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What Will Corporate America Do With All That Cash? Share Buybacks? No. Bond Buybacks. PDF Print E-mail
Written by Burnham Banks   
Tuesday, 06 December 2016 02:58

Last Tuesday, the FT asked the question "Where will corporate America's overseas cash pile go?" Excellent question.

Until Trump proposed a repatriation tax and lower overseas corporate taxes, the share buyback binge which has propelled the US equity market for the past 7 years was set to peak. Goldman Sachs estimates that the tax holiday will result in 200 billion USD of repatriations. The expectation is that most of this cash will be directed at share buybacks and dividends, although share buybacks will likely dominate as the more tax efficient shareholder reward.

Let's try to argue against this consensus scenario. There are basically three things you can do with corporate cash, you can buy back shares, you can buy other companies, you can invest in capacity, or you can retire debt. Interest rates are rising which implies that, one, indebtedness is expensive, and two, investment in capacity faces a higher hurdle rate of return. Buying back shares raises the leverage of the company making it relatively more indebted. Buying other companies raises leverage far faster than share buybacks. Investment in capacity may be justified if final demand picks up but, ceteris paribus, higher interest rates means less investment. How about retiring debt either through buy backs or simply attrition.

Net debt to EBITDA for S&P 500 companies rose from 1.1X in 2013 to 1.7X while total debt to EBITDA rose from 3.6X to 4.6X. This is a considerable increase in leverage in a short time. The scope for a deleveraging cycle is ample. If US companies embark on strengthening their balance sheets, by eschewing share buybacks and reducing indebtedness, the impact on credit spreads could be significant.

From 2002 to 2007, credit spreads tightened as leverage fell. From 2007 to 2008, leverage rose and credit spreads surged, although the catalyst to be fair was not in the corporate credit market but in the housing market. The credit rally from 2010 to 2014 coincided with balance sheet deleveraging. What is remarkable about the credit market has been the rally from February 2016 to date which has occurred while corporate leverage is still increasing. If corporates start reducing their leverage, we could be seeing a more sustained rally in credit and spreads reaching for the lows of the 2004 -2006 period.

Last Updated on Tuesday, 06 December 2016 03:01
 
If Trump Had Won And Then... How Markets Might Have Reacted PDF Print E-mail
Written by Burnham Banks   
Monday, 28 November 2016 02:14

If in the immediate aftermath of Donald Trump winning the US election, equities had crashed, credit spreads had widened, bonds had sold off, the dollar was strong yet gold had surged. And held on to these trends for more than a day. What would the present look like?

The only resemblance to the above scenario to the current reality is that bonds had fallen as inflationary expectations rose, driven by Trump’s spending plans and tax cuts. What might the analysis of this alternate reality look like?

The outlook for equities is poor. US equities are already facing a profits recession if not an economic one. The economic cycle is advanced and a slowdown is probable. Add to this higher debt costs and the impact on balance sheets which have in the last 5 years been expanded to take advantage of low rates, buy back shares and pay dividends, and the prospects for business look poor as debt service rises, leverage rises organically, and the refinancing becomes more expensive and difficult.

Equities will not be the only ones to suffer, credit spreads are likely to widen as credit quality deteriorates.

USD will likely be strong. The low repatriation tax and subsequent lower tax on foreign earnings is likely to encourage inflows. Interest rate differentials across the curve support the USD. As a net importer, the retreat from trade is net positive for USD.

The market reaction to a Trump victory would prompt the Fed to delay raising rates and to generally adopt a dovish stance. While this is at odds with the President’s wishes, the Fed will want to demonstrate its independence, stave off recession, or worse, stagflation, and would be tempted to consider resuming QE. That said, reviving QE would be controversial, so the immediate action is to do nothing. The yield curve steepens as capital seeks low to no duration risk free assets.

The picture for emerging markets would be complicated. As strong USD would be good for terms of trade, which are very important for export nations. However, countries with significant USD debt would face rising debt and debt burdens as rates also rose. High risk aversion is generally bad for emerging markets and the net impact would be bad for emerging market assets.

Ceteris paribus, the situation for Europe would be less poor. A weak EUR would be reflationary. While European yields would rise in sympathy with USD yields, the fact that Europe was deleveraging and Europe can raise debt in EUR, and the ECB remains in QE mode, cushion the blow on Europe. Any sell off would be a buying opportunity.

With the long duration USD assets off the table, the attention would turn to bunds and JGBs. Non USD duration would rally. Since short term rates dispersion was low, cost of FX hedging is also low. European rates would remain low and be capped even at the long end. For Japan, the aim of maintaining a steep yield curve beyond 10 years will become more challenging leading to a selloff in banks.

 

In summary:

US equities fall – economic cycle peak, earnings peak, higher debt service, pressure on multiples.

US credits widen – as above.

USD curve steepens – inflation fears pressure the long end. Fed holds the short end.

USD strong – Inflation, capital flows from tax changes, interest rate differentials.

European equities outperform – Weak EUR, less levered than US, lower debt service, re-rating potential.

European credit outperforms – as above.

EUR curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

EUR weak – dual of strong USD.

Japanese equities maintain bifurcation along JPY lines.

JGB curve flattens – demand for duration not met in USD, FX hedging costs low, low inflation.

JPY weak – dual of strong USD.

Gold strong – Risk aversion and inflation hedge.


Last Updated on Monday, 28 November 2016 02:15
 
Trump Wins Election. What Would You Do? PDF Print E-mail
Written by Burnham Banks   
Friday, 11 November 2016 04:57

What would you do?


Russia:

· Christmas came early. Cosy up to Donald.

· Help the US out of NATO.

· Help Turkey out of NATO.

· Test the resolve of NATO by threatening Estonia, Latvia, Lithuania.

· Help the US out of trade pacts.

· Seems sympathetic to Russian strategy in Middle East.

 

China:

· Christmas came early.

· Time to replace TPP with a China led trade agreement.

· Reach out to Europe to form trade alliance. Possibly reach out to Canada and Mexico to form trade alliance.

· Push the AIIB initiative, the CIPS system, RMB internationalization, One-Road-One-Belt.

· Test US resolve in South China Sea, Taiwan and Japan, dam all the rivers. But balance this with the need to subvert US hegemony. It may be beneficial to be magnanimous and conciliatory.

 

Eurozone:

· Too busy with Dutch general elections in March, French presidential elections in May, German general elections in the autumn.

· Too busy with the Brexit.

· Worry about Turkey, Russia and NATO.

· What happens to TIIP, is China interested in a trade deal?

· Could the same popular revolt happen in Europe? How to appease voters? Be more populist?

· Rethink refugee and immigration policy.

· Weak EUR, no excuse for Draghi to keep expanding QE.

 

UK:

· Special relationship? The Foreign Secretary Johnson has called Trump unfit to lead. Perhaps he will want to reconsider that position.

· Too busy with Brexit, friendly fire from the Tory Eurosceptics and a febrile atmosphere in Brussels.

· Trying to cut deals with China and India, who may now be receptive. Thank god it’s not all bad.

· Europe may be rethinking immigration policy. Easier Brexit negotiation?

 

Japan:

· There goes the TPP.

· If JPY goes to 90 Japan will have a problem.

· How to work with China? RCEP?

 

Middle East:

· Trump will go easy on Israel which will be a problem for Palestinians.

· And hard on Iran which will sooth the Saudis.

· And easy on Putin and Assad which will disappoint Syrians.

· And easy on Turkey.

· It’s complicated and requires a considered, deliberate and judicious approach lest the solutions propagate further problems. A bit like dealing with hydra.

 

India:

· Re-shoring could accelerate on US tax plan. Loss of FDI.

· Trump anti-China position could be good for Indian pharma. On the other hand the ACA is a big source of demand for Indian generics. If ACA is repealed, there could be negative impact on Indian pharma. It’s a toss up.

· Cosy up to Trump in dealing with ISIS. Sideline Pakistan.

 

 


Last Updated on Friday, 11 November 2016 05:00
 
Trump Has Won. Its Time To Unite And Get To Work PDF Print E-mail
Written by Burnham Banks   
Friday, 11 November 2016 08:35

Every so often democracy produces a result that is extreme and polarizing. The personal qualities displayed by Donald Trump were far from desirable or exemplary and his proposed policies appear vague, incomplete or ill-conceived. Yet Trump addresses some deficiencies, even if his remedies may be questionable.

While 47% of eligible voters did not vote and more people voted for Clinton than Trump, the fact remains that over a quarter of the people voted for Trump. That’s 25% of people who chose a misogynistic, avaricious, egotistical, disingenuous tax evader. Some of this may have been a protest vote against an opponent they felt they could not trust.

However, it is more probable that Trump represents the feelings and ideology of more people than we care to admit. It is an uncomfortable truth about the human race, about ourselves. We are less likely to condemn or punish another if we have been guilty of the same crimes, even if to a lesser degree.

That Trump lost the popular vote may tempt one to redesign the voting mechanism, but no voting system is perfect. What America and indeed the world needs to do is to give Donald Trump the opportunity to prove himself worthy or not. America’s democracy means that a man untrained and inexperienced in the workings of government can now lead the country. There are, however, useful checks and balances in the form of Congress. If we have to worry it is that the Republicans control the House and the Senate, albeit with an insufficient majority to force policy through.

The demonstrations against Trump should stop, as should the calls for “faithless electors” to confound the election result, or actions to impeach the President Elect as a political means to stop him from taking office. If Trump is prosecuted for one of his allegedly sham commercial practices it should not be a politically motivated action.

To unfairly deny the President Elect is to deny democracy. America has the institutions and the systems to constrain a rogue President. In the meantime, Trump has 4 years to prove himself. If he doesn’t it will be 4 years lost and some work for his successor or successors to cure. There are worse outcomes in the world, incumbents who cannot or will not be removed, despots who outstay their welcome and defy the will of their people and nepotic dynasties. Trump at least is the will of a quarter of the people. The silent 47% bear some blame and chronic non-participation should result in a permanent loss of voting rights. The nation should pull together, including the 25% who voted against Trump, to steer the country to a better future, even with all the pushing and pulling associated with a liberal democracy. It would be wrong to simply work against the man. It might give him cause to undeservingly seek a second term. If he fails despite the support of the country then there is no excuse.

Last Updated on Friday, 11 November 2016 08:37
 
Global Debt Levels, Central Bank Policy, Implications for Interest Rates and Bonds. Nov 2016 PDF Print E-mail
Written by Burnham Banks   
Tuesday, 01 November 2016 07:44

We have had central banks telegraph their intentions to us for years now, and mostly those signals have been dovish. Recently, however, there has been a backup in bond yields and some uncertainty around what central banks want and what they can achieve.

Is the current correction in bonds similar to the taper tantrum of 2013 when the Fed signalled an end to quantitative easing, or is it a shorter, shallower correction, or is it a more durable reversal in the one way market for bonds since the crisis of 2008?

Let’s explore a slightly cynical view of the world, that central banks are in fact not independent of their political masters and that the government uses all the apparatus at its disposal in the management of the economy.

Global debt levels have risen from 87 trillion USD (246% of GDP) in 2000 to 142 trillion USD in 2007 (269% of GDP) and to 199 trillion USD (286% of GDP) in 2014. Despite deleveraging of particular sectors in the aftermath of 2008, aggregate debt levels did not drop but instead accelerated.

A plausible strategy for dealing with excessive debt would run as follows:

1. The first order of business is to ensure that the holders of the debt are strong and do not attempt a market sale which would bring about price discovery.

2. Market rates of interest need to be contained to facilitate the refinancing of existing debt towards longer maturities. This involves suppressing two elements, the first is the underlying government bond curve, and the second, the credit spread.

3. A strong holder of debt is the government since it pursues objectives beyond economic and commercial ones.

4. The government needs to finance debt purchases with the issue of government debt. This will lead to an increase in the national debt, from in most cases already elevated levels. A strategy needs to be found to reduce the cost of government debt.

5. Central bank purchases of government bonds are an efficient means of financing the government’s debt purchases and moderating financing costs. In the case of more determined programs, central banks may buy corporate debt to suppress the credit spread as well as the base interest rates.

6. A pool of investment capital sufficient to finance and refinance the debt needs to be maintained and developed.

7. Excessive savings are to be encouraged as they are another source of cheap funding. Inequality of wealth supports excessive savings and may therefore be tolerated.

8. To channel savings to fund government debt, banks need to be encouraged to buy government bonds. Under Basel III, government bonds have a risk weight of zero, making them highly capital efficient investments despite their low yield. The zero capital consumption of government bonds makes banks demand highly inelastic. In the US, in the 12 months to Oct 2016 the holdings of US treasuries and agency MBS by banks has risen from 2.16 trillion USD to 2.43 trillion USD.  Western and Southern European banks’ holdings of government securities has more than doubled from 627 billion EUR in Sep 2008 to 1,422 billion EUR in mid-2016. This has been aided by credit lines (LTRO) for which government securities are eligible collateral.

9. The slower is economic growth and corporate profit growth, the lower must financing costs be maintained in order to prevent the excessive growth of the total debt. Ideally, the objective is to at least attain steady state if not shrink the stock of debt.

If the above conjecture is true, then interest rates will be capped over the long run. The current rise in interest rates would be a short term (3 to 6 months) phenomenon.

On this basis, while we would be tactically short the 10Y UST at 1.8, we would be long the 10Y UST between 2.0 – 2.3, and the 30Y UST between 2.84 – 3.06.

 

Last Updated on Tuesday, 08 November 2016 01:38
 
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