Friday 28 February 2020

Where are Treasury yields going from here?

Yields have cratered this week on *fears* of the Coronavirus, which had killed a total of 2800 Chinese (about 2 weeks worth of road traffic fatalities in China). 

The virus will be less contagious in April as the temperatures warm up, but I accept its likely to spread more before then. 

Overall it is a narrative, the real story is that risk assets were inflated and the real economy has been slowing to near recession levels for months, hence low bond yields and Corona disruption is just the final straw for the slowdown/ recession scare in H1-2020

TSYs started rallying the moment the Fed stopped growing its balance sheet in the new year

I think the Fed probably does a 50bps and 25bps cut in the next two meetings, probably in that order and 10yr Treasury yields bottom in the 2nd week of April at perhaps 75-85bps

And from that level, given the 'MMT politics' they are an absolutely terrible medium term investment

Question is what will be the good investments?
  • High div yield, low multiple, high quality, low ESG score US extractive industry and smoke stack stocks, some have a 6% yield already, but I think can fall more first
  • Distressed EM sov debt
  • GARP EM equity in the better EM countries
  • Dislocated credit. So if spreads blow out, then buy them as a mean reversion trade
  • If EU agree a fiscal pact then I would look in the EU
  • UK GARP names, I have been told UK plc names outside the index are lowly valued
  • Gold
  • Structured bonds paying curve steepness, coupons like 2-10 spread x4 or 5-30 spread x 8 , as the US curve should steepen when the market realises the Fed is going to stay loose as nominal GDP rises
  • Areas of private markets that are genuinely short of capital and not swamped with MBAs brandishing large cheque books, so usually any asset class that has just been through a downturn or cant be leveraged 10x

Wednesday 26 February 2020

US moves to a net oil export position

US oil production has ground higher and products supplied slipped in the last few months & the US has moved to now a fairly consistent (small so far) net oil exporter. Demand in the US is essentially flat for 20 years now.

Question is who can the US take export market share off over the next few years?

Iran and Vene have already been 'whacked' and if anything Vene's production will climb from here.

If there is no obvious new sanctions candidate, it will have to be delivered by low market prices or OPEC voluntarily surrendering production share.

With Permian marginal producers being long run viable in the $50s range, GCC will have to fiscally consolidate over the next few years.

Tuesday 25 February 2020

Has Private Equity LBO'd the Hotel California?

According to this chart from Bain's 2020 LBO study, there seems to be about 2.5-3x as many LBO deal entries than exits in this cycle? 

For example in 2010-2012 there were around 3,000 deals per year, but in the last 4 years exits were only about 1,000-1,250. 

While the exit value of the sucessful deals seems to be about double what was invested, the question also arises of what happened to the other deals that haven't been exited after 5-10 years? 

Bain found that out of the successfully exited deals, 71% failed to meet the margin improvement targeted when the deal was entered into - and this has been during an economic recovery period and only covering exited deals. 

If after 5-10 years, only about 40% of deals are being exited and most of them were behind target, what has happened to the others? After all, this cycle has been the longest and most accommodating ever for US corporates. 

Meanwhile, in terms of the current market environment and outlook, we know that with record amounts of capital being raised from LP's, the last two years' US LBO's have been done at all time record valuations. 

According to S&P, 2018 and 2019 have seen average US LBO multiples of over 11x EBITDA (which means that half of all deals were done above 11x), with Europe only slightly behind. 

According to Bain, 10-year returns of US LBO's have been similar to the S&P index return, despite LBO companies being small to mid-cap in size and highly leveraged. 

This suggests there is no wholesale inefficiency in the LBO's and, in fact, the LBO sector is probably overcapitalized. 

The sources of return on exited deals also don't suggest any great value add by the GP's and instead highlight the dependency on margin levels and multiples.

Additionally, if only about 40% of the older deals are realized, it might raise questions on what valuations are being used on the remaining (struggling?) deals, to generate these stated IRR's.

We know the best vintages are done at 8-9x depressed EBITDA following a downturn, not at >11x on falling, late cycle EBITDA. 

To finance these record multiples, the GP's have arranged deals with ~5.5x EBITDA from senior loans (aka leveraged loans) and the balance, another ~5.5x, from equity. 

So these LBO financing structures and return outlooks are underpinned by a combination of corporate margins and valuation multiples. But unfortunately US margins are in the process of falling, as they always do late cycle, until there is a recession. 

Longer run average after tax profits as a percent of GDP are 5-7% vs 8.7% in Q3 2019. So circa 5% after a downturn and 7% after a growth cycle. If US profits fell to the middle of that range, 6% from 8.7% in Q3 19, profits would fall 41%. 

EDITDA is not as sensitive as after tax profits, but lets assume a 41% profit drop equates to roughly a 30% EBITDA drop for an average LBO company. 

Let's assume a recent LBO with $1 of EBITDA was done at $11 enterprise value, financed with a $5.50 senior loan and $5.50 of equity. Then after a downturn the loan market is only willing to finance LBOs at 8.5x EBITDA. 

Using the $1 of current EBITDA, this drops to 70c. At 8.5x the 70c EBITDA the company is worth just $5.95. But the senior debt was $5.50, so the equity residual has fallen to just 45c, vs the original LP commitment of $5.50; that's over a 90% loss of equity driven by a fall in margins and a fall in mulitples. 

So you would assume this would breach loan covenants and the deal would be toast?

But here is where it gets more interesting. LBO GP's are judged, in part, on how many deals go to zero. So if a company's business has not blown up and the issue is more the amount of debt/ EBITDA, then the GP's have an huge incentive to keep a bad deal alive. 

Over 5-10 years, as nominal GDP grows, most companies should see substantial revenue and therefore EBITDA growth, so by keeping a bad deal alive, even if it involves drip feeding more equity in after a downturn, it keeps management fees coming to the GP, a positive carry option for the GP on a recovery and avoids difficult conversations with LPs, but all at the cost of the fund IRR and liquidity to the LP.

Once an LP commits to a new private equity fund, during the investment period they pretty much can't get out of the capital calls and then they are dependent on when the GP chooses to exit investments, years later. 

So to abridge the famous song;

Welcome to the Hotel California
Such a lovely place (such a lovely place)...

...You can check out any time you like,
But you can never leave!'

Monday 24 February 2020

The Bond market calls out for more rate cuts from the Fed

The US 10 yr yield has never closed a month lower than this and is within about 4bps of the all time lows in 2016 

I think the environment echoes the late 60s and 70s where the Fed was forced to go through several hiking and cutting cycles to try and balance growth, employment and inflation. 

The bond market is clearly saying cut 2-3 times. Fed funds is pricing about 1% EFFR by the end of the year now.

The 60s and 70s show the outlook for equities is very dependent on the path of profits. A 5-10% fall in profits would be treated badly, while resilient profits or a rebound should be welcomed by investors.

Was the economic bounce since October just a dream?

Was the risk rally/ supposed economic bounce since October all a dream? 

...while the rising continuing claims, falling C&I loans, weakening corp margins, rising inventory liquidation, private sector contribution to Q4 GDP of almost zero, reinverting bond curve this year, they all told the real story, which is that the US is nearly in a recession 

Despite 1.5% rates and a $1Tn plus fiscal deficit We are 5 weeks from the start of Q2, which would be about when a conspiracy theorist would expect the Fed to dump the equity market in order to hurt Trump's reelection campaign/ economic credibility.

Thursday 6 February 2020

Is Venezuela about to get caught up in Trump's 'Fight Against Socialism' election campaign?

As a recap, I had previously speculated that a Maduro in power for the long haul would have to turn to the Chinese and Russians to make it work and would probably need to restructure the debt, into say a 'Dim sum bond' strip.

The bonds don't seem to have really moved since, the EMBI+ ETF has sold out of most of its sovereign exposure and has just $20m of market value left in mostly PDVSA bonds. Last April it had per its financial statements $639m in par, vs $248m par now, so a 61% reduction. They have also reduced the October 2019 holding by 44%. Given the remaining bonds only have a market value of $20m, most of the overhang from the EMBI+ ETF has gone. 

If we take that as a proxy for foreign institutional drip feed into the market, then most, but not all, of it has happened.

Long term I think the bonds are cheap, the issue is near term and intermediate term catalysts.

Longer term, as discussed in the prior article, Maduro staying in power, relaxing price controls, allowing some dollarisation, attracting some new investment, seeing some economic improvements and giving control of the oil fields to foreign oil companies is one possibility.

If PDVSA bring in foreign oil companies, then the bond holders can sue to intercept the royalty/ production sharing payments, if they don't restructure the bonds. So at some point it would be easier to restructure. Although it would be complicated and leave most US held bonds as defaulted holdouts unless sanctions were relaxed.

Then there is the short term. Are we at the bottom?

Trump's 'Fight Against Socialism' re-election campaign

We know Bernie Sanders is almost certainly going to win the Democrat nomination this time. He will be running on a 'progressive, socialist/ social democrat' campaign. 

Trump will run on a freedom, 'American values', capitalism, jobs and economy platform.

I saw this article today following Juan Guaido being praised by Trump in his State of the Union speech. Specifically:

"The senior administration official also described “good momentum” since Maduro’s party failed to wrest control of the national assembly from Guaido last month, and said there would be some “impactful measures” within the next 30 days to further cripple Maduro’s rule.

The only possible topic up for negotiation with Maduro’s government was a discussion of “certain guarantees” upon his exit, the person added." 

So question is what do they plan? They will likely to be fighting Bernie in the election campaign in Q2 and Q3. They could dovetail 'further actions' against Vene with a generalised 'Fighting Against Socialism and for American Values' campaign platform.

The main effective lever they have, but haven't pulled yet, would be to discretely coordinate army and police deserters in Colombia or Brazil and then support them to cross the border. So far neither Colombia or Brazil have supported this option. In my opinion that would lead to a relatively quick and, in the scheme of these things, peaceful transition to a democratic country that enters a recovery programme. Another option would be a military coup, but only the CIA would know how viable that is at the moment.

I'm not sure why Trump hasn't pulled this lever yet, apart him his general aversion to conflict, we know John Bolton and the CIA/ Military have offered such options already.

Trump, with respect to dealing with Iran, only signed off on kinetic action, and that was only one targetted strike against Qassem Soleimani, after Iran killed US personnel and Soleimani was planning more attacks. Maduro hasnt killed or to my knowledge threatened any US citizens. So perhaps Trump's hurdle for authorising direct intervention is much higher than where the current situation is.

I think if the US policy starts to become interventionist, then you see the final leg down to 5,6,7c or so, but as the conflict is short lived and people start to see a positive outcome the bonds will be back in the 20s as the path forwards is cleared up.

Clearly I would personally support this democratic outcome, but the reality is, unless an action like this is taken, I don't see Maduro leaving voluntarily. Further US based administrative controls wont make much of a difference, particularly if the economy starts to recover after dollarisation and regulations being lifted.

The country is only about 30m people, with the oil wealth and a basically sensible socialist/ nationalist government, it should be a growing country. If Maduro manages to engineer a recovery, you never know, perhaps he could even win another election.