01.20.2022
Candy Chronicles

From CBS News:

M&M's iconic characters — six different colored "lentils," each with their own personality — have gotten a modern makeover for a "more dynamic, progressive world," Mars said Thursday. The redesign is focused on creating a sense of belonging and community, as well as spotlighting the character's "personalities, rather than their gender." 

The green M&M and the brown M&M will have a more friendly relationship, showcasing a "force supporting women." The two characters' dynamic will have them "together throwing shine and not shade," the company said.

Cocoa mass, skimmed milk powder and glucose syrup for all. 

 

 

Unfamiliar Flying Object
Private equity goes public.

Private equity goes public.  Luxembourg-headquartered CVC Capital Partners has retained a trio of investment banks to lay the groundwork for an IPO later this year, Bloomberg reports.  CVC, which struck a deal to buy secondary buyout firm (i.e., transacting in an already p.e.-owned asset) Glendower Capital back in September, is targeting a listing on the London Stock Exchange in the back half of this year at a prospective $20 billion dollar valuation. 

That comes on the heels of last week’s Nasdaq debut for peer TPG, which garnered a $9 billion initial valuation and has enjoyed a warm welcome in this financially chilly January, with shares subsequently up a cool 14%. 

With numerous Fed rate hikes this year now a consensus expectation, floating-rate debt thrives relative to its fixed-rate counterpart. The S&P/LSTA Leveraged Loan Index rose yesterday to its highest level since July 2007.  The gauge has returned 63 basis points for the month through yesterday, comfortably ahead of the minus 1.2% return for the Bloomberg High Yield Index and negative 2.2% for Bloomberg’s investment grade gauge.  That salutary price action has not escaped Wall Street’s attention, as loan funds enjoyed nearly $2 billion in inflows during the week ended Jan. 12 per data from Refinitiv, the most bountiful seven-day stretch since 2013, the year of the rates-roiling “taper tantrum.”  

Unsurprisingly the primary market remains wide open.  Earlier this week, Bain Capital and Hellman and Friedman launched a $6.75 billion loan deal to help finance its $17 billion leveraged buyout of healthcare software firm Athenahealth announced on Nov. 22.  That secondary transaction will confer a hearty profit on Athenahealth’s current owners, as Veritas Capital and Elliott Management’s Evergreen Coast Capital paid $5.47 billion for the firm in February 2019.

Indeed, as the great bull market kicked into fifth gear last year, price was no object for the p.e. barons and their limited partners. The median leveraged buyout took place at a price tag of 12.8 times adjusted Ebitda through Sept. 30 per Pitchbook, easily topping the 10.3 times multiple seen in the bumper year of 2007.  Those price tags evinced no sticker shock: Domestic leveraged loan volume exceeded $600 billion last year according to S&P’s LCD unit, the highest since at least 2013, while M&A-driven loan activity reached $331 billion, easily topping the $275 billion highs set in 2018.

On form, fancy prices and bountiful volume beget precarious capital structures.  M&A backed leveraged loans sported a median debt burden of six times Ebitda last year, LCD finds, topping 2007 for the most aggressive ratio on record and a full 1.5 turns higher than non p.e.-sponsored loans.  By the same token, $147 billion of p.e. sponsored loans were issued by firms rated single-B-minus or lower by at least one of the three credit rating agencies, also a record high.

Private credit, which has helped foment that boom by providing high-interest rate loans to smaller and often-less creditworthy concerns, has burst on the scene in tandem with the p.e. golden age, doubling in size since the end of 2014 to $1 trillion. That mushrooming growth has raised eyebrows, as Moody’s warned of “systemic risks” in the category back in October, pointing to rising borrower leverage, dwindling lending standards and an illiquid trading profile.

That warning appears to have fallen on deaf ears. Citing a survey by investment consultancy bfinance (sic) of 90 insurance firms managing an aggregate $5 trillion, the Financial Times relayed Monday that 61% of respondents plan to reduce their allocation to conventional fixed income over the next 18 months in favor of “unfamiliar assets” including private equity and private credit.  Nearly three-quarters of respondents expect their portfolios to become less liquid over the next year-and-a-half. 

Noting that his firm plans to allocate 25% of its portfolio to alternative investments by next year compared to about 19% as of last fall, AXA group chief risk officer Alban De Mailly Nesle explained his rationale to the pink paper: “They provide much higher profitability in a low credit spread context, and strong resilience to challenging economic contexts and crisis compared to other asset classes.”

Time will tell on that score. See the analysis “Bridge to growth” in the Nov. 12 edition of Grant’s Interest Rate Observer for a look at a representative private debt deal featuring a fast-growing but unprofitable and unrated p.e.-backed software company

QE Progress Report
A hefty $88 billion sequential advance pushed Reserve Bank Credit (i.e., interest-bearing assets on the Fed balance sheet) to $8.83 trillion.  That’s up 19.5% year-over-year and 114% from early 2020. 
Recap Jan. 20

Stocks took a late tumble for a third straight day, as early gains were vaporized to leave the S&P 500 and Nasdaq 100 nursing 4% and 5% losses so far this week, despite some relief from rates as the two-year yield fell to 1.02% and the long bond to 2.12%.  WTI crude pulled back to $84 a barrel, gold retreated to $1,833 an ounce and the VIX rallied to near 26 from 19 last Friday. 

- Philip Grant

01.18.2022
Dow Theory
Timing is everything.

Timing is everything. This morning, Exxon Mobil Corp. saw its share price approach $73, extending to an impressive 19% gain in this young 2022 and marking its best levels since the bug barged in. 

As HFI Research noted on Twitter, Exxon has generated a near 100% total return since it was kicked out of the Dow Jones Industrial Average back on Aug. 31, 2020, ending a 92-year run in the venerable, 30-stock index.    Meanwhile, Exxon’s New Economy replacement has since conferred little glory on the Dow, as Salesforce.com, Inc. has seen shares fall by 16% since that sea change sixteen months ago. 

 

Braveheart
Central bank largesse has functioned as a primary driver of the digital asset boom,

Central bank largesse has functioned as a primary driver of the digital asset boom, analysts at Morgan Stanley contended last week.  The imposition of near- or sub-zero interest rates, comprehensive asset purchase plans and generous fiscal stimulus programs have served as “drivers of exceptional cryptocurrency price rises” during the Covid era.  

Sheena Shah, head of cryptocurrency research at the investment bank, observed that bitcoin’s market capitalization has corresponded to the growth rate of global money supply since its formative days in 2013.  As that metric peaked on a year-over-year basis last February, the fact that bitcoin’s rate of annualized price appreciation crested a month later burnishes that hypothesis.

As the crypto boom stalls with bitcoin now hovering near $41,500 (39% below its October levels), pressing security risks compound hodler worries. Yesterday, hackers reportedly made off with $15 million worth of ethereum from the Crypto.com digital exchange, which is the industry’s fourth largest centralized trading venue according to CoinGecko with nearly $3 billion in volume over the past 24 hours.  Singapore-based Crypto.com, which recently forked over $700 million to purchase the naming rights for the Staples Center in Los Angeles and hired actor Matt Damon for a commercial featuring the advice that “fortune favors the brave,” disclosed yesterday that it is halting withdrawals after “a small number of users experienced unauthorized activity in their accounts.” 

Digital research site Immunefi found that hackers and other scammers pilfered more than $10 billion from crypto investors last year, a not-insignificant sum even relative to the asset class’ $2 trillion total market value. 

To be sure, recent struggles have put the crypto loyalist’s devotion to the test. Last week, Moody’s analyst Jaime Reusche told Bloomberg that the Republic of El Salvador is facing growing default risks thanks to the aggressive machinations of 40-year-old President Nayib Bukele.  El Salvador, which spent about $71 million to buy 1,391 bitcoins for its national treasury (equivalent to about 3% of nominal GDP last year), is sitting on about $14 million in unrealized losses at current price levels.  Speaking of the country’s digital portfolio, Reusche warned that “if it gets much higher, then that represents an even greater risk to repayment capacity and the fiscal profile of the issuer.”

Moody’s, which cited "a deterioration in the quality of policymaking" in its decision to cut El Salvador to Caa1 back in July, has made little headway on persuading the Central American nation’s leading lights to pivot towards more conventional policies.  Yesterday, Bukele took to Twitter to declare via a widely-used acronym that his country “doesn’t give a f***” about the rating agency’s disapproval.  

Unfortunately for the self-described CEO, the bond market does.  Today, El Salvador’s $800 million dollar-pay 7 3/4% bond issued in 2003 and maturing in 12 months slumped to a fresh lifetime low of 78 cents for a yield-to-worst of 38%. 

Recap Jan. 18

Stocks and bonds alike endured another brutal day to begin the truncated trading week, as the S&P 500 and Nasdaq 100 lost 1.6% and 2.6%, respectively, to extend to 4% and 7% declines so far in January, while rates leapt higher across the curve with the two-year yield logging another virus-era high of 1.05% and the long bond reaching 2.19%, its highest in seven months.  WTI crude broke out to $85.50 to establish a fresh post-2014 peak, gold ticked lower to $1,813 an ounce and the VIX jumped to 23, up nearly four points on the day.  

- Philip Grant

01.14.2022
Seigniorage Central
Today, the Federal Reserve announced that it sent $107.4 billion of income earned from its QE-bloated portfolio

Today, the Federal Reserve announced that it sent $107.4 billion of income earned from its QE-bloated portfolio to Uncle Sam last year, up from $86.9 billion in 2020. 

Also, today, The Wall Street Journal reported on a lawsuit led by Texas Attorney General Ken Paxton and joined by over a dozen other states against Google. The search giant, plaintiffs allege, rigged online ad markets to enrich itself at the expense of customers: “under Google’s Bernanke program, AdX would at times knock out the second-highest bid, allowing the third-highest bid to win, thus depriving the publisher of revenue, according to the complaint. At the same time, Google would charge advertisers the price of the second-highest bid and pocket the difference,” the complaint said.

Why the Google coders would deem the initiative “Bernanke” remains a mystery. 

Travel Channel
Overseas has been the place to be so far in 2022, as the MSCI World ex-USA Index has enjoyed 380 basis points of outperformance

Overseas has been the place to be so far in 2022, as the MSCI World ex-USA Index has enjoyed 380 basis points of outperformance compared to the MSCI USA Index in the month-to-date through yesterday.  That’s on track for the best relative monthly performance for non U.S. equities since November 2020.  The recent trend is broad-based, as 90% of foreign markets have outperformed the S&P 500 over the last 21 trading days, data from Sentimentrader show. 

Might the foreigners’ fast start represent a blip on the radar, or perhaps augur the reversal of a long-term bias towards buying American? The MSCI USA Index sports a $41.9 trillion market cap, compared to $19.7 trillion for the MSCI World ex-USA Index, which tracks other developed markets across the globe. That 68% market share for United States stocks compares to less than 50% in 2010 and 37% in 1995.  

Pre-Crisis PR
Talk about a New Year's resolution.

Talk about a New Year’s resolution. “The year 2022 will be one of turnaround, stability and one where things get back on track,” Turkish Treasury and Finance Minister Nureddin Nebati told Bloomberg today.  “We resolved the exchange rate issue,” the freshly-installed cabinet member declared, referring to President Recep Tayyip Erdogan’s announcement last month that the government would compensate citizens for FX-related losses on deposits of at least three months. Since that decree, the Turkish lira now trades at 13.55 per dollar, compared to the 16.41 nadir logged in mid-December but well off the sub 9:1 exchange rate from early October.   

With the currency problem ostensibly solved, the emboldened Nebati went on to predict that “we’ll enter the general elections in June 2023 with single digit inflation.” Official CPI logged a 36% annual advance in December, following a counterintuitive easing cycle from the Central Bank of the Republic of Turkey on the orders of easy money aficionado Erdogan, pushing the benchmark one-week repo rate to 14% from 19% in August. 

As the political class patiently waits for the tide to reverse, citizens deal with the fallout of Erdogan’s inflation-stoking policies.  Today, a dozen members of the BBC’s Istanbul bureau commenced a strike after rejecting their employer’s proposed 20% raise for calendar 2022.  The Journalists Union of Turkey (TGS), which represents the disgruntled employees, added in a statement that “the currency’s collapse has reduced the cost to the BBC of the Istanbul’s staff wages. . . by nearly half.” 

The lira’s precipitous price action could pose still larger problems for the government.  The CBRT disclosed a week ago that it burned through $7.3 billion in foreign reserves last month in open market operations designed to prop up the value of the lira. That leaves net reserves at just $7.9 billion, while analysts at Goldman Sachs peg net reserves at negative $66 billion after accounting for funds borrowed from domestic lenders and foreign central banks.  

Indeed, any further round of protracted lira weakness could spell trouble for the local financial system, as some 30% of Turkish bank loans were denominated in foreign currency as of the end of 2020, analysts at S&P Global observed in December. “Balance of payment and related financial stability risks are rising,” the rating agency warned.  

An increasingly volatile political environment further muddies the waters for the second-largest component of the $20 billion iShares J.P. Morgan USD Emerging Markets Bond ETF. Erdogan’s approval rating slid to 38.6% last month according to a Metropoll survey, down from 55.5% in early 2020, while 57.2% disapprove of the President, compared to 36.6% at the onset of the pandemic.  

Recap Jan. 14

Acute pain in the Treasury complex highlighted today’s proceedings, as the two-year yield jumped to 0.97% to mark a fresh Covid-era high while the long bond ascended to a near three-month peak at 2.13%.  Stocks managed a modest bounce off yesterday’s sharp selloff with the Nasdaq 100 gaining 75 basis points.  WTI crude ripped past $84 a barrel to test the multi-year highs logged in October, gold ticked lower to $1,816 an ounce and the VIX pulled back to near 19, giving up about half of yesterday’s gains. 

- Philip Grant

01.13.2022
Point of Sale
This one's worth 1,001 words.

This one’s worth 1,001 words.  Behold a telling chart from Charles Schwab chief investment strategist Liz Ann Sonders, depicting the share of S&P 500 constituents priced at more than 10 times sales as of year-end:


 
While the proportion of S&P 500 firms commanding that lofty multiple is unprecedented in modern history, the ghosts of cycles past loom over today’s proceedings.  Back in 2002, Sun Microsystems co-founder Scott McNealy offered the following post-mortem in a Bloomberg interview, referencing the fanciful assumptions underpinning the computer hardware firm’s skyscraping valuations achieved during the heady days of the first tech bubble: 

Two years ago, we were selling at 10 times revenues when we were at $64 [a share]. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. 

And that assumes with zero research and development for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

Sun Microsystems, which saw its market capitalization shoot past $100 billion during the peak of the mania, sold itself to Oracle in 2009 for a $7.4 billion price tag, including debt. 

Relief Valve
No green on this screen.

No green on this screen.  The U.S. Dollar Index (DXY) edged to a fresh two-month low today, extending its losses from yesterday’s 60 basis point decline which marked the worst one-day showing in eight months.  

It’s been a swift turn in fortunes, as the DXY was perched at its best levels since early in the pandemic just four weeks ago. As the dollar wrapped up its best year relative to a basket of peers since 2015 last year, sentiment followed in kind.  The Bank of America Global Fund Manager Survey for December found that bullish positioning toward the buck reached a seven-year high. 

That was then. “The dollar has clearly rolled over,” Peter Boockvar, chief investment officer at Bleakley Advisory Group, told Bloomberg. “In hindsight, it only rallied last year because the Fed was ahead of the Bank of Japan and European Central Bank in tightening.” With major overseas central banks now ramping up their own hawkish rhetoric, that first-mover status is in the rear-view, as German Bund and Japanese Government Bond Yields have darted higher of late. “The rise that we’ve seen in real yields over the last six weeks to two months has been a global phenomenon,” observed Karen Ward, chief EMEA market strategist at JPMorgan Asset Management, noted in a Bloomberg Television interview today.

Meanwhile, a stark fundamental divergence in the pandemic crisis response could help shape the currency markets. Domestic M-2 money supply leapt by 40% over the two years through 2021, compared to a 13.1% for Japan, 13.7% for Germany and 7.8% for Switzerland (the latter two data points are through Nov. 30 of last year). “U.S. monetary excess is sticking out like a sore thumb,” Michael Howell, CEO of London-based CrossBorder Capital Ltd. concluded to Grant’s last month. 

That monetary bacchanal has, of course, manifested in the hottest inflation regime since the early days of the Reagan administration.  Yet fast-eroding purchasing power has spurred no evident alarm for Uncle Sam’s sovereign creditors, as bond prices have remained well bid despite deeply negative real yields. As Grant’s Interest Rate Observer posited a month ago, “maybe inflation’s burnt offering will turn out to be the greenback itself.”  See the analysis “Inflation fall guy” in the Dec. 10 issue for more. 

QE Progress Report
Reserve Bank Credit rose $17 billion from a week ago, pushing the sum total of interest-bearing assets on the Fed balance sheet to a fresh high of $8.74 trillion.  That’s up 19% from a year ago, and 111% from the early stages of 2020 before the bug barged in. 
Recap Jan. 13

A flat early showing devolved into a sharp selloff, as the S&P 500 and Nasdaq 100 sank 1.4% and 2.5%, respectively to leave the bears back in control following a few days of constructive price action.  Treasurys rallied in bull-flattening fashion, with the two-year yield declining three basis points to 0.87% and the 10-year falling five basis points to 1.7%, gold ticked slightly lower to $1,822 an ounce and WTI crude pulled back to $81.50 a barrel to reverse a portion of yesterday’s outsized advance.  The VIX pushed higher by 15% on the strength of that afternoon downdraft in stocks, finishing back above 20.  

- Philip Grant

01.12.2022
Over the Hump
Fourth quarter earnings season is set to get rolling,

Fourth quarter earnings season is set to get rolling, with S&P 500 components projected to generate a 21.7% year-over-year uptick in earnings per share, estimates compiled by FactSet show. That sits slightly higher than the 20.9% estimate logged in September and would mark the fourth straight quarter featuring bottom line expansion of more than 20%. 

But as the pandemic slowly fades into the rear-view, those explosive figures look set to settle into more banal territory.  Annual earnings growth will foot to 45% across 2021 if analyst expectations for the final quarter prove accurate, figures which are projected to contract to 6.3% for the now-underway first quarter, then 4.2% for the three months ended June 30. 

Then, too, 61 S&P 500 companies issued negative earnings guidance ahead of their imminent fourth quarter results, the most since the second quarter of 2020, while 25 constituents provided a positive earnings preannouncement, also marking the fewest since the depths of the pandemic. 

Adjust-in-Time
Today’s splashy December CPI report,

Today’s splashy December CPI report, which featured a headline 7% year-over-year advance to mark a second straight 39-year high in the data series, established another unwelcome milestone for the U.S. worker.   Real average hourly earnings fell by 2.4% from a year ago, marking the ninth straight month of negative inflation-adjusted wage growth.  That represents a sea change from the pre-virus norm, as real wage growth remained in positive territory in nearly every month from 2013 to 2019. 

Indeed, workers at a wide variety of household names find themselves behind the eight ball.  A Brookings Institution study of hourly workers at 13 of the largest U.S. employers including McDonalds, Target and CVS published last month found that only one (Amazon) paid workers a living wage of $17.70 an hour as of October, meaning a level sufficient to afford basic necessities in a household with two full-time working adults and two children. 

Might a raft of wage increases enacted to counter current price pressures help entrench the increasingly “untransitory” inflation regime?  U.S. businesses are budgeting a 3.9% increase in average pay in 2022, the Conference Board found last month. That’s the highest reading since 2008 and compares to a planned 3.0% wage hike for this year as of April 2021.   

Perhaps most tellingly: the return of cost of living adjustments (COLA), or automatic pay increases designed to help workers keep pace with inflation. On Dec. 21, striking Kellogg Co. employees ratified a labor pact including a new COLA clause, following a November agreement between Deere & Co. and the United Auto Workers featuring automatic quarterly wage adjustments.    

Inflation-burnished transfer payments have been codified at the federal level, as well. Social security recipients will receive a 5.9% COLA increase this year, the largest raise since 1983 and nearly quadruple the 1.65% average annual hike seen over the past 10 years.  

Public servants duly read the tea leaves. Bloomberg reported yesterday that Securities and Exchange Commission employees have accused chairman Gary Gensler of conducting “an aggressive, anti-employee agenda” in contentious negotiations over pay and benefits.  The attorney-heavy staff, who earn an average annual salary of more than $200,000, demanded that federal mediators intervene after talks produced little beyond ill will. “He’s kind of a ‘my way or the highway’ kind of guy, and that’s how he’s dealing with the union,” Greg Gilman, president of the Chapter 293 union representing the SEC employees, told Bloomberg. Labor strife seems to follow the SEC chair, as staff at the Commodity Futures Trading Commission voted to unionize after Gensler departed as CFTC head during the Obama administration. 

That phenomenon isn’t confined to the 50 states, as the inflationary mindset takes hold far and wide.  Politico reported on Nov. 23 that the trade union representing staff at the European Central Bank demanded higher wages this year, as the central bank’s proposed 1.3% raise “no longer protects our salaries against inflation.” With similarly acute price pressures plaguing the Old Continent, including a 5% year-over-year rise in Euro Area CPI (triple the post-1997 average)  “the gap between these two figures means that each of us will suffer a permanent loss in purchasing power,” the International and European Public Services Organization (EPSO) lamented in an email. “The ECB is not able (or willing?) to protect its own staff against the impact of inflation!”

Public facing communications evince slightly less concern over the subject. On Nov. 17, the same day that the EPSO launched that email broadside, ECB vice president Luis de Guindos declared in a television interview that: “The reality check is going to be the evolution of inflation next year. . . if you look at the drivers, the transitory nature of these drivers of inflation are quite clear and are going to become tangible and evident next year.”

Someone tell the rank and file. 

Recap Jan. 12

Stocks managed to build on their recent strength with modest gains across the S&P 500 and Nasdaq, though the indices finished well off their early-session highs, while Treasurys traded weaker across the board following today’s CPI data, with the two- and 30-year yields each rising three basis points to 0.91% and 2.09%, respectively.  WTI crude jumped to near $82 a barrel for its best finish in two months, gold edged higher to $1,826 an ounce for its fourth straight green finish, and the VIX fell another 4% to slip below 18.  

- Philip Grant

01.11.2022
Bottoms Up
In with the new, sort of.

In with the new, sort of.  The Japan Exchange Group unveiled a long-expected reorganization of the Tokyo Stock Exchange today, featuring 1,841 companies designated in the newly formed “prime” section of the Topix. That distinction, reserved for companies “which center their business on constructive dialogue with global investors,” replaces the existing 2,185-strong “first” category, which didn’t require companies to talk to shareholders.  

While the “prime” contingent faced ostensibly more rigorous selection criteria, the fact that the vast majority of components made the cut left some observers underwhelmed. “I’m not sure what the point was,” Travis Lundy, an analyst at Quiddity Advisors, groused to Bloomberg. “It will not meaningfully alter anything.”  For its part, the TSE deemed the move a “first step,” with President Hiromi Yamaji adding that “today’s announcement is the starting line of a long road towards sustainable growth and medium- to long-term enhancement of corporate value.” 

There is plenty of room for enhancement: Analysts project that Japanese equities will produce a 9.1% return on equity this year, compared to 10.3% in Europe and 22% in the U.S.  Mr. Market has not overlooked that relative inefficiency from the world’s third-largest economic power. The Topix has generated an annual 8.4% total return over the past decade in dollar terms, lagging the 9.2% for Europe’s Stoxx 600 Index and far behind the 16% for the S&P 500. The Land of the Rising Sun’s benchmark index now sports an enterprise value equivalent to 8.6 times the full-year 2022 consensus Ebitda estimate, compared to 10.2 times for the Stoxx 600 and 14.4 times for the S&P. 

Structural shortcomings have helped constrain Japanese returns and keep a lid on valuations; might better days be ahead?  A white paper from GMO published this month makes that case, as authors Drew Edwards and Rick Friedman point out that the corporate sector has successfully expanded profit margins in recent years on the strength of operational maneuvers like price increases and cost cuts, pushing net income margins to near 6%, up from less than 2% throughout the 1990s and less than 4% across most of the last two decades.  The Topix has enjoyed a 166% jump in earnings per share since Prime Minister Shinzo Abe was reelected in late 2012, lapping the S&P’s 66% bottom-line growth over that period.  

The problem, rather, lies in overly conservative balance sheets, stocked with cash and other low-yielding, relatively unproductive assets.  Though payout ratios have risen to roughly 50% from 30% in the late 1990s, profits and free cash flow have grown at a faster pace, leaving more than 50% of non-financial companies with net cash balances.  Fortunately, balance sheet management represents a relatively “easy” lever to enhance shareholder returns: pay a dividend or buy back shares. “We see recent profit improvements in Japanese companies as durable and secular in nature,” GMO concludes. 

At least one household name appears to share that viewpoint.  Last week, Warren Buffett’s Berkshire Hathaway filed paperwork paving the way for a yen-denominated bond offering of unspecified size.  That prospective sale would mark the fourth straight year in which the financial heavyweight issued yen-pay debt, including a ¥430 billion ($3.7 billion) slug in 2019, one of the largest offerings ever from an overseas company.  That bond issue acted as a de facto currency hedge, with Berkshire announcing in summer 2020 that it had taken roughly 5% stakes in a basket of Japan’s largest trading companies, including Grant’s pick-to-click Mitsubishi Corp. (up 35% in dollar terms since the Feb. 7, 2020 publication date, compared to a 14% advance for the Topix). 

As the Oracle of Omaha lays the groundwork for another shopping spree, where might discerning investors find attractive opportunities in Japan?  See the Jan. 22 and May 28, 2021 editions of Grant’s Interest Rate Observer for a selection of long ideas. 

Recap Jan. 11

The bulls remained in control after yesterday’s upside reversal, as the S&P 500 gained 90 basis points, finishing at session highs to close back to within 1.1% of unchanged on the year.  Treasurys caught a modest bid with the 10- and 30-year yields ticking to 1.74% and 2.07%, respectively, while gold jumped to $1,823 an ounce and WTI ripped higher by 4% to $81.50 a barrel. The VIX retreated by a point to settle near 18.  

- Philip Grant

01.10.2022
Tale of the Taper
Last week’s 1.9% decline in the S&P 500 augurs poorly

Last week’s 1.9% decline in the S&P 500 augurs poorly for 2022, if history is any guide.  According to data from CFRA Research, stocks have averaged an 11.5% annual return over the past 92 years when logging gains over the first five sessions of the year.  When equities are underwater after that initial five-day trading stretch, the average annual return is minus 0.9%. 

The bearish start to the year is hardly confined to the stock market.  This morning, the price of bitcoin sliced below $40,000, extending its decline to as much as 14% in this young 2022. That marks the digital ducat’s worst start to the year since at least 2012, when the benchmark cryptocurrency was still in short pants.  With the liquidity tide ebbing ahead of the Federal Reserve’s anticipated policy tightening, sentiment has turned in kind. Jay Hatfield, CEO of Infrastructure Capital Advisors, told Bloomberg today that “bitcoin could end 2022 below $20,000.”

Similarly, Bianco Research president and eponym Jim Bianco relays that the 30-year Treasury absorbed a hefty 9.35% loss last week on a total return basis. That not only marks the worst single weekly performance on record going back to 1973 but would also represent the fifth worst annual showing over that period. As for the drivers of that historically poor performance, Bianco offered the following postmortem:

Simply put, the bond market saw one of its worst weeks in history because bond market players finally "got it" that the Fed is going to end liquidity. This kicked off a big scramble to get out and not be the "bond bag holder" when the Fed printer is turned off.

Indeed, as the Fed continues its pivot from full-speed monetary accommodation (see last Friday’s ADG for a review of Federal Reserve Bank of San Francisco president Mary Daly’s policy 180 over the past eight months), persistently escalating price pressures add urgency to the situation.  Wednesday’s reading of the December CPI will feature a 7.1% year-over-year headline increase, if economist guesstimates are on target. That would mark the hottest print since 1982 and compares to measured annual price increases of 6.2% in October, 5.4% in June and “just” 2.6% in March 2021. 

That unwelcome trend has not escaped Washington’s attention. During this past weekend’s meeting of the American Economic Association, establishment financial thinkers including former Treasury Secretary Lawrence Summers, ex-White House chief economist Jason Furman and Council of Economic Advisers chairman Glenn Hubbard each contended that the Fed is behind the eight ball in dealing with the situation.  Stanford economist John Taylor, architect of the eponymous rule guiding monetary policy, argued that the Fed funds rate should now be somewhere between 3% and 6% based on current economic conditions, instead of the current 0% to 0.25% range. 

Some Eccles Building alumni share that view.  Former Federal Reserve Bank of New York President Bill Dudley put it this way in a Bloomberg Opinion column today: “I have news for those who think the U.S. Federal Reserve has turned more hawkish on inflation: It has only just begun.” Noting that the median Fed staff forecast calls for inflation (as measured by the Core Personal Consumption Expenditures Price Index) to fall to 2.1% by 2024 – with a stop at 2.6% this year – from 5.3% in 2021, despite a projected funds rate of 2.1% by the end of 2024 (well below the 2.5% “longer run” projected funds rate), Dudley concludes: “This is a remarkable, even surreal forecast. Inflation won’t be a problem, even if the Fed does little to rein it in.”  

Instead, persistent PCE readings of 2.5% to 3% would call for a funds rate of potentially as high as 3% to 4%, Dudley believes.  As that suggested range is far higher than market expectations, as measured by Eurodollar futures, “the ‘taper tantrum’ may have been merely delayed, not avoided,” the former Fed governor warned. 

On the bright side, investors won’t have to wait long for clues on the monetary mandarins’ next move. Fed chairman Jerome Powell is set to face the Senate Banking Committee tomorrow morning for his renomination hearing, with pointed questions from the political class surely in store. 

Recap Jan. 10

The bulls scored a sorely-needed win today, as the S&P 500 and Nasdaq 100 indices erased early losses of 2% and 2.7%, respectively, to finish little changed. The back end of the Treasury curve also caught an intraday bid with the long bond yield finishing at 2.08% compared to 2.15% this morning, while the two-year finished at 0.9%, compared to just 0.2% six months ago.  WTI crude slumped to near $78 a barrel, gold eked back above $1,800 an ounce and the VIX rose 3% to 19.5. 

- Philip Grant

01.07.2022
Tea Leaf Dot Plot
"I would prefer to see us adjust the policy rate gradually

"I would prefer to see us adjust the policy rate gradually and move into balance sheet reduction earlier than we did in the last cycle," Federal Reserve Bank of San Francisco president Mary Daly told listeners-in at a virtual conference today. 

Those remarks, following a December payrolls report that featured 4.7% annual wage growth (the sixth straight reading of at least 4% for a metric that never topped 3.5% over the 10 years through 2019), mark a swift about-face for the head of the second-largest Reserve bank by assets. Back on Sept. 29, Daly declared that conditions warranting monetary tightening this year “would be a tremendous win for the economy, [but] I don’t expect that to be the case.” Eight months ago, Daly told CNBC of the then $120 billion per month-strong asset purchase program “it’s not yet time to start thinking about talking about relaxing the accommodation we’ve given.”  
 

Shotgun Wedding
Silent partners wanted:

Silent partners wanted:  Last year, 98 U.S. firms conducted an initial public offering using a dual-class share structure, data from University of Florida Professor Jay R. Ritter show, representing 32% of the domestic IPO class in 2021. That’s both the highest gross tally and highest proportion of total IPOs since at least 1980.  For context, about 90% of existing public companies in the U.S. sport a traditional one-share, one-vote system, according to the Council of Institutional Investors.

Noting to the Financial Times that ownership structures conferring up to 20 votes per share to founders and corporate insiders now represent “the new normal,” T. Rowe Price head of corporate governance Donna Anderson adds that the practice looks set to continue unabated despite the mushrooming growth of ESG (environmental, social and governance)-focused investment mandates: “The stock exchanges and regulators put up no limitations, and most of the time demand for the offering is unaffected by the heightened long-term governance risk.”   

That break from historical norm comes as last year’s IPO slate reached uncharted territory.  Thanks to the proliferation of special purpose acquisition companies, domestic IPO volume exceeded $300 billion in deal value last year, nearly double the prior high-water mark established in 2020 and triple that seen during the peak of the first tech bubble.  Stripping out those blank check deals, conventional IPO proceeds of roughly $150 billion easily marks a pre-pandemic record. 

With Wall Street increasingly along for the ride as founders remain at the wheel, a recent patch of rough terrain leaves the Johnnies-come-lately with acute motion sickness. As of early November, the crowded 2021 IPO class had enjoyed an average 12% advance from its listing price according to Dealogic.  By the last week of the year, that average performance had swung to a 9% decline.  Similarly, the Renaissance IPO Index, which gauges the largest, most liquid new U.S. listings and is rebalanced on a quarterly basis, has slumped to its lowest level since November 2020, when the S&P 500 sat some 24% below current levels.


Renaissance IPO Index, five-year chart. Source: The Bloomberg

Performance “issues” aside, there’s more where that came from, as the global tally of so-called unicorns (i.e., firms valued at upwards of $1 billion in the private markets) now stands at 956 companies per CB Insights. That’s up from 563 just over a year ago and 269 in 2017.  While the recent bearish price action has reportedly led some hopefuls to ratchet down their valuation expectations, lawyers and bankers alike told The Wall Street Journal last week that all but a handful of those planning early 2022 debuts are expecting to move forward. “None of the companies we’re working with have gone pencils down,” Josh Bonnie, co-head of the global capital markets practice at Simpson Thatcher & Bartlett LP, told the Journal.

Scribble on, pencils. 

Recap Jan. 7

Stocks remained on the back foot, with the S&P 500 falling by 40 basis points to wrap up the first week of 2022 with a near 2% loss, while the Nasdaq 100 declined by 1.1% to finish at its lowest close since late October.  Another bear-steepening selloff in Treasurys saw the 10-year yield advance to 1.77%, its highest since the bug barged in in early 2020, while gold managed a modest bounce to $1,795 an ounce and WTI pulled back to $79 a barrel.  Bucking the weakness in equities, the VIX dropped nearly a point to finish south of 19. 

- Philip Grant

 

01.06.2022
Between the Hedges
It's raining money on Wall Street.

It’s raining money on Wall Street. The passive investment machine kicked into full gear in 2021, as worldwide inflows into exchange traded funds blew past $1 trillion over the eleven months through November, easily topping the full-year record haul of $735 billion established in 2020.  The venture capital industry similarly reached new heights in 2021:  Investors allocated $93 billion towards seed- and early-stage startups last year through December 15 per PitchBook, lapping the $52 billion sum seen in 2020 and triple that of 2016. 

Some investment categories, however, had to settle for relative scraps. Global hedge funds gathered a net $24 billion in assets over the first nine months of 2021, data from HFR show, yet on pace for the first annual inflow since 2017.  The three years through 2020 delivered a net $110 billion in withdrawals. 

Lackluster performance informs that cold shoulder: the HFR Global Hedge Fund Index rose a modest 3.65% last year, a fraction of the 28.5% total return for the S&P 500.  “Alpha [was] terrible,” Salvatore Cordano, co-CEO at Investcorp-Tages, told the Financial Times yesterday, referring to investment returns independent of market gyrations.  

Hedge funds’ waning popularity is reflected in dwindling compensation for the general partners, as the once customary 2% management fee and 20% performance fee schedule fall by the wayside. Management fees registered at 1.36% on average in the third quarter per HFR, while the average incentive fees came in at 16.17%. Each marked the lowest reading on record (HFR was founded in 1992).   

That compression hasn’t been enough to coax major investors back into the asset class:  Marcie Frost, chief executive of the $500 billion California Public Employees Retirement System (Calpers), described industry fees as “problematic” to the FT on Dec. 22, adding that the country’s largest pension fund has no plans to invest in hedge funds after completely exiting the category in 2014.  Calpers, whose board voted in November to upsize its private equity and private credit allocations to 13% and 5%, respectively, from 8% and less than 1%, while adding $25 billion of embedded leverage to help reach its 6.2% annual return target, believes that the public markets are “a little overheated,” Frost added. 

Might the solution to asset-price sticker shock be found within the industry structure pioneered by Alfred Winslow Jones? The traditional “hedged” fund, which first rose to prominence in the post-World War II era, represented a true market neutral strategy. Designed to produce satisfactory absolute returns across bull and bear markets alike, a successful hedged fund produced outperformance over the course of full investment cycles despite typically lagging during good times. Of course, with only a pair of nasty multi-month downdrafts (in late 2018 and early 2020) since the post-financial crisis bull market got underway and near-zero rates helping confer ever-richer valuations on favored industries, the recent environment has been particularly ill-suited for that old school, agnostic strategy.  The Nov. 26 edition of Grant’s Interest Rate Observer put it this way:  

At certain speculative junctures, prudence itself becomes unprofitable, and this juncture – say, the five or six years starting in approximately 2015 – has been the showcase of that paradox. Reaching for yield and chasing after performance were once what a conscientious fiduciary would never stoop to do. In the age of ZIRP (and the full heat of indexation), those offenses against good practice became almost compulsory. 

Of course, the past 21 months have proven particularly painful for the conservatively positioned. Last year’s meme-stonk frenzy, in which sometimes fundamentally-shaky companies enjoyed parabolic share price rallies after capturing mainstream attention, further complicates life for the prudent manager who uses short selling to maintain a balanced book, Grant’s noted:

In a sense, hedged investors, dodging the meme stock enthusiasts, are in the same unenviable position as professional poker players when pitted against overconfident amateurs. In both cases, the professional, knowing the odds, should beat the unseasoned, all-in novice, but it takes money to call the tyro’s bluff – and sometimes the tyro wins. 

For now, at least, evidence suggests the tide may be turning. Following yesterday’s 3.3% wipeout in the Nasdaq Composite Index, a whopping 40% of the components of that tech-heavy gauge now sit 50% or more below their respective 52-week high, Sundial Capital Research’s Jason Goepfert reports. 

See the analysis “Hedged for the long run” in the Nov. 26 edition of Grant’s for a speculation on the revival of the largely dormant hedged fund, featuring an enlightening profile of a longstanding industry mainstay.  

QE Progress Report
Reserve Bank Credit, or interest bearing assets on the Fed balance sheet, footed to $8.72 trillion this week. That’s up 0.5% from the middle of December, 19% from a year ago and 113% from March 2020. 
Recap Jan. 6

Stocks consolidated yesterday’s acute selloff, with the S&P 500 and Nasdaq 100 each finishing unchanged to remain weaker by 1.5% and 3.4%, respectively, so far in this young 2022, while the VIX remained just below 20. The Treasury curve flattened a bit after some aggressive weakness to start the year, with the two-year yield settling at 0.87% and the long bond at 2.08%, while gold was clubbed by 2% to $1,789 an ounce and WTI crude advanced to the cusp of $80 a barrel.  

- Philip Grant

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