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 billion demonstration of the evanescence
of modern business value. Creative destruction may be salutaryit is salutary.
Still and all, destruction costs money.
Creditthe promise to pay moneyis the subject of this unfolding
narrative. Junk bonds are in the foreground, 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 prepared to assign a cause to the downturn
that hasnt fully materialized yet. Six
carefree years of Fed-engineered zeropercent 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 collective fear of losing money, point A.
It ends with the collective fear of not
making money, point B.
Point A finds lenders and borrowers nursing the wounds of the bust
that followed the boom. The penitents resolve to be more careful if
only the market will give them another chance. They do not disavow
leverageit is, after all, the raison
detre 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 corresponding borrower. No more updating their
Facebook status when they ought to
be reading prospectuses, either.
The passing years leach away memories of the bust. Bankruptcy filings

become rarities as prosperity spreads

its blessings. The return of the itch to
speculate means that, for the professional investor, generating gains takes
precedence over avoiding losses. Leverage 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 crystallization 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.

Grants on vacation

Grants Interest Rate Observer, taking its

summer vacation, will resume publication
with the issue dated Sept. 4, 2015.

It sounds like we dont 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
Americas 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, issued 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 reasonably argue that the prospects for U.S.
consumer spending should be pretty
good, given rising employment, growing 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 something 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 persuasive 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 authorswho include Neha Khoda and
Rachna Ramachandranare alert to
the cyclical facts of life.
Reversion to the mean is the foremost cyclical fact. Trees dont 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)

2 GRANTS / AUGUST 7, 2015

(Continued from page 1)

Too quiet out there

15%

Moodys trailing 12-month issuer default rate

for global speculative-grade debt

12

12

1/70

1/75

1/80

1/85

1/90

1/95

1/00

1/05

1/10

default rate

default rate

15%

6/30/15

source: Moodys

to date to little more than 1%has by

no means corrected the manifold excesses that are so much in need of correcting, the authors assert. Not only is
the market not out of the woods, Contopoulos 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 releveraged, somewhat of an anomaly
during periods of decent growth, low
default rates and strong equity markets, 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 mining, and materials. . . . The conclusion
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, commodity, rate, liquidity and, most importantly, 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 returns to skepticism, securities analysis and due diligence. They have

prolonged the commercial lives of marginal businesses that, were they forced
to finance themselves at normal interest rates, might be pushing up daisies
in some reorganization proceeding.
At the spring 2014 Grants Conference, Martin Fridson, now chief investment officer at Lehmann Livian Fridson Advisors, imagined the next wave
of speculative-grade defaults. It would
begin in 2016, he projectedthat 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. Yetremarkablyin 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 halfdecade after it happened. But it did
actually happen, and I think that the
only conceivable explanation is the
Feds extraordinary intervention.
Contopoulos et al. compare 2015 to
1998, a year best remembered, if at all,
for the flameout of Long-Term Capital 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 flattish junk-bond returns. Front and center, too, was the concentrated issuance
of speculative-grade debt in a certain

favored industry. The fair-haired segment of 1998 was telecommunications,

that of the present is, or rather was,
commodities. High yield typically
overbuilds in one industry before realizing stress in that sector, the BAML
report observes.
We would amend that statement.
Credit markets tend broadly to overbuild. They tend especially to overbuild when tempted by governmentally suppressed interest rates. Junk
bond yields beginning with the number five and sovereign debt yields
beginning with the number one-half
of one have proven temptations impossible to resist.
Intimations of trouble in telecom
did not, at first, trouble the broad junk
market. Investors wrote it off as a speculative 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: Were seeing similar 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 example 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 personal computers. As recently as 2012,
the companys 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 income of minus $222 million.
A second AMD division, the enterprise, 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 Grants Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.

GRANTS / AUGUST 7, 2015 3

declining cash and rising inventories.

Revenue declined by 35% vs. the previous 12 months, a plunge that included
a 54% drop-off in the legacy PC segment. Not only is PC demand falling,
but AMD is also taking a smaller share
of what remains. So its quite possible, 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 maturity is March 2019, which, at this rate,
may be closer than it seems.
It falls to management to keep up
a brave faceif not management,
who?and AMDs chief financial officer, Devinder Kumar, tried to put
the minds of dialers-in at ease on the
second-quarter conference call. As far
as the financing is concerned. . . , he
said, I monitor the capital markets
pretty closely and if the need arises,
obviously, well access the capital market. . . . If you think about it, with the
cash that we have, we also have ABL
[asset-backed revolving credit accommodation] availability that we put in
place in the late part of 2013 and thats
not all fully tapped out.
In his expressed optimism concerning the hospitality of the credit
markets, Kumar recalled the words of
Chicagos 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 usto repeatthat were in it.
Its no news at all that the PC business is in long-term decline. What is
new is the bond markets recognition
of that fact. The stock market has
long been fully briefed. AMD common is heavily shorted and hugely expensive to borrow (a trader we know
was offered 25,000 shares at a cost
of 16 % of the share price per annum). It trades at around $2 a piece,
lurching higher in response to periodic recalls of borrowed shares. Altogether, some 24% of the companys
633 million-share float is sold short.
On July 28, Moodys slashed the rating 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

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4 GRANTS / AUGUST 7, 2015

Bonds tag along

$50

AMD stock price

40

40

30

30

August 4, 2015:
$2.13

20

20

10

price per share

price per share

$50

10

1/95

1/97

1/99

1/01

1/03

1/05

1/07

1/09

1/11

1/13

1/15

source: The Bloomberg

robatic this time around because the

need has been greater. The need must
explain Chicagos otherwise inexplicable success last month in placing $743
million of 7.55% taxable general obligation 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, proprietor of the monthly Credit Strategist,
points out that a July 24 court decision
by the Cook County Circuit Court
scuttles plans of Mayor Rahm Emanuel to restructure the citys pension
funds in such a way as to postpone

bond price

105

Junkland gets the memo

105

AMD 7s of July 1, 2024

95

95

85

85

75

75

65

65

55

9/11/14

source: The Bloomberg

12/15

3/11/15

6/11

55

7/30

bond price

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 previously in the darkcertainly, 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 beensomething
to do with intellectual property assets?
With a hoped-for upturn in the PC
market? A potential takeoverthe 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,
youll recover your principal at maturity
while earning the coupon in the interim. 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
kings ransom compared to the Treasurys 2%-and-something 10-year paper. Then, too, the argument goesor
wentthe 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-

their inevitable insolvency. If, as the

court held, benefits once promised
but now unpayable cannot be renegotiated, bondholders may be out in
the cold. The negative outlook, said
Moodys in May when downgrading
Americas third-largest city to junk,
also reflects our expectation that
Chicagos credit quality will weaken as
unfunded liabilities of the municipal,
laborer, police and fire pension plans
grow and exert increased pressure on
the citys operating budget.
Lewitt: Why any responsible manager would think that an 8% taxable
yield on a 27-year bond or a 5.7% taxexempt yield on a 24-year bond is sufficient compensation for the risk of
owning Chicagos debt is a total mystery, particularly in view of the recent
experience of those who rushed to buy
Puerto Ricos 8% Series A general obligation 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 speculative-grade marketas recently
as a week ago, the ex-commodity portion 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

GRANTS / AUGUST 7, 2015 5

Dueling indices
How, demands Fred Kalkstein, broker at Janney Montgomery Scott, could
the governments Employment Cost
Index for the second quarter have registered 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 reduce compensation in a slump. Maybe
theyre too tenderhearted. But they
dont forget. The cuts they didnt
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
economy expands and the unemploy$34
33

ment rate declines. Janet Yellen has

cited the Daly and Hobijn doctrine in
her speeches.
From here on, its Kalkstein who
deserves the plug. The data are the
trouble, as he persuasively shows. The
Employment Cost Index is a less informative measure of wage and benefit
pressures than an alternative government index called the Employer Costs
for Employee Compensation (ECEC).
The ECI treats the landscape of the labor 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 assumption 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 employment 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
(Continued on page 8)

Whom do you believe?

135

Employer Costs for Employee Compensation (left scale)

vs. Employment Cost Index (right scale)

130

compensation in dollars per hour

ECEC
32

125

31

120
ECI

30

115

29

110

28

105

27

100

26

95

25

3/05

3/07

source: Bureau of Labor Statistics

3/09

3/11

3/13

90

6/15

ECI index level

point a finger of blame to where, in this

publications estimate, it ought to be
pointed: By inducing reach-for-yield
behavior, the Fed may have incentivized the market to overlook fundamentals, 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, failure has become rarer. Over the past
12 months, according to Moodys, just
2.3% of the market, measured as a
percent of all speculative-grade issuers, 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 higherthat 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 yearsome time
next yearhe 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 Grants. The market right now
is sayingby my interpretation
that the default rate will run about
3% over the next 12 months. That
gets you into the first half of 2016. .
. . The Fed may be able to stave that
off through continuing Herculean efforts, 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, according 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; thats
normal, said Tran Anh Tuan, the acting president of the Ho Chi Minh City
Institute for Development Studies, a
government planning agency. They
can learn from failure. Thats a good
way to develop.
Over to you, Janet Yellen.

6 GRANTS / AUGUST 7, 2015

Credit Creation
10%

(in millions of dollars)

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

2,536,592

2,451,947

2,044,312

*totals may not add due to rounding

MOVEMENT OF THE YIELD CURVE

4.0%

4.0%

3.5

3.5

3.0
2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

3 month

6 month

source: The Bloomberg

2 year

5 year

10 year

30 year

0.0

yields

yields

3.0

8/4/15
5/6/15
8/4/14

mortgage rate in %

July 29,
July 22,
July 30,

2015
2015
2014
The Fed buys and sells securities
Securities held outright
$4,239,745 $4,244,822 $4,137,038
Held under repurchase agreements
0
0
0
and lends
Borrowingsnet
201 192 245
and expands or contracts its other assets
Maiden Lane, float and other assets
216,668
216,053
226,498
The grand total of all its assets is:
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

Total

U.S. mortgage rates (left scale) vs

Federal Reserve Balance Sheet

There they go again

7
6
5
4
3

Bankrate.com U.S.
30-year fixed

1/00

1/02

1/04

1/06

source: The Bloomberg

Try this
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 second, as paid-up subscriber Michael Harkins is wont to observe, is less intuitive.
The borrower builds equity faster by paying 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 mortgagors firstyear payment comes to $5,729, of which
$1,761 is devoted to principal amortization. Compare and contrast a 10%
mortgage rate. Ones 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 dinner guests. Most refuse to believe him
(check the math).
ZIRP- and QE-powered real-estate
bull markets are once again interrupting the sleep patterns of conscientious
central bankers. The functionaries slash
interest rates to induce the kind of inflation they prefer. What they get instead is
the kind of inflation that the asset-owning 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 identical negative 0.75%. For one reason or

GRANTS / AUGUST 7, 2015 7

Cause &

s. house prices (right scale)

Effect

230

Annualized Rates of Growth

210
S&P/Case-Shiller Composite-20
Home Price Index

(latest data, weekly or monthly, in percent)

190

150

index level

170

130
110

. Home Mortgage
national avg

1/10

1/12

1/14

90

7/15

at home

3 months 6 months 12 months

0.5%
-0.5%
2.3%
7.0
4.0
1.3
31.2
35.4
22.7
10.9
13.0
12.4
6.6
8.2
7.7
13.1
9.7
-14.5
3.0 5.6 6.6
4.4 8.4 6.4
5.1 6.5 5.7
6.4
7.0
6.4

Reflation/Deflation Watch

Latest week Prior week
FTSE Xinhua 600 Banks Index
13,020.43
14,023.91
MoodysIndustrial Metals Index
1,500.86
1,507.66
Silver
$14.75
$14.49
Oil
$47.12
$48.14
Soybeans
$9.81
$9.91
Rogers Intl Commodity Index
2,434.59
2,478.52
Gold (London p.m. fix)
$1,098.40
$1,080.80
CRB raw industrial spot index
448.52
447.20
ECRI Future Inflation Gauge
(June) 100.5
(May) 101.3
Factory capacity utilization rate
(June) 78.4
(May) 78.1
CUSIP requests
(July) 1,741
(June) 1,564
Feds reverse repo facility (billions)
132.0
79.4
Grants Story Stock Index*
103.6
103.9
*Index=100 as of 7/31/2013
Grants Never-Never Index**
180.7
187.6
**Index=100 as of 1/4/2013

Year ago
8,879.56
2,043.31
$20.41
$98.17
$12.25
3,565.94
$1,285.25
531.50
(June) 104.8
(June) 79.1
(July) 1,873
101.0
116.1
196.9

EFFECTIVENESS OF THE MONETARY POLICY

M-2 and the monetary base (left scale) vs. the money multiplier (right scale)
$16

10x

12

6/04

M-2

6/06

6/08

monetary base

6/10

6/12

money multiplier

6/14 6/15

money multiplier

another, real estate prices have shot

higher. Swedish house prices showed a
13% spike in the 12 months to May. Norwegian 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
toppiest since 1991.
What, then, should a central bank
governor do? Do notnotraise interest 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 economists prescribe in a new Federal Reserve Bank of San Francisco Economic
Letter. Thus, using this type of policy
tool may cause the central bank to deviate 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 supervision and regulationnamely 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.

in $ trillions

1/08

Federal Reserve Bank credit
Foreign central bank holdings of govts.
European Central Bank
Commercial and industrial loans (June)
Commercial bank credit (June)
Asset-backed commercial paper
Currency
M-1
M-2
Money zero maturity

8 GRANTS / 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 barometer 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.

rather on the investment opportunities

that angry headlines usually surface. Five
discrete investmentstwo pairs of unloved emerging stocks and a Brazilian
corporate bondare featured below.
Each is cheap, each has meriteach
had merit even before its price was
sawed in half in sympathy with the
goings-on in Turkey, Greece, Brazil,
Russia, South Africa, Argentina, Colombia, 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 instance, Grants, Aug. 8, 2014). Perhaps,
in 2015, its the long-delayed consequences of the suppression of moneymarket interest rates that will set markets on their ear.
Still, cheap business value is a rare commodity. It warrants a certain tolerance for
macroeconomic dislocation. If it werent
for the dislocation, the value wouldnt be
there for the plucking in such profusion.
In Mondays Financial Times, the CEO of a
Brazilian truck manufacturer was quoted
as saying, In my professional life, Ive already passed through 17 [economic] crises. He must have been grateful for so
many buying opportunitiesand for so
many reciprocal selling opportunities
even if he didnt think to mention it.

Global verbiage glut

From time to time, Ben S. Bernanke,
central banker turned blogger and capital-introduction professional, vouchsafes
his latest thoughts on a concept of his
own devising, the global savings glut.
By the former chairmans telling, an excess of savings in emerging markets is the
cause of ultra-low interest rates the world
over (it isnt the Feds doing). Could that
be true? Yesor 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 dont mean to
deny that the emerging world is in a jam
or that the difficulties are not traceable
to macroeconomic causes. Our focus is

What goes up...

12%

emerging market forex reserves as percent of world GDP

10

10

1/95

1/97

source: IMF

1/99

1/01

1/03

1/05

1/07

1/09

1/11

1/13

4/15

world GDP

world GDP

12%

What pulled the rug out from under

the emerging markets is still a topic of
learned macroeconomic debate. Commodity 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 Peoples Republic. On the upswing,
China suppressed the renminbi-dollar
exchange by buying dollars. It printed
the renminbi with which to do the buying. In consequence, in China, moneysupply growth accelerated, interest rates
declined, official dollar holdings soared
and factory chimneys smoked.
Now, the processes are reversing. Official dollar holdings are dwindling, economic growth is decelerating, capital is
fleeing. Well, capital appears to be fleeing the Peoples 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, theyre 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, unprocessed 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 information on the makeup of only one-third of
international currency reserves. The other 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 billion on the high side and $44 billion on
the low side. As you could drive a truck
through the difference, you hesitate before saying much more than the not altogether informative, emerging market
currency reserves have declined.
Irresolution similarly set the tone
of a report in Mondays Financial Times

GRANTS / AUGUST 7, 2015 9

75

Not in the plan

ruble exchange rate (left scale) vs. price of oil (right scale)

$120

70

110

rubles per dollar

65

100

rubles per dollar

60

90

55

80

50

70

45

60
price of
Brent crude
per barrel

40
35

8/1/14

10/3

12/5

2/6/15

4/3

6/5

price per barrel

on supposed capital flight from China:

Analysts broadly agree that China has
experienced capital outflows on an unprecedented 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 insistence on quantitative macroeconomic
diagnosis. Some policy errors have created 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 ringgit 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 leverage. 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 Chinas 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 liability risk.
On form, muses Russell Napier, an
independent strategist and co-founder
of Electronic Research Exchange, downturns in emerging markets tend not to
stop until theres a major default. Observe, 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 controls, that is a de facto default, Napier
says. Turkey is one of the biggest components 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.
Weve lent money to emerging markets
before, but weve never lent it to them
in this form of bonds, which are theoretically liquid through open-ended funds. It
is the holding of them through open-end-

50

8/3

40

source: The Bloomberg

ed funds which is dangerous if someone

does impose capital controls or if someone defaults.
So theres no guarantee that whats
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
Grants, 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 Uberized. 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 Depository Receipt); Grupo Nutresa SA, a top
Colombia-based food distributor, processor 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 familiarperhaps all too familiarto constant readers. They are Sberbank (SBER
on the Moscow and London exchange;
SBRCY is the American Depository Receipt); 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, Russias largest bank, has declined by 41% in
dollar terms (it is up 2% in rubles); Moscow 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 remain 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%, according 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 loanloss provisioning, rising non-performers
(now 3.9% of total loans, up from 3.2%
a year ago) and contracting net interest margins in consequence of a central
bank rate that jumped to 17% in December 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 GRANTS / AUGUST 7, 2015

Perpetuity on sale

$120

price of General Shopping 10% senior unsecured perpetuals

110

110

100

100

90

90

80

80

70

70

60

60

50

50

40

11/10

11/11

11/12

11/13

bond price

bond price

$120

40

11/14

8/4/15

source: The Bloomberg

ich is projecting a boost in the payout to

6.10 rubles per share in fiscal 2016.
Dilma Rousseffs Brazil is perhaps a
more inviting place than Vladimir Putins Russia, but that speaks chiefly to
the weather. With respect to inflation,
the immediate economic outlook and
currency depreciation, the two countries are very nearly peas in a pod. Which
brings us to the perpetual, 10%, dollardenominated 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
$20

Monetary turbulence
Avianca share price (left scale) vs. Colombian peso (right scale)

18

3.100
2,900

share price

pesos per dollar

16

2,700

14

2,500

12

2,300

10

2,100
Avianca Holdings

8
6

11/8/13

5/9/14

source: The Bloomberg

11/7/14

5/8/15

1,900
1,700

8/4/15

pesos per U.S. dollar

ferred, which confers no voting rights

but holds an identical economic interest to that of the common, is priced at
53% of book value and 4.5 times earnings. 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 stormsin
1998 when Russia defaulted on its sovereign debt following the Asian crisis,
and in 2009 as a result of the Great Recession. Despite that, its book value per
share in U.S. dollar terms posted a compound 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 notwithstanding, 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 Moscow Exchange have risen. They leapt
by 124% in the first quarter (secondquarter results are due on Aug. 5, the
day after we go to press). On the firstquarter call, MOEXs management laid
out a five-year plan to boost growth
through initiatives in commodities
trading, over-the-counter derivatives
clearing, risk management and collateral management.
Moscow Exchange is priced at 9.8
times trailing net income; the 3.87 rubleper-share payout delivers a 5.5% dividend
yield. J.P. Morgan analyst Alex Kantarov-

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 currency. Taking in reals, it must pay out
a certain number of dollars. The local currencys plunge in depreciation
stresses the balance sheet and introduces the apprehension that partly
explains the bargain price of the bonds
(sky high Brazilian interest rates explain the rest). General Shoppings 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 management teams experience and successful track record in development,
judges Moodys in a June bulletin. The
other side of the ratings coin concerns
that sinking currency and the interestrate problems that go with it.
The bull story on the General Shopping 10s harps first on operations, second on asset coverage. At year-end 2014,
CBRE appraised the value of the assets
at $880 million. If we take all liabilities, Daniel Delabio, Explorador portfolio manager, tells Grants, were talking 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

GRANTS / AUGUST 7, 2015 11

the total properties. Its good value even

in a distressed scenario. That is point
one. Point two is that we dont 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, taxes, depreciation and amortization. And
that should be enough to pay interest.
Even if they dont get any new funding,
or any new bank loans for the next two
years, they should be able to pay principal and interest.
Were talking about the senior debt,
Delabio goes on. But they also have
subordinated bonds, where they can pay
coupons in kind. So were talking about
a company that has enough EBITDA today 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 coupons. 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, signifying Peru, Indonesia, Colombia, Turkey
and South Africa. As BNP sees the situation, they are a kind of United Nations of
financial risk.
The intrepid team at Explorador dissents from that top-down fatwa. As of
June, 18.5% of their fund was apportioned 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 Colombia in the monetary race to the bottom).
The Colombian stock market has fallen
by 59% in dollar terms from its November 2010 peak. Five years ago, the MSCI
Latin American index traded at 15 times
the average of 10 years trailing net income. 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 subsidiaries 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 & Poors
rates its debt B-plus for higher-quality
junk; in the 12 months to March 31, operating income covered interest expense
by a slim 1.5 times. The shares are quoted at 4.5 times earnings.
Avianca is a sum-of-the-parts story,
too. On July 13 came word that management had sold 30% of its LifeMiles B.V.
subsidiary, a six million member consumer 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 Aviancas overall $1
billion equity market cap, youre almost
getting the stand-alone airline for free.
Yes, he adds, the oil price implosion has
damaged Colombian GDP. It has simultaneously raised up Avianca.
One-third of Aviancas costs are tied
to oil, Delabio goes on. And lower [consumer] 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 were being conservative.
Grupo Nutresa SA, our final EM submission, 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 problematical 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 restaurants. It employs 39,000. As Explorador does the arithmetic, Nutresas food
business changes hands at 17.6 times
next years likely earnings and at 1.5
times book. John Haskell, Exploradors
head of research, reckons that Nutresa
trades at a 37% discount to comparable
worldwide food companies.
Says Haskell: They have a 61% market share in Colombia. Their market
share comes about because they have
been advertising for decades in Colombia. 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. Theyre not only in Colombia; theyre also across Latin America. . .
. 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, president of the Federal Reserve Bank of Atlanta, 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, Nutresa and its ilk will still be standingthey
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 DAlberto, Sales & Marketing
Grants is published every other Friday, 24 times a
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Vol. 33, No. 16d-ctr

AUGUST 7, 2015

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

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

Try this at home

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 toppiest since 1991.
What, then, should a central bank
governor do? Do notnotraise interest 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 economists prescribe in a new Federal Reserve Bank of San Francisco Economic
Letter. Thus, using this type of policy
tool may cause the central bank to devi-

10%

ate 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 supervision and regulationnamely 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.

There they go again

U.S. mortgage rates (left scale) vs. house prices (right scale)

210
S&P/Case-Shiller Composite-20
Home Price Index

8
mortgage rate in %

230

190

170

150

130

4
3

110

Bankrate.com U.S. Home Mortgage

30-year fixed national avg

1/00

1/02

1/04

source: The Bloomberg

1/06

1/08

1/10

1/12

1/14

90

7/15

index level

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 second, as paid-up subscriber Michael Harkins is wont to observe, is less intuitive.
The borrower builds equity faster by paying 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 mortgagors firstyear payment comes to $5,729, of which
$1,761 is devoted to principal amortization. Compare and contrast a 10%
mortgage rate. Ones 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 dinner guests. Most refuse to believe him
(check the math).
ZIRP- and QE-powered real-estate
bull markets are once again interrupting the sleep patterns of conscientious
central bankers. The functionaries slash
interest rates to induce the kind of inflation they prefer. What they get instead is
the kind of inflation that the asset-owning 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 identical negative 0.75%. For one reason or
another, real estate prices have shot higher. Swedish house prices showed a 13%
spike in the 12 months to May. Norwegian house prices climbed 6.6% in the 12

Grants is Webcasting the

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