After giving serious thought to going short the more bubble-icious areas of the Chinese economy, I’ve reconsidered my position.  Dwelling a bit on the Japanese experience is helpful in this regard, as both countries’ statist governments have driven their respective economic miracles through mercantilist policy and structural imbalance in favor of current account surpluses and export growth.  In both cases, bureaucrats have allowed the facades of western markets to flourish while simultaneously working to insure that they have as much control over the system as possible.  Both have their own unique reasons for embracing free markets, and both do so very much on their own terms.  They are economic parasites on the floating foreign exchange markets and have financed the United States’ decades of living beyond its means, engendering the most significant structural economic shift since the collapse of Bretton Woods.  Both countries will face eventual ruin if they do not address their structural imbalances and while Japan’s day is at hand, it is still early days for the Chinese central bank.  As such, the shorts might be years or even decades early to the party.  If Japan’s experience is any guide, this is certainly the case.

The raw numbers on Chinese loan growth and real estate appreciation are extraordinary enough to merit some serious attention.  However, if you’re going to take the volume of problem loans as the basis of a short thesis, there are several things worth considering.  China and Japan’s large structural surpluses create a financing problem for central economic planners, who need to fund the enormous mounting pile of dollar assets without blunting the competitiveness of the export sector.  This entails maintaining currency weakness and keeping domestic consumption (and wages) low through a combination of social policy, taxes, and inflated asset prices.  For Japan, the need to grow domestic liabilities was a large part of the go-go years of the late ‘80s as the MOF pushed the system as hard as it could to keep extending credit.  In a nation where credit analysis arrived almost contemporaneously with the internet, this was never going to be possible forever, but as long as nominal growth remained positive the BOJ and the MOF could pretend it would.  And this is where asset bubbles come in to play.

Problem loans are only problem loans when the music stops.  As long as the government can keep nominal GDP rolling, the domestic currency weak, and rates low, liabilities, and hence the current account surplus, can be extended indefinitely.  In this area Japan has likely long since exhausted its range of favorable policy options after decades of stubbornly backing itself into a corner and refusing to surrender its imbalances.  As the public debt pushes past the point of no return, their day of reckoning might be at hand.  This year’s early run in the yen is certainly interesting from this perspective, as a sharp spike in the yen will likely be the ultimate harbinger of doom and the most profitable macro opportunity in the east along with its logical counterpart, short JGBs.  Such a move would finally force the mothballing of decades of accumulated export capacity for which there is little real economic need and mark the final implosion of the long since hollowed out financial sector.  The effect this would have on the internally funded public debt and the domestic equity market, still largely propped up by cross-shareholdings, is potentially devastating.  Japanese shares are cheap on many metrics and I’ve heard a number of people talk about the contrarian attractiveness of Japan, but as far as I can tell things will have to get worse (and possibly much, much worse than many have imagined) before Japan sees a secular turnaround.

We’ve touched on China’s savings glut and the structural forces driving price appreciation in real estate and equities.  This is the domestic impact of mercantilist structures that keep domestic consumption and wages low in order to maintain international competitiveness and drive growth in the domestic export sector. A drop in YoY Chinese CPI in January is interesting in this context and points to the deflationary drag of a structurally imbalanced economy, which must be offset by the expansion of liabilities.  As the Japanese MOF can attest, keeping this equation in balance while maintaining a solvent banking sector is difficult, unless nominal growth is juiced enough to make the point moot.  While Japan has long since lost the ability to control this lever of the economy, the People’s Bank has not and will likely continue to foment bubbles as long as it can.  And hence the fundamental problem with the short China thesis:  if credit has been expanded indiscriminately to the point where the volume of problem loans is systemically threatening, the central bank has immense incentives to continue to grow asset bubbles and keep nominal GDP growth as high as possible.  It also has enormous resources and many policy levers with which to do so.  As such, this is not somewhere where I want to be short.

China’s push to reign in lending as global concerns about the sustainability of lending practices has likely been driven by fears for the ability of its corporate and financial sector to access international capital markets.  Markets have been unkind to Japanese borrowers ever since they woke and realized that this is a country that has operated with little profit incentive for decades and only superficially bears resemblance to the western idea of free market capitalism.  A similar realization among westerners that Chinese banks are the bureaucracy’s medium for shoveling credit down the throats of whoever can take it and not stewards of shareholder capital would be hugely damaging to the Chinese growth story.  However, I wouldn’t count on the government to follow through on its tightening rhetoric as the need to keep asset prices advancing becomes more pressing.  This will likely be a superficial measure to keep investors happy and prevent a large enough drop in markets to jeopardize the system’s integrity.  The PBOC can probably keep juggling these looming problems for a long period of time, possibly even for decades.  In the end, however, there is no escape from the eventual fallout of mercantilist obstructionism of the market.

I still remain bearish on US treasuries, and the outlook for US rates in the context of a potential Japanese implosion remains unfavorable.  Increasing direct exposure on this front through remains unlikely however, as the symbiotic nature of the US and Japan’s historical relationship and the potential feedback from an implosion of Japanese imbalances remains difficult to analyze in isolation-  there are simply too many moving parts to this scenario.  A Japanese meltdown would likely put pressure on the dollar and would add to supply/demand imbalances during a period of historically large issuance, but the international ramifications would be large enough that the effect could be offset by a flight to US dollar assets and relative safety, or any number of unforeseen effects.

For now, I will keep my eye on the yen.

-bleichröder

There has been a lot of interesting news flow from China as of late:

• Market liberalization  intended to boost shares?

• Signs of a real-estate top

• Technical pressure (i.e., selling unrelated to value)
• Retail fund flows, apparently, remain strong.

China’s rapidly industrializing economy will, like any other developing nation, have its busts as well as booms.  Previously I touched on some of the key drivers that make China a very difficult short despite the apparently unsustainable valuations in mainland A-shares.  Beijing’s massive foreign reserves certainly remain a major risk to would be short-sellers, but as cracks begin to show profitable short opportunities may be at hand.

Despite the one-time impact of generous fiscal stimulus, China’s domestic growth outlook remains tied to its export sector and its status as a global low cost producer.  The country has moved up the value chain as lower value-added exports like textiles have shifted to places like Vietnam and Cambodia which should tie its fate more closely to Western economies, any theories of ‘decoupling’ aside.  In the near-term, China will continue to be the beneficiary of restructuring in the west as manifested through off-shoring, and thanks to the system’s limited ties to market forces things could keep bubbling for some time.

The real estate market, whether a bubble or not, is worrying due to the rate of price increase.  Home prices in many cities have doubled in as many years which is especially troublesome in the context of China’s restricted internal movement. Home prices aren’t being driven up by urbanization and new immigrants to the cities, but by people moving around within cities.

State directed investment and credit growth has severely negative implications for sustainable domestic growth and this seems to get glossed over in many bullish discussions of China.  China’s government may have come a long way from the policy tragedies of the Great Leap and Cultural Revolution, but one needs to be cognizant of the fact that this is not a system where the market is control.  Jim Chanos’ off the cuff analogy of China-as-Dubai x 1000 is for this reason unsatisfactory, as China is in some ways better off and in others worse.  Dubai was more of a Middle Eastern Las Vegas, while China already seems to be building a more run-of-the-mill statist bubble.

Even if you find state growth numbers questionable (as I do), the effect of imported interest rate policy is also extremely troublesome, and even more so if you are in the bullish camp that takes growth figs at face value.  With China’s highly under-developed retail financial system, there are limited options for the country’s domestic savers.  State-mandated interest rates at banks create a captive funds flow that fuels buying in equities and real estate (the A-share premium is a tangible manifestation of this).  Keep in mind these are generally unsophisticated retail buyers.  Much of China’s savings is also re-invested into the export economy, which given the global growth outlook seems questionable.

What will be the spark to bring it all down?

Rising interest rates, either from the government’s attempts to slam on the brakes (which they seem to be doing rather half-heartedly) or from a rationalization of the currency peg, could be a catalyst.  Developed economies have to contend with markets responding to liberal fiscal and monetary policy while simultaneously floating huge sums of debt, and with interest rates at current levels the near-term rates outlook (as discussed elsewhere on this blog) is strongly negative.  Higher developed market rates are probably just as likely a near-term mechanism as a domestic rate movement and, of course, a sizeable sovereign default could also do the trick.  Over the coming weeks I plan on taking a harder look at sectors and specific names that are worst exposed to a correction and may be looking to add short exposure.  The setup is ominous and presents not more than a few challenges to successful realization, but the potential for profit is there.

As the world’s third-largest telecom by market cap, VOD has a unique and hard to replicate portfolio of assets that generates strong operating cash flow.  With a FCF yield of 8% and an 8.7 p dividend, the shares have a bond-like yield of almost 6%.  The company has leading positions in a number of developed markets while maintaining a strong presence in fast-growth emerging markets in Africa, the Middle East, and Asia, which nicely balances the company’s growth profile.  A summary of VOD’s consolidated businesses by market provides an overview of the company’s global market position:

A sum of the parts valuation can shed some light on the buried value of VOD’s unconsolidated investments, which were carried on the balance sheet at a cost of £0.62 a share.  Ex-Verizon, the business is worth between £0.83-£1.00/share, with the low end of the range reflecting an assigned discount to peers and the high end assuming that VOD’s local businesses deserve to trade in line with peers.  At current market prices the VZ stake is worth £0.55, but that value could rise to as high as £0.70 in a negotiated transaction with the company, implying a total firm value between approximately £1.40-1.70.  SFR and SAFCOM are probably worth £0.185-£0.21, bringing total NAV to £1.59-1.91, although this is by necessity a back-of-the-envelope calculation as SFR are privately held with Vivendi, who do not break out numbers on SFR sufficient to do a more rigorous valuation. 

Shares are similarly attractive on an asset basis, although an asset valuation is complicated by the presence of significant intangibles, the bulk of which reflect acquired spectrum licenses.  However, as these are indefinite life assets that give the company its right to operate, they do have tangible value.  If assume the carrying cost of the spectrum licenses equals fair value, remove the non-spectrum intangibles, and adjust for accounting distortions, VOD has a NAV/share of £1.62, a premium of almost 20% from current levels.  This assumes that balance sheet carrying cost equals fair value for the associate investments, which is conservative.  The table below shows NAV calculated with an assigned premium to book value on the associated investments and with the value of the associates removed, to allow comparison to the figures suggested above.

Strong NAV creates a floor on value and limits the risk of slower than expected sales growth, and at current price levels the risk is largely to the upside.  On a sustainable earnings power basis VOD likely deserves to trade closer to £1.60-1.70.  DCF valuation produces an approximate range of values between £1.30 and £1.80 depending on the type of model employed and what assumptions are used.  A simple FCFE model that assumes 5% CAGR of revenues with declining margins over 3 years and consistent capex/sales of 14% (the trailing 3-year average reinvestment rate against broker consensus estimates of 11%) implies a value of £1.50/share, which rises to £1.69 with margins remaining at 2009 levels.  Lowering near-term compound growth to as low as estimated global population growth (i.e., no ‘excess’ return) lowers this value to about £1.31.  Both values are conservative as they run contrary to management guidance that costs will be cut by up to £2 bn by year end 2012, which would imply margin expansion of 240-480 bps.  Incorporating these assumptions with 5% revenue growth implies a value of £1.90-£2.10 and £1.77-£1.99 without any ‘excess’ growth.  Extrapolating management estimates of gross cost savings into margin expansion is unrealistic, however, as it is fierce price competition among mobile telcos that has led to such ambitious cost-cutting schemes.  In the near-term, price competition can be expected to offset any margin boost, but the prospect of a permanent improvement in cost structure could add sharply to the upside earnings potential of VOD.

Using an excess return model that assumes that VOD’s return on invested capital fades over time to the firm’s cost of capital and employing a 5-year fade period implies a value of approximately £1.30-£1.40.  Although many of VOD’s markets are highly competitive, the technical nature of the mobile telecom business makes it oligopolistic with strong barriers to entry, suggesting that this assumption is highly conservative.  Using this approach as a check on the range of FCFE DCF values computed above suggests that the scenarios considered are reasonable.

There are several catalysts that could unlock value in shares of VOD.  A Verizon buyout would allow VOD shareholders to monetize the underlying value of the holding and could allow for a special dividend or a large repurchase of shares.  Less attractive would be if proceeds were reinvested in new acquisitions, although VOD have proven themselves to be a savvy acquirer in the recent past by successfully integrating acquisitions and managing them to higher returns on capital, which limits downside in this scenario.

The U.K. business offers an additional potential catalyst for VOD.  The U.K. business has the lowest margins of any single market that VOD competes in, reflecting the tough competition and pricing amongst the 5 competing telcos there, although ARPU is second only to Spain and the US.  VOD could spin-out or sell the weak UK business, potentially into a combination with another weak player in the UK (Virgin Mobile or 3Group), raising group-wide margins and returns on capital.  A similar consolidation with the company’s 44%-owned SFR associate is possible in France, although the French market is generally much more favorable and the remaining 56% is owned by Vivendi, who would be less likely to lead an out-right consolidation as compared to a hypothetical VZ deal as discussed above.

Outside of a deal, VOD has a number of options it can pursue to spur value-creation which I feel are underappreciated at current trading levels.  While I don’t like relying on pro-forma forecasts to support a valuation argument, I think the above assumptions are conservative enough and at current prices investors are paying little for this upside optionality of 25-30%.  A unique, hard to replace asset base strongly limits downside in a worst case scenario and is further protected by the strong dividend yield.  Even in a ‘double-dip’ situation where global growth again grinds to a halt, the utility-like nature of revenues will protect earnings and limit the risk of a permanent loss of capital.  While pricing power for mobile telcos is likely to remain weak in the very near term, the sector’s underlying economics are attractive enough to justify investment and any improvement in growth prospects could lever returns strongly on the back of management’s £2 bn cost cutting program.

disclosure: bleichröder is long VOD

Industry Price/Sales & TTWO vs. S&P500

TTWO have struggled mightily in recent years, consistently demonstrating an inability to manage the product development cycle.  A bloated cost structure and persistent delays have rendered the company unprofitable except in years when it has delivered a major release in its premier GTA franchise, which is the company’s most profitable.  The last GTA game generated almost $800M in sales and the series has been among the most successful video game properties in industry history- 2005′s GTA: San Andreas is still among the top 10 highest selling titles of all time.  Outside of GTA, the company has a handful of other proprietary titles as well as 2K Sports, a modestly successful publisher of licensed sports games.  A cursory comparison of TTWO’s cost structure to its larger rivals Activision Blizzard (ATVI) and Electronic Arts (ERTS) speaks to some of the company’s problems.  Product costs are incurred in production and reflect licensing and royalty fees to hardware makers as well as shipping and distribution costs (note that ERTS doesn’t break out licensing costs separately from product costs).

Back in the summer of 2008, Electronics Arts offered to buy Take-Two for $26/share in an offer that valued the company at around $2 billion.  Management refused to negotiate the offer and ERTS hit back with a hostile tender which ultimately failed as management maneuvered to block the bid.  At the time, management claimed that the offer was too low and that ERTS were trying to steal the company before its blockbuster GTA 4 was released.  Other buyers were rumored to be in the wings with the arb community briefly pricing the shares above $27.15, but as the broader markets unraveled so did talk of a deal.  We can roughly get a sense of how this bid valued the company by normalizing 2008 earnings by the average write-off of capitalized development costs over the cycle and by assuming ERTS could cut overhead costs by 10%.  Adding a 20% control premium and assigning a 10% discount rate, we get:

Subsequently, TTWO sold its low-margin distribution business (Jack of All Games) at a loss for a total consideration of $36.5M cash in early December 2009, leaving management to focus on fixing the core publishing business.  Because of its consistent lack of profitability, valuing TTWO requires some extrapolation and normalization of past results to ascertain its going concern value.  Historically, the market has valued TTWO at between .8 and 1.4X revenues.  Using the average revenues for the publishing business over a full development cycle (in this case, FY 2005-2009) and valuing the company on a price/sales business implies the following values:

As a consistent money loser, the next logical step is to examine TTWO’s liquidity position.  At year end 2009, the company had $102M in cash and $100M remaining on a line of credit, and was burning cash at the rate of $622,000 a day.  At this rate, the company would run out of cash in late October of next year.  However, 2009 FCF was impacted by a historically large build-up in receivables and significant development delays in a number of titles that were pushed back to 2010.  Based on consensus estimates for 2010, we can expect FCF to be around -$100M in 2010, which will give the company around 2 years.  Liquidity is then not a substantial concern, barring any hideous product delays, significantly higher than expected costs, or total product launch failures.

In a given year, TTWO typically earn between $700-850M in revenues.  In the last year of a GTA release (which was the last profitable year in recent memory) the company earned $1.23 billion in revenues.  If we value the company using a 10% discount rate on 2008 earnings, we get a value of around $13.  If we assume a buyer could cut overhead costs by 10% and paid a 20% control premium, value could be as high as $20 a share.  However, arbitrarily using 2008 as a base year is obviously a less than perfect solution, and we must look at some alternative measures of value to get a sense of what the company is worth.

Spreading the company’s revenues over the length of the game development cycle and deducting normalized costs over the same period gives some idea of how unsustainable their business model is.  Development costs need to be cut and unprofitable titles need to be abandoned if the company is to have a hope of producing something resembling a sustainable performance.

Valuing GTA from the perspective of an outside acquirer will allow a sense of how much value the market attributes to the remaining publishing business.  Since TTWO break out revenues for GTA, this can be accomplished by estimating the cash flows from the most recent release (GTA IV), which was developed during FY2005-2007 and released during 2008.  Interviews with developers suggested that the total cost of the game was around $100M.  This analysis conservatively assumes development costs at twice this level and also provides an estimate based on a pro-rata attribution of total development costs over the cycle to the series.

At current trading prices, this would imply the non-GTA publishing business is worth $4-5 a share ($300-400M).  If another publisher were to buy the company, shareholders could hope for a price between $15-20 a share, implying 50-100% upside from current prices.  As an independent company, TTWO’s going-concern value is far less certain and the shares are unattractive as anything but a consolidation play.  However, a buyer here is protected by the GTA franchise, which limits the downside at current prices and places a floor on value of around $8 (assuming the remaining game properties  and proprietary technology are largely worthless).  In an industry where operating profits need to be constantly reinvested to fund growth capex and keep a steady stream of new titles, franchises are valuable properties that allow developers to cost-effectively produce content .  Taking the assumed value of the GTA franchise as a worst case value and assuming there is equal probability of a high or low bid with a 10% required return, we only need a 1/3 chance of a deal going through to realize positive expected value.  Industry consolidation was ongoing pre-LEH and with Icahn in position shareholders have a decent shot at monetizing the value buried underneath TTWO’s cost structure.  The case for a deal is made stronger by the fact that TTWO are controlled by ZelnickMedia, an investor run by former BMG CEO Strauss Zelnick.  While Zelnick and cohort Ben Feder rejected the 2008 deal, they might jump at the chance to take a cash-out given the way things have gone in the past year.  Even without a deal, on a revenues basis the company would probably be priced more towards $13-15 in a better market for game publishers.

At the price Icahn and Harbinger paid, the risk-reward relationship is compelling.  The shares rallied strongly the Friday before Christmas, reducing the margin of safety to a value-oriented buyer, but the opportunity remains for those with interest in the space.

disclosure: bleichröder is long TTWO

Many have highlighted the questionable underpinnings of the Chinese rebound and with good reason- the strong rebound witnessed in China amounts to a combination of generous fiscal and monetary stimulus and the aftershocks of an enormous inventory bounce in the western economies.  The IMF’s recent survey of Asia offers a couple of graphs that nicely sum up the closeness of this relationship by examining exports of electronics, which are a strong component of the Asian export economy.

Although this is obviously far from a perfect exercise, another interesting angle on this is visible in the relative performance of the most export-sensitive indices with China.  Note the outperformance of the VN Index (exports/GDP of 76.8%) and the KOSPI (52.9%) against the Shanghai Composite and Bangladesh’s DSE20 index (19.4%).  The CSE All-Share (24.9%) would have also been a good candidate but has been buoyed by the removal of the civil-war discount (for now) while it is also worth noting that the KOSPI has more recently lagged nom. GDP.

The most optimistic have offered the intellectually lazy and factually questionable idea that a Chinese consumer will be emerge to gradually pick up the slack from weak secular OECD demand moving forward as the Chinese economy rebalances itself and emerges as the new driver of global growth.  The bear camp see rampant over-investment (investment spending of 87%/GDP in ’08) driven by the state which at best is fueling a credit and asset bubble and at worst is leading to a gross misallocation of resources worthy of a Las Vegas subdivision.  I think the reality of the situation is somewhere between these two gross oversimplifications.

China has a long way to go before it has anything resembling a robust consumer economy and its insistence on weak monetary policy is the most obvious manifestation of this.  If China had a consumer economy worth talking about, there wouldn’t be all the fuss about the artificially cheap CNY, which simultaneously benefits exports and promotes consumption by disadvantaging savers.  In a similar fashion to Japan during its spectacular rise in the 1960’s, the Chinese are big savers, although in China’s case there is no need to offset a lack of foreign capital.  In 2008 savings accounted for almost 50% of GDP, with the young and the old forming the biggest portion of a large household savings.  This speaks to China’s unique circumstances and is attributable to the lack of social services, the cost of housing, and  weak consumer lending.  The fact that Chinese save as much as they do in the context of the dismal mandated rates available at Chinese banks suggests it is also a likely a driver of speculative investment in domestic real estate and equities.

The undeveloped consumer economy is similarly problematic to the bear camp- bubbles here mean are an entirely different thing than in the developed west.  There has been worrying appreciation in certain sectors, most notably in residential real-estate which has attracted the attention of investors and policy makers alike, but given the country’s relative economic youth and the active application of countercylical policy these are as yet not so large as to be a call for serious alarm.   This is particularly true in the context of valuations prevailing in the west at the moment.  Functionally this is a nation that still bears resemblance to the US in the 19^th century- half of the populace are still agrarian peasants engaging in low-output farming, the banking system is severely undeveloped with most forms of consumer lending almost nonexistant, there is a general lack of critical infrastructure, oftentimes weak regulation and enforcement, and massive income inequality.  Discussing a housing bubble in a nation that is still in its early stages of urbanization seems to me, a bit premature.

While China’s nominal progress has sent it to the top of most economic fact books, this is still a nation with per-capita GDP of less than a tenth of the US or Japan. There is an enormous amount of room to run and China’s high-growth cycle is unlikely to unravel anytime in the near future.  If the experience of Japan is indicative, which peaked with 10% of global exports before collapsing on itself, China still has room to run even in its saturated export economy when demand recovers and as it continues its shift in orientation to higher value products gradually over time.  Overcapacity is unlikely to remain as such for long and strong investment, while certainly uncomfortable for the global economy, is probably not as far out of line as may seem at first glance given the relatively early stage of development China is still in.    Videos like this one certainly highlight the dangers of state-directed investment, but in doing so also point to some of the large unmet needs in some areas, such as affordable urban housing.

One unique variable for China that will be almost certain to cause some interesting dislocations moving forward is its bizarre policy-driven demographic structure.  Shang-Jin Wei at Columbia and Xiaobo Zhang of the International Food Policy Research Institute have attributed a portion of the savings glut to the need among the severely numerically disadvantaged Chinese bachelor to save up to buy a home and a car so that one day they might be able to hope to find a wife.  The social and economic consequences of such distortive policy could have an enormous range of effects- rising crime rates, emigration, civil unrest- and certainly highlights the limits of its political system.

While China will eventually have to shift itself to a more domestically-oriented economy and its savings rate and investment cycle forms a substantial obstacle to such a recentering, the situation is far from approaching the sort of imbalances that generated enormous bubbles and sparked economic collapse in the United States.  Also somewhat reassuring is that unlike many of their western counterparts, China is surprisingly willing to engage in counter-cyclical policy and has a forceful range of policy tools to manage society on all levels which it is more than willing to use. While this is far from a perfect system (as the more notable examples of resource misallocation and the one-child policy demonstrate), it does allow for comparatively rapid adjustment and overhaul when the need becomes acute enough.  Chinese policy-making is driven by the lessons of the latter-day Soviet Union and is motivated by a chronic fear that if the government fails to deliver economic prosperity it will soon find itself hanging from lamp poles. In some ways, this couples the government’s economic interest more closely to that of the people than the American congressional system does- it will be interesting to see over time which has fared better in navigating the global recession.

-bleichröder

Regardless of what your feelings are on what sustainable economic growth will look like moving forward, continuing long-term profit growth is not possible without reinvestment.  While some top-line figures have looked more positive, the bulk of earnings power has of late been driven by cost-cutting.  This is certainly not news and has been heralded by your average CNBC talking head as being supremely excellent as any top-line growth will subsequently flow straight to the bottom line (this is usually accompanied by emphatic hand gestures).  True enough.  However, as firms accumulate drug dealer-like hoards of cash, they aren’t reinvesting to grow their business- in the short run this is the source of the spectacular inventory drawdown.  At a certain point this factor will move from a positive to a negative as it represents a de facto veto of the market’s bullish US economic sentiment by corporate managers.

In a perfect world, an equity investor is foregoing surety of income in a belief that the company they are funding will be able to deploy their money to ‘build shareholder value’ at a return in excess of cost of capital, although of late this generally refers to levering up by buying overvalued shares in the midst of a rabid bull market.  As access to capital markets improves, growing cash piles have more negative implications-  this is why the market has traditionally penalized such firms deemed to be holding ‘excess’ cash (although in my mind no one can ever have ‘excess cash’).

I won’t be back in the office until the first of the month and accordingly won’t have Bloomberg access (hence the gov. issue charts), so I will have to rely on data from a recent Journal article (you can find the article here).  The Journal and its quoted pundits are keen to interpret the large cash holdings at S&P 500 firms as being a net positive, indicating firms recovering from a period of tight credit and will soon be able to redeploy funds for more rip-roaring gains.  While limited access to credit markets was certainly a short term driver of cash stockpiles, general overcapacity and limited opportunities for reinvestment is the other much uglier side of this.  As mentioned previously, this phenomenon has materialized in financial sector in the lack of credit growth despite unprecedented monetary slack and is perhaps more an indictment of balance sheet quality, but is related nonetheless.

In this respect, the response of the prices of capital goods is worrying.  The inventory bounce is noticeable, but the flattening and subsequent tail of what is a better representative of long term investment would seem to confirm the above hypothesis.

Of particular interest is the recent tail in equipment and software spending-  for all of the hype on tech and the coming turn in the corporate reinvestment cycle (which always seems to be just around the corner), a rebound certainly hasn’t materialized yet in the data.  Google’s massive $24 bn hoard, which the WSJ article mentions, is one manifestation of this.  Certainly something I’ll be keeping an eye on moving forward.

-bleichröder

For those unfamiliar with his market approach, Hendry is currently bearish on equities, commodities, and China.  He’s keen on USD although has restricted his fund to opportunistic positions in interest rate derivatives.  I am generally favorable to his allocation, especially his purchases of CDS on J-Power (9501 JT), which appear severely mispriced.  Having witnessed their painful rejection of TCI, I have a pretty poor fundamental outlook on the company and its management.  Meanwhile, their debt level would make them a good candidate for a Macquarie infra fund.  While I find many of the individual components of his argument attractive, in sum I am left with some nagging doubts about the cohesiveness of the thesis.

If one had to engage in the dangerous exercise of trying to pinpoint the boom’s precise origins,  the most likely culprit would be the inflationary dynamic of politically directed lending.  Add in the frictions driven by the difficult dynamics of aging rich countries and fast growing poor countries to a barn-burning financial sector that has been running laps around regulators for decades and you have most of the background for huge asset and credit bubbles.   As we stand in the aftermath of a near total global collapse, interventionist central bankers the world over have made enormous commitments to attempt to minimize the fallout.  Unfortunately, this situation has become increasingly common in the past three decades and once again markets find themselves a part of an enormous, seat of the pants social experiment in a science that remains at a comparable level of understanding to say, medieval astronomy.  As governments are more active than ever in the markets, investors are suitably concerned about what the ultimate outcome of their actions will be.

I’m with him on the implications of slackening demand from China as the trade deficit contracts alongside an enormous supply of treasuries.  However, our opinion sharply diverges over Japan, the second largest holder of Treasuries after the Chinese, with around 21.2% of the outstanding.  The dire Japanese fiscal position puts their ability to continue funding American debt into doubt with potentially serious ramifications for Treasury yields.  Problematically, Hendry raises the specter of Japan’s fiscal nightmare as both a potential domestic crisis and as an example of how the US can save itself by maintaining low nominal interest rates.

Hendry’s optimistic scenario assumes an orderly transition in the United States from overactive consumer to diligent saver.  Robust savings will keep the government out of the dog house as consumers and banks fortuitously reallocate to government debt alongside slackening foreign demand.  He highlights Japan and the immediate post-war American experience as support that such good fortune is indeed possible.  Such a scenario is conceivable in light of the nation’s collective interest and its financial resources, but  enormous problems of momentum and coordination remain that seem difficult to surmount.  As the recent global political-economic experience (and Japan’s in particular) highlights, democratic governments need to teeter at the edge of the fiscal abyss before serious corrective action can be taken.  Historically, politicians’ fiscal profligacy has generally only been checked by rising debt service costs and punishing inflation, and I see little reason as to this time around should be any different.  The current American congress and its president, who seems to be shooting for an economic legacy somewhere between Jimmy Carter and Hoover, certainly do not inspire confidence.

A similarly beneficial adjustment might have avoided the pain of the enormous asset and credit bubble that formed in the boom years, and despite its apparent magnitude and severity no such self-fulfilling solution was forthcoming then.  I would not expect anymore such benevolence on behalf of capital markets now as then to correct emerging imbalances.  As the US consumer has deleveraged, shedding about $126 bn in consumer credit, the personal savings rate has climbed sharply, with some like Richard Clarida at PIMCO see it topping 8%.  The proverbial $14 trn question is where these savings are directed.  I would argue in the context of the dismal yields available to savers and inflation expectations (whether justified or not being irrelevant) they are likely to look beyond treasuries in aggressively seeking yield.  Simply put, I can’t imagine a significant reallocation to treasuries without higher yields coming first, absent a comprehensive overhaul of the tax and entitlement system that could directly incentivize such a shift (say, moiving to a more consumption based tax regime while adding exemptions for savings and for holding government debt).

Hendry alludes to the American yield hog in suggesting that there is enormous capacity to absorb government debt among US banks by highlighting their purchase of a $6.2 trn steaming pile of MBS from 2004-2006.  Arguably this hunt for yield has been seen in the HY market, which is probably even more overvalued than equities may or may not be.  Why US households and institutions would suddenly do an about face and allocate to low yielding treasuries in a robust bull market for equity, debt, and commodities is beyond me.  A significant correction (with emerging markets being the most likely candidate) would drive a strong rally in Treasuries and other ‘less risky’ assets but this is not the structural reallocation Hendry conceives.  Ultimately, I think another downward leg in the markets would prompt more questions than it answers with respect to America’s ability to borrow at low nominal rates-  here it is important to consider the growth forecasts embedded within those of debt/GDP.

Hendry highlights the experience of Japan, with its internally funded debt and its decades of low nominal yields as an example of the potential for a self-regeneration.  Interestingly, he does so while simultaneously conceding that Japan’s day of reckoning may finally be near after having been forestalled for the better part of 20 years.  Japan had the good fortune to implode into what proved to be a decade of strong growth and falling yields regionally and globally, albeit with a few notable hiccups.  Against this back drop Japanese yields have been kept low by large purchases of debt by households and banks, which have expanded their allocations to government debt by 5 and 4X respectively.  Hendry largely glosses over the unique factors of the Japanese experience- the allocation to gov. debt among households is a demographic and to a certain extent a cultural artifact, with the traditionally strong savings rate fading in recent years as an aging population has begun to slowly spend its accumulated wealth.  Holdings among banks have risen to meet supply largely due to the captive nature of this market.  Many of the big buyers of Japanese government debt, such as Japan Post Bank ($1.7 tr, ~25% of the outstanding) and the state pension (~11%) are semi-private organizations with little market incentive.  In raising the case of J-Power, Hendry perhaps unwittingly alludes to the close connectedness of the Japanese corporate and political structure that allows such chicanery- J-Power’s aggressive rebuke of TCI was accomplished as its cross-shareholding brethren closed ranks around the activists while government regulators looked the other way.

Japan must quickly resume growing healthily if it has any hope of servicing the interest on its debt, much less paying down debt equal to 200% of GDP.  As Japan pays the price for decades of excess debt and slow growth, its low nominal yields are more likely to have been the cause of its eventual demise rather than a sustaining force.   By severely reducing the need for restructuring and reform they have allowed Japan to enjoy an untenable position for far too long and their long term economic future is very much in doubt.  Despite Hendry’s lack of faith in the United States’ ability to whether a period of sustained higher rates, it may be its best chance to return to economic health as quickly as possible.

While some, including Jeff Matthews (who may or may not be making this up), are bullish on the sector and see enormous opportunity, others are less sanguine about the near-term future for the American homebuilding sector.  I would fall into the latter category.

Let’s try and forget the speculative flipping and fraud that boosted the market at the margin (this seems to be the Congress’ preferred mode of thought) and pretend there wasn’t any excess construction. Back of the envelope calculations suggest that hitting the 65% rate would imply around 4.7 mm homes that will be rendered excess- that alone is roughly equal to the number of homes completed in the US from 2006-2008.  Apartment vacancies have also risen to historically high levels during a period of declining home ownership, which would also add support to the idea that there is a massive overcapacity of housing stock for the time being.

Thanks to a government strategy to limit damage to the economy by recreating the turbocharged leverage of the mid-2000’s bull market, money is once again astoundingly cheap.  The average 30-year fixed mortgage rate at around 4.90% allows the American borrower credit at a slim 50 bps behind the full faith and credit of the US government.  That this rate underprices the risk of long-term lending 30 year seems to be a bit of an understatement while more than 300,000 a homes a month slide into foreclosure.   Politically directed credit flows generally don’t have the best track record, and with rates at such stimulative levels I don’t see this ending well.

Anecdotal observation notes that home-flipping infomercials seem to be recession proof and there are still legions of Americans making millions working from home a few hours a week.  Is it impossible to suggest that America’s aspiring real-estate investor class has returned for a second round of speculative buying?

Your average American is keenly aware of the massive bust in housing and is accustomed to sharply rising real estate prices, having witnessed the spectacular accident of long term appreciation of home prices.  Your average fellow, never the most astute market participant, generally seems to retain the belief that real estate is a great long-term investment.  Its tangible and ‘they aren’t making any more of it’, and a less than stellar decade in the markets has turned many retail buyers off of financial assets.  With rates at pre-collapse levels and prices well off their peak, I would not be shocked to learn that more than a fair share of amateur Donald Trumps who missed out on the first round have been buying distressed properties as ‘investments’.

While isolated pockets of the nation will likely enjoy robust and relatively durable residential real-estate recoveries owing to local agglomeration economies (say, portions of Manhattan, the nicer bits of Silicon Valley, etc.), the large part of America is likely to continue below-trend housing growth for the foreseeable future.  While I’d agree with Herr Matthews on the bullish near-term prospects, I would do so more on a belief that the Federales have successfully reinflated a highly speculative bull market that has raged for years.  In doing so they are forestalling the inevitable:  fundamentally, this is a sector that remains grossly overbuilt and is headed for a period of secular low growth after it slowly and painfully works off the enormous excess capacity.  Unless you believe the future will resemble the pre-2008 past, I would seek greener pastures.

-bleichröder

The Federal Reserve’s stated goal of moderating the business and credit cycle while maintaining full employment through enlightened policymaking demands a macroeconomic understanding of such a comprehensive and elegant nature as to rank alongside a quantum theory of gravity.  It also offers a hypothesis to explain the surprisingly resilient decoupling of risk assets from fundamental reality.

While I hate to add to the heap of market-as-degenerate gutter drunkard analogies tossed around by the media and punditry (especially in my first post), here’s one more for you:

The old notion that the Fed’s job is to ‘take away the punch bowl’ before the party got out of hand seems a bit outdated given the unprecedented scale of government involvement in capital markets.  The events of the past year have generated a policy response more akin to throwing a carte blanche booze and drug bonanza with the hopes that you’ll be able to gradually cut off the raging crowd before anyone gets out of control and your place is burned to the ground.  Think something between a Big-10 game day kegger and the party Jonny Depp throws in Blow.

Last week’s FOMC statement added a series of qualifiers to Helicopter Beard’s easy money promises in an apparent attempt to reduce uncertainty over any eventual exit strategy.  To that end, Beard & Co. (not the Milwaukee brokerage firm) have likely been successful.  While their dove-ish leanings driven by the mortal fear of a liquidity trap were already well known to all, it now seems almost certain that the Fed will keep the taps flowing until there is tangible economic recovery significant enough to cause improvement in the labor market.  This has very worrying implications for inflation- blame the Congress, the Full Employment Act, and the politicization of economic policy.

James Grant and other similarly sensible folk have long highlighted the absurdity of the modern Federal Reserve and its dangerous focus on attempting to maintain inflation by whatever favored index it chooses to manipulate, which is relevant to only those Americans that require neither heat, electricity, nor food (crackheads?).  Any discussion of inflation driven by artificially low Fed rates should arguably include not only commodity prices (which were an important component of the last period of costly inflation), but the prices most sensitive to interest rate fluctuations- those of financial assets.

The fundamental underpinnings of risk assets have long since disconnected from economic reality but are widely intelligible in the context of a market broadly gaming the Fed’s accommodative policy, long liquidity and short dollars.  Despite being prematurely declared dead on several occasions, the robust bull run has been surprisingly resilient and broadly-based and seems likely to continue absent a major external shock or an unexpected Fed hike.  The recent up-trend in gold, which has traditionally been regarded by more hawkish central bankers (the Volcker Fed zum beispiel) as a market signal of the need to tighten offers a counterpoint to the relatively benign movement in the CPI.

Inflation has remained constrained to financial assets as significant deflationary forces remain in the real economy owing to the slow and painful deleveraging process.  This is observable in the falling velocity of money and in the lack of credit growth which have offset the large uptick in M2 and the prolonged period of near-zero interest rates.  A revived credit mechanism, which by definition will precede any real economic recovery, has the potential to re-couple the real and financial economies in a dangerous fashion.  Until there is credit growth, inflation will be restrained.  Until there is credit growth, there won’t be substantial economic recovery, which is likely to be the soonest point at which the Fed withdraws its support.  It may then be necessary for the Fed to suddenly reverse its position to halt an inflationary process that will already have moved beyond its control- given their less than stellar record of implementing counter-cyclical policy, I guess this really wouldn’t be that surprising.  The worrisome fiscal dynamic complicates the situation, but the Congress will likely only act to check fiscal profligacy until it is faced with a serious crisis- inflation or weak demand for Treasury auctions are both possibilities- that’s a topic for another post.

The delicate situation of the government’s recently purchased banking dependents adds further support to the Fed-overshoot hypothesis (the ol’ ‘Fed tightening bankrupts the marginal borrower’) .  Raising rates could inflict serious pain on lenders and would begin to narrow the enormous lending spreads that are allowing banks to gradually patch up their balance sheets.  The ‘earn your way out’ exit has long been a policy of Federal bank regs and was last seen on a large scale in the pre-RTC response to the S&L crisis- do whatever you have to to make them nominally solvent, give them explicit government backing and cheap credit, and then tell them to earn their way out (the preferred route then was to plunge headfirst into commercial real estate and HY debt).  Unsurprisingly, this isn’t a good idea.  It’s akin to inviting the survivors of the substance-abuse orgy you’ve hosted to stay with you until they get back on their feet, with a promise to lend them however much money it takes to repay the crippling gambling debts they owe to your neighborhood loan shark.  In the best case, you’ll likely be out the cash you lent them and in the worse you’ll be robbed blind by a bunch of conniving thugs.

Adding these perverse incentives to the Fed’s limited policy flexibility and what amounts to a stated preference for inflation suggests the Fed is headed for a type-1 error of enormous inflationary potential.  The seemingly contradictory flattening of near interest rate futures alongside a widening of TIPS breakevens is consistent with the view advanced above of a market in the intermediate stage of a fiscal and monetary policy-induced inflationary spiral, as are the widely divergent inflation forecasts of market observers, for all that’s worth. Until the Fed moves to limit the impact of loose monetary policy, the most likely result is the continuing strength of a dangerously frothy market built on little more than cheap money being used to game federally-inflated asset bubbles.  Sound worryingly familiar?

-bleichröder