax: (212) 809-8492.
First-class postage is paid at New York, N.Y. Annual subscription rate is $1,175 in the United States and Canada; $1,215 to all other areas. Single issues, $115 each. Group, bulk and gift subscription rates are available on request. Visit our Web site at www. grantspub.com. Copyright 2015 Grant’s Financial Publishing Inc. All rights reserved. Grant’s® and Grant’s Interest Rate Observer® are registered trademarks of Grant’s Financial Publishing, Inc. Copyright warning and notice: It is a violation of federal copyright law to reproduce or distribute all or part of this publication to anyone (including but not limited to others in the same company or group) by any means, including but not limited to photocopying, printing, faxing, scanning, emailing, and Web site posting. The Copyright Act imposes liability of up to $150,000 per issue for infringement. Information concerning possible copyright infringement will be gratefully received. See www.grantspub.com/terms.php for additional information.
Subscribers may circulate the one original issue received in the mail from Grant’s, for example, using a circulation/routing slip. Multiple copy discounts and limited (one-time) reprint arrangements also may be available upon inquiry.
®
Vol. 33, No. 16d-ctr
Two Wall Street, New York, New York 10005 • www.grantspub.com
AUGUST 7, 2015
We have broken out the centerfold story for your reading comfort. No broken headlines across pages any longer.
Try this at home Low, low mortgage rates are a double blessing, at least to the would-be house buyer. The first reason is obvious: They make a house more affordable. The second, as paid-up subscriber Michael Harkins is wont to observe, is less intuitive. The borrower builds equity faster by paying a low rate than he does a high one. A $100,000, 30-year mortgage will serve as a financial test dummy. At a 4% rate of interest, the mortgagor’s first year payment comes to $5,729, of which $1,761 is devoted to principal amortization. Compare and contrast a 10% mortgage rate. One’s first-year payment comes to $10,531, of which just $556 is earmarked for principal amortization. Harkins performs this interest-rate parlor trick for his financially sophisticated dinner guests. Most refuse to believe him (check the math). ZIRP- and QE-powered real-estate bull markets are once again interrupting the sleep patterns of conscientious central bankers. The functionaries slash interest rates to induce the kind of inflation they prefer. What they get instead is the kind of inflation that the asset-owning portion of the community prefers. Thus, the central banks of Sweden and Norway have reduced policy rates to minus 0.35% and 1%, the central banks of Denmark and Switzerland to an identical negative 0.75%. For one reason or another, real estate prices have shot higher. Swedish house prices showed a 13% spike in the 12 months to May. Norwegian house prices climbed 6.6% in the 12
months to June. Copenhagen apartment prices have soared by 25% in a year. Swiss home prices, according to the UBS Swiss Real Estate Bubble Index, are the toppiest since 1991. What, then, should a central bank governor do? Do not— not —raise interest rates: “[R]ough calculations show that the size of rate increase needed to do so might also boost unemployment and push down inflation,” a trio of economists prescribe in a new Federal Reserve Bank of San Francisco Economic Letter. “Thus, using this type of policy tool may cause the central bank to devi-
10%
ate significantly from its goals of full employment and price stability.” The Fed would seem to prefer the certainty of job losses after a bubble burst than the possibility of job losses before a bubble becomes inflated. “[W]hile monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation—namely that it gets in all of the cracks,” former Fed governor Jeremy C. Stein cracked at a St. Louis Fed research symposium in February 2013.
•
There they go again
230
U.S. mortgage rates (left scale) vs. house prices (right scale) 9
210 S&P/Case-Shiller Composite-20 Home Price Index
8 % n i e t a r e g a g t r o m
190
7
170
6
150
5
130
4
110 Bankrate.com U.S. Home Mortgage 30-year fixed national avg
3
1/00
1/02
1/04
source: The Bloomberg
1/06
1/08
1/10
1/12
1/14
90
7/15
i n d e x l e v e l
Grant’s is Webcasting the Fall 2015 Conference on October 20. Of course, nothing’s better than being at the Plaza Hotel yourself (who are you going to meet while staring at your iPhone?). Next best thing is our day-long Webcast—live. And if you should happen to miss the live event, on-demand viewing is yours, too. It will be available just a few short days after the conference wraps up. In person: $2,150, includes breakfast, lunch and cocktail reception. Webcast: $1,750 gets you the complete virtual experience, including the ability to participate in a live Q&A. Register now at www.grantspub.com/conferences.
“Cheer up, Herbert! Grant’s is Webcasting the Fall Conference! Questions? Please call 212-809-7994 or email
[email protected]
