#risk

A gem on how to work our way out of the coming economic crisis

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Jonathan Rochford of Narrow Road Capital has written a gem on the role of central banks in spawning this current crisis. An excerpt here:

The rapid and widespread sell-off over the last four weeks is a textbook systemic deleveraging. Whilst the culprits are many; hedge funds, risk parity strategies and investors using margin loans have all been caught out, the underlying cause is excessive leverage across the economy and particularly the financial system. The timing of the unwind and the economic damage from the Coronavirus wasn’t predictable, but such a highly leveraged system was like a truck loaded with nitroglycerin driving down a road dotted with landmines.

Frustratingly, this inevitable deleveraging was clearly predicted. Rather than act to reduce systemic risks central banks encouraged governments, businesses and investors to increase their risk tolerances and debt levels.

Naturally, it fits our own long-held view on central banks.

Jonathan adds some sensible actions which are contained in this link. The question remains whether governments will put principle ahead of expediency in the cleanup?

GEzus Priced super far?

US Corp prof.pngIt is not rocket science. Generally higher interest rates lead to lower profitability. The chart above shows that quarterly pre-tax US profitability is struggling. We took the liberty of comparing the profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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With the Fed moving toward a tightening cycle, we note that the spreads of Baa 10yrs to the FFR has yet to climb out of its hole. During GFC it peaked at 8.82%. It is now around 3%.

US Moodys

Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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Corporate America binged on cheap credit over the last decade and given the spreads to Aaa ranked corporate bonds were relatively small, it was a no brainer. In 2015, GE’s then-CEO Jeff Immelt said he was willing to add as much as $20 billion of additional debt to grow, even if it meant lower bond grades. We can see that the spread today is a measly 0.77%. Way off the 3.38% differential at the time of GFC. Still nearly 50% of corporate debt is rated at the nasty end.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper its balance sheet. So as an investor, would you prefer the safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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In any event, the 4.64% 10yr Baa corporate bond effective yield is half what it was at the time of GFC. Yet, what will profitability look like when the relative attractiveness of US Treasuries competes with a deteriorating corporate sector in terms of profitability or balance sheet?

Take GE as an example. Apart from all of the horror news of potential dividend cuts, bargain basement divestments and a CEO giving vague timelines on a turnaround in its energy business things do not bode well. Furthermore many overlook the fact that GE has $18.7bn of negative equity. Selling that dog of an insurance business will need to go for pennies in the dollar. There is no premium likely. GE had a AAA rating but lost it in March 2009. Even at AA- the risk is likely to the downside.

Take GE’s interest cover. This supposed financial juggernaut which was at the time of GFC the world’s largest market cap company now trades with a -0.17x interest coverage ratio. In FY2013 it was 13.8x. The ratio of debt to earnings, has surged from 1.5 in 2013 to 3.7 today. It has $42bn in debt due in 2020 for refinancing.

By 2020, what will the interest rate differentials be? There seems to be some blind faith in GE’s new CEO John Flannery’s ability to turn around the company. Yet he is staring at the peak of the aerospace cycle where any slowdown could hurt the spares business not to mention the high fixed cost nature of new engines under development. In a weird way, GE is suffering these terrible ratios at the top of the cycle rather than the bottom. Asset fire sales to patch that gaping hole in the balance sheet. Looks like a $4 stock not a $14 one.

The “bigger” point about the FANG sell off

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While the press is waxing lyrical about the unprecedented loss caused by a sell off in FANGs (Facebook, Amazon, Netflix & Google) we should note that it overlooks one factor. Before getting to that, to start with the sell off in gross dollar terms it is unsurprising given the already highly inflated value of the base stocks. So if A $500bn market cap Facebook loses 4% it is equivalent to $20bn. On one day FB lost a Fiat Chrysler. It’s math. Let’s not forget that Bitcoin is now worth $165bn but let’s not let that bubble spoil the party.

The problem that faces financial markets is the advent of ETFs. While stupefyingly simple to understand as an investor it is that same simplicity that breeds complacency. ETFs are simple products that enable investors to pay much lower fund management fees to buy easy to understand baskets- whether coal, gold, oil or FANGs. There are 106 ETF products that own Facebook as a Top 15 holding with that averaging between 5% and 10% of the entire fund.

Yet on the way up things are rosy. It is what happens on the downside that has yet to be fully tested. Around two years ago, CM wrote a report which warned of the risk of ETFs on the downside, especially levered ETFs (i.e. you buy a 2x levered FANG fund which means if FANG stocks go up 5% you theoretically get 2x the return for any given move up or down.

However in times of uncertainty (i.e. heightened risk) the options markets that price risk move magnitudes on the downside vs the upside. Meaning for an ETF to replicate what it proclaims on the brochure becomes much more difficult meaning the fund may under or overshoot the promises. Also in certain markets (e.g. US & Japan) where stocks on the exchange have limit up/down rules on the physical stock, should a market crash ensue, the ETF prices on the theoretical values of stocks that may not have opened for trading. What that means is that the ETF may reflect a market that is 10-15% below where it actually eventually opens. Meaning poor ETF buyers get gouged. However the computer algorithms in the ETF end up chasing, not leading the market which in and of itself creates more panic selling further reducing market confidence. Where a market might have traditionally fallen  3% on a given piece of bad news, ETFs tend to react in ways that might cause a market to retreat 6%. Indeed market volatility is amplified by ETFs.

At the moment market behavior is exceedingly complacent about risk. Before GFC highly complex products like CDOs and CDSs were the rage. 99% had next to no clue how they operated but they found their way into the local government investment portfolios of even small country towns in Australia.

ETFs on the other hand are strikingly simple to grasp but that also means we pay far less attention to the risk that goes with them. That is the bigger worry. People complacently thinking their portfolios are safe as houses may wake up one morning wondering why some flash crash has caused Joe and Joanne Public’s retirement nest egg to get decimated.

 

Why MiFID2 is like Spectre and why 007 needs Q more than ever

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Risk is a great leveler. Everyone has different thresholds of it. Of course when you’re young, risk is easier to take. Have a family, take on a mortgage, private tuition and heaven forbid you get wiped out in a divorce – the risk reward equation is constantly swinging. Catching up with an old client last night put a smirk on my face. In 2018 MiFID2 comes to life. For financial markets people it is the latest EU regulations which has many service providers in a blind panic. Investment clients will have to select “research” He spoke of the current equity broker market being a bit like a huge buffet. Lots of selection but hardly a Michelin star in sight. He said he’d met with many bulge bracket brokers who are all tinkering at the edges. Never before has the dangers of not taking risk been greater. While Musk might be tearing up the EV world, MiFID2 is a massive disruptor for financial services and the collective might of the alpha egos inside it can’t summon a slither of courage to be different.

It is easy to hide behind compliance. If I had my way I’d staff compliance with lawyers rather than those with a penchant for saying “no”. MIFID2 is such a huge chance yet all brokers are like rabbits in a headlight. A lawyer will tell you how far you can go. A compliance officer is more worried about protecting his own hide so maximum risk off is the safest option. So worried about compliance are finance companies in some circumstances they outnumber the people they’re assigned to police. Name me one prison where guards outnumber inmates?

The latest trend is to hire product managers. Enlightened ones who are entrusted to revolutionize the research offering. One asked what makes a good product manager? I replied one that is prepared to completely blow up the old model. More importantly one whose management will give him or her carte blanche to start a revolution and to act decisively on hiring analysts with true out of the box vision. Yet time and time again these senior managerial risk experts turn into complete novices and hire conservative group thinkers who have no desire to rock the boat. Throw on top the outsourcing to aggregators like SmartKarma and all you have is an even bigger buffet of substandard gourmet. The aggregator model will not be a success unless it reforms to have serious quality control of which it claims it has but in reality hasn’t.

MiFID2 is a bit like Spectre in a Bond film. The baddie Bond girl is like the client. The equity broker is Bond. If it wasn’t for 007’s array of gadgets from Q-branch (research) he’d be toast. The new breed of product managers (Q) are not creative enough to give equity salespeople (007) the upper hand to woo the baddie Bond girl. The problem is even worse because under MiFID 007 will be unable to use carefully rehearsed lines, expensive meals or fancy sports cars to catch his prey. So without a creative Q, brokers will end up being annihilated by the baddie Bond girl without even so much as a kiss in her death grip. Sadly baddie Bond girl needs to justify her actions to Spectre. Too. She won’t waste time in meeting M to plead her conversion. Quite frankly if 007 can’t deliver the goods she has every right to feel no emotion if he dies.

Q has always been the innovator. The one trying to stay well ahead of the curve. Let’s face it. Every Bond film we see comes out with something new to dazzle. Baddie Bond girl is never easily impressed so without properly engaging, well thought out, reasoned and in depth balanced research, 007 will die a slow death chewing on his high calorie low quality buffet which Q unimaginatively sprinkled Tabasco on.

Baddie Bond girl wants to be charmed. Like Pussy Galore ditching the poison gas canisters for a mild sleeping agent over Fort Knox, Baddie Bond girl will be only too happy to oblige switching broker repellent for commission dollars if Q makes the difference.

So to me MiFID 2 is an absolute bounty for the Michelin star research providers. Ones who give clients such a gustation experience that they can’t wait to book another opportunity to pay for another culinary experience.

In closing perhaps the biggest schadenfreude in all of this is three realization of how internal politics which have driven sell side bonuses gets exposed when next to no clients want to dine at their smorgasbord.

I’m no fan of MiFID2 but now that it is coming I see it as a huge opportunity rather than a sign to wave the white flag. Bring on January 2018.