Born to Run
Greenlight Capital’s annual client letter

Greenlight Capital’s annual client letter highlights the latest stock market singularity: Hometown International (HWIN on the pink sheets), a New Jersey-based purveyor of “home-style” sandwiches and other fare.

Hometown, which sported a $105 million market cap as of yesterday following a 795% rise from the end of 2019, operates a single deli in the township of Paulsboro which generated about $36,000 in total sales over the past two years. That’s equivalent to about $2,900 in market cap per dollar of revenue during that period.  Mr. Market’s generosity amply supplemented that thinly-sliced revenue stream.  Thanks to a $2.5 million equity raise, net cash from financing jumped to $2.2 million last year, up from $160,000 in 2019. 

Sandwich-as-a-Service. Yours for about $100 million

Other details paint the picture of an outfit focused on more than slinging high-quality grub. As Jonathan Maze of Restaurant Business Online notes, Hometown spent $320,000 on consulting fees last year, including $15,000 monthly to Tryon Capital Ventures for research and development and $25,000 monthly to Macau-based firm VCH Limited to “build a presence with high net worth and institutional investors."  Language in the 10-K that the company intends to seek out “a business combination with a private entity whose business presents an opportunity for shareholders” potentially suggests that HWIN could serve as a vehicle for a reverse merger transaction. 

All things considered, the fact that pre-revenue battery concern QuantumScape, which is the subject of a scathing report by a short seller (see yesterday’s ADG), and joke cryptocurrency Dogecoin have garnered valuations of $13 billion and $50 billion, respectively, makes $100 million for a sandwich shop sound positively value-laden.  Buy low. 

Hidden Valley
Smooth sailing ahead in junk bonds, perhaps.

Smooth sailing ahead in junk bonds, perhaps. On Tuesday, Fitch Ratings revised its 2021 and 2022 high-yield default rate forecasts to 2% and 3% from 3.5% and 4.5%, respectively. Abundant liquidity and limited near-term maturities following a wave of refinancing activity have taken most pandemic-related economic risks off the table, the rating agency believes. 

Mr. Market seems to agree, as spreads on the ICE BAML High Yield Index finished at 325 basis points over Treasurys yesterday, well below the 554 basis point average across the 1997 to 2020 period and near the 316 basis points post-crisis nadir established in October 2018.   

The persistent bid in credit has rendered the “high-yield” term increasingly archaic. Analysts from Goldman Sachs found last week that only about 10% of the junk market offers a 500 basis point pickup over Treasurys, compared to 25% in November. Similarly, yields on the triple-C-rated component of the Bloomberg Barclays High Yield Index sit near a record low 6.26%, down from 10% as recently as October.

Dwindling creditor compensation juxtaposes with limited room for operational error among that highly-speculative cohort.  A report today from Bank of America calculates that, even after excluding the bottom 10 percentile from the index and assuming 25% Ebitda growth over the next 12 months, triple-C’s sport a hefty 14 turns of implied forward leverage along with just 1.3 times interest coverage. 

Might the placid current environment be helping mask stress within those ranks? In a Tuesday commentary for LCD, Lehmann Livian Fridson Advisors chief investment officer Marty Fridson observed that the current 3.1% ratio of distressed issues (defined as those trading with at least a 1,000 basis point option-adjusted spread over Treasurys) marks a notable contrast with persistent industrial slack.  

Thus, the 74.4% reading for March capacity utilization sits 520 basis points below the 1972 to 2020 average, per the Federal Reserve.  As Fridson notes, over the 17 monthly occasions since 2001 in which capacity utilization fell below 75, the high-yield distress ratio averaged 25.5% with a prior low reading of 10.7%, more than triple the current figure.  The dean of high yield writes that:

I believe the [most] likely explanation of [that divergence] is that the Fed’s current, unprecedentedly aggressive intervention is distorting market signals. 

If the market were reflecting high-yield issuers’ credit measures in a more customary fashion, spreads would exceed 1,000 basis points on a great many bonds that are currently flying below the radar but possibly fated to crash land within the next 365 days. 

Recap April 16

Treasurys took a breather following their sharp rally this week, as the 10- and 30-year yields rose slightly to 1.59% and 2.28%, respectively.  The path of rates appears to matter little to the currently-bulletproof stock market, as the S&P 500 rose another 40 basis points to wrap up the week with a 1.4% gain and extend to an 11.5% year-to-date advance.  Gold reached a seven-week high at $1,776 an ounce (that’s the spirit!), WTI pulled back towards $63 a barrel, and the VIX marked another virus-era low near 16. 

- Philip Grant

Corner Case
Recent data from the U.K. Debt Management Office show that

Recent data from the U.K. Debt Management Office show that the Bank of England’s £742 billion ($1.02 trillion) holdings of government bonds topped those both of foreign investors and domestic pension and insurance funds as of Sept. 30. Thanks to a 51% jump from the year-ago period, BoE balance sheet holdings footed to more than 30% of total government liabilities as of Sept. 30, up from 23% in the third quarter 2019.

“The speed of [that] build-up is pretty striking, to put it mildly,” John Wraith, head of U.K. rates strategy at UBS, commented to the Financial Times on Monday.   Wraith relays that at the current £150 billion per annum purchase target, the BoE is on pace to own half of all conventional, fixed-rate gilts by the end of the year. 

Plug and Play
Electric vehicles are taking over Wall Street,

Electric vehicles are taking over Wall Street, as investors have responded to the parabolic ascent of Tesla, Inc. shares by showering capital on a raft of industry entrants.  Following a 9% pullback since early February, the S&P Kensho Electric Vehicles Index sports a $1.55 trillion market cap, double its July 2020 valuation.  

Many of those hopeful constituents have big things planned.  As of mid-December, at least 10 EV concerns that have come public via special purpose acquisition companies forecasted $1 billion or more in revenues in 2024 compared to less than $50 million last year, utilizing the relatively lax restrictions for SPAC-affiliated entities against issuing rosy long-term projections. 

That projected industrywide boom has invited some skepticism. A March paper co-authored by Research Affiliates chairman Rob Arnott argued that the electric vehicle craze contains the necessary hallmarks of “a big market delusion.”  Arnott and Co. explain: 

Big market delusions generally begin with innovation or disruption that opens a new market, such as cannabis, or reinvents an old one, such as advertising. The hallmark of a big market delusion is when all the firms in the evolving industry rise together even though they are often direct competitors. 

Investors become so enthusiastic that each firm is priced as if it will be a major winner in the evolving big market despite the fact this is a fallacy of composition: the sum of the parts cannot be greater than the whole.

Even within the euphoric and highly speculative electric vehicle realm, lithium ion battery developer QuantumScape Corp. (QS on the NYSE) stands out from the crowd. The company, which counts legacy giant Volkswagen AG as its largest investor, rallied by 255% in the four weeks after it came public in a SPAC deal on Nov. 27.  At its peak, pre-revenue QS commanded a $50 billion market cap, easily topping Ford Motor Co.’s $35 billion valuation.  

That was then. QuantumScape, which featured among a Grant’s survey of SPAC-affiliated picks-to-not-click in the Dec. 25 analysis “Short this index,” has since seen shares fall by more than 70%.  On Jan. 4 alone, QS crumbled by more than 40% after the company filed a registration statement with the SEC allowing for certain insiders to liquidate their holdings. 

Some critics are pulling no punches. Today, activist short sellers Scorpion Capital issued a report calling QuantumScape: “A pump and dump SPAC scam by Silicon Valley celebrities that makes Theranos look like amateurs.” (But what do they really think?)

The short sellers assert that QuantumScape management is misleading investors with fanciful claims over progress in developing breakthrough solid-state battery technology, and that “key data slides in QuantumScape’s presentation appear to be fabricated.”  Shares fell by 12% today in response to that broadside, leaving a $13.5 billion market cap for what is decidedly not the Ford Motor Co. 

For more on QS and a bevy of other SPAC-related electric vehicle concerns, see that indispensable analysis from the Dec. 25 edition of Grant’s

QE Progress Report
A $35 billion sequential increase in Reserve Bank Credit pushed interest-bearing assets at the Fed to another fresh high at $7.69 trillion.  The annualized three-month growth rate accelerated slightly to 20.4% from 20% last week, while year-over-year growth contracted sharply once again, to 35% from 46% a week ago. 
Recap April 15

An acceleration of the recent rebound in Treasurys left the 10- and 30-year yield at 1.56% and 2.25%, respectively, each at its lowest in more than a month.  Stocks rallied again with the S&P 500 extending to an 11% year-to-date gain, gold jumped nearly 2% to $1,764 an ounce, and WTI crude advanced above $63 a barrel.  The VIX held below 17 for a sixth straight session. 

- Philip Grant

The Sum of All Fears
From Bloomberg:

From Bloomberg:

Fears that Europe’s post-pandemic economic recovery will prompt central banks to take their foot off the gas are brewing in the bond market.

While a brightening outlook potentially imperils the current paradigm of aggressive monetary support, a long-term supply deluge has perhaps also played a role in the rise in benchmark German 30-year yields to 0.26% from minus 0.20% as of year-end.  Roughly 15% of continental sovereign debt sales featured maturities of 25 years or longer in the first quarter according to data from Nordea Bank, a record share.   

Not everyone, however, views this as a problem.  European Central Bank general council member and Bank of Italy governor Ignazio Visco told CNN today that: “There is demand for very long term debt and not enough supply.” 

The red sea flows stateside.

The red sea flows stateside.  More than a quarter of U.S. stocks failed to generate positive net income last year, Bernstein analysts led by Toni Sacconaghi reported yesterday, the highest proportion in at least the past 50 years.  Technology companies were amply represented within that group, with 37% of sector constituents generating a loss in 2020. 

No profits, no problems, as that tech subset generated a 65% equal-weighted total return and 92% market-cap weighted return last year, easily topping the 40% figure for the domestic tech sector as a whole.  That run-up has helped foment some fancy valuations, as 36% of the money-losing tech universe garnered market caps equivalent to at least 15 times sales, topping the previous 33% peak in 2001 as well as the 24% logged during the depths of the financial crisis. 

As Sacconaghi and co. relay, that not only stands at nearly double the share of similarly expensive, lossmaking companies within the broader market, but also spells bad news in terms of historical performance.  Over the past 50 years, highly-valued and unprofitable equities have lagged the broader market by an average of 1% on a one-year basis, and 10% on a five-year view. The tech stocks within that expensive cohort have seen a 1% average one-year excess return, but that is overshadowed by a meaty 28% relative performance deficit over a five-year horizon. 

While equity investors who choose wisely in high-risk enterprises can enjoy outsized gains, creditors seeking the return of principal along with a little extra have traditionally given a wide berth to such speculative tech concerns.  That appears to be changing, as private lenders increasingly dabble in the sector via private loans which can then be packaged into asset-backed securities. 

The Wall Street Journal reported Friday that firms such as Golub Capital, Owl Rock Capital Partners and AllianceBernstein have extended some $2 billion in such loans to fast growing, unprofitable software companies since November, underscoring the ability of those firms to access capital in a variety of different formats. Golub, which has never suffered a default on those private loans since commencing the practice in 2013, last week priced an ABS deal to yield 3.2%, down from 4.72% in its first such structured transaction in fall 2019. 

Kroll Bond Rating Agency, which assesses the private loans, notes that the bulk of the borrowers sit near the basement in terms of credit quality, with ratings equivalent to single-B or triple-C, suggesting that the loans are vulnerable to impairment in the event of adverse business or economic conditions.  “It is a relatively new asset class with limited recovery data,” the rating agency adds. 

Recap April 13

A very strong long bond auction this afternoon helped solidify a bullish day for Treasurys, as the 10- and 30-year yields each fell towards multiweek lows at 1.62% and 2.30%, respectively.  Stocks caught another bid with the S&P 500 enjoying its seventh green finish in nine tries to extend to a 10.3% year-to-date gain.  Bitcoin rallied to a new high near $63,000, WTI crude pushed back above $60 a barrel and gold rose 80 basis points to $1,746 an ounce. 

- Philip Grant

Bit by Bit
Crypto broker Coinbase Global, Inc. is set to make its public debut on Wednesday,

Crypto broker Coinbase Global, Inc.  is set to make its public debut on Wednesday, via a direct listing on the Nasdaq exchange under the ticker COIN.  Projected valuation stands at $100 billion, compared to a combined $166 billion market cap across the Nasdaq, the Intercontinental Exchange (parent company of the New York Stock Exchange) and CME Group, and up from an $8 billion valuation in its most recent private funding round in 2018.

Reading the tea leaves, one legacy operator looks to get with the times. This afternoon, the NYSE announced on Twitter that it will sell so-called first trade non-fungible tokens, or digital renderings of IPO debut prints that “memorialize a company’s First Trade using the blockchain’s digital ledger and provide irrefutable proof of authenticity and ownership.” 


The “inherent unpredictability” of Coinbase’s business noted in its Feb. 25 form S-1 filing can lead to big things when times are good. The company generated estimated net income of between $730 million to $800 million in the first quarter, far above the $128 million bottom line achieved during full-year 2020.  Similarly, revenues soared to $1.8 billion over the first three months of 2021, compared to $1.3 billion throughout last year.  Outsize price appreciation in the crypto complex underpinned those results, as bitcoin hovered near $60,000 this afternoon, up from $11,500 six months ago.  

Extrapolating those figures could prove tricky. “We may earn a profit when revenues are high, and we may lose money when our revenues are low,” explained CEO Brian Armstrong in the S-1, “but our goal is to roughly operate the company at break-even, smoothed out over time, for the time being.” 

The prospect of pressure on Coinbase’s elevated fee structure could constrain the currently booming bottom line.  As The Wall Street Journal notes today, an investor who purchases $100 worth on bitcoin on Coinbase would owe $3.49 in transaction expenses, compared to $1.50 and $0.50, respectively, on competing exchanges Kraken and Bitstamp.  As traditional equity brokers can attest, the maturation of an asset class can spell un-bullish things for commission structures. 

Then, too, features inherent to the Coinbase business model may also help explain management’s decision to play down the prospects for structural long term profitability. As FT Alphaville noted last week, Coinbase conducts market making activities to facilitate trading activity among smaller customers, leaving it (unlike the legacy bourses) exposed to the risk of loss on principal positions.  

In addition, COIN disclosed that it routinely acts in a prime-broker capacity, “advanc[ing] funds and settl[ing] on behalf-of credit eligible customers,” activities from which legacy exchanges are barred from undertaking due to conflict-of-interest regulations.  Utilizing a gold rush analogy, University of Houston finance professor Craig Pirrong puts it this way:

CME is like the hardware store selling shovels to the prospectors: Coinbase is more like the prospectors [themselves]. 

Some details surrounding corporate governance may also invite closer inspection.  On March 19 Coinbase forked over $6.5 million to the Commodity Futures Trading Commission to settle allegations of wash trading (or illegitimate self-dealing transactions designed to inflate trading volumes) from 2015 to 2018.  The company allegedly matched orders from a pair of in-house automated trading platforms, potentially result[ing] in a perceived volume and level of liquidity of digital assets, including bitcoin, that was false, misleading or inaccurate.” 

The Journal reported last week that Coinbase co-founder Fred Ehrsam, who served as president from 2014 to 2017 and part owner of crypto prime broker Tagomi Holdings, which Coinbase purchased last year, will serve as an independent director, assuming one of the three seats on the company’s audit committee.  Venture capitalist and lead independent director Fred Wilson, who has been on the Coinbase board of directors since 2017, will also join the committee, helping form an arrangement that University of Tennessee accounting professor Terry Neal termed “more than a bit unusual.” Ehrsam and Wilson control 8.9% and 8.1% of voting shares, respectively, each coming in just below the 10% threshold at which point directors are barred from independent status.

On the other hand, that ownership concentration on the audit committee may not persist indefinitely. The S-1 notes that no registered stockholder is subject to lock-up restrictions and, as the offering is a direct listing, it is major shareholders, rather than the company itself, selling into the deal.  For more on Coinbase, see “Disruptors cash out” from the March 5 edition of Grant’s.     

Recap April 12

Status quo this time, as the S&P 500 consolidated last week’s near 3% advance, while Treasury yields remained little changed  following 3- and 10-year note auctions this afternoon.  WTI crude rose towards $60 a barrel, gold pulled back to $1,732 an ounce and the VIX held below 17 for a third straight session. 

- Philip Grant

Early Riser
Time to hit the beach then?

Time to hit the beach then?  With a 2.7% rally this week and 10% gain year-to-date, the S&P 500 finished the day at 4,128.  That exceeds the average 4,099 year-end price target among 11 surveyed Wall Street strategists, Bloomberg reports.

With first quarter earnings season set to commence next week, member companies within that broad index have a high bar to clear.  The sell side is calling for an aggregate 23% earnings growth from a year ago, which would mark the largest bottom-line expansion since 2018, when the effects of the Trump-era corporate tax cuts took hold. 

Blind Man's Bluff
Behold the supersonic boom in special purpose acquisition companies.

Behold the supersonic boom in special purpose acquisition companies.  More than 300 such blind pools have come public so far this year according to SPACInsider, raising an aggregate $99 billion. That blows past the prior $83 billion, full-year record established in 2020.  For context, the pre-coronavirus peak in aggregate IPO proceeds stood at just $64.8 billion. 

Lofty promises have been part and parcel of the recent deal craze, as SPAC promoters have availed themselves of the ability to issue long-dated and perhaps rose-colored operating forecasts that are prohibited in traditional IPOs.  The Financial Times notes that a cohort of nine auto-focused tech companies that listed via SPAC last year projected an aggregate $26 billion in revenues by 2024, slightly above the group’s combined $139 million top line in 2020 (that target represents a 270% compound annual growth rate). 

Even the regulators are noticing. The process in which a blank check company combines with an operating business looking to list on a public exchange, “gives no one a free pass for material misstatements or omissions,” John Coates, acting director of corporate finance at the SEC, declared in a statement yesterday, adding that such deals should feature “the full panoply of federal securities law protections – including those that apply to traditional IPOs.”

There is no doubt that the SPAC frenzy is helping fuel historic deal activity, particularly in the glamourous technology sector. Global tech M&A spending footed to $302 billion in the first quarter, according to 451 Research. For context, that figure averaged $119 billion across the four quarters of 2019, while quarterly tech M&A volumes only exceeded $200 billion twice over the 2002 to 2019 period.

Then, too, promotors have coughed up a pretty penny to secure their tech industry prizes.  SPAC-sponsored deals took place at a median price of 12.9 times sales in the first three months of the year, more than triple the 4.1 times median price-to-sales ratio for non-blank check transactions.  451 Research analyst Brenon Daly wrote Monday that: “So far this year, SPACs have, to some degree, overshadowed rival buyers with far more financial and operational stability, not to mention much more time-tested M&A track records.” 

Regulatory scrutiny aside, elevated price tags in tandem with saturated supply have crimped the ability of operators to secure PIPE (i.e., private investment in public equity) financing, a key cog in the SPAC machine. With 117 SPAC-related deals announced so far this year, 497 blank-check entities are currently seeking their own dance partner, according to Refinitiv, while only about a quarter of all SPACs listed in 2020 or 2021 have completed a transaction. 

The clock is ticking:  Entities that fail to find a merger target within two years are typically unwound, with promotors obliged to return capital to investors.  “There is a lot of indigestion,” a senior bank executive tells the FT. “The pendulum has swung to where, if you’re in the market with a PIPE right now, it’s going to be really hard and painful” to attain financing.  “There’s only so much illiquid exposure that investors are going to want to take,” added another. 

For an in-depth analysis of SPAC mechanics and a survey of 10 representative blind pools (seven of which acquired automotive tech or mobility-related businesses), see the analysis “Short this index” in the Dec. 25 edition of Grant’s

Recap April 9

Another whiff of inflation, this time the form of a 4.2% year-over-year advance in the March Producer Prices Index (topping the 3.8% consensus and the highest reading since 2011), helped apply some modest pressure on rates, as the 10- and 30-year Treasury yields backed up to 1.66% and 2.33%, respectively.  Stocks enjoyed a late ramp to finish higher by about 70 basis points on the broad S&P 500, while WTI crude dipped to near $59 a barrel and gold retreated to $1,743 an ounce.  The VIX marked another virus-era low at 16.70, down 1.5% on the day. 

- Philip Grant

Eyes on the Prize
That's hot.

That’s hot.  Hotel scion Paris Hilton extolled the virtues of bitcoin in a CNBC interview last week, saying of the digital ducat: “It’s definitely the future.” The ubiquitous 2000s-era socialite subsequently added “laser eyes” to her Twitter profile, denoting a laser-focus on the price of bitcoin reaching $100,000.

Nice lasers

That move earned an approving response from MicroStrategy, Inc. CEO and bitcoin evangelist Michael Saylor (Almost Daily Grant’s, Dec. 8), who tweeted: “If you don’t understand laser eyes, you don’t understand bitcoin. Welcome to the team, Paris Hilton.”

Learning by Doing
A grand economic experiment continues to unfold in Turkey.

A grand economic experiment continues to unfold in Turkey.  Measured consumer and producer prices raced higher by 16% and 31%, respectively, in March from a year ago, figures that analysts at Commerzbank termed a “disaster.”  Yet the country’s strongman President Recep Tayyip Erdogan has an unorthodox strategy for taming that scourge. In a speech yesterday, Erdogan assured members of the ruling AK Party that “we are determined to bring down inflation, which has recently accelerated, down to single digits. We are also determined to reduce interest rates to single digits.” 

Recall that Erdogan abruptly fired Central Bank of the Republic of Turkey Governor Naci Agbal on March 20, two days after the monetary mandarin hiked the benchmark repo rate to 19% from 17%.  AK Party veteran Sahap Kavcioglu replaced the hawkish Agbal (who oversaw 875 basis points of tightening in his sub-five month term), becoming Turkey’s fourth central bank boss in the last two years. 

Foreign investors responded to the latest leadership shuffle by hitting the bricks. International equity funds sold $1.9 billion of Turkish equities and bonds in the week ended March 26 according to Bloomberg, the largest such outflow since May 2006.  Similarly, the lira has declined by 11% against the dollar since Agbal was shown the door, extending to a 65% drop since Erdogan began to consolidate power following the failed coup d’état in mid-2016.  Gross foreign exchange reserves fell to $48 billion on Friday, down nearly 11% in two weeks. 

Political allegiance aside, the new CBRT head’s policies may prove similarly disappointing for the hair-triggered President. Kavcioglu told listeners-in to the annual general assembly meeting last week that raging price pressures “require a strict policy stance,” adding, of his previously stated commitment to bring inflation down to 5%, that “we will continue to use all the tools we have, effectively and independently.”  The CBRT is set to conduct a policy meeting one week from today, with surveyed economists expecting a status-quo outcome. 

Erdogan Toprak, deputy chair of the opposition Republican People’s Party, warned online news site Duvar English on Tuesday that acute danger looms if President Erdogan gets his way. “These previously-attempted backdoor [stimulative] policies via interest rates and credit expansion will cause complete economic collapse.” 

On the other side of the coin, political realities await. “There is no doubt that in the case of a significant exchange rate increase or a new interest rate hike, this new governor, even the Treasury and Finance Minister, will be sacked too,” added economist Ugur Civelek. “It is the duty of every CBRT Governor and Treasury and Finance Minister in the recent past, present and future to protect Erdogan’s reputation and take the blame for him.  One will come and the other will go.” 

Yield-hungry U.S. investors could feel the sting of a protracted problem in the Bosporus. Turkey stands as the third largest issuer weighting in the iShares J.P. Morgan USD Emerging Markets Bond ETF, which sports $18.2 billion in assets under management. 

QE Progress Report
Reserve Bank Credit, or interest-bearing assets on the Fed balance sheet, increased $15 billion from last week to $7.66 trillion.  That represents a 20% three-month annualized growth rate, while year-over-year growth shrank to 46% from 59% a week ago and 78% on March 25. 
Recap April 8

Stocks rose moderately as the bulls retained firm command, leaving the S&P 500 higher by 1.9% for the week so far and a cool 9.1% year-to-date.  Rates continued to retrace their late winter selloff, with the 10- and 30-year Treasury yields declining to 1.62% and 2.32%, respectively.  A weaker greenback supported key commodities, as gold rallied to $1,757 an ounce and WTI crude edged to near $60 a barrel, and the VIX closed below 17 for the first time since Feb. 20 of last year.  

- Philip Grant

Support Group
Dallas Fed President Robert Kaplan defended the Federal Reserve’s decision to

Dallas Fed President Robert Kaplan defended the Federal Reserve’s decision to maintain near-zero overnight interest rates in tandem with the ongoing $120 billion-per-month in asset purchases in an interview with The Wall Street Journal yesterday: “When we’re in the middle of a crisis, we should be aggressively using our tools, so I agree with what we’re doing now in terms of asset purchases and stance of policy generally.”  The central banker forecasts 6.5% growth in GDP this year, along with a 4% measured rate of unemployment at year-end from 6% in the March reading.  

While Kaplan currently lacks a vote on the Federal Open Market Committee, the decision makers look to fully back that view. Minutes from the March 16-17 FOMC meeting released this afternoon included the following: “Participants noted that it would likely be some time until substantial further progress toward the Committee’s maximum- employment and price-stability goals would be realized.” 

Mr. Market appears to be offering his own dissenting vote.   Following an 82% rally from the March 2020 lows, the S&P 500 commands a Shiller P/E ratio of nearly 37 times inflation-adjusted, 10-year average earnings. That towers over the median 15.8 times valuation over the past 150 years, and is eclipsed only by the 1999 to 2000 period for the most expensive on record. 

Credit markets similarly seem to be enjoying conditions that bear little resemblance to an ongoing crisis. The spread over Treasurys on the Bloomberg Barclays High Yield Index slipped to 292 basis points yesterday, the narrowest premium for speculative-grade corporate bonds since July 2007. Similarly, yields on the triple-C-rated component of the Bloomberg Barclays High Yield Index reached a record low 6.10% yesterday. 

Issuers have duly made hay during the sunny weather, as high-yield supply footed to a record $149 billion over the first three months of the year.  The good times have rolled on into April. This morning, single-B-plus-rated casual dining chain Bloomin’ Brands sold $300 million in eight-year notes at a 5 1/8% coupon in its bond-market debut, well inside of initial price talk ranging from 5.75% to 6%.  Priced at par, the issue promptly broke towards 102 cents on the dollar this afternoon for a 4.74% yield-to-worst. 

Boomtime conditions are likewise visible in leveraged loans, or tradeable, floating-rate bank debt generally issued by speculative-grade borrowers.  Prior to a miniscule 3 basis point decline in March, the S&P/LSTA Leveraged Loan Index enjoyed an 11-month winning streak, garnering a cumulative 20.7% total return over that period. 

Domestic loan issuance footed to $180 billion through March 31, topping the prior quarterly record of $171 billion established in 2017. Creditors had little compunction over backing more speculative concerns, as loans rated single-B-minus or lower accounted for a record 40% of total issuance per S&P’s LCD unit, topping the record 36% share set in 2020. Commensurate with the friendly conditions, outright credit-negative deals have returned in force. So-called dividend recap transactions, or loans used to finance payouts for a borrower’s private equity promoter, reached $20 billion in the first quarter, the busiest such period since the end of 2016.  

Euphoric financial markets are one thing. Bloomberg’s Brian Chappatta relays that RBC Capital economists Tom Porcelli and Jacob Oubina’s aggregate weekly payrolls calculation, which includes average hourly earnings, average weekly hours and headline employment figures, show that private sector workers are now earning more than they did before the bug bit in February 2020. There’s more where that came from. The Labor Department yesterday released its February Job Opening and Labor Turnover Survey, finding that employment vacancies reached 7.37 million, up nearly 600,000 in two months and near the November 2018 record high going back to 1999 of 7.55 million availabilities.

For more on the implications of crisis-era policy overlaid with a fast-recovering economy and white-hot asset prices, see the analysis “A case of overstimulation” in the most recent edition of Grant’s Interest Rate Observer dated April 2. 

Recap April 7

Stocks finished flat for the second straight day as the S&P 500 continues to consolidate from Monday’s move to new highs, while Treasurys gave back the bulk of yesterday’s rally with the 10- and 30-year yields rising to 1.67% and 2.36%, respectively.  WTI crude advanced to near $60 a barrel, gold pulled back to $1,738 an ounce, and the VIX retreated to a fresh virus-era low near 17. 

- Philip Grant

Arrears Window
Cash management maneuvering in the Middle East.

Cash management maneuvering in the Middle East.  Bloomberg relays today that the Saudi Arabian Oil Company (a.k.a. Aramco) is in negotiations with investors including Apollo Management to sell a $10 billion stake in the country’s oil pipelines.  

That follows yesterday’s report from Bloomberg that foreign firms including  Reston, V.A.-based Bechtel Corp. “are pursuing billions of dollars in unpaid bills from Saudi Arabia’s government for work done on the Riyadh metro project.”  The currently-stiffed contractors have escalated the matter to the American, French and Spanish embassies in Saudi Arabia. By way of response, the Royal Commission for Riyadh City asserted that “the aforementioned claims are being assessed as per a dispute resolution process stipulated within the contract.” 

Other factors could explain those slow-walked payments.  The Kingdom of Saudi Arabia ran a $79 billion fiscal deficit last year, equivalent to 12% of GDP (nearly triple 2019’s shortfall relative to output), while FX reserves fell to $438 billion as of Jan. 31 from a $730 billion high water mark in September 2014.  Awash in red ink, the government responded last year by tripling the value added tax to 15% and raising its self-imposed cap on sovereign debt to 50% of GDP from 30%. 

Aramco similarly staggered through 2020, as the pandemic and lockdown-induced wipeout in energy prices last spring helped catalyze a brutal year for the mostly-state-owned enterprise. The oil concern’s net income footed to $49 billion last year, a 44% decline from 2019. Thanks in large part to its $69 billion purchase of a majority stake in chemicals maker Saudi Basic Industries Corp., (Sabic), Aramco’s net debt rose to $162 billion last year, more than double the $72 billion of borrowings at the end of 2019. 

The company responded to the abrupt turn in conditions by tightening its checkbook, slashing capital expenditures to $27 billion from $33 billion in 2019, and on March 21 revising its capex forecast to $35 billion from a $40 billion to $45 billion range. 

Prior events color the current situation. Aramco’s 2019 IPO on the local Tadawul stock exchange was far from a home run, featuring the flotation of 1.5% of the state-owned company at an implied $1.7 trillion valuation, short of de facto ruler Crown Prince Mohammed bin Salman’s reported goal of a 5% sale at a $2 trillion market value. 

Concerning data regarding the future productivity of the behemoth Ghawar oil field (easily the world’s largest) was part and parcel of that disappointing debut. In its bond prospectus issued in spring 2019, Aramco revealed a production capacity of just 3.8 million barrels per day at the Ghawar, far below the U.S. Energy Information Agency’s 2017 daily output estimate of 5.8 million barrels.  In addition, the prospectus showed that with some 48 billion barrels of crude remaining in the ground out of an original 125 to 130 billion barrel cache of recoverable reserves, the Ghawar was already more than 60% depleted (Almost Daily Grant’s, April 11, 2019). 

Meanwhile, bin Salman told reporters last Tuesday that he is counting on local enterprises to invest $1.3 trillion in capital spending into the Saudi economy over the next decade, with Aramco and Sabic kicking in 60% of those funds.  In exchange for that generous donation, Aramco could decrease its $75 billion in annual dividends, the vast majority of which accrue to the state government.  

Prospective dividend relief could prove a temporary boon for the oil giant, and a further dose of stress for government bean counters. Last year, Aramco paid the Kingdom a total of $110 billion across dividends, royalties and income taxes.  That’s not only far in excess of the $49 billion in net income and free cash flow generated in 2020, but also a material chunk of the Saudi government’s $272 billion state budget last year.

Then again, rising tides (or sand dunes) lift all boats.  Of his new spending initiative, bin Salman declared last Tuesday that it “will not harm the shareholders of those companies because instead of getting dividends in cash, you’re going to get growth in the stock market.” 

Recap April 6

Stocks took a breather after yesterday’s steep ascent left the S&P 500 at a fresh high, up 8.5% year-to-date and 82% from its March 2020 nadir, while Treasurys continued their rebound with the 10- and 30-year yields declining to 1.66% and 2.32%, respectively.   WTI crude bounced back to $59.50 a barrel after yesterday’s rout, gold rose to $1,745 an ounce and the VIX managed to close above 18 for its second straight green finish.  

- Philip Grant

Strictly Business
Last call in the Middle Kingdom?

Last call in the Middle Kingdom? The People’s Bank of China has instructed banks to tighten lending standards in order to cool down a red-hot property market, reports the Financial Times.  That follows last month’s warning from China Banking and Insurance Regulatory Commission chair Guo Shuqing: “Many people buy homes not to live in, but to invest or speculate,” Guo noted. “This is very dangerous.” 

There looks to be plenty of room for a downshift. Medium and long-term consumer loans, mostly mortgages, ballooned to a record RMB 1.4 trillion ($210 billion) over the first two months of the year, up 72% from pandemic-addled 2020, while new home sales rose by 133% from a year ago.  Last year, Nationwide house prices jumped 8.7%, far outpacing the reported 2.3% rise in GDP.  On Jan. 1, Beijing debuted its “three red lines” policy, which limits developers’ net debt at 100% of equity and liabilities at 70% of total assets while mandating that short term borrowings must not exceed cash reserves.  Those who fail to comply are barred from further borrowings. 

To be sure, aggressive borrowing is endemic across China’s corporate sector, not least in housing-related enterprises. Citigroup economist Li-Gang Liu calculated that some 600 listed companies in China sport leverage ratios at least 20 percentage points above their sector averages, representing a combined RMB 11 trillion in market capitalization, equivalent to one-sixth of the total stock market.  Among that highly indebted contingent, a 100 basis point increase in the benchmark lending rate would consume the equivalent of 30% of their bottom line to meet that increased interest expense.  Within the cohort of notably leveraged property developers (accounting for roughly one-third of the total group), that same 1% tightening would gobble up 42% of their bottom lines. 

Those facts color the efforts of China Evergrande Group (3333 on the Hang Seng), the nation’s largest property developer and Asia’s most prolific high-yield debt issuer, to put itself on the right side of the new regulatory regime.  Evergrande announced on last Wednesday’s earnings call that it plans to cut gross debt to RMB 590 billion by June 30 from the current RMB 674 billion, then to RMB 450 billion and RMB 350 billion in 2022 and 2023, respectively. Currently coloring outside each of the three red lines, Evergrande management predicted that they will be in compliance with two of the three directives by Dec. 31, and all three a year after that.   

Divestitures from Evergrande’s hodgepodge of side businesses, including a 10% stake in online home and auto sales portal FCB Group for a projected $2.1 billion, are central to the deleveraging strategy. Yet listless recent performance from the conglomerate’s core operations may undermine those goals.  Evergrande generated RMB 507 billion in revenue last year, well below the RMB 566 billion analyst consensus.  So-called adjusted core profit slipped by 26% to RMB 30 billion, while gross margins fell to 24% from 28% and 36% in 2019 and 2018, respectively. 

Indeed, the bond market remains skeptical.  B1/single-B-plus rated Evergrande’s senior secured, dollar-pay 8 3/4% notes due 2025 last changed hands at less than 80, equivalent to a 15.52% yield-to-worst and 1,459 basis point spread over U.S. Treasurys. 

Evergrande is far from the only developer caught offsides by the recent sea change.  Last week, Shanghai and Shenzhen-based Yuzhou Group Holdings Co. Ltd. (1628 on the Hang Seng) disclosed a drop in 2020 earnings to RMB 117 million, 97% below its 2019 bottom line of RMB 3.61 billion, earning a downgrade to B1 from Ba3 at Moody’s Investors Service.  The company subsequently told investors that revenues over the first half of 2020 are likely to be restated to as little as RMB 7 billion from the RMB 14 billion reported last August.  Management is said to be seeking a waiver on an interest coverage covenant governing a dual currency loan signed last month. 

By Yuzhou's lights, outside forces were responsible for that dramatic reassessment.  According to a Wednesday dispatch from Bloomberg, the company attributed that profit and revenue evaporation to auditor Ernst & Young’s “strict” revenue recognition standards, which prevented  the company from consolidating certain projects onto its balance sheet. 

Sure, blame the umpire.

Recap April 5

Another round of scalding economic data, in tandem with a placid Treasury market, spelled good news for the bulls, as the 10-year yield held at 1.71% after the March ISM Services Index to its highest on record going back to 1997, helping propel the S&P 500 higher by nearly 1.5%.  WTI crude sank below $59 a barrel, off more than 4% on the day, gold held steady near $1,730 an ounce and the VIX rebounded to near 18 after reaching a virus-era low on Thursday. 

- Philip Grant

Haves and Have Nots
It was a quarter to remember in fixed income.  Over the first three months of the year, the 30-year Treasury suffered a total return loss of 15.66%, its worst quarterly showing since inflation-wracked 1976, while investment-grade corporate bonds generated a return of negative 4.7%.  On the other side of the coin, the most speculative junk bonds thrived, with triple-C-rated corporate bonds returning nearly 4% for the quarter. 
Automatic Teller
Automobiles are an increasingly scarce commodity.

Automobiles are an increasingly scarce commodity.  Data from Edmunds show that nationwide dealership inventory of new vehicles fell a chunky 36% from a year ago.  A shortage of semiconductor chips, cited by Ford Motor Co. in yesterday’s announcement that it will idle production of F-150 trucks at a pair of plants for two weeks, is a primary culprit.   

With demand perky as the economy rebounds, prices are on the hop.  Average transaction prices for new trucks and cars reached an estimated $54,800 and $34,400, respectively, up 7.2% and 22% from March 2020.   It’s the same story for used vehicles:  Wholesale inventories stand at 19 sales days’ worth of supply as of mid-March, compared to a 23 day average supply, helping push Manheim’s Used Vehicle Value Index to a record high 175.5 in March, up 23.7% from a year ago. 

Surging prices and homebound, cyberspace browsing customers have been a winning combination for Carvana Co. (CVNA on the NYSE), the online-only used car retailer which famously dispenses its vehicles through giant vending machines.  Carvana sold some 244,000 cars last year, up 37% from 2019.  That’s despite an aggregate 7% decline in used car registrations in 2020, according to the National Automobile Dealers Association.  

As business booms, the Carvana C-suite looks to expand its purview.  The nine-year-old company announced a planned $500 million in new investments last month, including building out 10 new inspection and repair centers to add to its 11 existing sites, as well as hiring roughly 5,000 new full-time employees to join its total current staff of 10,400. 

Mr. Market is a firm believer in the Carvana story. Shares are up a cool 1,669% since the April 2017 IPO, including a 38% ascent following a bearish analysis in the Aug. 7 edition of Grant’s Interest Rate Observer.  That leaves CVNA sporting a $48 billion enterprise value, equivalent to 77 times adjusted Ebitda estimates for 2023. For context, profitable and slow-growing retailer AutoNation sports an EV-to adjusted-Ebitda ratio of 7.2 times 2023 guesstimates.

Similarly, Caa2/triple-C-plus-rated Carvana last week sold $600 million in bonds due 2027 at a 5.5% coupon, an offering both priced inside of 5.75% initial price talk and upsized from an original $500 million deal.  Currently trading at 101 cents on the dollar, the bond carries a 432 basis point option-adjusted spread over Treasurys.  That compares to an average 542 basis point premium for companies within the Caa-rated component of the Bloomberg Barclays High Yield Index. 

Yet those recent operational and financial tailwinds have not been enough to guide Carvana toward profitability. CVNA has generated a cumulative operating loss of near $1 billion since its debut on the public markets, with combined adjusted Ebitda of minus $780 million and a $2.8 billion free cash flow burn.  Last year’s 42% jump in revenues from 2019 was accompanied by a 24% increase in net losses. 

While shareholders and creditors alike happily finance the loss-making enterprise, some insiders emphatically ring the register. Ben Mackovac, co-founder at Strategic Value Bank Partners and paid-up subscriber to Grant’s, observes that Ernest Garcia II, owner of former Carvana parent DriveTime Automotive Group and the father of current Carvana CEO Ernest Garcia III, has personally sold $1.9 billion worth CVNA stock in the open market since the end of October.  

QE Progress Report
A $43 billion sequential decline in Reserve Bank Credit left the stock of interest bearing assets on the Fed’s balance sheet at $7.64 trillion.  That’s up 19.9% on an annualized three-month basis, while year-over-year growth sank to 58.6% from 70.6% last week as the calendar now overlaps with last year’s onset of the asset shopping spree. 
Recap April 1

Stocks caught a strong bid, with the S&P 500 finishing at the highs of the day to wrap up this holiday-shortened week with a 1.1% gain, while Treasurys  also fared well with the 10- and 30-year yields falling to 1.67% and 2.33%, respectively.  Gold edged higher to $1,730 an ounce, WTI crude jumped back above $61 a barrel and the VIX fell to near 17, easily the lowest close of the coronavirus era.  

- Philip Grant

Out of Sight
The golden ticket, 2021 edition.

The golden ticket, 2021 edition. The world has gone wild for non-fungible tokens, i.e., blockchain-based digital collectibles spanning both traditional pop culture such as art, sports and music, and contemporary communication, including memes and GIFs. 

Three-year-old Dapper Labs, which owns collectible platform NBA Top Shot, announced yesterday that it has raised $305 million in a private round led by Tiger Cub hedge fund Coatue Management, dwarfing its prior $52.5 million in total financing and valuing the company at $2.6 billion.  NBA Top Shot, which sells video highlights packaged by the league and garners a 5% commission on all secondary market transactions, saw $200 million in secondary trading volume in February, equivalent to $120 million in annual revenue at that pace. 

Likewise, art world heavyweights are looking to get in the game following last month’s Christie’s-brokered $69 million NFT auction of a piece from Mike Winkelmann, a.k.a Beeple. Contemporary icon Damien Hirst announced in mid-March that he is working on his own line of NFTs consisting of 10,000 paper works created five years ago and now stashed in a vault.  The new project “challenges the concept of value through money and art,” Hirst promised. 

Of course, art collectors and galleries conventionally display things you can touch, a feat that is difficult when the piece in question lives in the digital ether. Looking to tackle the problem, some companies are working to design hardware to allow aficionados to view their prize in analog.  “Sometimes you’ve got to lean on the old world or the familiar to help people navigate the new,” Zoe Scaman, founder of “culture and entertainment strategy studio” Bodacious Ltd., explained to The Wall Street Journal last week.  

While some anticipate big things for NFTs, others see a different role in the cultural zeitgeist. BNP Paribas CEO John Egan commented in an interview with Bloomberg last week that “I don’t think we could find many more risky categories of assets at this point. I think it’s probably akin at this stage to going to the casino. You know you’re going to spend money but maybe you’re doing it for the enjoyment, for the experience.”

Some NFT owners have indeed rolled snake-eyes.  A report yesterday from Vice Motherboard detailed the experience of unlucky collectors whose wares simply disappeared from their digital “wallet,” with only a “404 error” page remaining.  Ontario-based property manager Tom Kuennen explained to Vice that, after shelling out $500 for an Elon Musk-related JPEG file image in February, he noticed that the piece had disappeared without a trace. 

The problem:  When a buyer purchases an NFT, the blockchain registers your ownership and contains a link to a website hosting the image. However, that buyer is then relying on a website to remain active and continue hosting the work while maintaining the proper links to access it.  If the website disappears or otherwise removes the art, the unlucky collector has no recourse. “There was no history of my ever purchasing it, or ever owning it,” Kuennen lamented to Vice. Then again, the anonymous nature of the blockchain confers some social benefits in these situations. “If [the NFT] goes up 100 times, you resell it. If it doesn’t, well, you don’t tell anyone.”

Your secret is safe with us.  

Recap March 30

Stocks finished slightly lower for a second straight day, following the S&P 500’s late rally to new highs on Friday, while Treasurys recouped early losses with the 10-year yield finishing unchanged at 1.71% and the long bond dropping three basis points to 2.37%.  A rip to near-five month highs on the Dollar Index helped put the hurt on key commodities with gold and WTI crude falling to $1,683 an ounce and $60.5 a barrel, respectively.  The VIX fell more than 5% to finish below 20.  

- Philip Grant

Monetary Policy Diktat
“I repeat my call to our citizens to bring gold and foreign currency they keep at home into the economy through financial institutions,” declared Turkish President Recep Tayyip Erdogan following a cabinet meeting today.
The Wait
Percolating prices in the Middle Kingdom:

Percolating prices in the Middle Kingdom: A bulletin today from The Wall Street Journal documents widespread cost pressures among Chinese exporters, as fast-rising raw materials prices in tandem with global supply bottlenecks have led at least one toy wholesaler to raise prices on new orders by as much as 15% since the beginning of March.  Similarly, a Jiangxi province-based maker of work boots raised prices in late February after receiving notices of 10% to 30% hikes in the cost of raw materials used for both products and packaging.

“In my nearly 25 years in China, I’ve never experienced anything like this,” Rene de Jong, director of outdoor furniture manufacturer Resysta AV Ltd., tells the Journal.  

It’s the same story stateside, as companies across a range of industries are flagging a rapid change in conditions. “Costs are going up everywhere,” Ted Doheny, CEO of packaging producer Sealed Air, tells the Financial Times today. “It’s a big deal.”  On a Wednesday earnings call, Jeff Harmening, CEO of cereal giant General Mills, forecasted a 3% inflation rate for the year while noting “broad-based [pressure] across commodities, across logistics, across things like aluminum and steel."

Economists at the Federal Reserve have taken notice, penciling in a 2.2% rise on the personal consumption expenditures index for calendar 2021, up from 1.8% three months ago.

Then again, with the funds rate near zero, the monetary mandarins have made sure to telegraph their intentions to stand aside and let things play out.  Data from Arbor Research show that recent Fed communications have been increasingly dotted with passive language. Terms like “wait,” “some time,” “transient,” “patience,” and “long way” have appeared in official communications at a far higher rate than at any other time over the past 24 years. 

Passive Aggressive

Transient or not, the return of inflation (or rather, the fear of it) is helping deal some significant pain in longer-dated Treasurys. The 10-year yield reached 1.75% last Thursday, more than doubling in four months, while the 1 3/8% Treasury bond due in August 2050 has plunged to 78 cents on the dollar to yield 2.42% from 99 cents as recently as late September.  As Uncle Sam prepares to dole out another round of stimulus, the bond market is suddenly awash in supply.  Year-to-date Treasury issuance stands at $4.1 trillion according to Bloomberg, up nearly 50% from a year ago. Globally, the supply of new government debt is up a cool 78% from this time in 2020.  

The implications of a continued upside move could prove far-reaching. “It’s especially disturbing to see the rates market becoming unanchored and putting in more risk premium,” Matt King, global head of credit products strategy at Citi, commented to Bloomberg Friday. “If it carries on, and does so very rapidly, then you will also have an outflow from credit and potentially equity funds in a way that proves destabilizing. Then the question will be whether that effects the economy.” 

See the March 19 edition of Grant’s Interest Rate Observer for a comprehensive look at, and the potential implications of, an unscripted bout of disorderly price action in the world’s largest and most liquid bond market. 

Recap March 29

Stocks held firm after the S&P 500 jaunted to new highs on Friday, while Treasurys came for sale again with the 10- and 30-year yields rising to 1.71% and 2.36%, respectively.  Gold slipped to $1,709 an ounce, WTI crude rose towards $62 a barrel, and the VIX jumped 10% to near 21.  

- Philip Grant

Bygones, Inc.
Like a Phoenix, rising from Arizona:

Like a Phoenix, rising from Arizona:  OId friend WeWork Cos. is back on the scene, agreeing to merge with blank check firm BowX Acquisition Corp. (BOWX on the Nasdaq) at a $9 billion enterprise value.

The co-working concern, which formerly commanded a $47 billion private market valuation following multiple investments from SoftBank Group Corp.’s Vision Fund, famously imploded in 2019, narrowly averting bankruptcy and jettisoning founder Adam Neumann.  As Zerohedge notes, WeWork generated a $9.9 billion operating loss across the five years through 2020, outstripping the cumulative $9.5 billion top line over that period.

That was then.  The marketing document, which touts a “clear path to adjusted Ebitda breakeven” by the fourth quarter, forecasts revenues of near $7 billion in 2024, up from $3.2 billion in both 2019 and 2020, with adjusted Ebitda reaching $2 billion in 2024 compared to a projected $900 million adjusted Ebitda loss this year.  

For now, at least, Mr. Market appears to be looking past snafus towards a bright future.  Shares in BOWX finished the day at a 17% premium to net asset value. 

Peace Dividend
It's good to be the boss.

It’s good to be the boss.  According to data from LCD, supply of domestic leveraged loans used to fund dividend recapitalizations (i.e., payouts to the borrower’s private equity sponsor) have footed to $20 billion so far this year, marking the busiest quarter for loans undertaken for that purpose since the end of 2016. 

While adding debt to reward insiders might appear to be an adverse credit development, some take a more sanguine view.  A Tuesday bulletin from S&P Global Ratings announced an upgrade of Luxembourg-based vehicle glass repair company Belron Group, S.A., to double-B-plus from double-B.  The rationale: “Resilient performance and proposed dividend recapitalization.” 

Shape Up or Ship Out
The imminent reorganization of Japan's equity market

The imminent reorganization of Japan’s equity market is encouraging some shareholder friendly behavior across the Land of the Rising Sun, Bloomberg reports today.   As the Tokyo Stock Exchange prepares to split into three classes (prime, standard and growth), exchange constituents are unwinding minority stakes in other businesses and bolstering corporate governance in a bid to secure a coveted prime designation ahead of a June 30 deadline.  

“We are seeing some companies move to unwind their cross-shareholdings,” analysts at SMBC Nikko Securities recently observed. “Companies that struggle to meet the [prime] criteria may ask some shareholders to divest their positions and are also considering buybacks or equity issuance” to get on the right side of the stock-market fence. 

The stakes are high: Companies within the prime designation, encompassing those with a free float market cap of at least ¥10 billion ($96 million) will be guaranteed membership in the new Topix Index, thus maintaining representation in major exchange traded funds.  Last week, the Bank of Japan announced that it will only purchase ETFs tracking the Topix Index henceforth.

The BoJ’s stock portfolio was estimated at ¥46.6 trillion, encompassing upwards of 90% of domestic ETFs, as of year-end. “I don’t think that most companies really understand the implications of this, which is that a lot of small-cap companies are going to be, to use the British soccer expressed, ‘relegated’ to the second section,” Gifford Combs, managing director at Dalton Investments, told Grant’s in January. 

As Japan’s corporate sector engages in some spring cleaning, investors find a bit of relative cushion in terms of valuation.  Currently, the Topix sports an enterprise value equal to 9.8 times consensus 2022 Ebitda, a healthy discount to the 13.1 times EV to 2022 Ebitda for the S&P 500 and slightly below the 10.3 times for Europe’s Stoxx 600 Index.  For more on Japanese stocks, including a review of the upcoming listing criteria change and bullish analyses of a trio of local companies, see the Jan. 22 edition of Grant’s Interest Rate Observer

Recap March 26

A feverish late-session sprint higher in stocks left the S&P 500 up 1.6% from near unchanged with an hour to go, leaving the broad index at a fresh closing high. Treasurys came for sale with the 10- and 30-year yields pushing to 1.67% and 2.38%, respectively, WTI crude bounded back toward $61 a barrel and gold edged higher to $1,731 per ounce.  The VIX fell below 19, testing its virus-era nadir.  

- Philip Grant

Blue Note
Rotation has been the name of the game recently,

Rotation has been the name of the game recently, as the S&P 500 slipped 3% from all-time highs last Thursday through this morning while a rebound in Treasurys pushed the 10-year yield briefly below 1.60% today from 1.73% four days ago.  That follows an 18% advance in the broad equity index from Oct. 1 through March 17, while the 10-year yield more than doubled over that period. 

A potential catalyst for the trend reversal:  Quarterly rebalancing among large investment funds from stocks into bonds, as outperformance by the former throughout the fourth and most of the first quarter has thrown asset allocations out of whack.  “It should be happening as we speak,” Nikolaos Panigirtzoglou, cross-asset research analyst at J.P. Morgan, tells the Financial Times.  Balanced mutual funds, which often carry 60% stock and 40% bond portfolio mandates and manage about $7.5 trillion globally, will shuffle some $136 billion in assets from equities to fixed income by March 31, Panigirtzoglou estimates. 

Rebalancing-induced pullback or not, some stock jockeys are taking the move hard. Here’s CNBC pundit Jim Cramer sharing his sorrows on Twitter this morning: 

Yeah, it's real bad out there. Read my tweets from last night. . . Depression stage. . . The stages of grief are playing out.

Tipping Points
Fed chair Jerome Powell reaffirmed an extended timeline

Fed chair Jerome Powell reaffirmed an extended timeline for potential policy tightening in an interview with National Public Radio this morning:

As we make substantial further progress toward our goals, we’ll gradually roll back the amount of Treasury and mortgage backed securities that we’re buying. And then in the longer run, we’ve set out a test that will enable us to raise interest rates.

Of course, an unscripted revival of long-dormant inflation metrics could throw a wrench in those well-laid plans. But on that score, no worries: In a webcast yesterday, New York Fed president John Williams added that he “doesn’t’ see any inflationary pressures building” over the next few years. His colleague Charles Evans of the Chicago Fed declared today that “I think by 2022 we’re still going to be struggling to get inflation to 2%,” while going on to predict that “it might be 2024 before we actually raise our interest rate target.” 

One thing is for sure, key consumer prices are on the hop here in 2021. According to AAA, average U.S. gasoline prices stand at $2.87 cents a gallon; up from $2.12 per gallon in November and a seasonal, pre-covid average of $2.40 a gallon in the five years ended 2019.  More broadly, analysts at Jefferies relay that an in-house gauge points to roughly 11% inflation across agriculture and energy commodities, matching the recent highs seen in 2007 to 2008 and 2011. 

Accordingly, the mindset of both Mr. Market and the general public appears to be shifting.  The Bank of America Global Fund Manager Survey for March finds that inflation has assumed the top tail risk among respondents, ending a 12 month streak in which coronavirus stood as the most pressing concern. A net 93% of investors expect inflation to rise in the next 12 months, the highest proportion on record going back to 1995.  Similarly, a survey this week by data firm CivicService finds that 77% of respondents expressed trepidation over rising prices, with 42% deeming themselves “very concerned” while only 17% are “not at all concerned.”   

Full-steam-ahead fiscal policy further complicates matters. Government spending footed to 33.6% of GDP last year according to data from Bianco Research, well above the 24.4% in the 2009 response to the Great Recession and eclipsed in U.S. history only by the 1943 to 1945 World War II era, after which spending promptly collapsed.  That trajectory appears unlikely to be repeated, as the New York Times reported that the Biden administration is preparing to follow its recently-passed $1.9 trillion stimulus plan with a $3 trillion spending package.

The prices paid component of regional Fed surveys and the ISM survey are on the march. The z-score for these surveys, which measures the number of standard deviations above or below the long-term mean, hit 1.918 in March, a level only surpassed once (in July 2008 when oil hit $150 per barrel) in the last 40 years.

While both data and sentiment seem to point towards regime change, psychological factors could ultimately loom larger than the monetary and fiscal mandarins currently expect. In Ruffer LLP’s annual The Ruffer Review, chief investment officer (and Grant’s Fall 2021 Conference speaker - advt.) Henry Maxey writes:

What history shows is that inflation is often a collective behavioral phenomenon—with all the non-linear dynamics that implies. If we think of it in this way, we may be drawn to the lesser-discussed fiscal theory of inflation

This holds that a loss of confidence in a government’s ability to service and repay its debt results in a repudiation of the country’s bonds and an inflation caused by currency weakness. A confidence crisis like this occurs suddenly, rather than in a predictable, mechanistic manner. Think tipping points.

QE Progress Report
Reserve Bank Credit (the sum total of interest bearing assets at the Fed) rose $49 billion from a week ago to mark a fresh high-water mark at $7.69 trillion.  That keeps the annualized three-month growth rate unchanged at 20.7%, though year-over-year growth sank below 71% from 78% a week ago thanks to the calendar lapping the onset of emergency asset purchases last spring. 
Recap March 25

A post-virus low in weekly jobless claims precipitated a bullish reversal in stocks, as the S&P 500 erased an early 1% decline to finish higher by 50 basis points,  while Treasurys gave back early gains to leave the 10-year yield at 1.63%. WTI crude was clubbed by nearly 5% to $58.50 a barrel to continue to recent whipsaw price action, the VIX fell by nearly 7% to finish back below 20 and gold retreated to $1,726 an ounce.

- Philip Grant

Call Back
The final chapter has perhaps yet to be written in last year's explosive late summer rally

The final chapter has perhaps yet to be written in last year’s explosive late summer rally in technology shares, featuring a frenzied 18.5% ascent in the Nasdaq 100 Index from July 24 to Sept. 2. Coinciding with, and perhaps amplifying, that move: Aggressive call option purchases from SoftBank Group Corp., pegged by The Wall Street Journal at $4 billion, following a reported $10 billion shopping spree in tech stock common shares earlier in the summer. 

Domestic authorities are now putting those machinations under the microscope. In response to a Freedom of Information act submitted by PlainSite founder Aaron Greenspan for materials related to SoftBank’s trading activities last year, counsel at the Securities and Exchange Commission declined the request on the grounds of exemption 7(A).   To wit: 

We have confirmed with [the SEC’s] Division of Enforcement staff that the investigation from which you seek records is still active and ongoing . . .  disclosure could be reasonably expected to cause harm to the ongoing and active enforcement proceedings because, among other things, individuals and entities of interest in the underlying investigation could fabricate evidence, influence witness testimony and/or destroy or alter certain documents. 

Power to the People
"You can't compete against stupidity,"

"You can't compete against stupidity," commented Starwood Capital Group chairman and CEO Barry Sternlicht on CNBC this morning, regarding the boom in special purpose acquisition companies. "It's a little out of control. No, it's a lot out of control. Don't expect Wall Street to regulate the launch of SPACs. They're making too much money. If you can walk, you can do a SPAC." 

Indeed, there are currently 550 special purpose acquisition companies outstanding according to data from SpacInsider, of which 436 are in search of a merger target.  Sternlicht’s firm has itself sponsored six separate blank check enterprises. 

With the deal market saturated, one promoter looks to Joe and Jane sixpack to carry the load.  Bloomberg reports today that a London-based, retail oriented blank check vehicle, dubbed The People’s SPAC, is set to raise pre-IPO sponsor funding via crowdsourcing. The offering will be capped at $100,000 per accredited investor.  The People’s SPAC will likely target a transaction in the tech or media sectors in Western Europe and hopes to list on the Nasdaq exchange during the second quarter.

Flagging recent performance in various retail favorites might make that a tougher sell. Since reaching a record high on Feb. 17, the IPOX SPAC Index has declined by 22%, returning to its lowest levels since early January.  Similarly, a Goldman Sachs basket of stocks favored by retail traders slipped by 7% over the prior six trading sessions, while the ETFMG Alternative Harvest ETF, which invests in cannabis companies, is off 32% from its Feb. 10 high-water mark.

Then, too, a variety of metrics suggest the retail cohort is losing interest as life slowly transitions back towards normal. Off-exchange equity volumes, which encompass the bulk of retail activity, registered at 42% of total turnover over the past 10 days, compared to 50% in late January, while daily turnover in the ARK Innovation ETF (ARKK on the NYSE Arca) has averaged just over 12.4 million shares over the past five sessions, compared with 26.5 million shares over the five trading days through March 10.  Perhaps most tellingly, free trading app Robinhood is no longer listed as among the top 100 most popular apps on the Apple App store, after holding the top spot just six weeks ago. 

Retail’s staying power may soon be put to the test via that avatar of the current bull market, as Robinhood announced yesterday that is has filed confidential paperwork with the SEC for an initial public offering.  The company has recently seen its private market valuation reach near $40 billion in the secondary market, Bloomberg’s David Ritter finds, compared to an $11.2 billion value in a private series G funding round conducted last August. 

Recap March 24

WTI crude jumped by more than 5% to finish near $61 barrel and recoup a chunk of its recent losses, while stocks came under pressure for a second straight day with the S&P 500 declining by 50 basis points and the Nasdaq 100 off by 1.7%. Treasurys caught a modest bid despite a soft five-year note auction, with the 10- and 30-year yields finishing at 1.61% and 2.31%, respectively, gold remained in a tight range with a $1,733 per ounce closing price, and the VIX advanced back above 21. 

- Philip Grant

Game Reset
A year ago today

A year ago today the S&P 500 logged its nadir in the virus-induced financial panic, down 34% from its prior high-water mark reached little more than a month earlier.  Since that time, the broad equity average is up a cool 76%, the largest one-year trailing return in the index’s history. That leaves the S&P at 35.5 times economist Robert Shiller’s cyclically adjusted earnings ratio, a threshold exceeded only in the tech bubble of 1999 to 2000. 

As prices and valuations press toward the sky, hibernating bears have opted to hit the snooze button.  Data from FactSet and Goldman Sachs show that median short interest on the S&P 500 has fallen to 1.5% of market capitalization, matching the lows last seen in 2000. 

The Incredible Bulk
The recent bid in commodities has been manna for the global shipping industry.

The recent bid in commodities has been manna for the global shipping industry.  Yesterday, the Baltic Dry Shipping Index reached its highest level since summer 2019, up some 70% so far this year.  

With market conditions on the boil, some traders are forced to scramble. A March 12 dispatch from S&P Platts relayed that one capesize bulker (the largest dry cargo ships which are typically used to transport iron ore and coal) was recently dispatched to transport timber logs from Uruguay to China, while another is set to ferry grains in Brazil later this month.

That improvisation “just shows you how tight the overall dry-bulk market is, and it’s only going to get tighter,” John Wobensmith, CEO of Genco Shipping and Trading Ltd., told Bloomberg last Thursday. The surge in rates is “not something that is for the next three months, this has got legs going well in to 2022 because of the low supply situation.” Wobensmith reports that day rates for capesize vessels have averaged about $18,000 per day so far this year, up nearly 40% from the 2020 baseline, a rate he expects to push higher still. 

Indeed, a sparse order book for new vessels could amplify that move.  Orders foot to less than 7% of total tonnage according to IHS Markit, approaching the lowest on record going back to 2005 and down from a whopping 50% at the end of 2010.  Supply should remain curtailed for some time, as new ship deliveries typically take two years to turn around.  Then, too, the International Maritime Organization has announced plans further tighten shipping emission standards by 2030 (following up on rules enacted last year capping the sulfur content of bunker fuel used by seaborne vessels) further complicating the calculus of bringing new shipping capacity online, as participants await details of the new rules. 

Beyond improving supply and demand dynamics, conservative industry capital structures relative to the 2007 to 2010 industry boom, and subsequent bust, could serve shipping investors well.  In a March 15 interview with American Shipper, Deutsche Bank head transportation analyst Amit Mehrotra commented:

I think, in general, when you look at the maritime equity landscape, whether its dry bulk or tankers, there are just a lot fewer landmines out there. You’re unlikely to get blown up owning a shipping stock, because most of the [industry] balance sheets have so much equity in them now.

[Now] you’re not buying a shipping stock hoping that rates turn before the company runs out of cash, which, over the last 10 years, was really how you invested in shipping. 

How to capitalize on the global shipping rebound? See the March 5 edition of Grant’s Interest Rate Observer for a bullish analysis of a pair of industry players. 

Recap March 23

Another rally in rates left the 10-year Treasury yield at 1.63%, its lowest in more than a week, but that didn’t help stocks as the S&P 500 lost 75 basis points to erase yesterday’s gains while the tech-heavy Nasdaq 100 slipped by half a percent.   Energy prices were hammered for the second time in four trading days with WTI crude finishing below $57 compared to $65 a week ago, gold pulled back to $1,726 an ounce and the VIX popped by 7.5% after logging a post-virus low yesterday. 

- Philip Grant

The Beeple Has Spoken
Here’s digital artist Mike Winkelmann,

Here’s digital artist Mike Winkelmann, a.k.a. Beeple, offering his assessment of the bourgeoning non-fungible tokens market to Fox News yesterday, following his sale of one piece for a cool $69 million earlier this month:

I absolutely think it’s a bubble, to be quite honest. I go back to the analogy of the beginning of the internet. There was a bubble. And the bubble burst.

Unbullish Things Afoot
A weekend bombshell:

A weekend bombshell:  Turkish President Recep Erdogan fired central bank head Naci Agbal in the wee hours on Saturday, a mere five months into his term and two days after the Central Bank of the Republic of Turkey raised its benchmark one week repo rate to 19% from 17% in an effort to cool raging price pressures (measured inflation grew by 15.6% year-over-year in February).  Incoming governor Sahap Kavcioglu will be Turkey’s fourth central bank boss in the last two years.

Investors voted with their feet.  The lira collapsed to 7.76 per dollar, down nearly 8% from Friday, while the 10-year Turkish government bond yield jumped some 500 basis points to near 19%, the Bolsa Istanbul 100 Index sold off by 10% in lira terms and five-year credit default swaps leapt to as high as 472 basis points from 307 basis points on Friday according to Bloomberg, the biggest one-day increase on record. 

“We’re really trying to gauge what the level of commitment to the lira is,” Simon Harvey, senior foreign exchange market analyst at Monex Europe, tells The Wall Street Journal. “We know in Turkey that interest rates are politically sensitive.”  

Mr. Market, for one, has made his preferences clear. Over the near-six-month stretch with Agbal at the helm (during which the Nov. 13 edition of Grant’s Interest Rate Observer suggested that “bullish things may be afoot in Turkey”), the CBRT raised rates by a combined 875 basis points, coinciding with a 18% rally in the lira against the dollar and 28% updraft in local currency terms for the Borsa Istanbul 100 Index through Friday.   

His successor likely has a different strategy in mind.  In a Feb. 9 column for the Yeni Safak daily newspaper, Kavcioglu deemed it “saddening” to see Turkey saddled with high interest rates at a time when continental European governments are paid to borrow, arguing that tightening monetary policy would “indirectly open the way to increasing inflation.” That echoes the philosophy espoused by Erdogan in a summer 2019 speech: “As far as I’m concerned, the most important reason behind high inflation is high interest. If you don’t bring down high interest rates, then high inflation will not come down.”

With Kavcioglu now seemingly free to put that theory to the test, the risk of capital flight and heavy-handed government response looms.  Gross foreign exchange reserves footed to $52.7 billion as of March 12, up from a 15-year low of $40.4 billion shortly after Agbal took over.  Some observers are less than optimistic. “With Naci Agbal’s removal from the central bank, Turkey loses one of its last remaining anchors of institutional credibility,” wrote Société Générale strategist Phoenix Kalen. “Turkey may soon be headed toward another currency crisis.” 

Ironically, citizens of one of the planet’s most financially repressed economies are bearing the brunt of Turkey’s prospective pivot towards easy money. According to Tokyo-based currency trading providers Gaitame.com Co. and Money Partners Co., more than 90% of customer positions in the lira vs. yen currency pair were long the former as Japanese savers attempted to generate income.  For context, the yield on the 30-year Japanese Government Bond currently stands at 0.64%.  

Recap March 22

Treasurys caught a solid bid, with the 10- and 30-year yields declining to 1.69% and 2.39%, respectively, helping push the Nasdaq 100 higher by 1.7% while the broad S&P 500 advanced by 70 basis points.  The VIX closed below 19 for the first time since the coronavirus began wreaking havoc in the U.S., while gold and WTI crude each edged lower, to $1,739 an ounce and $61 a barrel, respectively. 

- Philip Grant

Use the search box above to access older ADG content.