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® V o l . 3 3 , N o . 1 6 Two Wall

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® V o l . 3 3 , N o . 1 6 Two Wall Street,

Vol. 33, No. 16

Two Wall Street, New York, New York 10005 • www.grantspub.com

AUGUST 7, 2015

Fault lines in credit

In writing off all but tag ends of its Nokia acquisition of little more than a year ago, Microsoft produced a $7.5 bil- lion demonstration of the evanescence of modern business value. Creative de- struction may be salutary—it is salutary. Still and all, destruction costs money. Credit—the promise to pay mon- ey—is the subject of this unfolding narrative. Junk bonds are in the fore- ground, money is in the background. No further need to reach for a certain kind of yield, we are about to contend; higher speculative-grade yields are coming to you. In advance, we are pre- pared to assign a cause to the downturn that hasn’t fully materialized yet. Six carefree years of Fed-engineered zero- percent funding costs will prove the fundamental reason for the next gust of defaults. The prospective rise in the federal funds rate will turn out to be a causative footnote. The credit cycle is a mass migration of the mind. It begins with the col- lective fear of losing money, point A. It ends with the collective fear of not making money, point B. Point A finds lenders and borrow- ers nursing the wounds of the bust that followed the boom. The peni- tents resolve to be more careful if only the market will give them an- other chance. They do not disavow leverage—it is, after all, the raison d’etre of speculative-grade finance. They rather pledge to employ it more prudently. They will henceforth lend at rates that are sensibly aligned with the evident risks of the correspond- ing borrower. No more updating their Facebook status when they ought to be reading prospectuses, either. The passing years leach away mem- ories of the bust. Bankruptcy filings

become rarities as prosperity spreads its blessings. The return of the itch to speculate means that, for the profes- sional investor, generating gains takes precedence over avoiding losses. Lever- age creeps (at length, it gallops) back into the market, and pricing comes to favor the seekers of funds, rather than the providers of funds. Point B is the apex of optimism. Point A of the present cycle we may pinpoint as March 2009, the nadir of stocks and credit. Point B, we shall guess, has just passed. The crystalliza- tion of boom-time optimism occurred on July 16. The oversubscribed sale of more than $1 billion of debt by the Ba-1-rated City of Chicago was the red letter event. A two-line quotation in the Chicago Tribune before the sale took place could speak for broad swaths of American speculative-grade finance.

Grant’s on vacation
Grant’s on vacation

Grant’s Interest Rate Observer, taking its summer vacation, will resume publication with the issue dated Sept. 4, 2015.

“It sounds like we don’t have much of a choice,” said Alderman Nicholas Sposato, concerning the feasibility of the then prospective issuance. “This is a way to at least put our finger in the hole in the dike for now.” The fingers in the dike, duly inserted, belong to America’s fiduciaries. For many a moon, the prices of junk bonds failed to register bad news. That has begun to change. Thus, the Bon-Ton Stores 8s of June 2021, is- sued at par in May 2013, were quoted at 84 as recently as mid-May of this year; they change hands today at 75, a price to yield 14%. “One might reason- ably argue that the prospects for U.S. consumer spending should be pretty good, given rising employment, grow- ing wages and falling energy prices,” colleague David Peligal observes. “The Bon-Ton clientele is not high end, so its demographic should benefit more on the margin. The fact that the bonds are sinking is perhaps telling you some- thing about changing perceptions of credit risk.” A July 30 report on the junk market by Michael Contopoulos et al. at Bank of America/Merrill Lynch makes a per- suasive case that, if the top in the junk market is not in, it is likely not far off. “The future is what it used to be” is the promising title. Plainly, the au- thors—who include Neha Khoda and Rachna Ramachandran—are alert to the cyclical facts of life. Reversion to the mean is the fore- most cyclical fact. Trees don’t grow to the sky; the cure for high prices is high prices, and the cure for low prices is low prices. The junk market, though it has suffered a rocky couple of weeks— thereby trimming returns in the year

(Continued on page 2)

default rate

2 GRANT’S / AUGUST 7, 2015

(Continued from page 1) Too quiet out there 15% 15% Moody’s trailing 12-month issuer default
(Continued from page 1)
Too quiet out there
15%
15%
Moody’s trailing 12-month issuer default rate
for global speculative-grade debt
12
12
9
9
6
6
3
3
0
0
1/70
1/75
1/80
1/85
1/90
1/95
1/00
1/05
1/10
6/30/15
default rate

source: Moody’s

to date to little more than 1%—has by no means corrected the manifold ex- cesses that are so much in need of cor- recting, the authors assert. Not only is the market not out of the woods, Con- topoulos et al. insist, it is “not even in the woods yet.” Well, the market is in the woods of debt. Over the past several years, speculative-grade companies have re- leveraged, “somewhat of an anomaly during periods of decent growth, low default rates and strong equity mar- kets,” the report observes. The authors relate that they have looked at leverage in its many different facets: “We have run the numbers using unadjusted EBITDA, adjusted EBITDA including and excluding energy, metals and min-

.” The conclusion

ing, and

is the same, no matter how the data are sliced, they find: “[C]ompanies have re-levered to an extent not seen since the late 1990s.” Apocalyptic, the BofA/Merrill team is not, bearish it is: “In our view, com- modity, rate, liquidity and, most im- portantly, fundamental pressures have yet to fully affect the market, and when they do, we expect further price loss across a broader set of companies.” Naturally, all cycles are different. Radical monetary experimentation is the standout characteristic of this one. Zero-percent funding costs have pulled forward consumption and pushed back distress. They have reduced the re- turns to skepticism, securities analy- sis and due diligence. They have

prolonged the commercial lives of mar- ginal businesses that, were they forced to finance themselves at normal inter- est rates, might be pushing up daisies in some reorganization proceeding. At the spring 2014 Grant’s Confer- ence, Martin Fridson, now chief invest- ment officer at Lehmann Livian Frid- son Advisors, imagined the next wave of speculative-grade defaults. It would begin in 2016, he projected—that is, it would likely begin in 2016 if past were prologue. The wrinkle was that, in this day of monetary activism, the past may not be prologue. Thus, in 2009, 13.3% of the speculative-grade issuer universe defaulted. It was far and away a record for any year in the 45 years since the data were first collected. Yet—remark- ably—in 2010 the default rate subsided to 3.3%, slightly below the long-term average of 4.6%. “I would submit that is physically impossible,” said Fridson, still amazed at this occurrence a half- decade after it happened. “But it did actually happen, and I think that the only conceivable explanation is the Fed’s extraordinary intervention.” Contopoulos et al. compare 2015 to 1998, a year best remembered, if at all, for the flameout of Long-Term Capi- tal Management. The year 1998, like 2015, saw plunging oil prices, swings in quarterly GDP readings of as much as four percentage points, apprehension over a Fed tightening cycle and flat- tish junk-bond returns. Front and cen- ter, too, was the concentrated issuance of speculative-grade debt in a certain

favored industry. The fair-haired seg- ment of 1998 was telecommunications, that of the present is, or rather was, commodities. “High yield typically

overbuilds in one industry before real- izing stress in that sector,” the BAML report observes. We would amend that statement.

Credit markets tend broadly to over- build. They tend especially to over- build when tempted by governmen-

tally suppressed interest rates. Junk bond yields beginning with the num- ber “five” and sovereign debt yields beginning with the number “one-half

of one” have proven temptations im- possible to resist. Intimations of trouble in telecom did not, at first, trouble the broad junk

market. Investors wrote it off as a spec- ulative outlier. Only gradually did they lose faith in industries and companies that they had previously assumed to be safe. Skepticism proved contagious once it set in. “It is this heightened skepticism that ultimately feeds into capital markets, creating a re-pricing of risk and ultimately a lack of desire to fund risky companies,” the authors say, and they add: “We’re seeing simi- lar behavior today. A year ago, weakness was isolated to metals and mining and pockets of retail. This ‘idiosyncratic’ weakness bled into energy in the fall, and now is beginning to affect wireline, technology and financial companies.” Advanced Micro Devices is an ex- ample of a speculative-grade issuer to which the market has belatedly given the fish-eye. Incorporated in 1969 and public since 1972, AMD is a Silicon Valley senior citizen. It designs and markets semiconductors for use in per- sonal computers. As recently as 2012, the company’s PC-centered business designated “computing and graphics” generated revenue of $4.7 billion and operating income of $129 million. That was as good as it got. In the first six months of 2015, AMD logged revenue of just $911 million and operating in- come of minus $222 million. A second AMD division, the “en- terprise, embedded and semi-custom” unit, is both profitable and growing, though it is not so profitable, nor so fast growing as to lift the corporate whole. Companywide revenue and earnings per share both peaked in 2011. EPS turned negative in 2012 and has not returned to the black. Second-quarter 2015 results featured dwindling sales,

Copyright ©2015 by Grant’s Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.

GRANT’S / AUGUST 7, 2015 3

declining cash and rising inventories.

Revenue declined by 35% vs. the previ- ous 12 months, a plunge that included

a 54% drop-off in the legacy PC seg-

ment. Not only is PC demand falling,

but AMD is also taking a smaller share

of what remains. “So it’s quite pos-

sible,” Peligal points out, “that AMD only generates total 2015 revenue of

slightly more than $4 billion. If true,

it would be down by a little more than

25% from 2014. The closest debt matu- rity is March 2019, which, at this rate, may be closer than it seems.” It falls to management to keep up

a brave face—if not management, who?—and AMD’s chief financial of- ficer, Devinder Kumar, tried to put the minds of dialers-in at ease on the

second-quarter conference call. “As far

as

said, “I monitor the capital markets pretty closely and if the need arises, obviously, we’ll access the capital mar- If you think about it, with the cash that we have, we also have ABL [asset-backed revolving credit accom- modation] availability that we put in

place in the late part of 2013 and that’s not all fully tapped out.” In his expressed optimism con- cerning the hospitality of the credit markets, Kumar recalled the words of Chicago’s Alderman Sposato. Willing fingers plugging leaky dikes is all very well in the bullish portion of the credit cycle. The gentlemen will find that the fingers are hard to come by in the bearish portion. It seems to us—to re- peat—that we’re in it. It’s no news at all that the PC busi- ness is in long-term decline. What is new is the bond market’s recognition

of that fact. The stock market has

long been fully briefed. AMD com- mon is heavily shorted and hugely ex- pensive to borrow (a trader we know was offered 25,000 shares at a cost

of 16 ½% of the share price per an-

num). It trades at around $2 a piece, lurching higher in response to peri- odic recalls of borrowed shares. Alto- gether, some 24% of the company’s 633 million-share float is sold short. On July 28, Moody’s slashed the rat-

ing on four issues of senior unsecured AMD notes to Caa2 from Caa1, the new rating being four notches from

C, which means finis. “As a result of

projected operating losses,” said the agency, “credit metrics will be very weak, with negative EBITDA relative

the financing is

,” he

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Bonds tag along $50 $50 AMD stock price 40 40 30 30 20 August 4,
Bonds tag along
$50
$50
AMD stock price
40
40
30
30
20
August 4, 2015:
20
$2.13
10
10
0
0
1/95
1/97
1/99
1/01
1/03
1/05
1/07
1/09
1/11
1/13
1/15
price per share
price per share

source: The Bloomberg

to $2.5 billion of adjusted debt, and negative free cash flow.” The senior unsecured AMD 7s of 2024, which had changed hands at 85,

a price to yield 9.5%, as recently as

July 2, are quoted at 68 today, a price to yield 13%. The problems that have lately come to light were not previ- ously in the dark—certainly, not when the 7s came to market in June 2014. As those securities flew out the window and into the hands of yield-famished investors at 100 cents on the dollar, the AMD share price was quoted at just $4.

Here was a broad hint that something was wrong. Whatever the bull case on the stock might have been—something

to do with intellectual property assets?

With a hoped-for upturn in the PC market? A potential takeover—the bull case on the bonds was as modest as the

bull case for a corporate debt security has ever been. To wit: “If all goes well, you’ll recover your principal at maturity while earning the coupon in the inter- im. The upside is par. The downside is default with uncertain recovery.” At least, that was the pre-ZIRP value proposition. Radical monetary policy transformed the arithmetic.

A 7% yield to a 10-year maturity is a

king’s ransom compared to the Trea- sury’s 2%-and-something 10-year pa- per. Then, too, the argument goes—or went—the Fed would lift the funds rate most deliberately, if at all. Creditors have reached for yield as long as there have been yields to reach for. The reaching has been more ac-

robatic this time around because the need has been greater. The need must explain Chicago’s otherwise inexplica- ble success last month in placing $743 million of 7.55% taxable general obliga- tion bonds due 2042 and $346 million of 5.5% general obligation tax-exempt bonds due 2039. The creditworthiness of the issuer in no way accounts for it. Our friend Michael Lewitt, propri- etor of the monthly Credit Strategist, points out that a July 24 court decision by the Cook County Circuit Court scuttles plans of Mayor Rahm Eman- uel to restructure the city’s pension funds in such a way as to postpone

their inevitable insolvency. If, as the court held, benefits once promised but now unpayable cannot be rene- gotiated, bondholders may be out in

the cold. “The negative outlook,” said Moody’s in May when downgrading America’s third-largest city to junk, “also reflects our expectation that

Chicago’s credit quality will weaken as unfunded liabilities of the municipal, laborer, police and fire pension plans grow and exert increased pressure on

the city’s operating budget.” Lewitt: “Why any responsible man- ager would think that an 8% taxable

yield on a 27-year bond or a 5.7% tax- exempt yield on a 24-year bond is suf- ficient compensation for the risk of owning Chicago’s debt is a total mys-

tery, particularly in view of the recent experience of those who rushed to buy Puerto Rico’s 8% Series A general obli- gation bonds due 2035 in March 2014. Those bonds are guaranteed tickets to the boneyard.” Something is changing, as the BAML analysts observe. Caa spreads widened in the first four months of the year, even as the broad junk market rallied. Not that such cracks have yet defaced much of the surface area of the spec- ulative-grade market—“as recently as a week ago, the ex-commodity por- tion of high yield was still yielding less than 6%.” Team BAML adds that the evident complacency is no bullish sign but a worrying one, “just a delay of the inevitable and an indication that there is room to move lower in price.” They

bond price Junkland gets the memo 105 105 AMD 7s of July 1, 2024 95
bond price
Junkland gets the memo
105
105
AMD 7s of July 1, 2024
95
95
85
85
75
75
65
65
55
55
9/11/14
12/15
3/11/15
6/11
7/30
bond price

source: The Bloomberg

GRANT’S / AUGUST 7, 2015 5

compensation in dollars per hour

point a finger of blame to where, in this publication’s estimate, it ought to be pointed: “By inducing reach-for-yield behavior, the Fed may have incentiv- ized the market to overlook funda- mentals, creating sensitivity to those metrics when macro liquidity begins to dry up. Given the near doubling in the size of the market since 2008, we think crowded trades are likely to unwind, meaning both high yield as an asset class as well as crowded sectors.” As the market has grown larger, fail- ure has become rarer. Over the past 12 months, according to Moody’s, just 2.3% of the market, measured as a percent of all speculative-grade issu- ers, has defaulted, one of the lowest rates since the start of record keeping in 1970. The narrative just presented would suggest that the default rate is headed much higher—that if it were a stock, you would want to own it. Invited to freshen up his forecast that the next default cycle is right around the corner, Fridson replies that he stands by it. Next year—some time next year—he expects “a multi-year period in which the default rate is at or above the long-term average of 4.6%” to get underway. “I still think it is possible,” Fridson tells Grant’s. “The market right now is saying—by my interpretation— that the default rate will run about 3% over the next 12 months. That gets you into the first half of The Fed may be able to stave that off through continuing Herculean ef- forts, but then again, maybe not. With everything they are doing, maybe we will still see some natural, cyclical economic forces play out.” It happened in Vietnam last year, ac- cording to a July 20 dispatch in The New York Times, when, in the wake of a debt crisis, 78% of registered companies in Ho Chi Minh City went broke. “But the creation of new companies has since gathered pace,” the paper said; “so far, 26% more new companies have been formed this year than in the same period last year.” “‘Weak companies will fail; that’s normal,’ said Tran Anh Tuan, the act- ing president of the Ho Chi Minh City Institute for Development Studies, a government planning agency. ‘They can learn from failure. That’s a good way to develop.’” Over to you, Janet Yellen.

ment rate declines.” Janet Yellen has cited the Daly and Hobijn doctrine in her speeches. From here on, it’s Kalkstein who deserves the plug. The data are the trouble, as he persuasively shows. The Employment Cost Index is a less infor- mative measure of wage and benefit pressures than an alternative govern- ment index called the Employer Costs for Employee Compensation (ECEC). The ECI treats the landscape of the la- bor market as if it were frozen in place. The ECEC treats that landscape as if it were ever changing. The ECEC, which takes more time to calculate than does the ECI, has been rising faster than the ECI. It would seem to deserve at least as much attention as the ECI. Built into the ECI is the assump- tion that the structure of markets has remained as it was in 2013. The ECEC measures the current cost of employee compensation to reflect how, and in what form, the labor market might have evolved. Suppose that recent employ- ment growth happens solely in better paying jobs. The ECEC, picking up on the change, will show a rise in average compensation. The ECI will not because it will capture no such movement toward high-quality work. In the same vein, the ECEC is more likely than the ECI to reflect a migration to lower-paying jobs. Businesses, like the people who work for them, live and breathe and adapt. The second-quarter ECEC is slated for publication on Sept. 10. In the first

economy expands and the unemploy- (Continued on page 8)

How, demands Fred Kalkstein, bro- ker at Janney Montgomery Scott, could the government’s Employment Cost Index for the second quarter have reg- istered the smallest sequential gain in three decades, up by a mere 0.2%. How was it possible in the sixth year of a business expansion during which 12.2 million jobs were created? How can the ECI have risen by just 0.2% when, in the first quarter of the plague year 2009, that very index registered a gain of 0.3%? How is it possible? The Fed seems not to wonder. To explain the ECI-derived data, the mandarins have developed the theory of “pent-up wage cuts.” Employers, so the thinking goes, are loath to re- duce compensation in a slump. Maybe they’re too tenderhearted. But they don’t forget. The cuts they didn’t implement stack up like traffic on the Long Island Expressway. “[T]he accumulated stockpile of pent-up wage cuts remain and must be worked off to put the labor market back in balance,” contend Mary C. Daly and Bart Hobijn of the Federal Reserve Bank of San Francisco. “In response, businesses hold back wage increases and wait for inflation and productivity growth to bring wages closer to their desired level. Since it takes some time to fully exhaust the pool of wage cuts, wage growth remains low even as the

Dueling indices

ECI index level Whom do you believe? $34 135 Employer Costs for Employee Compensation (left
ECI index level
Whom do you believe?
$34
135
Employer Costs for Employee Compensation (left scale)
vs. Employment Cost Index (right scale)
33
130
ECEC
32
125
31
120
ECI
30
115
29
110
28
105
27
100
26
95
25
90
3/05
3/07
3/09
3/11
3/13
6/15

source: Bureau of Labor Statistics

mortgage rate in %

mortgage rate in % 6 GRANT’S / AUGUST 7, 2015 C redit C reation There they

6 GRANT’S / AUGUST 7, 2015

Credit Creation

There they go again 10% U.S. mortgage rates (left scale) v 9 8 7 6
There they go again
10%
U.S. mortgage rates (left scale) v
9
8
7
6
5
4
Bankrate.com U.S.
30-year fixed
3
1/00
1/02
1/04
1/06
1

source: The Bloomberg

Try this

Federal Reserve Balance Sheet

(in millions of dollars)

 

July 29,

July 22,

July 30,

2015

2015

2014

The Fed buys and sells securities… Securities held outright Held under repurchase agreements and lends… Borrowings—net and expands or contracts its other assets… Maiden Lane, float and other assets The grand total of all its assets is:

$4,239,745

$4,244,822

$4,137,038

0

0

0

201

192

245

216,668

216,053

226,498

federal reserve Bank Credit

$4,456,614

$4,461,067

$4,363,781

Foreign central banks also buy, or monetize, governments:

Foreign central bank holdings of Treasurys and agencies $3,327,998 $3,340,353 $3,309,299

European Central Bank Balance Sheet*

(in millions of euros)

 

July 31, 2015

June 26, 2015

July 25, 2014

Gold

€ 364,458

€ 383,966

€ 334,431

Cash and securities

1,400,206

1,279,223

959,215

Loans

543,636

555,596

507,819

Other assets

228,292

233,162

242,847

Total

€ 2,536,592

€ 2,451,947

€ 2,044,312

*totals may not add due to rounding

MOVEMENT OF THE YIELD CURVE

yields 4.0% 4.0% 3.5 3.5 3.0 8/4/15 3.0 5/6/15 2.5 2.5 8/4/14 2.0 2.0 1.5
yields
4.0%
4.0%
3.5
3.5
3.0
8/4/15
3.0
5/6/15
2.5
2.5
8/4/14
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
3 month
6 month
2 year
5 year
10 year
30 year
yields

source: The Bloomberg

Low, low mortgage rates are a double blessing, at least to the would-be house buyer. The first reason is obvious: They make a house more affordable. The sec- ond, as paid-up subscriber Michael Har- kins is wont to observe, is less intuitive. The borrower builds equity faster by pay- ing a low rate than he does a high one. A $100,000, 30-year mortgage will serve as a financial test dummy. At a 4% rate of interest, the mortgagor’s first- year payment comes to $5,729, of which $1,761 is devoted to principal amor- tization. Compare and contrast a 10% mortgage rate. One’s first-year payment comes to $10,531, of which just $556 is earmarked for principal amortization. Harkins performs this interest-rate parlor trick for his financially sophisticated din-

ner guests. Most refuse to believe him (check the math).

ZIRP- and QE-powered real-estate bull markets are once again interrupt-

ing the sleep patterns of conscientious central bankers. The functionaries slash

interest rates to induce the kind of infla-

tion they prefer. What they get instead is the kind of inflation that the asset-own-

ing portion of the community prefers. Thus, the central banks of Sweden

and Norway have reduced policy rates to minus 0.35% and 1%, the central banks

of Denmark and Switzerland to an iden- tical negative 0.75%. For one reason or

money multiplier

GRANT’S / AUGUST 7, 2015 7
GRANT’S / AUGUST 7, 2015 7

Cause & effeCt

230 s. house prices (right scale) 210 S&P/Case-Shiller Composite-20 Home Price Index 190 170 150
230
s. house prices (right scale)
210
S&P/Case-Shiller Composite-20
Home Price Index
190
170
150
130
110
Home Mortgage
national avg
/08
1/10
1/12
1/14
7/15 90
index level

at home

another, real estate prices have shot higher. Swedish house prices showed a 13% spike in the 12 months to May. Nor- wegian house prices climbed 6.6% in the 12 months to June. Copenhagen apart- ment prices have soared by 25% in a year. Swiss home prices, according to the UBS Swiss Real Estate Bubble Index, are the toppiest since 1991. What, then, should a central bank governor do? Do not—not—raise inter- est rates: “[R]ough calculations show that the size of rate increase needed to do so might also boost unemployment and push down inflation,” a trio of econ- omists prescribe in a new Federal Re- serve Bank of San Francisco Economic Letter. “Thus, using this type of policy tool may cause the central bank to de- viate significantly from its goals of full employment and price stability.” The Fed would seem to prefer the certainty of job losses after a bubble burst than the possibility of job losses before a bubble becomes inflated. “[W]hile monetary policy may not be quite the right tool for the job, it has one important advantage relative to su- pervision and regulation—namely that it gets in all of the cracks,” former Fed governor Jeremy C. Stein cracked at a St. Louis Fed research symposium in February 2013.

Annualized Rates of Growth

(latest data, weekly or monthly, in percent)

 

3 months

6 months

12 months

Federal Reserve Bank credit Foreign central bank holdings of gov’ts.

0.5%

-0.5%

2.3%

7.0

4.0

1.3

European Central Bank Commercial and industrial loans (June)

31.2

35.4

22.7

10.9

13.0

12.4

Commercial bank credit (June) Asset-backed commercial paper

6.6

8.2

7.7

13.1

9.7

-14.5

Currency

3.0

5.6

6.6

M-1

4.4

8.4

6.4

M-2

5.1

6.5

5.7

Money zero maturity

6.4

7.0

6.4

Reflation/Deflation Watch

 
 

Latest week

Prior week

Year ago

FTSE Xinhua 600 Banks Index Moody’s Industrial Metals Index Silver Oil Soybeans Rogers Int’l Commodity Index Gold (London p.m. fix) CRB raw industrial spot index ECRI Future Inflation Gauge Factory capacity utilization rate CUSIP requests Fed’s reverse repo facility (billions) Grant’s Story Stock Index* *Index=100 as of 7/31/2013 Grant’s Never-Never Index** **Index=100 as of 1/4/2013

13,020.43

14,023.91

8,879.56

1,500.86

1,507.66

2,043.31

$14.75

$14.49

$20.41

$47.12

$48.14

$98.17

$9.81

$9.91

$12.25

2,434.59

2,478.52

3,565.94

$1,098.40

$1,080.80

$1,285.25

448.52

447.20

531.50

(June) 100.5

(May) 101.3

(June) 104.8

(June) 78.4

(May) 78.1

(June) 79.1

(July) 1,741

(June) 1,564

(July) 1,873

132.0

79.4

101.0

103.6

103.9

116.1

180.7

187.6

196.9

EFFECTIVENESS OF THE MONETARY POLICY

M-2 and the monetary base (left scale) vs. the money multiplier (right scale)

$16 10x 12 8 8 6 4 4 0 2 6/04 6/06 6/08 6/10 6/12
$16
10x
12
8
8
6
4
4
0
2
6/04
6/06
6/08
6/10
6/12
6/14 6/15
M-2
monetary base
money multiplier
in $ trillions

world GDP

world GDP

8 GRANT’S / AUGUST 7, 2015

(Continued from page 5)

quarter, the ECEC showed sequential growth of 1.1%; the ECI registered a rise of 0.7%. In the fourth quarter of 2014, the ECEC showed a sequential gain of 2.9%; the ECI registered a rise of 0.5%. Wait till the FOMC finds out. If the ECEC is the better barome- ter of wage and benefit compensation, there are changes afoot in the labor market. Either they will take the form of rising wages (and perhaps of rising prices) or of lower business operating margins. You can pick your poison.

Global verbiage glut

From time to time, Ben S. Bernanke, central banker turned blogger and capi- tal-introduction professional, vouchsafes his latest thoughts on a concept of his own devising, the “global savings glut.” By the former chairman’s telling, an ex- cess of savings in emerging markets is the cause of ultra-low interest rates the world over (it isn’t the Fed’s doing). Could that be true? Yes—or perhaps no. As with the nonstop talk about secular stagnation or a commodity super cycle or the drawdown in international monetary reserves, you start to wonder what the words signify. “Not much,” is the thesis of the essay now in progress. Buying low and selling high is rather the point. So saying, we don’t mean to deny that the emerging world is in a jam or that the difficulties are not traceable to macroeconomic causes. Our focus is

rather on the investment opportunities that angry headlines usually surface. Five discrete investments—two pairs of un- loved “emerging” stocks and a Brazilian corporate bond—are featured below. Each is cheap, each has merit—each had merit even before its price was sawed in half in sympathy with the goings-on in Turkey, Greece, Brazil, Russia, South Africa, Argentina, Co- lombia, China, etc. (India, one of the former so-called BRICs, is a bullish breed apart). The sawing suffices to

show how macroeconomic problems can overwhelm business fundamentals. It turned out that in 2007-08, the only relevant American “fundamental” was the broad mispricing of credit. In 2014, the defining Russian fundamental was the looming bear market in oil (would that we had seen it coming; see, for in- stance, Grant’s, Aug. 8, 2014). Perhaps, in 2015, it’s the long-delayed conse- quences of the suppression of money- market interest rates that will set mar- kets on their ear. Still, cheap business value is a rare com- modity. It warrants a certain tolerance for macroeconomic dislocation. If it weren’t for the dislocation, the value wouldn’t be there for the plucking in such profusion. In Monday’s Financial Times, the CEO of a Brazilian truck manufacturer was quoted as saying, “In my professional life, I’ve al- ready passed through 17 [economic] cri- ses.” He must have been grateful for so many buying opportunities—and for so many reciprocal selling opportunities— even if he didn’t think to mention it.

What goes up

12%

10

8

6

4

2

0

emerging market forex reserves as percent of world GDP

0 emerging market forex reserves as percent of world GDP 12% 10 8 6 4 2

12%

10

8

6

4

2

0

1/95

1/97

1/99

1/01

1/03

1/05

1/07

1/09

1/11

1/13

4/15

source: IMF

What pulled the rug out from under the emerging markets is still a topic of learned macroeconomic debate. Com- modity prices have broken as the dollar has rallied. EM stocks and currencies have plunged. The burden of servicing dollar-denominated debt outside the 50 states is becoming more onerous. These are the symptoms of the problem. What is the cause? Recalling that booms not only precede busts but also cause them, one turns to the People’s Republic. On the upswing, China suppressed the renminbi-dollar exchange by buying dollars. It printed the renminbi with which to do the buy- ing. In consequence, in China, money- supply growth accelerated, interest rates declined, official dollar holdings soared and factory chimneys smoked. Now, the processes are reversing. Of- ficial dollar holdings are dwindling, eco- nomic growth is decelerating, capital is fleeing. Well, capital appears to be flee- ing the People’s Republic. To explain the ambiguity on this point requires a short, instructive detour. The IMF reports that foreign currency reserves held by emerging economies plunged by $533 billion to $7.5 trillion in the 10 months till April. Nothing like it has ever been seen before. It was far and away the steepest decline since the start of record keeping in 1995. One is worried, of course. The data must signify something, they’re so big. And they do signify something. What they signify is how little anyone really knows about the cross-border flows of hot money. That $533 billion is a raw, unpro- cessed datum. It requires adjustment for the changing value of the dollar, against which other currencies are valued, and it requires adjustment for variations in the

composition of international reserves. It happens that the IMF has hard informa- tion on the makeup of only one-third of

international currency reserves. The oth- er two-thirds it must guess about. The uncertainties reduce the careful

analyst to expressing the size of reserve flows not as a single point but as a range of possibilities. In this case, the range

may be expressed as between $533 bil- lion on the high side and $44 billion on the low side. As you could drive a truck

through the difference, you hesitate be- fore saying much more than the not al- together informative, “emerging market

currency reserves have declined.” Irresolution similarly set the tone of a report in Monday’s Financial Times

GRANT’S / AUGUST 7, 2015 9

on supposed capital flight from China:

“Analysts broadly agree that China has experienced capital outflows on an un- precedented scale. But they disagreed about their size, causes and risk to the economy.” Note well: other than “size, causes and risk.” No sense, then, on too great insis- tence on quantitative macroeconomic diagnosis. Some policy errors have cre- ated a deflationary undertow, others an inflationary over lift. The dollar surges, EM currencies buckle. Country-specific, heterogeneous problems have yielded uniform, homogeneous outcomes of one particular kind: Bear markets dot the EM landscape. Records are beginning to fall. Thus, for instance, the Malaysian ring- git and Indonesian rupee have fallen by 16.9% and 12.7% against the dollar in the past year to levels not seen since the end of the Asian financial crisis in 1998. Turbulence mixes badly with lever- age. It is not farfetched to expect some thunderclap of a bankruptcy in the EM world. With regard to China, a Hong Kong-based friend of this publication, asking not to be named, advises colleague Evan Lorenz that China’s fast-growing, $30.5 trillion asset banking system is at risk. “Deposit growth is very weak right now,” our source relates. “Maintaining that growth requires you to take more li- ability risk.” On form, muses Russell Napier, an independent strategist and co-founder of Electronic Research Exchange, down- turns in emerging markets tend not to stop until there’s a major default. Ob- serve, says Napier, how very much like Mahathir Mohamad, prime minister of Malaysia during the Asian financial crisis, the president of Turkey, Recep Tayyip Erdogan, is beginning to sound with his railing against the “interest rate lobby” and his accusations of “treason against this nation.” “If Turkey imposed exchange con- trols, that is a de facto default,” Napier says. “Turkey is one of the biggest com- ponents of the emerging markets debt index. I think it would be tantamount to the BNP Paribas closing those three mortgage-backed securities funds in 2007. People would realize the lack of liquidity and the higher credit risk and things would come to a halt very quickly. We’ve lent money to emerging markets before, but we’ve never lent it to them in this form of bonds, which are theoreti- cally liquid through open-ended funds. It is the holding of them through open-end-

Not in the plan 75 $120 ruble exchange rate (left scale) vs. price of oil
Not in the plan
75
$120
ruble exchange rate (left scale) vs. price of oil (right scale)
70
110
65
100
rubles per dollar
60
90
55
80
50
70
price per barrel
45
60
price of
40
Brent crude
50
per barrel
35
40
8/1/14
10/3
12/5
2/6/15
4/3
6/5
8/3
rubles per dollar

source: The Bloomberg

ed funds which is dangerous if someone does impose capital controls or if some- one defaults.” So there’s no guarantee that what’s cheap may not become cheaper. If the point needed proving, the gold-mining stocks would nail it down. They have wasted away to the point that we at Grant’s, their close and loyal friends, hardly recognize them by sight on our brokerage house statement (note for the file: Buy more at the bottom). Then, too, American equity values remain Uber- ized. A sell-off in New York would likely not be seen as a bull market catalyst in Bogota, Sao Paulo or Moscow. Herewith our picks to click (or, in the case of the Russians, to re-click) at some indeterminate date: Avianca Holdings SA, the Colombian airline (AVH is the ticker for the New York-listed American Depos- itory Receipt); Grupo Nutresa SA, a top Colombia-based food distributor, proces- sor and marketer (the peso-denominated common shares are listed in Bogota); the senior debt of General Shopping Brasil S.A., a financially leveraged owner and operator of Brazilian shopping malls; and a pair of Russian equities that may be fa- miliar—perhaps all too familiar—to con- stant readers. They are Sberbank (SBER on the Moscow and London exchange; SBRCY is the American Depository Re- ceipt); and Moscow Exchange (MOEX, listed on itself). One year ago, these pages prophesied that “as tensions subside, so will Russian equities come in for what the comrades used to call ‘rehabilitation.’” Tensions

have not subsided, the oil price has not rallied and the ruble has not recovered. In the past 12 months, Sberbank, Rus- sia’s largest bank, has declined by 41% in dollar terms (it is up 2% in rubles); Mos- cow Exchange has fallen by 31% in dollar terms (it has rallied by 21% in rubles). Each company remains profitable. Each remains value-laden, and each remains a kind of call option on normalcy. We re- main bullish (to declare an interest, your editor owns Sberbank). In picking Russia, this publication failed to pick a winner. Real Russian GDP is on track to sink by 3.4% this year

as the rate of inflation tops 15%, accord- ing to a forecast by the IMF. Sberbank

is a mirror to those circumstances: It has

reported sharply lower net income (down

58% in the first quarter; second-quarter results are due on Aug. 27), higher loan- loss provisioning, rising non-performers (now 3.9% of total loans, up from 3.2%

a year ago) and contracting net inter-

est margins in consequence of a central bank rate that jumped to 17% in Decem- ber from 8% four months earlier; 11% is the current rate. Still and all, the bank

remains profitable. In the first quarter,

it earned 12.5% on equity, down from

the 20%-plus returns generated in 2013 and 2012 but more than respectable in the comparative light of, for instance, J.P. Morgan Chase & Co., which earned 10.2% on equity in the first quarter. Sberbank common is priced at 75% of book value and 6.2 times trailing earnings; the (shrunken) dividend delivers a yield of 0.6%. Sberbank pre-

10 GRANT’S / AUGUST 7, 2015

Perpetuity on sale $120 $120 price of General Shopping 10% senior unsecured perpetuals 110 110
Perpetuity on sale
$120
$120
price of General Shopping 10% senior unsecured perpetuals
110
110
100
100
90
90
80
80
70
70
60
60
50
50
40
40
11/10
11/11
11/12
11/13
11/14
8/4/15
bond price
bond price

source: The Bloomberg

ferred, which confers no voting rights but holds an identical economic inter- est to that of the common, is priced at 53% of book value and 4.5 times earn- ings. It yields 0.9%. “Throughout its post-Soviet history,” observes Boris Zhilin, co-founder and

principal of Armor Capital, “Sberbank has weathered at least two severe storms—in

1998 when Russia defaulted on its sov-

ereign debt following the Asian crisis,

and in 2009 as a result of the Great Re- cession. Despite that, its book value per share in U.S. dollar terms posted a com- pound annual growth rate of 17% from

1997 through the end of 2014 (the ruble

lost about 90% of its value vs. the U.S. dollar throughout this period). In other words, painful upheavals notwithstand- ing, those who held shares of Sberbank did very well, provided a sufficiently long-term investment horizon.” For the grandson, then. Even faster than the ruble exchange rate has fallen, the earnings of Mos- cow Exchange have risen. They leapt by 124% in the first quarter (second- quarter results are due on Aug. 5, the day after we go to press). On the first- quarter call, MOEX’s management laid out a five-year plan to boost growth through initiatives in commodities trading, over-the-counter derivatives clearing, risk management and collat- eral management. Moscow Exchange is priced at 9.8 times trailing net income; the 3.87 ruble- per-share payout delivers a 5.5% dividend yield. J.P. Morgan analyst Alex Kantarov-

ich is projecting a boost in the payout to 6.10 rubles per share in fiscal 2016. Dilma Rousseff’s Brazil is perhaps a more inviting place than Vladimir Pu- tin’s Russia, but that speaks chiefly to the weather. With respect to inflation, the immediate economic outlook and currency depreciation, the two coun- tries are very nearly peas in a pod. Which brings us to the perpetual, 10%, dollar- denominated debt of General Shopping. Quoted at 48 cents on the dollar, the securities yield 20%; at par value, $250 million are outstanding. We come by the General Shopping story through our value-seeking friends

at Explorador Horizon Fund L.P., which manages $300 million and is based in Sao Paulo. General Shopping owns and

operates 16 shopping malls in southeast

Brazil, mostly in the state of Sao Paulo;

the founding family, the Veronezis, own 60% of the stock. The rest trades on the

Brazilian public market. General Shopping is an example of

a good business chained to a bad cur-

rency. Taking in reals, it must pay out

a certain number of dollars. The lo-

cal currency’s plunge in depreciation stresses the balance sheet and intro-

duces the apprehension that partly explains the bargain price of the bonds

(sky high Brazilian interest rates ex- plain the rest). “General Shopping’s B1 senior unsecured debt and corporate

family ratings reflect the good quality of its portfolio with solid margins and high occupancy rate as well as the man- agement team’s experience and suc- cessful track record in development,” judges Moody’s in a June bulletin. The other side of the ratings coin concerns that sinking currency and the interest- rate problems that go with it. The bull story on the General Shop- ping 10s harps first on operations, sec- ond on asset coverage. At year-end 2014, CBRE appraised the value of the assets at $880 million. “If we take all liabili- ties,” Daniel Delabio, Explorador port- folio manager, tells Grant’s, “we’re talk- ing about total debt of $570 million. So still you have $200 million-plus of value in excess of liabilities. The market value of the debt is less than half the value of

pesos per U.S. dollar Monetary turbulence $20 3.100 Avianca share price (left scale) vs. Colombian
pesos per U.S. dollar
Monetary turbulence
$20
3.100
Avianca share price (left scale) vs. Colombian peso (right scale)
18
2,900
pesos per dollar
16
2,700
14
2,500
12
2,300
10
2,100
Avianca Holdings
8
1,900
6
1,700
11/8/13
5/9/14
11/7/14
5/8/15
8/4/15
share price

source: The Bloomberg

GRANT’S / AUGUST 7, 2015 11

the total properties. It’s good value even in a distressed scenario. That is point one. Point two is that we don’t think it is going to restructure or needs to go that route. They are not against the wall to do anything, because cash liquidity is very high. Today, their cash position is 1.5 times earnings before interest, tax- es, depreciation and amortization. And that should be enough to pay interest. Even if they don’t get any new funding, or any new bank loans for the next two years, they should be able to pay princi- pal and interest. “We’re talking about the senior debt,” Delabio goes on. “But they also have subordinated bonds, where they can pay coupons in kind. So we’re talking about a company that has enough EBITDA to- day to pay its cash interest payments but also has the optionality to defer coupons on the subordinated debt, which would be in favor of the senior bonds. So a bond at 48 cents with those dynamics, there is asset coverage, there is liquidity, there is seniority to the subordinated bonds, and you should be able to collect your cou- pons. With time, this should re-rate, and the bond should move up in price.” Acronym is the lingua franca of the EM world. First came the BRICs. They were succeeded in 2013 by the Fragile Five. And now, through the offices of BNP Paribas, come the “PICTS,” signi- fying Peru, Indonesia, Colombia, Turkey and South Africa. As BNP sees the situa- tion, they are a kind of United Nations of financial risk. The intrepid team at Explorador dis- sents from that top-down fatwa. As of June, 18.5% of their fund was appor- tioned to Peru, 13.8% to Colombia. As for the latter, much of what could go wrong already has. Before its price collapsed, oil generated more than half of Colombian export sales. In the past 12 months, the Colombian peso has depreciated by 36%, the third worst performance among the 150 currencies that Bloomberg tracks (Ukraine and Russia edged out Colom- bia in the monetary race to the bottom). The Colombian stock market has fallen by 59% in dollar terms from its Novem- ber 2010 peak. Five years ago, the MSCI Latin American index traded at 15 times the average of 10 years trailing net in- come. It trades at 9.6 times that 10-year trailing average today. Avianca Holdings S.A., the foremost Colombian airline, owns regional airlines in South and Central America. It has sub- sidiaries in Ecuador, El Salvador, Costa

Rica, Peru, Nicaragua and Honduras. Its on-time performance stacks up well against U.S. carriers, indifferently against neighboring ones. Standard & Poor’s rates its debt B-plus for higher-quality junk; in the 12 months to March 31, op- erating income covered interest expense by a slim 1.5 times. The shares are quot- ed at 4.5 times earnings. Avianca is a sum-of-the-parts story, too. On July 13 came word that manage- ment had sold 30% of its LifeMiles B.V. subsidiary, a six million member con- sumer loyalty program, for $343.7 million to Advent International, a private-equity investor. The purchase price valued the whole at more than $1 billion. “So,” says Delabio, referencing Avianca’s overall $1 billion equity market cap, “you’re almost getting the stand-alone airline for free.” Yes, he adds, the oil price implosion has damaged Colombian GDP. It has simul- taneously raised up Avianca. “One-third of Avianca’s costs are tied to oil,” Delabio goes on. “And lower [con- sumer] demand will be offset by lower oil-related expenses. So we see margins actually extending from 6% last year to 7.5% this year, and this is below company guidance. The company is guiding to 8% to 10% margins for the year, so we’re be- ing conservative.” Grupo Nutresa SA, our final EM sub- mission, is a prosperous, conservatively financed, $4.1 billion market-cap food distributor and processor. “The Nestle of Colombia,” a bull might call it. It is an exotic stock: to buy it, an American high net worth individual must execute a local share swap with his or her broker. Read on anyway. Nutresa crystallizes the problem of the good business yoked to a bad currency (and to a problemati- cal macroeconomy). Nutresa processes and distributes cold cuts, biscuits, chocolate, coffee, tea, juice, ice cream and pasta. It is Starbucks’ Colombian coffee vendor. It operates ice cream parlors and hamburger casual res- taurants. It employs 39,000. As Explora- dor does the arithmetic, Nutresa’s food business changes hands at 17.6 times next year’s likely earnings and at 1.5 times book. John Haskell, Explorador’s head of research, reckons that Nutresa trades at a 37% discount to comparable worldwide food companies. Says Haskell: “They have a 61% mar- ket share in Colombia. Their market share comes about because they have been advertising for decades in Colom- bia. Their brand equity provides an in-

tangible asset that provides a barrier to entry. They also have an incredibly dense distribution network. They have 100,000 individual partners with over one million points of sale. They’re not only in Colom- bia; they’re also across Latin . If I were Nestle and looking to enter Colombia or expand my market share, I would think seriously about what it would take to replicate what Nutresa has built up over decades.” On Tuesday, Dennis Lockhart, presi- dent of the Federal Reserve Bank of At- lanta, rattled the world when he uttered the not altogether novel words that the Fed may raise the funds rate. When the monetary dust finally does settle, Nutre- sa and its ilk will still be standing—they might be even cheaper.

®
®

James Grant, Editor Ruth Hlavacek, Copy Editor Evan Lorenz, CFA, Analyst David Peligal, Analyst Harrison Waddill, Analyst Hank Blaustein, Illustrator John McCarthy, Art Director Eric I. Whitehead, Controller

Delzoria Coleman, Circulation Manager John D’Alberto, Sales & Marketing

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mortgage rate in %

mortgage rate in % ® V o l . 3 3 , N o . 1

®

mortgage rate in % ® V o l . 3 3 , N o . 1

Vol. 33, No. 16d-ctr

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AUGUST 7, 2015

We have broken out the centerfold story for your reading comfort. No broken headlines across pages any longer.

Try this at home

Low, low mortgage rates are a double blessing, at least to the would-be house buyer. The first reason is obvious: They make a house more affordable. The sec- ond, as paid-up subscriber Michael Har- kins is wont to observe, is less intuitive. The borrower builds equity faster by pay- ing a low rate than he does a high one. A $100,000, 30-year mortgage will serve as a financial test dummy. At a 4% rate of interest, the mortgagor’s first- year payment comes to $5,729, of which $1,761 is devoted to principal amor- tization. Compare and contrast a 10% mortgage rate. One’s first-year payment comes to $10,531, of which just $556 is earmarked for principal amortization. Harkins performs this interest-rate parlor trick for his financially sophisticated din- ner guests. Most refuse to believe him (check the math). ZIRP- and QE-powered real-estate bull markets are once again interrupt- ing the sleep patterns of conscientious central bankers. The functionaries slash interest rates to induce the kind of infla- tion they prefer. What they get instead is the kind of inflation that the asset-own- ing portion of the community prefers. Thus, the central banks of Sweden and Norway have reduced policy rates to minus 0.35% and 1%, the central banks of Denmark and Switzerland to an iden- tical negative 0.75%. For one reason or another, real estate prices have shot high- er. Swedish house prices showed a 13% spike in the 12 months to May. Norwe- gian house prices climbed 6.6% in the 12

months to June. Copenhagen apartment prices have soared by 25% in a year. Swiss home prices, according to the UBS Swiss Real Estate Bubble Index, are the toppi- est since 1991. What, then, should a central bank governor do? Do not—not—raise inter- est rates: “[R]ough calculations show that the size of rate increase needed to do so might also boost unemployment and push down inflation,” a trio of econ- omists prescribe in a new Federal Re- serve Bank of San Francisco Economic Letter. “Thus, using this type of policy tool may cause the central bank to devi-

ate significantly from its goals of full em- ployment and price stability.” The Fed would seem to prefer the certainty of job losses after a bubble burst than the possibility of job losses before a bubble becomes inflated. “[W]hile monetary policy may not be quite the right tool for the job, it has one important advantage relative to su- pervision and regulation—namely that it gets in all of the cracks,” former Fed governor Jeremy C. Stein cracked at a St. Louis Fed research symposium in February 2013.

index level There they go again 10% 230 U.S. mortgage rates (left scale) vs. house
index level
There they go again
10%
230
U.S. mortgage rates (left scale) vs. house prices (right scale)
9
210
8
S&P/Case-Shiller Composite-20
Home Price Index
190
7
170
6
150
5
130
4
110
Bankrate.com U.S. Home Mortgage
30-year fixed national avg
3
1/00
1/02
1/04
1/06
1/08
1/10
1/12
1/14
7/15 90

source: The Bloomberg

Grant’s is Webcasting the Fall 2015 Conference on October 20. Of course, nothing’s better than

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