Originally published by Narrow Road Capital
Risk asset returns were solid in September with equities and credit up whilst commodities were mixed. Equities in Europe (5.1%), Japan (3.6%), the US (1.9%) and China (0.4%) rose with Australia (-0.6%) the odd one out. Credit posted good gains, particularly in high yield markets. US oil (9.7%) was the sole positive in the major commodities as iron ore (-21.4%), copper (-5.1%), gold (-3.1%) and US natural gas (-1.0%) all fell.
BIS Nails the State of Global Corporate Debt
The Bank for International Settlements (BIS) quarterly report is always worth the read. Whilst it is academic in style and length, it consistently raises material that matters. Taken from the September report, the graphic below highlights the big issues for global corporate debt. The rest of this short article explains each component and its importance.
The first graph shows that covenant quality is worsening and the proportion of debt without meaningful covenants is increasing. Lenders are competing against each other by offering borrowers weaker covenants (which increases the probability and severity of defaults in the long term) as well as lower margins. Covenants have become so uncommon investors automatically assume that the borrower must have problems if their new loans include covenants. The second graph shows that leverage is generally increasing whilst interest coverage is falling. Both of these trends point to higher risk in debt markets.
The zombie firms of the third graph are defined as companies at least ten years old that have earnings (EBIT) less than their interest bill. These firms have limited ability to invest in growing their businesses as their earnings are consumed by their debt repayments. In a normal environment, these firms would restructure their debts or be liquidated, but the loose credit environment has allowed them to continue operating as is. A good example of a zombie firm is Toys R Us, which struggled for years with excessive debt and underinvestment. In September it filed for bankruptcy, something of a rarity given debt markets will fund almost anything at the moment. The bankruptcy process should greatly reduce the company’s debt, allowing it to invest and compete fully again.
The last graph is arguably the greatest warning of the four. It shows that relative to 2000 and 2007, which were peak years for the previous credit cycles, the quality of debt outstanding is worse. The proportion of investment grade rated debt (A and BBB ratings) is noticeably lower in Great Britain and Europe. The lowest quality debt (C rating) has increased substantially in all regions. When the global economy next weakens, there are plenty of companies that won’t be able to service their debts. US leveraged loans are on track to break the issuance record set in 2007, another sign of the bullishness in global credit.
Whilst these graphs all relate to corporate debt, sovereign debt is showing the same deterioration in quality. Last month I described lending to Argentina, Greece and Iraq as dumb. This month I’ve written about the lunacy of lending to Tajikistan. It wouldn’t surprise me if North Korea was able to get a loan soon, although it might have to be funded through Chinese wealth management products to get around the sanctions!
Cryptocurrencies and Blockchain are Just Reruns of 90’s Bubbles
The old saying that history doesn’t repeat but often rhymes sums up the fervour surrounding cryptocurrencies and blockchain. The media loves to write about something new and sexy and the financial media loves to write about those things as well, especially when they involve volatile asset prices. As cryptocurrencies and their underlying technology, blockchain, satisfy all of those characteristics there’s daily coverage of their latest developments.
Investors often fall for shiny new toys as well. The original cryptocurrency, Bitcoin, has risen from mere cents in 2010 to over $3,500 today. Some speculators use these returns to extrapolate a story of massive potential future returns for Bitcoin and the over 900 other cryptocurrencies. A more pragmatic view is to see these returns and the wave of new cryptocurrencies issued each week as a sure sign of a speculative bubble. Two examples from the 1990’s can help us understand the mania surrounding cryptocurrencies and blockchain and their likely futures.
Cryptocurrencies and Baseball Cards
In 2010 Dave Jamieson wrote Mint Condition, the seminal book on the baseball cards bubble of the late 1980’s and early 1990’s. In this recent interview on Bloomberg Odd Lots he describes the background, the build-up and the eventual fall of this bubble. Baseball cards went from being a niche hobby to a big business in the space of a few years. Many new entrants began producing cards, flooding the market with variations on what is essentially a picture on a piece of cardboard. For some the cards became an alternative form of currency, with kids and adults alike buying them with a view that the prices would increase and they would make a fortune. It was a classic Ponzi bubble.
The development of cryptocurrencies today mirrors that of baseball cards. In the space of a few years we’ve gone from a handful of alternative currencies to dozens of initial coin offerings (ICO) a week. Each ICO claims to offer a unique angle on why it should flourish, but few pass the sniff test. For instance, developing technologies for the dental industry is a reasonable aim, but why fund it through the issuance of Dentacoin? Even Dogecoin, which was created as joke on the cryptocurrency scene, reached a market capitalisation of $400 million.
The future of cryptocurrencies will involve almost all of them dying off with only a handful surviving. Alternatives currencies do serve a purpose for those looking to engage in illegal activities or who need a way to get their money out of a country with a closed currency. (E.g. China or Venezuela) However, that’s thought to be a very small part of the current buyer base and there are many alternatives to cryptocurrencies to transmit wealth.
For those concerned about the value of fiat currencies in a time of central banks printing money, gold or real estate are better ways to protect wealth. Unlike alternative currencies, which have a near endless supply at close to no cost, there’s a very limited supply of these assets. The regular thefts of cryptocurrencies are another disadvantage, which is difficult to overcome without giving up anonymity. There’s no good reason to think that cryptocurrencies are any more valuable than a picture on a piece of cardboard.
Blockchain and the Internet
Unlike cryptocurrencies, blockchain has a decent future but it’s not worth the hype it is getting. Blockchain is a good way to store information and enable transfers, giving it the potential to replace many non-automated databases. However, the fanboys of blockchain have forgotten the lessons from the internet boom of the late 1990’s and are repeating the same guff about blockchain taking over the world.
Some of the hype about the internet boom has ultimately turned out to be correct, but it took far longer than expected and few survived to make a decent profit. Whilst people can order and purchase all sorts of things via the internet, even today US online retail spending is less than 10% of total retail sales. A handful of internet based businesses have thrived, but far more fell along the wayside as they simply couldn’t turn their hype into sales and profits. In many cases it wasn’t the technology at fault, it was that businesses and consumers simply didn’t want what was being offered.
Blockchain’s implementation is likely to follow the same pathway. Whilst blockchain can offer obvious improvements such as lower costs, faster transactions and lower error rates, many businesses will take a long time to adopt new technologies. In the finance sector, there are a myriad of outdated processes that can be improved. But banks, with their history of slow adaption and risk avoidance, won’t be rushing to change everything. When they do make a decision to change they will most likely do the work inhouse or engage contractors to retain ownership of the intellectual property. Only a handful of blockchain developers (or some other technology like it) will earn super-profits by developing solutions and charging clients on a per user/usage basis as Microsoft (NASDAQ:MSFT), Oracle (NYSE:ORCL) and SAP have done.
Conclusion
Cryptocurrencies and blockchain are the shiny new toys of this era, drawing in the attention of many and speculative investment of a few. Like the baseball cards and internet bubbles of the 90’s, these two sectors will almost certainly fail to live up to the hype. Cryptocurrencies are a Ponzi bubble just like baseball cards were. The lack of any material asset backing and the near endless minting of new currencies all but guarantees that only a few will survive with the vast majority becoming worthless. Blockchain can solve many database and asset transfer problems but the profits from its development are more likely to go to old industries that adapt to it than developers who create solutions. Investors are best placed by sitting on the sidelines and seeing how these bubbles shake out.
Would You Lend to Tajikistan?
The issue of bonds by Tajikistan this month follows on from recent low quality bond issues from Argentina, Greece and Iraq. Emerging market debt investors piled into the offering allowing the nation to issue US$500 million of ten year bonds at 7.125%. Investors who bought in cited the yield on offer and diversification as reasons to invest. For the B- rated (Standard & Poor’s) nation, with annual GDP of only $6.95 billion and no history of selling bonds, this issue is a big deal.
Tajikistan is amongst the poorest nations in Asia with annual GDP per capita of $968. The largest foreign income source is believed to be the drug trade as the nation shares a border with the world’s largest producer of opiates, Afghanistan. Expatriate workers in Russia are also a solid source of foreign currency. The main industry is an aluminium smelter, though the country itself has no bauxite to mine and is reliant upon imports. The need for large amounts of electricity to produce the aluminium is key to the purported purpose for the issue.
In the weeks before the issue, Tajik officials presented to potential investors. The first slide was map showing where the country sits, which is fitting as the country hasn’t issued bonds before with existing debt from China, the World Bank, the Asian Development Bank and the IMF. At a cost of $3.9 billion, the country is planning to build a hydro-electric power plant and the world’s tallest dam, with the project forecast to be completed in 2032. Fifteen years to build a dam and power plant might seem excessive, but construction works have started and stopped several times since 1976. The basic maths has the debt maturing five years before the project is due to be fully operational and the proceeds forming less than 13% of the overall funding with minimal other funds committed for the build.
The presentation to investors also included ten slides on the potential risks of the bonds and investing in Tajikistan. These include; the potential for social unrest in what is considered a dictatorship marked by cronyism and corruption, reliance upon good relationships with Russia and Uzbekistan (neighbouring Uzbekistan objects to the dam as it will change waterflows for its cotton industry), a weak banking system, very low levels of foreign reserves, relatively high debt to GDP for such a poor nation and the economic reliance on the drug trade.
In normal times, the above list of risks would have excluded Tajikistan from public financing with only friendly nations like Russia and China or development institutions willing to provide any funding. However, yield starved investors are willing to ignore almost any risk these days to chase just a little bit more yield. Ukraine (also B- rated) has just sold $3 billion of fifteen year bonds, less than two years since it gave bondholders a 20% haircut on their debts.
For Tajikistan’s bondholders, the potential pathways to default are obvious and many. The funds could be squandered by the nation’s president. The president could be forced out by a popular uprising with debts incurred by the prior regime repudiated. The dam may never be built, or might stall part way through due to cost overruns, technical difficulties or lack of funding. Neighbouring Uzbekistan might take military action to ensure water flows aren’t impeded. Russian and Chinese investment might dry up. The US might get sick of the drug trade and place sanctions on Afghanistan and Tajikistan. Tajikistan might exhaust the patience of its creditors and be unable to rollover its debts. Given all of these obvious risks, would you lend to Tajikistan?
Media Worth Consuming
Finance
How a one-man investigative operation exposes dodgy American companies. A US start-up gives house buyers a down payment in return for 1-3 years of Airbnb bedroom rentals. 15 reasons and 6 benefits from hiding your wealth. If you are starting out or just want a reminder, here’s 36 obvious truths about investing. Pensioners in two tiny Californian pension plans have had their pension payments cut by 70% and 92%. European soccer teams are promoting CFD providers offering over 300 times leverage. CFD exchanges will lever cryptocurrency bets up to 30 to 1. North Korea is stealing cryptocurrencies to finance its activities.
Jamie Dimon says he would sack any JP Morgan employee for trading bitcoin for “being stupid”, but JP Morgan is one of the biggest traders of Bitcoin in Europe. The company paid $13 billion for securitizing dodgy mortgages pre-crisis, but has pretended it did nothing wrong ever since.
HELOCs and second mortgages are booming in Canada, in some cases they are being used to defer bankruptcy. UBS estimates as much as $500 billion of factually inaccurate loans reside on Aussie bank balance sheets. Payments have been suspended on $8 billion of American student loans due to dodgy documentation and servicing. Earnings are becoming less of a driver of share prices, with monopoly power becoming more important.
Politics & Culture
Amazon (NASDAQ:AMZN) deletes negative reviews of Hillary Clinton’s book but keeps positive ones. Hillary’s collusion with Russia goes much further than Trump’s. She claims that women wanted to vote for her but were bullied by their husbands to vote for Trump. Electricity theft in India speaks volumes about corruption, poverty and treatment of women. 70% of large donors to Chicago’s mayor have or are seeking contracts with the city.
Hungary’s wall has reduced illegal immigration by 99%. How Venezuela went from being a middle income democracy to an impoverished dictatorship, thanks to socialism. Spanish police raid Catalan govt offices and make arrests in an attempt to halt the referendum on independence. Kurds vote overwhelmingly for independence, now the negotiations begin. The consequences when truth speech and opinion is categorised as “hate speech”.
Economics & Work
US courts are rejecting union claims to automatically deduct union fees from non-members. Generation free lunch – American teenagers are taking fewer part time jobs. The Washington Post attacks an employee who wrote about newspaper’s poor labour practices. Hawaii is considering universal basic income, but it would need a tax equivalent to $3,400 for every family that holidays there to pay for it. Million dollar packages are being offered at a Chinese start-up in a war for top talent. A book that tracks the journeys of itinerant American workers shows that bad choices are mostly to blame for their relative poverty.
Environment
Puerto Rico was trashed by hurricane Maria with ATMs and credit card terminals out of action. The devastation there is likely to lead to further depopulation and lower bond recoveries. Damage to the US Virgin Islands may lead it to default as well.
One hurricane damaged country is issuing warnings about damaged property rather than helping residents clean up. Economic morons forget the broken window fallacy and claim that hurricanes are good for economic growth. A grocery store chain is far better than the Red Cross at helping after the Texas floods. The US has $696 billion in mortgages in hurricane affected areas, how many homeowners will walk away? America’s subsidized flood insurance rewards stupidity, including paying out 22 times on one property in 38 years.
Wind farms without subsidies may not be economical and may never be built despite winning tenders and signing contracts. Australia has lots of space for pumped hydro, but needs large electricity price variations to make it work. China is planning to double its nuclear power generation in the next decade. US spot electricity prices are at record lows. Battery cars have lower lifetime emissions than petrol cars, but the gap isn’t as big as perceived.
More CO2 in the atmosphere increases crop yields but reduces nutrient density. A visual future of food. How the Netherlands exports huge amounts of food and agricultural know how. Can mass growing of indoor fruits and vegetables replace traditional farming? How to turn methane into edible protein.
Miscellaneous
There’s hardly any lines for the new iPhone and Apple's (NASDAQ:AAPL) suppliers are feeling the pain. Almost all of Baltimore’s share bikes are out of action from damage or theft. High limit credit card details can be purchased on the dark web for under $20. One man’s story of how it took three years to clean up his stolen identity. A nurse was arrested after choosing not to commit the crime of taking a blood sample from an unconscious patient. A hilarious take on shareholder activism is a must read for some light relief.