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The Institutional Risk Analyst

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US Equities: Unwinding the Yellen Leveraged Buyout

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,”

Citigroup CEO Chuck Prince

July 2007

New York | Watching new era car company Tesla (NASDAQ:TSLA) getting knocked down a couple of notches last week, it occurred to us that the Fed’s program of quantitative easing or "QE" amounts to a leveraged buyout (LBO) of the US equity markets. How else can we explain TSLA, a firm whose financial performance is measured by free cash outflow, being more valuable than far larger car companies that actually earn profits?

Think of it: TSLA is an LBO without any cash flow. Of course, the global equity markets are all about discounting future earnings or, in the case of TSLA, the next capital raise. With $7 billion in debt and a voracious appetite for other peoples’ money, TSLA embodies the new era notion that it is acceptable for companies to loose money until they grow large enough to be profitable -- maybe.

The archetype for this style of corporate management is of course Amazon (NASDAQ:AMZN), a firm that is happily consuming whole industries as it grows into a global horizontal and vertical monopoly – and all of this without so much as a peep from the Antitrust Division at the Department of Justice.

These and other questions will be considered later this week when The IRA participates in the Rocky Mountain Economic Summit in Victor, ID, just over the Teton pass from Jackson Hole. Sponsored by the Bronze Buffalo Foundation, The Hero Club and the Global Interdependence Center, the Rocky Mountain Economic Summit features speakers from all over the world considering the financial outlook from the stunning perspective of the Grand Tetons.

Our discussion on Thursday in Teton Springs will focus on the financial outlook for 2017 and beyond. Given the fact that the 10-year Treasury bond has risen in yield nearly 20bp in the past week, the first order of business would seem to be the direction of interest rates. But maybe not. We should heed warnings from no less than Ray Dalio that the central banker party is over, but this does not necessarily mean that the bond markets are the first concern.

Our basic view remains that this latest uptick in yields for US government debt is a pause amidst a continuing deflationary scenario. The manager of the world's largest hedge fund, Dalio says he is going to "keep dancing" with the markets even though central banks are reversing their easy money policies. Where is former Citigroup (NYSE:C) CEO Chuck Prince when we need him?

Reading the pronouncements coming from the latest FOMC minutes, it looks to us like the Fed’s portfolio will not be reduced down to the $1.7 trillion target until 2024. Our friend Bob Eisenbeis, formerly director of research at the Atlanta Federal Reserve Bank now chief economist at Cumberland Advisors, notes that this fact will keep Fed policy relatively easy for the next five years. And the minutes contain no hint that the Fed regrets QE or any of its other policy moves since 2008.

At present, the fact of the FOMC’s massive bond position is holding interest rates down. Ask not how long it will take for the 10-year to hit 3%, but rather the number of trading days it will take for the secular forces of deflation and growing global debt to push Treasury yields back down again towards 2% yield. Thus our fascination with Italian banks.

Despite the protestations of Fed Chair Janet Yellen regarding the complexity of monetary policy, it is quite easy to borrow billions when the central bank is playing “what if” with the global financial markets. Unlike the 1930s when Irving Fisher worried about debt deflation, this time around the secular demand for investments (aka “duration”) looks to be driving yields down even as the likes of TSLA drown on debt that, today at least, clearly does not seem money good. Our friend Charley Grant gives you the basic facts in a Wall Street Journal analysis:

“Yet Tesla needs to raise several billion dollars to meet its goals. Assuming a $1 billion cash balance and four quarters of similarly negative cash flow, Tesla would need to raise nearly $3 billion over the next year. At current prices, that amounts to roughly 6% of the total equity value. The more the shares slip, the greater the potential dilution of existing owners.”

Dilution indeed. Examples like TSLA aside, the basic problem we have with the rising rate scenario narrative that emerged last week is that corporate credit spreads remain extremely tight. All during the Trump Bump, let’s recall, as the 10-Year Treasury popped up to a whole 2.6% yield, corporate bond and swap spreads generally tightened.

The Fed-induced shortage of investment paper, combined with a shrinking market for equity offerings and a $300 billion drop in agency securities issuance in the mortgage market, are all combining to keep yield spreads tight as suggested by the chart from Fred below. Given the gyrations of the bond market, US mortgage origination volumes likely will barely reach $1.6 trillion in new issuance this year vs $2 trillion in 2016.

When we start to see high yield corporate bond spreads as described by the good folks at the St Louis Federal Reserve Bank edging up towards 6%, then we’ll start to give credence to the rising rate trade. Over the past three years, how many investment managers have been annihilated betting on rising interest rates and widening bond spreads? Too many to count. But to us the more relevant concern for Yellen & Co is the equity markets and its recent correlation with bonds, an unnatural circumstance that seems about ready to end.

Looking at spreads in terms of the Treasury market, the impact of the FOMC’s baby steps toward normalization is illustrated by the 10-year Treasury bond vs the 2-year T-note. Does this look like a market that is just dying to move higher in terms of yield? Compare the magnitude of last week’s modest move in the 10-year to the massive Trump Bump following the November 2016 election.

Our best guess is that the next major leg in the 10-year Treasury bond will be down in yield and up in price until we test the 2% threshold. Corporate debt issuance tracked by SIFMA is $100 billion ahead of last year’s levels through May at $884 billion and, more important, roughly a quarter of this amount was used to fund share buybacks by public companies. Significantly, share repurchases for the S&P 500 in Q1 2017 were $133 billion, just 1.6% less than Q4 2016 and 17.5% less than Q1 2016.

Source: SIFMA/S&P

The debt issuance numbers from SIFMA and share repurchase figures from S&P dwarf the level of new equity offerings at just $57 billion in Q1 2017, but it is important to note that stock buybacks also peaked in 2016. Of note, Ed Yardeni’s latest report on the subject of stock buy backs is must reading.

“The result of the buybacks is that net equity issuance has been negative for the last several years and bears a striking resemblance to the period leading up to the 2008 financial crisis,” David Ader wrote presciently in Barron’s last year. In this regard, consider the coincidence of the surge in corporate debt issuance in Q1 2017 and the performance of US stocks.

In the chart above, note the way that total MBS issuance has cratered since Q4 2016 thanks to the election of President Trump. Sadly, even a 10-year Treasury yield well below 2% will not revive the flagging fortunes of the US mortgage finance sector with an uptick in refinancing volumes.

So our message to the folks in Jackson Hole this week is that the end of the Fed’s reckless experiment in social engineering via QE and near-zero interest rates will end in tears. “Momentum” stocks like TSLA, to paraphrase our friend Dani Hughes on CNBC last week, will adjust and the mother of all rotations into bonds and defensive stocks will ensue. We must wonder aloud if Chair Yellen and her colleagues on the FOMC fully understand what they have done to the US equity markets.

The notion that five years of market manipulation by the FOMC (and other central banks, to be fair) can end happily seems rather childish, especially when you consider that the other great accomplishment by the Fed during this period is a massive increase in public and private debt. Once the hopeful souls who’ve driven bellwethers such as TSLA and AMZN into the stratosphere realize that the debt driven game of stock repurchases really is over, then we’ll see a panic rotation back into fixed income and defensive stocks.

The period from QE 1 in 2012 represents one of the most reckless episodes in the history of the US central bank, a period where the FOMC essentially encouraged a partial LBO of the US equity markets. The key question for the FOMC and investors seems to be this: How much new equity issuance can the markets support if public companies eventually need to reduce debt and rotate out of the LBO trade constructed by Yellen & Co?

Corporate credit spreads are the key indicator to watch, both in terms of the economy and the financial markets. It’s a game of financial musical chairs. Ray Dalio, Janet Yellen and all of us are dancing. When does the music stop?


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