Market Thinking

making sense of the narrative

Market Thinking October 2019

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The end of October is effectively year end for many funds and a lot of book squaring is taking place. Sterling has rallied, the dollar index has topped out and the strong outperformance of momentum stocks over value in the first three quarters continues to unwind. Meanwhile bonds have also rolled over as profits are locked in from the tremendous q4 2018 rally. Political noise in terms of Brexit, Trade Wars and impeachment will continue, but the real big political shifts are already underway, notably in the middle east and Eurasia as new gas pipelines make Russia quite literally a power broker between Europe and China. An increasingly isolationist US will start to contemplate a loss of $ hegemony and a new Presidential cycle and even if the threat of Elizabeth Warren style politics remains remote, a backlash against monopolistic profits and the power of business in politics is a threat to a lot of earnings on Wall Street that has not been priced in as yet.

Last month in Market Thinking, we discussed how Sterling, having come off its lows, was no longer responding to the bear narrative about the ‘disaster’ of a so called No Deal Brexit. As we noted at the time, this was not any kind of ‘opinion’ of the likelihood or not of a no deal Brexit, nor of whether indeed it would be as disastrous as the anti Brexit campaigners were claiming. Rather, it was a piece of classic market mechanics; quite simply, everyone who was ever going to buy into the ‘No Deal Disaster therefore sell sterling’ narrative had already done so. The currency had moved to the bottom of the band plus or minus 10% either side of 1.35 in the same way it had moved to the top of the band immediately before the referendum. As it reverses many have been caught out since, as is always the case, the narrative is most compelling just before the turning point – in this case in late August.

October has seen a further unwinding of this extended bear position back towards the mid point. Importantly, from a technical perspective, this move has taken it up through its long term moving average, turning 1.27 from a resistance level into a support level as well as confirming some key Fibonacci retracements  from the sell off that began back in May. Fibonacci models seem to work pretty well for currencies and in the concept of ‘looking at what they are looking at’ can prove to be very useful. The fact that the UK did not in the end Leave the EU on October 31st, but instead will face a General ‘Boris Brexit’ Election on December 12th, will doubtless be used to ‘explain’ movements over the next month as well as justify political positioning, but for investors, this looks to be settling back as ‘noise’.

Part of the same panic out of Sterling was an aggressive move into UK gilts, which in early October almost reached the early September low of 0.41% on the 10 year, but subsequently backed off to end the months nearer to 0.65%. As we noted at the time, this left a large potential ‘value trade’ in UK assets as high yielding UK equities such as are captured by the ETF IUKD LN (full disclosure, I own this in my pension) were at that point yielding over seventeen times the yield available on UK gilts. While they have subsequently rallied, the gap is still enormous in my opinion and certainly reinforces the view that there is no need to buy UK gilts unless the regulator makes you do so. Also that a trailing yield of almost 7% is where unrestricted pension money should be looking to park.

Nor was this just a UK phenomenon, other fixed income similarly gave back some of the year to date gains; US long bonds, Investment Grade Bonds and TIPs all backed up in yields in October, while ETFs offering higher yielding equities all jumped between 5 and 10% on the month. This reflected a combination of stretched valuations in other ares – the momentum stocks that had outperformed the value stocks for example all saw meaningful reversals in October consistent with a rotation from momentum growth into higher yield value.

Meanwhile China, the subject of the usual negativity over the summer, rallied 4% on the Shanghai Composite in the first half of October, before selling off to end the month basically flat on the Shanghai Composite and up 2% on the Shenzhen Composite. At the same time the offshore Yuan rallied. No doubt this was helped by some more positive rhetoric about the trade situation, but this too illustrated an ‘already in the price’ mindset. 

During October, we discussed the cautionary tale that is We Work and its implications for wider markets. We Work is not the first so called unicorn to explode, but it has shone a particularly bright light into some of the darker corners of the Venture Capital, Private Equity and Private Credit nexus, which should ring alarm bells in some of the more ‘staid’ institutions whose asset liability models and risk weighted asset calculations have been driving them into providing their ‘low risk’ capital for these so called alternative structures. Softbank and its subsidiary business the Vision Fund have been exposed as over-optimistic in their appraisal of the value of WeWork as a private company when their latest funding round valuation of $47bn was cut by almost 80% by investors who got a proper look at the accounting metrics being used – a classic case of the wisdom of crowds. Meanwhile the magic fairy dust of ‘tech’ with which the VC/PC/PE had sprinkled what was essentially a traditional office services company (but with free beer) was quickly blown off some of the pipeline of IPOs due to come after (the failed) one from WeWork. This in turn forced the ever ‘optimistic’ Investment Banks, whose valuation models seem to be “take whatever capital has been already invested, multiply it by 20 and then offer to sell 20% in an IPO” to scurry back to their desks, while their colleagues who had lent the likes of Adam Neuman hundreds of millions on the back of the stock they were going to sell ran to hastily check their covenants.

Over in the non traditional end of the fixed income market, the high yield bond market with WeWork’s B- or CCC+ debt that they had expected to be bailed out by ‘the dumb money’ in the Equity markets found their value drop from the excitement of 105 in late August to 80 in mid October and must be nervously eyeing up activist investor Bill Akerman’s call that both debt and equity could be worth zero. So too is the Mortgage Backed Securities market, which found itself with $3bn of loans to real estate that had been issued primarily on the back of WeWork as the main tenant. Part (perhaps the main part) of the problem that We work had as a business was a form of duration mismatch; they had signed up for huge long term leases, around $47bn in total (probably not a coincidence that this was also the last pre IPO valuation number) but only had around $4bn in shorter term ‘assets’. This has implications for the New York and London real estate markets more generally – another area, both through funds and direct investment that the supposedly cautious pension and insurance companies had been adding to in their ‘alternatives’ bucket.

The big issue for financial markets generally in my view therefore is that, just as in 2008, there are piles of leverage all over the place and many of the same people are involved with an expectation that someone else will pick up the bill (ie the equity markets). The vision fund itself is largely funded with high yield debt – owned mostly by Saudi Arabia and Abu Dhabi – and is thus a leverage funded structure taking equity stakes intending to deleverage themselves by selling into the bigger fool equity market at multiples of their in-price. The equity stakes they have been, frankly,  rushing to buy, had not been working out so well even prior to WeWork in a way reminiscent of the eccentricities of the dot com bubble. Meanwhile, the fact that the actual person apparently running the Visionfund is a certain Rajeev Misra (see this bloomberg story ) who was a complex derivatives trader at Deutsche Bank ahead of the GFC and is a childhood friend of its former CEO Anshu Jain should set off more than enough alarm bells for anyone I would have thought.

Softbank, the parent company behind the bailout has seen its shares drop by about a quarter over the last three months, while its 5 yr Credit Default Swaps jumped from a low of 140 to 260. Perhaps this shouldn’t be surprising since this particular project had taken a traditional cyclical business with a duration mismatch of highly liquid and volatile short term ‘assets’ and highly illiquid long term liabilities and thrown enormous amounts of leverage at it. In turn the provider of the leverage was itself heavily leveraged and everyone needed the equity market to pick up the tab. Unfortunately the equity portion of the deal was put in at valuations probably 5 x that of a disinterested observer. As they say “You can ignore economics, but it won’t ignore you.”

When thinking of the junk bond markets we also discussed the spectre of an Elizabeth Warren Presidency. Back in September I attended the CLSA conference here in Hong Kong where renowned US Political Pundit Frank Lunz suggested she would win the nomination. Six weeks later this looks even more likely and yet Wall Street seems unfazed. The biggest concern that we have is not actually the hit to the monopolistic profits of big Pharma, big Tech and big Finance that her proposed policies would produce (though that would certainly dent S&P earnings meaningfully) but her claim that on day one she would ban fracking. Leaving aside for a moment the loss of the economic benefits the US has enjoyed, the problem is the large amount of junk bond debt associated with the E&P companies exposed to fracking. XOP, the ETF exposed to these sorts of companies is down over 40% over the last 12 months as almost all fracking companies continue to make a loss, while Moody’s estimate there is around $240bn of debt maturing (and needing refinancing) through 2023. A ban on fracking would effectively collapse this section of the $1.2 trillion junk bond market completely, while forcing downgrades of bigger oil services company debts, likely pushing them from the $3trillion corporate debt market into junk status – a market which by then would have almost no liquidity.  To be clear, this is not saying that she will get in, rather that the market appears not to be even considering it. As we approach year end and the US starts to focus once more on the political cycle, it is unlikely to stay that way.

Energy is of course an essential component of all economies and one, now largely overlooked, aspect of the fracking and shale gas boom was the tremendous competitive advantage it gave to US industry in terms of input costs – most notably chemical companies using gas as a feedstock- but also in energy more generally. It also transformed the US from an oil and gas importer to an exporter, with important geo-political consequences. For example, when the proposed gas pipeline from Qatar through Saudi Arabia and Syria and hence via Turkey to Europe was rejected by Syria’s Assad in favour of an alternative route from Iran via Iraq, he suddenly lost the favour of the ‘west’ and we saw what happened next.

However, as the US became an LNG exporter rather than importer, this in turn became less important and the west has steadily moved away from Syria, including last month allowing a short term incursion by Turkey into the Kurdish held region of northern Syria as US forces withdrew. Instead, much geo-political activity has shifted to countering the building by the Russians of Nordstream 2 into Europe, a pipeline which, when completed, would give the Russians huge leverage against the Ukraine, the country through which the current pipeline to Europe runs and where negotiations are due at the end of this year. Ukraine of course has been at the centre not just of the current Joe Biden ‘investigations’ but with Crimea and Donbass has been the centre of much of the US tensions with Russia.

Russian gas increasingly ties Europe and Asia together

Nordsteam 2 and Turkstream will have major geo political implications.

The end of October thus saw the final potential blockage, environmental approval by Denmark, fall away, which means that the prospect of Gazprom, which owns the pipeline, failing to deliver on contracts and thus being sued – allowing US LNG exports to fill the gap this winter – has now gone. At the same time, eastern European states like Serbia and Hungary are in discussions with Russia about getting gas via the Turkstream pipeline. The first country to benefit from this one is, perhaps naturally, Turkey itself, which is having the effect of pushing Russia, Iran and Turkey closer together. The obvious consequence of this will be for Europe to start to drop sanctions against Russia, regardless of US pressure.

Meanwhile the Power of Siberia Pipeline to China will see Russia almost completely independent of the $ as a currency for its gas exports. Interesting indeed to note that while the price of natural gas is down quite sharply from its January peak, the ruble as a currency is actually stronger this year. Five years ago, the sharp fall in oil and gas prices put the ruble into a tailspin, reflecting the indebtedness (in $) of its oil and gas sector. That is no longer the case, indeed as observed, it is the US oil and gas sector that now has a debt problem. The fact that Russian Prime Minister Medvedev recently announced that “trading for rubles is our absolute priority” was perhaps not surprising, and while the rest of the sentence “which by the way should eventually turn the ruble from a convertible currency into a reserve currency” may be a bit of an exaggeration at this stage, it nevertheless should further question the long term status of the $ as the sole reserve currency.

To conclude. As we approach year end for many investors, focus will shift to the Political changes coming up in 2020. The UK will have a new government and likely be finally leaving the European Union, which in turn will be moving on to considering its role between China and the US, seeking to be independent of both. Russia will quite literally be a power broker between the two as its web of gas pipelines ties Eurasia together. Meanwhile, the US will be considering not only the threat to the $ hegemony that this entails, but also the threat to the current monopolistic profits that many of its largest companies are making as politicians increasingly focus on the ills of Crony Capitalism. With US stocks currently around 45% of global equities and for many investors all of their non domestic equity exposure, it might be time for some diversification.

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