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April Review: Shares Creep Up, Earnings Nosedive

Jonathan Rochford

Narrow Road Capital

A generally positive month for risk assets with commodities and high yield credit rocketing, whilst equities mostly eked out gains. Advances in equities were led by Australia (3.3%), with smaller gains for Europe (0.8%) and the US (0.3%) and losses for Japan (-0.6%) and China (-1.9%). The increase in commodity prices was broad led by iron ore (22.6%), US oil (20.4%) and natural gas (11.2%).  Gold (4.9%) and copper (4.3%) also rose. Investment grade credit tightened a little, but it was the big gains in US high yield that standout. The mid-February peak spread of 8.87% is a long way away from the 6.19% spread at April month end.

Quarterly earnings for S&P 500 companies are down 8% year on year and forecasts for future earnings continue to be revised down. This quarter is the worst earnings result since 2009 and yet the index is close to its all-time highs. Combine the two components and you get a price/earnings ratio of 23.9, an elevated level that has historically been followed by falling prices. So who’s buying? Share buybacks have been a strong catalyst this year, but now pensions are also being fingered. It’s obvious that interest rates have had a golden run that can’t be repeated, which means that a standard 60/40 stock/bond portfolio needs higher levels of stock allocation to hit return targets. However, over-allocation to risk assets near the peak creates huge drawdown risks for pension funds and endowments. Australia’s Future Fund is arguably the smartest manager of managers in Australia and has 22.9% of its assets in cash.

A pension fund in the US with 250,000 members has announced average pension cuts of 23% in order to stave off insolvency predicted to arrive by 2025 without this change. Another in the UK has upped contribution rates and reduced the salary basis to contain its deficits.

McKinsey’s report on long term return expectations is sober reading, with lower inflation, interest rates, company profits and multiple expansion all pointing towards below average investment returns for the next 30 years. It could be worse than what McKinsey has predicted though. It’s possible that the US, Europe and China might have economic outcomes and investment returns that look like Japan’s have for the past 25 years.

April saw the beginning of the quarterly GDP releases. The first reading for US GDP came in at 0.5%, with business spending falling and consumer spending flatlining. Business inventories continue to rise, with auto inventories particularly high. The underlying picture is that despite the headline job growth, consumers aren’t seeing big increases in their pay packets and the little extra they earn is swallowed up by fast rising healthcare and housing costs. As well as consumers shutting their wallets, US businesses are struggling to find revenue growth from export markets, with Europe, Japan and most emerging market economies stagnant or receding. Job cuts in transport and semiconductor companies, industries usually considered bellwethers, aren’t good signs.

High yield debt issuance came roaring back in April after the horrible start to the year. A case in point was Altice, who hit the markets with four issues in two weeks raising a total of US$12 billion. A wall of retail money is flowing into high yield bonds funds and it has to go somewhere. UBS believes we should be worried that an increasing proportion of risky and illiquid high yield debt is being held by mutual funds offering regular redemptions. US banks are providing financing to CLO managers to help them fund their 5% risk retention requirements. The banks would no doubt appreciate the CLO managers buying a few of the loans they have been stuck with this year in return. 

Poor revenue growth and higher debt levels for businesses means debt is growing much faster than EBITDA, pushing the average credit rating of US corporates down to BB. Both of those statistics help explain why the US is seeing a much faster pace of defaults this year. April was a particularly ugly month for defaults with Peabody and SunEdison amongst the big names to seek bankruptcy protection. One bright spot for now is emerging markets, with the emerging market high yield default rate currently lower than the one for the US. There’s even people suggesting that its now a good time to buy to emerging market debt. Fitch and Standard and Poor’s aren’t so optimistic.

The downgrade of Exxon Mobil, leaves Microsoft and Johnson & Johnson as the only US corporates with AAA ratings. The credit spread gap between AAA and AA is a tiny 0.17% and the gap between AAA and BBB is only 1.39%. At this point it simply doesn’t pay to be conservative, why not lever up and buy back some shares when debt is so cheap? Whilst I don’t know when it will happen, there will be a day in the future when the gap widens a lot and there will be a stampede to buy the safest debt available. But with rates so low, can investors deal with the negative real yield while they wait for the cycle to turn?

Long-time market commentator Jim Grant wrote a controversial piece for Time Magazine arguing how to make the US solvent again. It’s not just the explicit debt, deficits and low interest rates he worries about, but the attitude of indifference to all of it. The US Government and its citizens generally don’t care that their financial pathway is wildly unsustainable.  Wall St Week put forward a rebuttal, pointing to the low costs of servicing the debt and assets owned by the government. They believe any problems with the debt should be a long way down the road. There’s always someone who’ll argue that this time is different and they’ll be the right for at least a while. 

Neal Gabler’s article in the Atlantic started discussions about lifestyle expectations and the American middle class. He detailed how he has been existing on credit throughout most of his adult life. He put forward that it would less shameful to disclose you are taking Viagra than it would be to disclose you have debt problems. Megan McArdle noted that there are always excuses for living beyond your means, particularly when children are involved. Zero Hedge criticised Neal for being an upper middle class income earner with an overwhelming sense of entitlement.

I suspect that each generation in the West after those who lived through the Great Depression has worried less about saving. The easy availability of credit has enabled a lifestyle of apparently carefree spending. As a result, many people have forgotten how to live frugally and how to save. They think only to look up at the wealthiest people, ignoring the fact that they are rich compared to billions of people in other countries that live a very meagre lifestyle. Even when looking at those with more, the assets are obvious but the debt used to acquire those things isn’t.

Helping to supply consumers with debt are marketplace and peer to peer lenders. They are still growing strongly but a few growing pains have shown up. Lending Club is being sued by borrowers claiming they were charged usurious interest rates. Three tranches from recently issued securitisations have been put on rating watch as arrears are higher than expected. Citigroup has stopped warehousing new loans originated by Prosper.

In a lesson that Australian investors in hybrids might want to consider, a Canadian insurance company opted not to call a long dated bond. The insurer made the decision that the low rate it could pay for the next 30 years was too good to let go of. As a result, prices of the bond slumped as the call had been considered a fait accompli.

Australia’s economy is looking sluggish with Qantas downgrading its earnings outlook after businesses cut spending on flights. Consumers have been cutting spending as measured by credit card spending. The profits of the top 50 ASX listed companies are the lowest since 2009. There’s a record number of cranes at work in Australian cities, right at the time when the major banks are shutting off lending to foreign buyers who favour buying apartments. It’s possible that some Chinese buyers have used peer to peer platforms and credit cards to fund their down payments.

Last month I wrote about the potential for losses on residential lending to impact Australian banks. This month ABC’s Lateline highlighted the problems with banks fraudulently completing loan applications in order to make it look like borrowers can afford loans that they can’t repay without substantial hardship. Might a royal commission, in the absence of effective regulators, explore this a little further? If not, then the class action lawyers can’t be far away. It would be quite ironic if Slater and Gordon, who need the help of their banks to remain solvent, turned around and hit them with legal action on behalf of thousands of duped borrowers.

Also on the bank misconduct theme, Deutsche Bank admitted it had been part of cabal of banks that rigged the daily gold and silver price fixes. It has agreed to testify against others. Banks are also getting caught up in the Panama papers investigations and could face a round of fines for that. There’s plenty of criminals who have used these structures so there’s both tax evasion and money laundering angles. One thing to remember is that not everyone who has used offshore structures is automatically a criminal. If you live in a dictatorship you’d be crazy not to use offshore structures to protect at least some of your wealth.

China’s GDP officially came in bang on target at 6.7%, although some are arguing that it was really only 6.3%. There’s always anomalies with the Chinese GDP figures, this time 24 out of 28 provinces have reported GDP growth above the national average. This sort of stuff is just missing the forest for the trees, as debt grew at 11.9 times the rate of official GDP growth. You can live the highlife on a credit card for a while, but eventually the bill comes due.

The great wall of Chinese money found a new avenue for speculation this month. Trading volumes in commodity futures for rebar (steel) and iron ore rose to no.1 and no.3 for all commodities. Not surprisingly, prices and volatility for both have spiked. The exchanges have cracked down on this though, charging more for trades and increasing the margin required against these bets. As was the case with stock market interventions, this has brought the prices down somewhat and volumes have fallen substantially.

It’s near impossible to call a peak, but Chinese credit showed a number of key turning points in April. Downgrades are piling up, bond issues were pulled, credit spreads widened and leveraged bets on credit started to unwind. UBS noted that Chinese investors are also starting to realise that state owned entities can default with eight having repayment issues this year. The month of May will bring a wall of bond maturities that will test investors and borrowers. RBS put forward that Chinese bank lending to non-bank financial institutions is a black swan risk. Bloomberg noted that more than 50% of debt rated AAA by Chinese rating agencies doesn’t meet investment grade financial ratios. China’s Finance Minister has accused rating agencies of bias after they lowered their outlook for China. 

The highly acquisitive former property developer now conglomerate Evergrande attracted attention this month for spend ¥10 billion to increase its stake in a bank. Last year it bought a major stake in an insurer. Why the major interest in these areas? Perhaps it is because they are looking for stuffee vehicles to lend to and invest in its property developments. With a CCC+ rating from Standard and Poor’s and a debt to EBITDA ratio of 15 times they’ll need all the help they can get in keeping their lenders at bay. One writer asked if they might be too big to fail.

China’s biggest coal miner plans to cut 100,000 workers and has workers protesting about not being paid. It also has productivity one-third of its peers. George Soros opined this month that China looks like the US did in 2008 and that a hard landing is unavoidable. Whilst he is betting that China will fall, one former money manager for Soros is betting that China will flourish.

China’s companies are becoming a form of shadow bank as their receivables owed have blown out to US$590 billion with the cash conversion cycle at 192 days. The CEO of Credit Suisse is still a China bull saying "we never believed in a hard landing in China. I don't understand the obsession with the slowdown." For those thinking that debt for equity swaps will be a great help for China the former head of a Chinese restructuring company said such swaps should only be used when there is no alternative as it is painful to both shareholders and debtors. His firm had converted debt to equity for 281 state owned entities in 1999 and still had equity in 196 of those as at June 2015.  

Japan’s Central Bank is now a top 10 holder of 90% of Nikkei 225 companies via 55% ownership of all Japanese ETFs. Helicopter money can’t might be just around the corner and Deutsche Bank has laid out a plan for implementation.

Europe reported GDP growth of 0.6% and inflation of -0.2%. The ECB’s bond buyback program is having impact, but whether it is positive is questionable. US parent companies are using European subsidiaries to issue cheap debt with the issuance of 10 year and longer bonds ramping up. Ireland sold 100 year bonds at 2.35% and then Belgium did the same at 2.30%. France sold 50 year bonds at 1.92% but those bonds have fallen to 92, a lesson in duration risk.

Italy and Spain are pushing back on risk weights for government bonds. They are the most exposed to change with Italian and Spanish banks large holders of their nation’s sovereign debt. Banks in Belgium and Denmark have started paying interest on variable rate mortgages and a bank in the Netherlands is paying interest to borrowers that took out Swiss Franc loans. Santander in Germany is offering a two year teaser rate of -1% on personal loans.

Italy’s Atlas fund is taking shape and it looks worse than the acting in a spaghetti western. The plot is pretty simple, if the public won’t support a capital raising by a near insolvent bank than this fund will be the backstop. Healthier banks and insurance companies have been cajoled into providing the capital for this fund, meaning they will be subsidising their poorly performing peers. The main comments about the fund are that it isn’t anywhere near big enough with the €4.25 billion raised dwarfed by the €360 billion in non-performing loans. It’s first deal has been announced and it will use up one-third of the capital raised. Atlas won’t be able to take on the weight of the world, it’s eventually going to shrug and leave Italian banks to deal with their problem loans. On other Italian banking matters, customers are suing banks who encouraged them to borrow to buy bank shares that have since plunged. 

India is also having problems with excessive levels of non-performing loans at its banks. The Supreme Court ordered that investigations be undertaken into why the numbers aren’t adding up and one bank has responded by releasing an overview of the data relating to its problem loan watchlist.

Venezuela is peering over the edge with not just default but anarchy possible. Hyperinflation has gotten so bad that residents are carrying bundles of cash for everyday transactions, making them obvious targets for robbery. They can’t print more notes as they haven’t paid the printers for the last batch. The dam that feeds the hydroelectric generators that provide two-thirds of the nation’s electricity is practically empty. A five day weekend has been called to conserve electricity. Some naïve investors are trying to figure out how much could be recovered if Venezuela defaults and sells assets to repay debt. They should ask lenders to Greece to how that plan has worked out for them. If Venezuela does sell assets after defaulting the money will almost certainly be spent on its citizens, not on international creditors.

Speaking of Greece, its negotiations with the IMF continue to drag on with little progress. The IMF is insisting that Greece legislate measures for further spending cuts if its optimistic forecasts don’t eventuate. Obviously Greece isn’t happy with this as it will likely force them to take action to balance their budget in the not too distant future. Greece should save everyone a lot of time and just default on their debts and deal with the consequences. Only a few European politicians are still pretending that Greece will ever repay its debts.

Argentina returned to bond markets raising US$16.5 billion in bonds ranging from three to thirty years. Bloomberg reviewed the bond prospectus and the key line was “from time to time, the Republic carries out debt-restructuring transactions”. They certainly do, in fact eight times since 1824 and three times in the last 23 years. The Financial Times said investors have amnesia and cited the German Philosopher Hegel that “what experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it.”

The IMF is working overtime, with Angola, Ecuador, Egypt, Iraq, Jordan, Morocco, Sri Lanka and Tunisia looking for bailouts. Saudi Arabia took on its first loan in 15 years, a US$10 billion issue that is seen as a forerunner to future bond issues. Mozambique undertook a distressed exchange then revealed it had more debt than it had disclosed. D-Day looms for Puerto Rico with US$422 million due in early May that the country and Moody’s say it can’t pay. Congo has stopped paying VAT refunds to companies. Standard Chartered might take a US$1 billion loan loss in Indonesia after a judge ruled its loan to a coal miner was invalid.

On the back of all of that some may want to sell everything. I encourage holding higher levels of cash than usual but there are still good value investments available in some areas. This month I was recommending to clients a AAA rated, residential mortgage backed security offered at bank bills +2.75%. It may not sound exciting but the ASX accumulation index has only delivered bank bills +2.69% since its inception in 1980. 


Written by Jonathan Rochford for Narrow Road Capital on April 30, 2016. Comments and criticisms are welcomed and can be sent to

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Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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