July Finance and Economics Review: Asset Prices and Risk Levels Rising
Almost all risk assets rose in July, with strong gains in equities and debt. US equities are back to record highs finishing the month up 3.6% with strong gains in Japan (6.4%), Australia (6.3%), Europe (4.4%) and China (1.6%). Investment grade and high yield recorded very strong gains in the US and Australia. Commodities were a mixed bag with US oil down 14.0% and iron ore up 6.7%. Gold (2.2%), Copper (0.7%) and US natural gas (-1.4%) had smaller moves.
Ju
ly
Review:
Asset Prices and Risk Levels Rising
Key Data
31
-
July
-
15
30
-
June
-
16
31
-
July
-
16
US Investment
Grade Spread
0.71%
0.77%
0.72%
AUD Investment
Grade Spread
0.98%
1.27%
1.10%
US High Yield
Spread
5.36%
6.21%
5.54%
AUD Listed Note
Spread
3.47%
4.24%
3.92%
Almost all risk assets rose in July, with strong gains in equities and debt. US equities are back to record highs finishing
the month up 3.6% with strong gains in Japan (6.4%), Australia (6.3%), Europe (4.4%) and China (1.6%). Investmen
t
grade and high yield recorded very strong gains in the US and Australia. Commodities were a mixed bag with US oil
down 14.
0% and iron ore up 6.7%. G
old (2.2%), Copper (0.7%) and US natural gas (
-
1.4%) had smaller moves.
The big question for the month was the
dichotomy created by both risk assets and “safe haven” assets rising
. When
risk
assets perform well that usually indicates a strong economy. When bond price
s
rise (yields fall) that usually
indicates a weaker economic outlook and potentially
a
recession ahead. With both occurring at the same time which
one is right? There’s a
slew
of
different answers, but the simplest one is that
negative interest rates and quantitative
easing are
the tide that lifts all boats.
Central banks buy government bonds with the aim of pushing down yields. When investors sell their bonds to a central
bank th
ey can either put the money in a bank or go and buy other assets. When cash rates are near zero or negative,
cash rates look so bad
some say
that
there is no alternative
but to buy risk
ier
assets. We can see this in US investment
grade corporate bonds where
corporates are struggling to issue enough
to meet
demand
and the
new issue premium
has collapsed to almo
st nothing
. In markets like this you start to see people arguing about relative overvaluations, for
example
junk bonds are overpr
iced but are not as bad as equities
and
are emerging market
s
a trap
?
I use the term “safe haven” carefully now as
supposedly safe assets are becoming crowded
and aren’t necessarily safe
anymore. The idea that interest rates could increase is almost heresy. The cons
ensus view is that the world is awash
with cash and interest rates are going to be lower for longer. Investors are responding by
going all in on long bonds
.
The belief in lower for longer interest rates also underpins gains in equities, property and infrastructure investments
in recent
years. If the consensus is wrong asset prices could change quickly and dramaticall
y. The reigning bond king
Jeffrey Gundlach called
it a “
world of uber complacency
” and recommended investors sell everything.
The three main concerns for US equities are the high P/E ratios, a poor outlook for earnings growth and the quality of
earnings issue. The run up in indices this month was primarily P/E expansion as
quarterly earnings are showing only
1% year on year growth
. Bank of America has
14 out 20 indicators saying that equities are overpriced
and
energy P/E
ratios are literally off the chart
. The earnings quality issue
continues to grow
with
94% of S&P 500 companies now
reporting two types of earnings
.
Perhaps the only investment sector that fell hard during the month was UK property
. At least
nine unlisted property
funds with
total
assets of more than £15 billion halted redemptions
. There’s been a rang
e of responses, some funds
have slashed asse
t values and then re
-
opened, whilst one
sold a property at a 15% discount to the book value
. I wrote
about these issues last month so I won’t repeat
it all,
but this
is a
warning as what can happen to illiquid assets in
open
ended f
unds.
US high yield debt
is probably th
e sector that has the biggest risk of this type.
In long term economic indicators there’
s
five
ugly data points
this month.
Second quarter GDP for the US came in at a
measly 1.2%, following on from 0.8% in the first quarter. US consumers are spending up
, but
businesses ran down
bloated inventory levels and pulled back on investments
.
US restaurant sales are flat year on year
,
which could be a
pre
-
recession indicator
.
McDonalds is hoping to grow by stealing
market share from competitors
, so that will pretty
much guarantee margin compression on top of no revenue growth. The US
Cass F
reight index and global trade levels
are both saying economies are stagnant.
Lastly,
online job ads
in the US
have plunged this year
.
The d
ecline of
the
oil
price
this month is troubling for many highly indebted companies and countries. Standard and
Poor’s has seen
100 defaults in the first six months of 2016
, which is on pace to beat the record number of defaults in
2009
. Many of the def
aults are from
energy companies.
Supply is increasing as
Canada and Nigeria are coming back
on line
after recent disruptions.
Demand growth is flat
as
global economic growth is sluggish. Oil and associated
products in storage in
the US
,
China
,
Europe
and
at sea
are
at record levels
.
Banks
The Italian government is scrambling to put together two programs to support its banks
. The banks need help as the
pile of non
-
performing loans is bigger than the bank’s
tangible equity and provisions set aside for losses
.
F
ollowing on
from the Atlas fund
a
nother solven
cy program
is being proposed. This one
involves the government using €10 billion
of taxpayer money to
buy €50 billion of non
-
performing
loans from the banks
. A
separate
liquidity facility would
provide up to
€150 billion of senior debt
if depositors
and international lenders rush for the exits.
The most troublesome of the Italian Banks is Monte Dei Paschi. It was the only bank to outright fail the Europe bank
“stress” test, which is so weak it should be called a tickle test. A bailout is obviously
required and is being patched
together. Part one involves dumping
€50 billion
of non
-
performing loans onto the Atlas bailout fund. Atlas is expected
to receive another
€
15
billion
in order to be able to swallow those loans. Part two is a
€5 billion capital raising to be
underwritten by eight banks
. On face value the numbers for all of this don’t work and a lot more capital will be needed.
It’s also not
clear who be willing to throw good money after bad in the Atlas fund or Monte Dei Paschi, a taxpayer
funded bailout seems the most likely option. An updated business plan is due to be released in September.
European rules require shareholders and subordi
nated debtors to be wiped out before taxpayer funds are used.
Italy
is desperate to avoid a by the rules bailout of their banks as
retail investors own around
half of bank subordinated
debt
and this was
sold to them as an alternative to retail deposits
.
Italian pension funds are being asked to
help bail
out the banks
.
If there is a meltdown in Italian banks the
French and to lesser extent the German banks are most
exposed
.
Christine Lagarde has reassured investors that
Italy is not Greece
. She’s right, Italy is
m
uch
larger
than Greece
and
is too big to
f
ail
and too big to bail
.
The problems aren’t limited to Italy with a report by a Deutsche Bank economist having Spain, Portugal and other
European nations needing to
recapitalise their banks to the tune of €150 billion
. I’m not sure how much
t
he
author
has pencilled in for the German government to provide to his employer. The
comparisons between Deutsche Bank
and Lehman Brothers continue
. Deutsche
B
ank isn’t the only German bank attracting concern,
Commerzbank’s capital
ratios are falling but it is still paying dividends
.
Bremen Landesbank might need a taxpayer bailout
.
Regulators
In
news about regulators there’s
highlights and lowlights
this month. The highlight
is the Singaporean bank regulator
continuing its crackdown on dodgy dealings from the 1MDB scand
al. After dealing out the ultimate punishment to one
bank, cancelling its licence to operate,
Singapore is now seizing assets
a
nd heading down the pathway of handing out
fines to lessor offenders. Also
smart
is the
New Zealand central bank increasing th
e deposits required for home loans
in order to take the he
at out of property prices.
On the what are they thinking end of the spectrum US insurance regulators are considering
reducing the amount of
capital that needs to be held against sub
-
investment grad
e debt
. Their timing couldn’t be worse as defaults are
increasing and the experts are saying that the asset class is in the
extreme overvaluation zone
. Insurance companies
make around half of their profits f
rom investing
,
which
is
predominantly
in
investment grade debt. The right response
to their complaints about falling profits from lower yields is for central banks to return interest rates to normal
levels
,
not for regulators to “help” them by letting them
invest in riskier assets. Another dumb regulatory move was
Britain
reducing the counter
-
cyclical buffer on banks from 0.5% t
o 0%
. With the uncertainty of Brexit,
high growth in consumer
debt
and property funds locking
up
as property prices fall now is the time to increase the counter cyclical b
uffer.
After much talk of “the tough cop on the beat” prior to the election, Australia’s watchpuppy securities regulator ASIC
has returned to form. ASIC is doing a decent job of cracking down on small and medium sized financial firms that are
engaged in
misconduct as well some higher profile insider trading cases. However, when it comes to the big end of
town it really is a paradise for corporate crime with only the media to worry about. This month
IOOF escaped without
a penalty over a laundry list of misconduct
including insider trading and sacking a whistleblower who tried to get the
issues dealt with. Perhaps ASIC could get a few Singaporea
n peers to come over on secondment in order the lift the
culture at the Australian regulator. Similar to ASIC’s failings, a US government report found that the
US
Justice
Department had a too big to jail policy
when it came to misconduct committed by large banks
.
Monetary and Fiscal Policy
The practicalities of helicopter money are now being openly discussed with the O
ECD’s chief economist suggesting
that
you can’t
just
put money into bank accounts and expect people to spend it
. The alternative
is to give people retail
vouchers. It’s nice in theory but if that occurs get ready for a black market in retail vouchers, perhaps trading at a 5%
discount to face value. Whilst some would spend the voucher on frivolous things, as
was reported
with Austra
lia’s cash
splash in 2009, in the current income strapped environment I suspect many will spend a voucher on essentials like
groceries, utilities and fuel for their car. Many take it as a given that helicopter money will stimulate growth, but others
claim
that
the 2008 version in the US was a failure
.
The Bank of Japan announced
that it would
increasing its
buy
ing
of equities
by
another
¥3
trillion per annum, in what
was considered by many to be a major let down.
The Bank of Japan Governor said there is “
n
o need and no possibility
for helicopter money
” but he gave similar assurances
about not using negative interest rates
right before he
announced negative interest rates. This is an argument of semantics though, the central bank creates money to buy
governm
ent bonds, which supports the government
in
run
ning
massive budget deficits
for fiscal stimulus
.
The
latest
fiscal
stimulus package
from the Japanese government
is equivalent to 6% of GDP
. The only difference
between this and helicopter money is that the government decides where the money is spent rather than the
individuals that receive the cash from hel
icopter drops. Either scenario sets a country on the pathway to hyperinflation,
it is just a matter of time before money leaves to go somewhere that isn’t printing money. One indicator of the
problems with existing policies is
Japanese banks making 50 year loans for commercial property
in a desperate attempt
to get some yield from lending.
Perverse outcomes from terrible monetary a
nd fiscal policies aren’t limited to Japan. In Europe
negative yields are
spilling over into corporate bonds
. The ECB has spe
nt
€10 billion buying the debt of 43 issuers
, including debt issued
by
Glencore and two sub
-
investment grade rated companies
. The ECB’s buying of government debt is running at
three
times the pace of governments issuing debt
. Essentially the ECB is fast running out of lower risk assets to buy, so
there’s speculation that it will
start buying equities and/or high yield debt soon
. If they do start purchasing equities,
they can point to Japan and Switzerland as other
s
already doing it. Deutsche Bank’s economists continue to criticise
negative interest rate policies
calling them
“poison” and noting that they are “doing serious damage”
.
China
One article this month pretty much summed up the overbuilding iss
ue in China.
In aggregate
,
Chinese cities are
planning for 3.4 billion people in 2030
. That’s three times the existing populatio
n
and forecast
population
growth is
minimal.
Peak urbanisation may have arrived for China
, the
substantial slowdown in wage inflation
is
a strong indicator
that the demand for labour is flat at best. This aligns with recent reports of a substantial increase in the unemployment
rate. The city of Tieling is one example of
what happens when a construction and manufacturing bubble
pops
.
Remember that local governments earn most of their revenues from property development activities, which would
fall flat if urbanisation stops. A collapse in revenue would make debt servicing problematic, which is particularly
concerning as local government
s have seen an
enormous increase in their debt issuance in 2015 and 2016
. This
includes continuing to build coal fired power plants when the
existing plants are running at low capacity
. Local
governments are
blocking lenders from withdrawing credit
in order to protect jobs at zombie companies.
7.5% of
companies in China are believed to be econ
omically unviable
, with medium and large state owned entities the worst.
Last month I wrote about the first non
-
performing loan securitisations in China and it looks
like
this process is ramping
up.
T
he
Agricultural Bank of China is
planning to sell a US$1.6b securitisation o
f
non
-
performing loans
which includes
the underlying loans being marked down to 29% of face value. The ot
her big way that banks are planning to clean up
their loan books is debt to equity swaps, which are
expected to start soon
.
There’s
plenty to worry about with peer to peer lending
and a crackdown is coming for
wealth management products
.
In order to reduce fraud in these areas
executives are being given tours of prisons
, as a reminder of what might happen
to them when investors lose money. Given the concerns with these
sectors
,
investors
are
increasingly investing
ove
rseas or
putting their savings in a bank
. In a reminder that Chinese investors are still learning the ropes, one article
highlighted their
love affair with stock splits and stock dividends
. If a company is issuing more stock
they assume it
m
ust be good
.
The Chinese regulators are planning to reduce the
maximum leverage within
managed
funds from 70% to 50%
. In what
might be a sign that
the Minsky moment is near
,
corporate bonds sales are falling as default rates are increasing
.
Perhaps investors are starting to realise that Chinese ratings agencies can’t be trusted with
56% of AAA rated bonds
having sub
-
investment grade metrics
.
Chinese asset management firms will
have
to continue rais
ing
capital
in order
to deal with the expected wave of defaults. Bankruptcy and recovery processe
s
are still
problematic with
Dongbei
Steel going about its business as if nothing has happened
three months after it skipped debt repayments.
I sus
pect iron prices can’t remain at current levels for too much longer as Chinese
stocks piles are soaring once again
.
Chi
nese iron ore producers are
claiming that Australia and Brazil are dumping iron ore into China
, the clearest
indication yet t
hat they are suffering. The
higher prices for iron ore
are
driven by
credit growth
that
remains strong
and
investment by state owned entities
that
has skyrocketed this year
, neither of which can last forever.
Chinese state
owned entities are being
loy
al
to their masters, helping
to prop up both the yuan and share prices
.
Emerging Markets
Venezuela
keeps
get
ting
worse a
s
gold reserves are still being sold off to postpone an inevitable default
. Big
repayments are due in October and November and that’
s when a default might occur.
McDonalds
and
Kimberly Clark
are the latest businesses to halt production after being unable to obtain key
supplies
.
Mozambique is set to default soon, with the story of how it
fell from Africa’s most promising economy to its current
situation
an interesting one. Puerto Rico
paid $1.1 billion and defaulted on $977 million of repayments
in early July.
T
he
Puerto Rican water utility wants to raise $900m in new debt
and give existing debtors a 15% haircut.
The President
of Angola has warned that his country
will struggle to pay its debts
. Argentina hasn’t defaulted, but with
in
flation
running at 50% per annum and with interest rates at 30%
the aver
age citizen might think it has.
Turkey, Russia, China and Brazil all have
issues
with private sector debt levels
. Turkey’s political issues are well known,
creating a risk for its banks who
rel
y heavily
on
external funding
.
Russia is
raiding its sovereign wealth fund to maintain
government spending
,
retail sales are down 5.9%
and about
10% of loans a
t
banks are thought to be non
-
performing
.
But don’t worry about any of that
,
emerging market debt is
all the rage
.
I
nvestment refugees from negative interest
rate countries
need somewhere to put their money. The
P/E ratio for emerging market equities is well above long term
averages
.
India’s high yield bonds are
also
currently
so
ught after
. That seems a little odd given its banks are dealing
with a mountain of non
-
performing loans and
credit r
ating downgrades
. Indian
state banks are set for a
$3.4 billion
taxpayer recapitalisation
but some are saying
it won’t be enough
.
Politics
Republicans and Democrats both have
reintroducing Glass Steagall limitations for bank on their policy platforms
.
Cynics have suggested that this is just
a ploy to get donations from the big banks
and then do nothing after the election.
Here’s
a
documentary that
makes the case for
why Trump
can
keep calling Clinton crooked
. Expect to see more articles
like this one
–
Clinton versus Trump
–
who’s worse
? The
US Green party offered Bernie Sanders their leadership role
if he was
willing to switch allegiances.
W
ritten by Jonathan Rochford for Narrow Road Capital on
August 1
,
201
6
. Comments and criticisms are welcomed
and can be sent to
info@narrowroadcapital.com
Disclosure
This article has been prepared for educational purposes and is in no way meant to be a substitute for profess
ional and
tailored financial advice. It contains information derived and sourced from a broad list of third parties, and has been
prepared on the basis that this third party information is accurate. This article expresses the views of the author at a
point
in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to
publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including
securities linked to the performan
ce of various companies and financial institutions.
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