Once is happenstance, twice is coincidence and the third time it’s enemy action.  Reports that regulators are considering forcing for-profit education firms to migrate towards a not-for-profit structure hammered Chinese schooling stocks today, with shares of the New Oriental Education & Technology Group (EDU on the NYSE) enduring a 54% swan-dive.  

That follows Beijing’s ongoing broadside against Didi Chuxing (which includes a Bloomberg report yesterday claiming “unprecedented penalties” may be forthcoming) over alleged data collection abuses following the ride share giant’s celebrated June 30 listing on the NYSE and last fall’s salvo against Alibaba after co-founder Jack Ma dared to publicly criticize the Chinese Communist Party.  Foreign investors have taken the hint. Since logging its peak in mid-February, the Nasdaq Golden Dragon China Index, composed of American Depository Receipts tracking local businesses, is off a hefty 41%. 

Euthanasia of the renters? The National Multifamily Housing Council’s quarterly survey, released today, shows the tightest market conditions on record going back to at least 2006. A reading above 50 indicates that supply conditions are shifting in landlords’ favor, and vice versa. 

 
Source: The National Multifamily Housing Council

With activity on the hop and availability historically limited, tenants may be forced to pay up for some time.  “We calculate the market won’t be fully in balance until 2023 or 2024,” Ali Wolf, chief economist at real estate advisory firm Zonda, told the Financial Times Wednesday. “Assuming the economy continues to improve, and we continue to see the job growth numbers get better, I do think there will continue to be some upward pressure on rents.”  That trend could wield no small influence on broader inflation expectations.  “People don’t buy a used car every month whereas many pay rent every month,” Oregon University professor Tim Duy added.

The housing market has likewise gone into hyperdrive, in short order reverting to the sonic boom-like conditions that rival the headiest days of the mid-aughts.  Data released yesterday by the National Association of Realtors showed that the median “existing” home price reached $363,300 in June. That’s up a cool 23.4% from a year ago and 57.7% above the housing bubble peak logged in July 2007. 

Shelter, both for sale and for rent, is of course a lynchpin for the future course of inflation. The owners’ equivalent rent (OER) metric, which attempts to capture the change in a homeowners estimated proceeds from renting his or her dwelling, represents 23.7% of the Consumer Price Index.  Rent of primary residence, which measures contracted rental and prices, accounts for an additional 7.6% of the CPI.  Overall, the shelter component registered a modest 2.6% year-over-year advance in June, up from 1.5% in February but well below the 3% to 3.6% run-rate seen from 2016 to 2019, let alone the 5.4% advance in headline CPI.  

As rental contracts typically last one year and inflation indices capture prices on currently occupied domiciles as opposed to asking prices on vacant units, it takes about five quarters for trend changes in measured home or rental prices to appear in the CPI data, a June 9 analysis from Fannie Mae economist Eric Brescia finds. That suggests that last year’s deep freeze is still working its way through the system and will soon abate. 

Meanwhile, a dearth of affordable housing supply complements the ultra-tight rental conditions identified by the NHMC. Citing data from Freddie Mac, The Wall Street Journal relayed Wednesday that the annual construction pace of homes sized 1,400 square feet or less (a category typically denoting starter homes for first-time buyers) has remained stuck between 55,000 and 65,000 units per annum in recent years, compared to more than 400,000 new units in the late 1970s. 

“What was really striking to me was the consistently of the decline. . .irrespective of geography,” Sam Khater, chief economist and head of Freddie Mac's Economic and Housing Research division, told the Journal. “It’s all over the U.S. It doesn’t matter where.” 
Indeed, today’s heady conditions set the stage for persistently elevated inflation tomorrow.

Utilizing data from Zillow and Apartment List, Ben Breitholtz, data scientist at Arbor Research, predicts that OER will accelerate to between 4.8% and 6.3% year-over-year by December, equivalent to as many as 1.5 percentage points CPI from that 23.7%-weighted component alone.  

Fannie Mae’s Brescia comes to a similar conclusion. Under the economist’s baseline scenario, the shelter component will add 1.9 percentage points to the index by the second quarter of 2022, nearly accounting for the Federal Reserve’s entire 2% annual inflation target before the other two-thirds of the CPI come into play.   

Then, too, the lagging effects visible in the inflation data can work in the other direction once the boom runs its course.  Thus, while the S&P CoreLogic Case-Shiller 20-City Composite Index rose 105% from January 2000 to April 2006, OER rose only 20.3% over that period.  Over the following six years, the Case Shiller gauge declined by 33.9%, but OER registered an 11.7% increase. 

Transitory is a relative term.   

Stock jockeys enjoyed another euphoric day, as the S&P 500 managed another 100 basis point rally to complete a 3.6% four-day rally to emphatically erase Monday’s large decline and leave the broad index higher by 17.5% year-to-date. Treasurys settled down from their recent volatility with the 10- and 30-year yields holding at 1.28% and 1.92%, respectively. Gold slipped to $1,802 an ounce, WTI rose above $72 a barrel and the VIX pulled back by a modest 3% to finish just above 17. 

- Philip Grant

“Inflation is expected to follow a volatile course in the short term due to various supply and demand factors,” the Central Bank of the Republic of Turkey wrote after last Wednesday’s meeting. The CBRT, which kept rates unchanged for a fourth consecutive month, has endured heavy staff turnover in recent years under the auspices of strongman president and easy money advocate Recep Erdogan, culminating in the March 20 termination of Governor Naci Agbal two days after hiking the key rate to 19% from 17%. Perhaps dissuaded against further tightening, the CBRT last week promised that the future course of inflation “will be monitored closely.” 

There is lots to monitor.  Turkish CPI advanced at a 17.5% annual clip in June, the highest since the bug bit but well below the 25.2% local peak logged in 2018. Meanwhile, inflation has bounded higher at a 13.5% average annual rate since Erdogan tightened his grip on power following a failed coup d’état five years ago, compared to an average 8.1% over the five years through July 2016.  The foreign exchange market takes a dim view of the politically-hobbled CBRT’s ability to tamp down those raging price pressures, as the lira vs. dollar pair remains stuck near a record low exchange rate of 8.57 to the buck. 

The world’s largest miner takes a pause.  This morning, BHP Group announced that it will hold production steady over the next year, projecting between 278 and 288 million tons of iron ore output.  That compares to the 284 million tons of production over the 12 months through June 30 and is slightly below the company’s long-term target of 290 million tons per annum.

A sparse longer-term pipeline further colors that decision, as The Wall Street Journal notes that the company has just two major projects in development and is a minority partner to BP in one of those.  During the commodity price boom of a decade ago, BHP had 18 such ventures in the hopper. 

“Chasing production does not really make sense,” CEO Mike Henry told analysts in March. “The industry has a great track record of being quite pro-cyclical and that has ended in tears all too often.”  That discipline is paying off industrywide, as the world’s top 40 miners will earn $118 billion in net profit this year, nearly double that of 2019, if estimates from PricewaterhouseCoopers are on point.

A similar dynamic is underway among stateside energy majors. In April, Exxon reiterated full-year capex guidance at $16 billion to $19 billion for 2021, down from $21.4 billion last year and some $31 billion in 2019. The oil giant expects that figure to remain at between $20 billion and $25 billion from 2022 to 2025, down from a pre-virus projection of $30 billion to $35 billion in annual capital spending over that period.  Rival Chevron now targets $14 billion to $16 billion in capex through 2025, which is less than half of its spending levels in 2014 when WTI crude hovered near $100 a barrel. 

That belt tightening from major resource producers represents an increasingly stark contrast with other areas of the economy. Callum Thomas, head of research at Topdown Charts, noted in a June 15 blog post that capex among the energy and materials components of the S&P 500 have reached a record low relative to the index as a whole.  At the same time, the tech sector accounted for some 40% of S&P 500 capex, its highest share since at least 1981. 

 
That slimmed-down spending regime from energy and materials producers, Thomas believes, “helps sow the seeds for a sustained bull market in commodity prices.” At the same time, “one can’t help but notice how the record high capex by tech companies seems to echo the same pattern seen during the peak of the dot com bubble.”

The hair-raising rally in Treasurys was dramatically interrupted, as the benchmark 10-year yield turned tail from an intraday low near 1.13% to finish at 1.23%, while the long bond rose to 1.88% from 1.81% yesterday.  Stocks enjoyed a 1.5% gain for the S&P 500 to all but erase yesterday’s losses, while the VIX settled near 20, compared to 18.5 as of Friday’s close.  WTI crude rebounded nearly 2% to $67.5 a barrel, and gold remained in a tight range at $1,811 an ounce. 

- Philip Grant

The Department of Justice has opened a formal investigation into electric truck startup Lordstown Motors Corp. (RIDE on the Nasdaq), the company disclosed in a filing yesterday.  That inquiry follows a pair of subpoenas from the SEC pertaining to its October merger with special purpose acquisition company DiamondPeak Holdings Corp. 

Confusing corporate communications color that development. Back on June 8, Lordstown warned in an amended form 10-K that it was running out of cash and its status as a going concern was increasingly in question. 

Evidently attempting to calm nervous investors, Lordstown president Rich Schmidt declared one week later that the company had an order book that would cover its output for 2021 and 2022, adding that: “I don’t know the exact facts of the legal aspect of that, but they are basically binding orders that are committed here in the last two weeks, reconfirmed orders. They’re pretty solid, and I think that’s on the light side or conservative side.”  Two days later, Lordstown “clarified” in a filing that existing orders “do not represent binding purchase orders or other firm purchase commitments.” RIDE shares are down 57% year-to-date, leaving the pre-revenue firm’s enterprise value at $900 million. 

For more on Lordstown, and the other nine SPAC-related picks-to-not-click comprising the analysis “Short this index,” see the Dec. 25 edition of Grant’s Interest Rate Observer.

A new escalation in China’s crackdown on newly public Didi Chuxing (DIDI on the NYSE):  This morning, seven separate government departments paid the rideshare giant a visit to conduct a cybersecurity review, including the police, primary antitrust regulator and Ministry of State Security. That comes days after the Cyberspace Administration of China accused Didi of improperly collecting user data and two weeks after authorities barred the company from signing up new members and delisted its app. Shares traded lower by 4% in immediate reaction to that bulletin and remain 34% below the intraday peak on its June 30 IPO date.

Of course, today’s developments represent the latest instance of Beijing publicly asserting its dominance over China’s domestic technology champions, a phenomenon which began last fall with a crackdown on Alibaba after co-founder Jack Ma publicly criticized the Communist Party. 

That broadside is making some on Wall Street a little nervous. Goldman Sachs CEO David Solomon lamented in a Tuesday CNBC interview that “a large number of companies that have been planning to come [public in] the U.S. . . [but] because of the actions the Chinese government has taken, I think some of those companies will not come to the market at this point in time. . . I was surprised that this played out the way it did.” 

Lingering Sino-American tensions further complicate the calculus.  The Biden administration yesterday warned U.S. investors that doing business in Hong Kong is an increasingly risky endeavor, as mainland China continues to tighten its grip on the long independent city. “The situation in Hong Kong is deteriorating, and the Chinese government is not keeping its commitment that it made, how it would deal with Hong Kong,” Biden declared at a press conference ahead of the advisory.  

That follows China’s diplomatic snub earlier this week, as the Financial Times reported yesterday that Beijing refused a meeting with deputy secretary of state Wendy Sherman. That would have been the highest level powwow since the two sides endured a frosty summit in Alaska earlier this year. “China’s move is a dangerous one,” Georgetown professor Evan Medeiros told the FT. “It increases distrust, tension and risk of miscalculation during an already-fraught period.”

Investors in the 244 U.S.-listed Chinese American Depository Receipts are perhaps experiencing similar sentiments.  As Bloomberg’s Francis Chan noted Wednesday, those certificates tracking the price of Chinese stocks are off by 30% from their mid-February levels on average. Wall Street pros have taken notice, as China-related fears led investors to “sharply” curtail their exposure to emerging market equities as a category, Bank of America’s Global Fund Manager Survey for July finds. Even some die hard bulls are heading for the hills, as fund manager Cathie Wood cut the allocation to Chinese stocks in her ARK Innovation ETF to less than 1% from 8% five months ago. “From a valuation point of view, these stocks have come down and again from a valuation point of view, probably will remain down,” Wood told to Bloomberg Tuesday.

Yet those developments are of little concern to the throngs of emboldened retail punters. Instead, as animal spirits reign supreme, dip-buyers arrive en masse.  Bloomberg notes that the KraneShares CSI China Internet Fund (KWEB on the NYSE Arca), which is off by 40% from its mid-February highs, attracted a hefty $631 million worth of inflows over the first four days of the week, equivalent to more than 10% of the fund’s total assets. Meanwhile, the number of outstanding call options reached a record high last week, more than double that of puts. “Between all the call buying last Friday and all the inflows this week, it certainly seems like investors are trying to pick a bottom,” noted Chris Murphy, co-head of derivatives strategy at Susquehanna. “Maybe Cathie Wood getting out was the final contra sentiment indicator those investors needed.”

Stocks came under late pressure, with the S&P 500 and Nasdaq 100 each finishing near session lows to wrap up the week with a 1% loss, while Treasurys consolidated their impressive recent gains as the 10- and 30-year yields finished at 1.29% and 1.92%, respectively. The VIX jumped 8% to 18.4, gold pulled back to $1,812 an ounce and WTI crude held near $71 per barrel. 

- Philip Grant

Markets make opinions, crypto edition. Last week, Guggenheim chief investment officer Scott Minerd told CNBC that he believes bitcoin is undergoing a “crash” that could take the price to as low as $15,000.  That’s a stark reversal from late last year, when the digital ducats broke to a then-record high near $21,000 and Minerd concluded that “our fundamental work shows that bitcoin should be worth about $400,000.”

Other Wall Street luminaries are similarly rethinking the digital revolution. For instance, consider the below headline from Decrypt on April 15, two days after bitcoin logged its high-water mark near $63,000:

BlackRock CEO Sings Bitcoin’s Praises as Future ‘Great Asset Class’

That was then. A headline from CoinDesk today, with the price cut nearly in half from three months ago, strikes a different tone: 

BlackRock CEO Larry Fink Says There’s ‘Very Little’ Demand for Crypto

All aboard in the Middle Kingdom:  Foreign investors around the world hold a record $806 billion worth of Chinese assets, the Financial Times reports today. That’s up more than 40% from a year ago.  Bond holdings account for nearly three-quarters of that sizable sum. 

A dovish policy pivot colors that capital influx into the world’s second-largest economy. Last Friday, the People’s Bank of China slashed the reserve ratio requirement, or the amount of cash that banks must hold for a rainy day, by 50 basis points, unleashing some $154 billion in previously dormant cash into the financial system. The PBoC’s move follows months of softer-than expected loan growth and a relatively sluggish pace of money supply expansion. A further 50-basis-point cut is forthcoming later this year, economists surveyed by Reuters yesterday predict. 

“It is a signal, it’s a higher profile message I think, that the authorities are paying attention and alert to the possibility of downside risks,” Andrew Tilton, chief Asia economist at Goldman Sachs, told CNBC Monday. 

Rising distress in the local credit market represents one such pitfall. Some RMB 99 billion ($15.3 billion) worth of onshore bonds defaulted over the first six months of the year, a 35% increase from last year’s pandemic-addled total.  “We expect the number of defaults to jump in the next few months,” Wang Feng, chairman of Shanghai-based Ye Lang Capital, tells the South China Morning Post today. “Real estate companies and some debt-ridden state-owned enterprises are grappling with difficulties in managing their cash flows and are being closely watched.”

Property developer China Evergrande (3333 on the Hang Seng), Asia’s largest issuer of junk bonds and the world’s most-encumbered real estate firm, has earned no small dose of scrutiny. Higher-ups at China’s Financial Stability and Development Committee “urged” Evergrande founder and chairman Hui Ka Yan to “solve his company’s debt problems as quickly as possible,” Bloomberg relayed last week.  The discussed remedies include bringing strategic investors on board to help fortify the company’s shaky financials.   Net debt footed to RMB 570 billion in late June, which is down from RMB 717 billion at year-end but still equivalent to nearly seven times consensus 2021 adjusted Ebitda. The company hopes to trim that burden to RMB 350 billion by mid-2023, as it attempts to reach compliance with regulators’ three red line restrictions governing property sector balance sheets. 

Asset sales represent another avenue toward that goal, though the developer seems less than eager to embrace this strategy.  Evergrande yesterday responded to Chinese social media reports that it will sell property worth billions of dollars to rival firms by telling English language news service Yicai Global that it “reserves the right to hold such rumor spreaders legally accountable.”

Financial engineering, on the other hand, is front and center in the corporate “toolkit.” Bloomberg noted last week that Evergrande has turned to short-term commercial bills (which are not classified as debt securities) to finance itself, with its primary onshore subsidiary owing some $32 billion of those IOU’s as of December. “The amount of Evergrande’s outstanding commercial bills is massive,” Dong Ma, partner at BG Capital, observed. “It has apparently become a vital fundraising channel.”  B2/single-B-plus-rated Evergrande’s dollar-pay, senior-secured 8 3/4% notes due 2025 changed hands today near 65 cents, for a 2,191 basis point spread over Treasurys. A 1,000 basis point pickup typically connotes distress. 

The key question for the bulging ranks of China’s foreign creditors: might Beijing ride to the rescue if Evergrande proved unable to pay its debts?  Last week, a development fund led by the Jiangsu provincial government purchased a 16% stake in e-commerce outfit Suning.com, a subsidiary of conglomerate Suning Appliance.  Suning fell into distress after now deposed co-founder Zhang Jindong waived an RMB 20 billion payment due from Evergrande in September, a move that helped “his friend and Evergrande chairman Hui Ka Yan save his own company,” Bloomberg noted last month.

The transaction is an ominous development, some observers believe. A report from CreditSights last Wednesday argued that, rather than a bailout of existing debt-holders, capital injections of that nature serve to allow “local governments with good financial resources to acquire strategic investments at bargain prices. . . it is worth noting that the Jiangsu government did not directly inject capital into Suning Appliance but only invested in the crown jewel of the company, Suning.com.”  CreditSights also offered the following caveat: “government-backed liquidity assistance typically emerges in the debt restructuring process and might not be timely enough to avoid bond defaults.”

Treasurys continue to evince little concern over recent inflation data, as a strong rally across the curve left the long bond yield at 1.98%, while stocks gave back early gains to finish little changed. Gold rose to a near one-month high at $1,829 an ounce, WTI crude slipped below $73 a barrel and the VIX pulled back to near 16. 

- Philip Grant

“Welcome to the dawn of a new space age,” tweeted Richard Branson yesterday.  The British billionaire’s successful foray into suborbital space yesterday duly stirred animal spirits, as shares in his Virgin Galactic Holdings, Inc. (SPCE on the NYSE) touched a record $59.99 in the pre-market, up more than 150% year-to-date. 

SPCE’s voyage represents a “massive marketing coup,” writes Canaccord Genuity analyst Ken Herbert, a triumph which the company wasted no time in attempting to monetize. Virgin announced in a filing this morning that it will sell up to $500 million worth of common equity through a trio of investment banks, catalyzing a sharp reversal to leave shares south of $41 at the bell, down 18% from Friday’s close.  

Intraday roller-coaster aside, Virgin Galactic, which was at the vanguard of the recent special purpose acquisition company boom with a stock market debut back in October 2019, remains the apple of Mr. Market’s eye. Pre-revenue SPCE, which burned through $240 million of cash over the 12 months through March 31, currently commands a $9.5 billion enterprise value, equivalent to 17 times consensus 2025 revenue and 65 times adjusted Ebitda four years from now. 

Meanwhile, a fellow would-be space explorer and stock promotion expert provided his imprimatur.  The Wall Street Journal reports today that Tesla CEO Elon Musk has purchased a ticket on a future Virgin Galactic voyage. Branson may reciprocate, telling London’s Sunday Times that “Elon’s a friend and maybe I’ll travel on one of his ships one day.” 

High hopes abound as second quarter earnings season gets underway this week.  S&P 500 components will grow their bottom lines by a cool 63.6% from last year’s pandemic-depressed levels, if estimates from FactSet are on point.  That would mark the fastest pace of year-over-year earnings growth since the end of the financial crisis in 2009.  

During the second quarter, Wall Street analysts bumped up their aggregated earnings estimates across the S&P 500 to $45.03 a share from $41.97.  That 7.3% bottom-up estimate increase is the highest since FactSet began tracking the metric in 2002.  On average, analysts have trimmed their bottom-up earnings projections by 4% during each quarter over the past 10 years.  Early indications on that front are validating today’s atypical optimism:  66 S&P 500 companies issued positive earnings guidance relative to expectations this quarter as of July 2, marking the highest such proportion going back to at least 2006. 

Of course, that prospective windfall looks to be thoroughly discounted by eager investors, as the broad equity index has enjoyed a 17% year-to-date advance and sits at nearly double its March 2020 nadir.  The S&P 500 trades at nearly 22 times forward earnings, FactSet notes, well above the five- and 10-year averages of 18.1 and 16.1 times, respectively. 

Recent earnings boom aside, today’s fancy valuations are increasingly divorced from traditional fundamental underpinnings. As Bloomberg’s Cameron Crise has observed, equities derive their value from their net assets and future earnings prospects, as well as a third, vaguer component encompassing the expectations of a better tomorrow. To that point, a chart prepared by Bianco Research president and eponym Jim Bianco last week shows that just 36% of the S&P 500 valuation can be attributed to the index’s current book value and net present value of earnings estimates over the next three years.  The surplus 64% “hopes and dreams” component represents the highest proportion of the S&P 500’s value since 2000. 

 
That Y2K-era analogue should give investors pause, considering the dismal epoch which followed.  Jill Mislinski, research director at Advisor Perspectives, notes today that once the worm turned following the early 2000 market peak, it took the S&P 500 until mid-2007 to briefly reclaim its nominal peak price level. Of course, the financial crisis followed soon thereafter, and the broad index failed to reclaim its 2000 bull market crest again until early 2013.  The tech-heavy Nasdaq didn’t manage to match its March 2000 high water mark until 2015.  Adjusted for inflation, as measured by the CPI, the S&P and Nasdaq remained underwater for 15 and 18 years, respectively, after the tech bubble burst.

Smooth three- and 10-year Treasury auctions headlined a day of gently rising yields, as the 10-year note finished the day at 1.37%, while stocks enjoyed a modest bid with the S&P 500 cruising higher by 35 basis points to log another fresh high.  Gold and WTI crude each edged lower to $1,806 an ounce and $74 a barrel, respectively, and the VIX gave back an early 8% advance to remains near 16 at day’s end. 

- Philip Grant

Keeping the band together: With Fed chair Jay Powell’s four-year term set to expire in less than eight months, a former colleague and Biden administration bigwig likes what she sees. Treasury Secretary Janet Yellen “has told those close to her that she has a good relationship with Powell, and is pleased with how he has steered monetary policy through the pandemic-induced crisis,” Bloomberg reported yesterday.  That support could be crucial for Powell’s prospects of renomination, as alternative candidates more closely “aligned with administration priorities such as inequality and tighter banking regulations” remain under consideration.

While palace intrigue takes center stage in D.C., a seismic policy shift quietly continues as the monetary mandarins reverse one element of the unprecedented stimulus measures launched during last year’s depths.  The New York Fed noted in a statement this morning that it will begin “gradual and orderly” sales from its corporate bond portfolio held under the Secondary Market Corporate Credit Facility, beginning Monday. 

The SMCCF, established on March 23, 2020, accumulated a relatively modest $13.8 billion in corporate bonds and ETFs before the Fed announced the beginning of ETF sales last month (sometimes, it’s the thought that counts). The central bank has set a Dec. 31 deadline for full liquidation of the portfolio. 

Cryptos and blank check firms: a match made in heaven? Fintech concern Circle Internet Financial, Inc., issuer of the USD Coin (USDC), will go public via a merger with Concord Acquisition Corp., Circle announced today.  The entity will be listed on the NYSE under the ticker CRCL upon completion of the deal, at a $4.5 billion valuation.  

Circle, which offers a high-minded mission of “raising global economic prosperity through the frictionless exchange of financial value,” has lofty aspirations to match. The company, issuer of the second-largest stablecoin, or digital currency purportedly backed one-for-one by U.S. dollars, cites a total addressable market of $165 trillion, composed of $130 trillion in global M2 money supply and $35 trillion in global payments.

Of course, pie-in-the-sky financial projections from SPAC-affiliated companies are old hat, a phenomenon that has recently drawn the attention of key regulators (Almost Daily Grant’s, May 19). Circle predicted that assets under management will soar to $190 billion by the end of 2023 from $25.9 billion today. Total revenue will foot to $886 million in 2023, a 177% compound annual growth rate from this year’s projected $115 million top line, while active accounts will jump to above 30,000 in 2023 from 2,786 accounts expected this year, if management projections are on point. 

That breakneck pace of growth will likely translate to a modest bump in its gussied-up bottom line, as adjusted Ebitda would foot to $76 million in 2023, compared to an expected $76 million adjusted Ebitda loss this year. Favorable external forces, rather than rapid growth, may be the ticket to corporate prosprity.  A simultaneous 200 basis point jump in the yield curve next year would equal $940 million in incremental interest income, the company reckons. Such a move in 2023 would spell a $2.22 billion windfall. 

Yet unwelcome regulatory attention could serve to disrupt that stairway to financial Valhalla.  The Internal Revenue Service seeks documentation of customers who have undertaken crypto transactions equivalent to $20,000 or more on the venue between 2016 and 2020, the Department of Justice announced in April.   U.S. District Judge Richard Stearns acceded to the IRS summons, writing that “there is a reasonable basis for believing that cryptocurrency users may have failed to comply with federal tax laws.” 

Legal scrutiny has also served to exacerbate missteps from the c-suite. The company disclosed today that it took a $156.8 million loss stemming from its ill-fated acquisition of crypto exchange Poloniex in early 2018, near the first peak of crypto prices. Beyond a realized loss on the subsequent resale of Poloniex for $33.2 million in 2019, Circle also noted that it has accrued a $10.4 million contingent liability for a Securities and Exchange Commission complaint against Poloniex “with regards to the trading of cryptocurrencies that may be characterized as securities.” Furthermore, Circle estimates that a pair of subpoenas from the Treasury Department’s Office of Foreign Assets Control and an “Iranian government agency” concerning potential sanctions violations will result in further penalties of up to $2.8 million.

Meanwhile, a familiar problem stalks USDC: questions over the composition of assets backing the world’s second-largest stablecoin, just as with its larger peer Tether. CoinDesk columnist JD Koning noted Tuesday, that, as recently as Feb. 28, 2020, Circle held all customer accounts at U.S. banks under the auspices of the Federal Deposit Insurance Corp. In a subsequent attestation a month later, Circle added the category “approved investments,” suggesting that it was branching out into less secure collateral in hopes of generating income as short-term yields collapsed.  That is a particularly significant change considering that USDC issuance has mushroomed by more than 50-fold from the $400 million outstanding in early 2020. Then, too, Koning notes, different state laws allow for sometimes drastically divergent standards in terms of what constitutes approved investment products, leaving outside observers guessing as Circle declines to disclose which state guidelines it follows.

See the brand new edition of Grant’s Interest Rate Observer dated July 9 for more curious doings in crypto. 

The feverish rally in Treasurys put the crimps on stocks today, as the S&P 500 lost nearly 1% to erase its gains for the week as the 10-year yield fell to 1.29% and the long bond to 1.92%.  The VIX advanced to 19, extending to a 26% three-day gain after logging a fresh virus-era low on Friday, while WTI crude bounced back above $73 a barrel and gold held just over $1,800 an ounce.  

- Philip Grant

From the Associated Press:

Police arrested an Ankeny [Iowa] man after he threatened to blow up a McDonald’s restaurant for neglecting to include dipping sauce with his order of chicken McNuggets.

International Business Machines’ extensive 18-month email server migration has “gone off the rails,” leaving numerous employees frozen out of the system, tech news site The Register reported Wednesday.  “[Microsoft] Outlook won’t work with the new system, IBM Notes won’t work and the online email called Verse has now gone down,” one company insider groused. “Everyone has been affected and no fix is in sight.”  The snafu is telling, as another employee offered this rhetorical query: “If we can’t even handle our own cloud migration program then why would any customer trust us? 

While the optics of such an internal lapse are less than ideal, IBM pushes on. A spokesperson assured The Register (by phone) that the company is “leveraging a variety of alternative communications tools to ensure minimal disruption to our clients and business while we work to restore full email capabilities.”

See the Feb. 21, 2020, edition of Grant’s Interest Rate Observer for a bearish analysis of this longtime pick-to-not-click. 

You can’t accuse them of mixed messaging.  As percolating prices accompany post-virus recoveries across the West, key central bankers continue to bang the drum for ongoing monetary stimulus in tandem with near-zero (or negative) benchmark interest rates in hopes of further greasing the wheels of commerce. 

“We’ve made some progress for sure. We’ve seen progress in employment, we’ve definitely seen a big increase in inflation,” New York Fed president John Williams observed at a virtual meeting June 21. Still, the central banker concluded that: “we are quite a ways off from achieving my interpretation of substantial further progress” needed to curtail the $120 billion pace of monthly asset purchases, let alone an increase in the current 0 to 0.25% federal funds rate. 

As one of the Fed’s most influential members advocates keeping the pedal to the metal, the labor market continues to mend.  This morning’s reading of June payrolls showed headline unemployment at 5.9%, nearly matching the post-WWII average of 5.8%, while the broader U6 “underemployment” metric of 9.8% was below the 10.4% mean going back to 1993. Headline nonfarm payrolls footed to 146.5 million, down from the 153.1 million peak logged right before the virus barged in but nearly matching the five-year average of 147 million. 

On the other hand, the core Personal Consumption Expenditures Price Index jumped by 3.4% year-over-year in May, the hottest reading since 1992 and well above the Fed’s “symmetrical” 2% inflation target.  While the ultimate durability of that surge remains an open question, ongoing supply bottlenecks and labor shortages continue to fuel pockets of raging price pressures in the here-and-now.  A dispatch from The Wall Street Journal today notes that ride share firms Uber and Lyft are forced to serve up increasingly generous incentives to coax drivers onto the road.  Customers sure could benefit from some additional supply: According to data from third party data service Gridwise, fares on those platforms rose by 79% in the second quarter from their pre-pandemic, 2Q 2019 levels.  That comes three days after the release of the S&P CoreLogic Case-Shiller National Home Price Index for April showed that prices rose by 14.6% year-over-year, the fastest pace on record going back to 1987.

A similar dynamic is unfolding across the pond after measured inflation in the U.K. hit 2.1% year-over-year in May, topping all 33 economist estimates gathered by Reuters and marking the hottest reading since July 2019, when the benchmark interest rate stood at 0.75% compared to 0.10% today.  Bank of England governor Andrew Bailey played down that development in a speech yesterday, declaring that: “We expect this rise in inflation to be a temporary feature of the bounce-back. The reasons for taking this view are well-founded. It is not a vain hope or a matter of whistling in the wind.”  Bailey went on to predict that inflation would reach a 3% annual pace of increase later this year, before duly moderating. 

European monetary mandarins see the future even more clearly. This morning, European Central Bank President Christine Lagarde told France’s La Provence that “we will see a return to lower rates of inflation, as indicated in our projections.”  

Good thing, as the Eurozone CPI rose by 1.9% from a year ago in June, following May’s 2% year-over-year advance to mark the second straight month at or above Frankfurt’s inflation target of just under 2%.  As the ECB is charged with a single mandate of maintaining price stability, as opposed to the Federal Reserve’s dual directive of stable prices with maximum employment and the BoE’s secondary mandates of promoting growth and employment in tandem with low and stable inflation, it would seemingly be difficult for the ECB to justify maintaining its negative 50 basis point benchmark rate and ongoing €1.85 trillion ($2.2 trillion) asset purchase program in the face of lasting price pressures.

Meanwhile, the economy on the Old Continent looks to swiftly rebound, as measured unemployment dropped to 7.9% in May from more than 9% in 2017, while the June IHS Markit Manufacturing PMI showed the briskest pace of activity since at least 1997.  

Stocks continued to only go up, as the S&P 500 and Nasdaq 100 each rallied by near 1% to wrap up another week higher by 1.7% and 2.7%, respectively, while rates continued their recent strength with the 10-year yield reaching 1.43%, its lowest since early March.  Gold rose to $1,788 an ounce to continue its modest rebound, WTI crude held near $75 a barrel to consolidate recent gains and the VIX set another virus-era low near 15, but did manage to rally 5% off its pre-market nadir. 

- Philip Grant

Dancing while the music plays: June leveraged buyout volume footed to $69.2 billion through last Friday, Bank of America reported, already matching the second busiest single month on record.  In tandem with that deal derby, second quarter loan issuance used to fund LBOs reached its highest level since at least 2013, Bloomberg relays. 

That LBO loan deluge is pouring into the market for collateralized loan obligations, i.e., packaged and securitized collections of leveraged loans.  A whopping $200 billion in new supply has come to market already this year, representing about a quarter of existing supply as of year-end.  Bloomberg reports that S&P, the go-to rating agency for CLOs, is already booked solid through August, while Nomura reckons that the firm is reviewing more deals than in 2017 or 2018, two previous bumper crop years. 

As the everything bubble continues to swell, aggressive capital structures proliferate. For instance, Covenant Review finds that 42 loan deals with leverage ratios exceeding seven turns of Ebitda came to market this year through mid-June, compared to 20 over the same period in 2019 and just 11 last year. 

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Rapidly retreating debt covenants, or fine-print legal protections for lenders, accompany those extra dollops of debt. So-called covenant-lite structures featured in 85.2% of total loans outstanding in May, per S&P’s LCD unit, up from about 66% five years ago and just 17% in 2007.  More qualitative metrics tell the same story, as rival rating agency Moody’s reported last month that its proprietary Loan Covenant Quality Indicator (an aggregated, two-quarter rolling average based on the firm’s assessment of individual issues) deteriorated to easily the weakest level on record as of year-end. 

Those loosey-goosey terms can, of course, come back to haunt creditors when things go wrong, as in the case of a $200 million loan issued by private equity-backed mattress maker Serta Simmons Bedding. Recall that, last summer, financially-stressed Serta undertook a debt exchange with a lender group including asset managers Eaton Vance and Invesco, thereby elevating them in the capital structure over another cohort featuring p.e. mainstays Apollo and Angelo Gordon. For their part, the foiled p.e. contingent had sought to shunt the firm’s intellectual property assets into a new subsidiary, out of reach of the rival creditor group.  “They were threatening to absolutely screw us,” claimed Eaton Vance portfolio manager Craig Russ to The Wall Street Journal a year ago.

Wall Street has learned its lesson, sort of.  A Moody’s analysis last week found that only one-third of a sample of 45 leveraged loan term sheets signed in April and May contained express contract provisions preventing that “uptiering” maneuver utilized by Eaton Vance and Invesco. 

More broadly, the proliferation of cov-lite may not fully convey the erosion of creditors’ legal protections across speculative-grade credit. To that end, a series of recent analyses from Covenant Review have compared the documentations of a senior bond issued by Ancestry.com last November with one issued by First Data in fall 2007, a pair of p.e.-backed transactions representing “the worst sponsored deals” seen by the research firm in each cycle.  The verdict:

The Ancestry debt covenant is far worse than the debt covenant for the First Data bonds, and provides significantly more flexibility for incremental debt incurrence. It’s also far more difficult for a high yield analyst to assess incremental debt capacity under the Ancestry debt covenant, as there is far more flexibility for the issuer to ‘hide the ball’ on how future debt is incurred under that covenant or how existing debt is accounted for under that covenant.

The phenomena of increasingly debtor-friendly deal structures are not confined to the 50 states.  A report last week from the European Leveraged Finance Association shone the spotlight on issuers’ continuing usage of “Ebitdac” (that’s earnings before interest, taxes, depreciation, amortization and coronavirus) as a metric for calculating covenant capacity. As ELFA notes, numerous borrowers have argued that they can not only add back Covid-related costs and expenses to their financial metrics, but also estimated pandemic-related revenue losses.  

What’s more, recent credit agreements on both sides of the pond have featured clauses expressly allowing run-rate Ebitda touch-ups based on any costs, expenses, lost revenues or any other negative shocks arising from any future pandemic, not just Covid.  ELFA writes: 

These add-backs could permit the company to make corresponding adjustments for future pandemics or epidemics (arguably, a bad flu season that dampens demand for the company’s products could qualify). To prevent such a use, investors should, at a minimum, request that these clauses reference the WHO definition of a pandemic. 

Unfortunately, the trend in the drafting of these clauses seems to take the opposite position. 9fin [an ELFA-affiliated analytics platform] reports that the most recent examples of this type of clause have been even broader in scope than previous examples, permitting adjustments not only for future pandemics or epidemics, but also for any ‘outbreak, incident, disaster or similar such disruptions out of the Group’s control.’ 

Stocks edged higher, wrapping up the fiscal second quarter with the S&P 500 and Nasdaq 100 up by 15.3% and 13.4%, respectively, at the halfway point of 2021.   Treasury yields finished little changed as the 10- and 30-year yields finished at 1.46% and 2.08%, respectively, up from 93 and 146 basis points as of Dec. 31. Gold rebounded to $1,774 an ounce to narrow its first-half decline to 6.5%, while WTI advanced above $73.5 a barrel to log a heady 51.5% six-month advance.  The VIX toggled back below 16. 

- Philip Grant

Wall Street on sale.  Boutique investment bank Perella Weinberg Partners made its stock market star turn on Friday (PWP on the Nasdaq), after completing a merger with blank-check outfit FinTech Acquisition Corp. IV.  That marks a seminal event for the firm, which has been the subject of periodic IPO speculation since shortly after its founding in 2006.  

“Perella Weinberg is entering the next phase of scale and growth, with significant runway ahead,” JMP Securities analyst Devin Ryan wrote today. Indeed, global IPO supply has reached nearly $350 billion so far this year according to data from Bloomberg, easily topping the prior six month issuance record of $282 billion set in the latter half of 2020 and on pace to smash the full-year record of $420 billion established in 2007.  Last week saw more than $6 billion in domestic deal volume, the busiest such stretch this year.

An imminent blockbuster debut will further burnish those heady figures.  Chinese ride-share giant Didi Global, Inc. will soon raise up to $4 billion in a New York Stock Exchange listing, promoters expect, establishing the company’s value at about $67 billion in the biggest domestic IPO since Alibaba in 2014.  Scaled back from a previous $100 billion target valuation, Didi is having little trouble drumming up investor interest, as Bloomberg reports that the company will close its order book today instead of tomorrow as previously planned on account of “heightened demand.”  Overall, a hefty 17 domestic IPOs are set for this week, matching the busiest such stretch since 2006.  Some larger entrants also loom this summer: Retail trading platform Robinhood and automobile battery producer Clarios are targeting July debuts at valuations of roughly $40 billion and $20 billion, respectively, per The Wall Street Journal.  

“We’re all drowning in work,” Matthew Kennedy, senior IPO market strategist at Renaissance Capital, tells Axios. “I know the virtual roadshows of some sizable deals are sparsely attended since fund analysts only have so much time. And we’ve definitely noticed an uptick in prospectus typos” (see Friday’s ADG for one such example). 

Naturally, great expectations underpin the euphoric state of the primary markets.  A global survey of 8,550 individual investors conducted by Natixis this spring found that respondents anticipate a 14.5% post-inflation return over the long term, while small American investors expect to generate a whopping 17.5% over the long term, after accounting for inflation. A separate survey of financial professionals generated more modest figures, in the form of a 5.3% global and 6.7% domestic real returns over the long haul. 

Meanwhile, preternatural calm reigns. The Journal’s James Mackintosh notes today that the S&P 500 has not suffered a single 5% drawdown in the last eight months, marking the longest period since 2017 into early 2018 (a streak snapped by a volatility ordnance in February of that year).  For context, the broad market gauge endured nine such 5% pullbacks across 1999, including a 13% correction lasting from July to October of that year. 

In the long run, we’re all rich. 

It was another red-letter day for the bulls, as the major indices reached fresh records with the S&P 500 gaining 25 basis points and the Nasdaq 100 advancing by 1.2%, leaving the pair higher by 14.2% and 12.7% year-to-date, respectively.  Treasurys were also well bid as the 10-year yield fell to 1.48% and the long bond to 2.1%, while WTI pulled back below $73 a barrel and gold held steady at $1,780 an ounce.  The VIX finished below 16 for a third straight session.  

- Philip Grant

“Stocks at 40 times profits are cheap, Wall Street has discovered.” That tongue-in-cheek headline comes from Bloomberg today, referring to the fast-growing, strongly profitable and richly valued Facebook, Apple, Amazon.com, Microsoft and Google parent Alphabet (a.k.a. Faamg) quintet.  The group has a fan in Maneesh Deshpande, head of equity derivatives strategy at Barclays, who recently advised his clients to upsize their holdings. Deshpande notes that, though the Faamg’s sport a 35% premium to the S&P 500’s 30 times trailing price-to-earnings ratio, they trade at a roughly equivalent valuation to their December 2019 levels.

By contrast, the S&P trades at a premium to the 21 times trailing earnings seen at year-end 2019. “It’s like saying New York real estate is cheap right now, but it’s not going to be as cheap as Montana ever,” the strategist reasons to Bloomberg. The group “is cheaper relative to where it was. That is still notable.”

Mr. Market seems to be coming around to that view, as that Faamg cohort has enjoyed an average 6.3% month-to-date advance through yesterday, handily topping the 1.5% gains for the broader S&P 500.  That’s a change from the opening five months of the year, when the group managed an 8% advance on average, lagging the 12% move for the broad index  

Yet political risk factors lurk, as Washington increasingly appears to have big tech in its crosshairs. The House Judiciary Committee advanced a series of bills overnight, including a pair of measures which would target Silicon Valley giants: The American Choice and Innovation Act, which would bar tech platforms from conduct that “advantages the covered platform operator’s own products, services, or lines of business over those of another business user,”  as well as the Augmenting Compatibility and Competition by Enabling Service Switching Act,  which would compel big tech to allow users to more easily transfer their personal data from one platform to another. 

Then, too, the Senate last week confirmed outspoken Biden administration nominee Lina Khan to the Federal Trade Commission. That provides the five-member FTC panel with a three-seat Democrat majority, with each of that trio previously advocating for greater government oversight of big tech, as well as enhanced antitrust enforcement. 

A government crackdown on the big tech business models could hurt, as the Faamg’s account for a combined 22% weighting in the S&P 500, with Apple and Microsoft alone representing 11% of the broad stock market gauge.  For context, no single stock had topped the 6.4% S&P 500 share achieved by then-unstoppable IBM in 1985 until Apple managed to briefly top that threshold late last year. The intervening 36 years have been less kind to Big Blue, as IBM now stands as the 64th largest component in the market cap-weighted index with a modest 0.36% weighting. 

Meanwhile, flagging market-wide internals suggest those mega-cap monoliths may need to carry an increasingly heavy load to help stocks maintain their bullish momentum. Thrasher Analytics founder and eponym Andrew Thrasher noted on Twitter yesterday that, with the major indices at or near their respective high-water marks, just 3% of stocks within the tech-heavy Nasdaq composite logged a fresh six-month high yesterday. That’s down from more than 20% in late February.  

Stocks bounded higher after yesterday’s breather, with the S&P 500 extending to a hearty 2.4% for the week so far, while a strong seven-year note auction didn’t spur much action in Treasurys, as the long bond remained at 2.1%.  WTI crude pushed back above $73 a barrel, gold edged lower to $1,775 an ounce and the VIX slipped below 16 to approach its COVID-era lows. 

- Philip Grant