Observations by David Robertson, 10/1/21
It was another dicey week in the market. One item that jumped out was the number of searches for “Lehman Brothers” skyrocketed amidst concerns about Evergrande. In one sense there are good reasons people would want to better understand the connection. In another sense, it’s scary that so many investors are unfamiliar with Lehman and the context for where we are today.
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The pattern of futures popping up overnight only to give way in the morning and throughout the day continued into this week. The most discussed news, though, was the jump in rates. It is almost as if investors had hit the snooze alarm on rising rates so many times they became inured to the signals.
Not only are higher rates, newsworthy, they are potentially extremely harmful to portfolios. As themarketear.com highlighted this week: “Tech is the pillar of this market and the rate sensitive play. Technology is 80% bet on rates, 20% on continuation of market share, margin.” There will be more damage if rates stay elevated.
While rates got the attention, the jump in the US dollar was also notable and perhaps even more important. Some of the move was likely related to the prospect of the Fed tapering. Some of the move was likely related to some marginal flight to safety given the debt ceiling standoff. The persistence of the move combined with some large single day moves suggest something else is going on as well. It feels like an indirect effect of Evergrande and other troubled Chinese firms.
Finally, buybacks can significantly affect markets by significantly affecting the flows of money into stocks. Buybacks have a distinctly seasonal pattern, however. We are entering the slow period for a few weeks – and then buying should resume. Trade accordingly.
Bigger Gulp, Almost Daily Grant’s, Monday, September 27, 2021
“That monster transaction [Medline] underscores a bumper year for leveraged finance, as U.S. companies issued $786 billion of junk bonds and speculative-grade bank debt this year through mid-September according to S&P Global Market Intelligence. That already sets a record annual pace going back to at least 2008 with more than three months left in the year.”
“A common factor can help explain that yawning historical disparity [the inordinately large proportion of low-rated credits]: At the onset of 2020, Moody’s Investors Service relayed in a Sept. 7 note, 72% of companies sponsored by the 12 largest private equity outfits carried ratings of single-B-minus or below, compared to just 19% for those unaffiliated with the industry. Debt-funded payouts for the promoters factor heavily into that bifurcation, as 21% of private-equity-backed companies issued dividends funded by more borrowings from the time their ratings were assigned through June of this year. Overall, a quarter of the 181 issuers owned by the largest dozen p.e. firms found themselves on Moody’s distressed debt list (i.e., rated the equivalent of single-B-minus or lower along with a negative ratings outlook) as of July 1, compared to just 11% of the 834 companies outside p.e.’s purview.”
Two great points here by Grant’s. One is the issuance of credit this year has been huge. This is always a good warning sign for a turn. The other is the quality of credits. Increasingly, debt is being binged on in order to pay dividends to private equity owners. One can almost envision the rats running off the ship.
Joe Biden Doubles Down on Housing
“As we did almost two decades ago in The Institutional Risk Analyst, when IRA co-founder Dennis Santiago observed in 2005 that Countrywide and Washington Mutual were starting to shrink, let’s put down a marker for future reference. We think that the changes being contemplated by the Biden Administration at the FHA and FHFA to make housing credit even cheaper and more easily available will cause the next housing crisis.”
“Remember, these multifamily bank owned loans are 50 LTV [loan to value] affairs that have been the gold standard of bank credit for decades, but now we see multifamily assets moving in the opposite direction of other housing loans. Will we see buildings being abandoned by landlords in major cities around the US? The answer sadly is yes.”
Chris Whalen provides some useful insights into the all-important housing sector. One point is multifamily units are running headlong into a tough credit environment: “As and when the Fed begins to taper MBS purchases next year, mortgage rates will rise and so will the LGD for 1-4s and other housing loan categories.”
That in itself remains a fairly innocuous issue. However, small multifamily units are a huge source of loans from banks. “Once the cost of credit in 1-4s is again positive, banks will again face financial and operational risk from residential exposures. And as with so many things in business and in life, risk is about mean reversion.” In other words, be on the lookout for writeoffs from banks on multifamily loans and be on the lookout for this to shake up an otherwise complacent credit market.
Gas crisis shows why we must stop demonising fossil fuels ($)
“Abattoirs are short of the gas they need to stun animals, hospitals might not have the carbon dioxide they need for minor surgeries, and the nuclear industry is low on the gas they need for cooling. These things really matter. This mini crisis has been fairly quickly resolved, for now at least: the taxpayer is stepping in to subsidise a fertiliser factory for three weeks.”
“However that doesn’t mean you shouldn’t worry. You should. This incident serves as a timely reminder of just how reliant we are on fossil fuels. Despite our optimistic enthusiasm for wind and solar power, one way or another oil and gas use is shot through every part of our economic and social lives. That will be the case for many decades to come.”
The immediate insight here is the extreme shortages being experienced in the UK provide a useful preview of what can be expected in the US if policies and practices don’t change. In an important sense, we can see the future. The impact of such shortages can range from mildly inconvenient to short-term annoyances to longer-term disruptions - and can escalate from one category to another quickly.
The longer-term insight is much of the squeeze is avoidable because it is related to constraints placed on fossil fuels. The fact of the matter is fossil fuels still play a very significant role in the economy and cannot be eliminated quickly without consequences. In addition, the challenge is further complicated by moving goalposts: “The more energy we can get our hands on, the more we use — even if our use of it becomes more efficient.”
These shortages will provide an interesting test for many countries: Do they want to reduce fossil fuels badly enough to accept higher costs and greater inconveniences? Or, can sensible plans be made to gradually transition away from fossil fuels so as to minimize impact? I think we’re about to find out.
After a brief impulse of concern the prior week about Evergrande, traders bought the dip and continued on their merry way. Rather than completely fading away, however, concerns re-emerged as strategists considered follow-on risks and downgraded forecasts for the country. The following piece by the Economist is representative …
What are the systemic risks of an Evergrande collapse? ($)
“Ping An Bank and Minsheng Bank, both hit by sell-offs in recent days, had big shares of their total loan books extended to property groups in the first half of the year (see chart). Minsheng has tight links to Evergrande. Shengjing Bank, which is majority-owned by Evergrande, is thought to have lent heavily to the property company. A banking crisis is not the base case for many investors watching the situation. But “the situation would change very quickly” if a bank of Minsheng’s scale proved vulnerable, says a China-based executive at an asset manager. Central authorities would probably step in swiftly at the first sign of distress at a major bank, the investor adds.”
There certainly seems to be a lot of “rhyming” with bank problems during the financial crisis. While banks present real systemic concerns, the more immediate concerns are “Evergrande’s links to China’s shadow-banking system.” As the report highlights, “About 45% of its interest-bearing liabilities in the first half of 2020 were from trusts and other shadow lenders, which are opaque and typically charge higher rates, compared with just 25% for bank loans.”
Further, it won’t be easy to re-assign developments and construction projects to other parties. As the report also notes, “The crackdown on leverage has left few developers with excess cash to make such purchases.”
From a higher-level perspective, the challenge can be seen as one of navigating a restructuring program between the extremes of quantity and timing. Byrne Hobart ($) articulates this brilliantly in a recent Substack post:
“A crisis is partly a matter of time: there are debts that can be paid eventually, but can't be rolled over continuously, and that means that some loans that could be paid off at 100 cents on the dollar eventually will default, and the lenders will collect less than that, with effects that ripple outwards from there. A residential real estate crisis is expensive to resolve because it's hard to renegotiate so many small loans, while a financial crisis is hard to resolve because so many of the debts are overnight, and dodgy borrowers have a strong incentive to understate their problems until the very end, meaning that interventions usually come too late.”
Wealth (Side)Effects - Fed Guy
“The scale and speed of the rise in household wealth is simply unprecedented. The roughly $40t increase in household wealth over the past 2 years is real ‘money’ that can be spent on goods and services (just don’t all sell at once). This has obvious implication for consumption and inflation, but also on the public’s urgency to seek employment. Stopping the flow of unemployment payments may be less impactful in encouraging employment when the stock of wealth has grown tremendously.”
“The Fed appears confused by the labor market: there are many signals of a labor shortage even though the unemployment rate is also elevated. The Fed is holding rates low on the belief that the economy is far from maximum employment, even though inflation high. But if the ‘wealth effect’ has structurally changed the labor market, then the Fed is viewing the world through an outdated model. It may take much higher wages to reach the pre-pandemic unemployment rate. The Fed may be inadvertently running the economy much hotter than they realize.”
Kaplan Joins Rosengren In Retiring Amid Fed Ethics Probe
“The dual resignations also come just days after The Wall Street Journal reported that two advocacy groups and a former Fed adviser demanded that The Fed should fire at least one (and perhaps both) of the Fed officials over their ‘pandemic profiteering trading conduct’.”
The first article highlights in very clear language how the Fed seems to be running the economy hotter than they realize. It would be bad enough if they were just accused of viewing the world through an outdated model, but they also seem to be anchored on conclusions that defy common sense. The second article highlights the trading by a couple of Fed governors that is described as “pandemic profiteering”.
The common thread is the Fed’s increasingly tenuous degree of trust by the public. This matters because it has been an almost religious belief in the Fed’s ability to stifle downturns and guide the market higher that has gotten us where we are today. If trust in the Fed’s leadership continues to falter, investors will need to contrive a new narrative to drive the market or will need to consider the possibility of significantly lower prices.
The Financial System Red in Tooth and Claw: 75 Years of Co-Evolving Markets and Technology ($)
“This single innovation brings into sharp focus the deep interdependencies between technology and the financial system. By ensuring the security and privacy of data transmission, RSA established trust in all online transactions, and trust is at the very core of finance and commerce. It is no exaggeration to say that RSA encryption facilitated not just the entire e-commerce industry but also the spectacular globalization of the financial industry, which depends on encrypted telecommunications.”
“In my most recent [Financial Analysts Journal issue], I find not one article on ethics. The articles are full of probability graphs; they cover relative earnings forecasts, buy-side versus sell-side arguments, and the benefits of short extensions. But what of the benefits of making the best ethical decisions and keeping our clients’ trust? And how can we understand these issues? Our business is more than a hard science. The most important quality we bring to our clients is not our ability to calculate numbers or create graphs.”
If you are a student of history and enjoy learning lessons from the past, Andrew Lo provides an excellent overview of an industry not exactly replete with introspection. If you aren’t, there are a few points that stand out as providing particularly useful context for the industry.
For starters, it emphasizes the evolution of financial markets as a function of the evolution of technology and finance. The development and implementation of technologies, ranging from communications to calculations, has been a key driver in the development and implementation of financial services over the years. To imagine the future of finance is to anticipate which technologies will be developed and how they will be applied.
Another point is the role of ethics. The quote above, by Russell McAlmond, highlights “the overreliance on quantitative methods and models” and the under-reliance on ethics. While the CFA program has done a great deal to impose ethical standards on the industry, the failures are still depressingly frequent. For all of the intellectual horsepower the industry engenders, it still often has a hard time demonstrating its utility to society.
Did I Miss the Value Turn?
“Regardless of how we define value, value investing posted the worst drawdown in its history over the years 2017–2020.”
“Investors’ rejection of value stocks in the pandemic environment makes sense because these companies tend to have anemic growth and thin profit margins. Very legitimate bankruptcy fears drove investors to shun these value stocks and pursue growth stocks, more aggressively even than during the tech bubble of 1999–2000.”
In a week with rates spiking up, the discussion of the value factor is a timely one. As I have described in the past, the success of the growth factor has largely been due to the steady decline in rates. More growth, further out into the future, is worth more as rates drop. However, that all reverses when rates go up – as it appears they are starting to.
One point is that value is a very reasonable place for money to go under these conditions. If you don’t like bonds and growth stocks are under pressure, value makes perfect sense. Further, as Arnott explains, the vast majority of value underperformance has been due to revaluation (relative to growth). As a result, there are a couple of opportunistic reasons why value is looking more attractive.
Implications for investment strategy
While value looks especially interesting relative to growth at this point, it looks less appealing on an absolute basis. For one, as Arnott also explains, value stocks are also very sensitive to economic growth and financial stability. With the economy’s growth rapidly slowing and uncertainty surrounding the debt ceiling increasing, there are also clear fundamental hurdles for value. The idea that buyers of value stocks will need to be more selective is an issue I highlighted in a blog two and a half years ago.
Another concern about value is the US dollar. As Arnott notes, if you like value, you must love emerging market stocks: “International and EM stocks are far cheaper than US stocks, currently priced to support an annualized real-return forecast of 3% to 5%”.
True enough, but such stocks are also vulnerable to dollar liquidity – and the dollar has been on a run lately. Is this coincidence or a sign of trouble abroad? We do know central banks across the world are starting to raise rates to fight inflation. We also know higher rates in the US get propagated to the rest of the world through the shadow banking system and through Eurodollar loans. It would be surprising if highly indebted emerging markets were not facing liquidity problems under such conditions.
Finally, the argument for stocks has been a very simple one – just follow the Fed. Now, with the prospect of tapering becoming more immediate, the force of Fed intervention is diminishing. Further, with rate hikes on the table, there is a distinct possibility that direction of Fed policy will actually change – and become a negative factor. Lastly, with significant threats to its credibility, the ability of the Fed to guide market direction must also now be in question.
In short, declining rates helped the market as a whole and growth stocks relative to value. Increasing rates will help value relative to growth but won’t do any favors for the market as a whole.
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