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Rainbows over Canyonlands - Dave Stoker

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Tuesday, December 29, 2015

Financial Review

Driving Down Third Avenue

DOW – 23 = 17,528
SPX – 4 = 2056
NAS – 7 = 5040
10 YR YLD – .01 = 2.23%
OIL – 1.39 = 36.71
GOLD – 7.50 = 1069.80

Storms hit the South, Southwest and Midwest over the Christmas holiday weekend, unleashing floods and tornadoes that killed at least 43 people, flattened buildings and snarled transportation for millions during a busy travel time. The bad weather, or the threat of it, prompted the governors of Missouri and New Mexico to declare a state of emergency for their states. Flash floods killed at least 13 people in Missouri and Illinois. In Texas, at least 11 people were killed in the Dallas area over the weekend by tornadoes.

Oil prices were down again this morning, following a five-day rally that saw prices move to the highest level in three weeks. Iran repeated its goal of boosting exports after sanctions on the country are lifted. OPEC effectively abandoned output limits earlier this month. Today, Saudi Arabia announced it would boost production to defend its market share. The kingdom’s revenue from oil sales will make up about 70% of the budget next year, down from 73% this year and down from 89% last year.

The Saudi 2016 budget is estimated to be based on a $37 a barrel for Brent oil prices; the first Saudi budget in more than 10 years that is based on an oil price of less than $50 a barrel. For the Saudis this means big changes. They will cut government spending and reduce subsidies on energy, water, and electricity, plus they will privatize some state-owned entities. And for the first time in a decade, they will issue bonds to cover their deficits.

West Texas Intermediate crude is headed toward its second yearly decline. Brent, the benchmark for more than half the world’s oil, is poised to end 2015 with the lowest annual average price in 11 years; low oil prices have hurt oil-exporting countries and companies, but it has been a boon for consumers.

Major stock market drivers this year have included sluggish global and domestic growth, shrinking corporate profits, a stronger dollar, and lower commodity prices, especially in the energy markets. A drop in energy prices and other commodities hit the junk bonds. We have just recently seen an example of this dynamic at play in the collapse of Third Avenue Management. A quick recap: Third Avenue shut down on December 9th and blocked investor redemptions following losses of about 30%; its assets shrank to less than $800 million from more than $3 billion.

When compared with other junk-bond funds, Third Ave’s Focused Credit Fund carried an elevated amount of risk. The fund disclosed, for example, that its so-called Level 3 assets, or securities that are hard to value and trade, were 20% of assets at the end of July. And the fund had 76% of its portfolio exposed to very low-rated “CCC+” rated securities and below. Focused Credit found its way into the portfolios of mom-and-pop investors, pension plans, and nonprofits because the reality is that almost nobody pays close attention to the credit ratings and liquidity of junk-bond funds. So, for any of you that were in Third Ave, the first step is to fire the advisor that sold this junk to you.

Last Thursday PwC released its audit of Third Avenue. The fund made big bets on illiquid, hard-to-trade assets that included bankruptcy-related claims. Texas-based Global Geophysical Services, a provider of seismic data for exploration and production companies in the energy sector, turned out to be one of the fund’s biggest performance detractors during the fiscal year. Global Geophysical was not the only contributor, but it may have been a tipping point, a break in the levee. Bad performance begets redemption requests from investors, forcing a fund to sell already stressed assets at lower and lower prices. The result is a downward spiral of fund redemptions and forced sales.

And the damage is not distinct to the junk bond market. The big investment banks are also vulnerable, to a much lesser degree. OPEC projected that oil prices will remain at historic lows until at least 2040 before they rebound to $100 a barrel. The projections for continued low demand for oil could spell trouble for both the oil industry as well as the financial sector. With ongoing low demand and low prices, oil companies may have difficulty repaying loans from banks.

Through Sept. 2015, Bank of America had an increase in bad balances for its commercial credit business of $2 billion. The bank attributed a large portion of those bad balances to defaults on energy sector loans. They are not alone; JPMorgan, Citigroup, Deutsche Bank, and others will face similar pressures in the year ahead. The big investment banks can absorb many billions in big losses without fear of shutting down, however it could be enough to curtail lending to other sectors as well as significant cuts to dividends the big banks pay.

More US companies have defaulted on their debt this year than issuers from any other country or region. As of last week, S&P reports 111 companies worldwide had defaulted on their obligations, the highest tally since 2009 when the figure hit 242 for the same period. About 60% of this year’s global defaults have come from U.S. borrowers.

The cracks in the levee appear in what is known as the yield spread; this is the difference between the yield on a security and a comparable US Treasury bond. For example, investors in junk bonds are now demanding a higher yield to compensate for the extra risk. We are now seeing wider yield spreads on a variety of higher-yielding securities, such as investment-grade corporate bonds, municipal bonds, convertible bonds, preferred stocks, REITs, utilities, and MLPs. And remember that many of the bond funds that look like plain vanilla actually contain high yield or derivatives or alternatives.

The spread between Treasuries and CCC-rated bonds is now 16.1%. The spread between CCC-rated bonds and B-rated bonds is also blowing out. As of Friday, it stood at 9.0%, higher than at any point in the first nine months of 2008. The spreads to Treasuries between BB- and B-rated bonds have not yet blown past their 2008 pre-Lehman highs.

Now this is where it gets interesting. Today Saudi Arabia reassessed its federal budget based upon lower oil prices; they announced a $98 billion deficit, and they announced they will ramp up production. The year-end assessment is not unique to Saudi Arabia; it is standard operating procedure for oil companies big and small. Each year end the oil companies calculate their reserves based on the average price for oil and gas during the calendar year. Then, lenders use that valuation to calculate whether they will lend, cut lending, or stop lending. The calculation for 2015 will be a substantially lower value than it was for 2014 for most companies.

Does this portend a blood bath in the debt markets? Not necessarily. Wall Street’s biggest bond dealers are forecasting that blue chip companies will sell more than $1 trillion of bonds for the fifth straight year in 2016. Companies are expected to take advantage of borrowing costs that remain historically low. Meanwhile, four technology startups with billion-dollar-plus valuations are getting ready for initial public offerings in early 2016, following one of the slowest technology IPO years on record. While market conditions could alter their plans, Nutanix, Okta, Twilio and Coupa Software are in various stages of preparing to go public, and their performance could signal whether investors are once again willing to pay premium prices for startup IPOs.

Yields on investment-grade bonds reached a four-year high of 3.68% this month even as the Fed boosted its benchmark rate for the first time in nearly a decade. The Fed thinks the economy is strong, or at least strong enough to withstand the problems in the energy market and subsequent problems in the credit markets. If the Fed is right, the junk bond market represents a bargain, but only for those with a cast iron gut. The thinking for the Fed is that low energy prices are a good thing for the world’s largest energy consumer. They might be right.

Strong online sales and demand for furniture and women’s apparel helped U.S. retail sales grow by a “solid” 7.9% this holiday season – up from 5.5% last year – according to MasterCard Advisors, which tracks customer spending. Online sales grew 20% in the holiday season this year.

FedEx drivers had to work extra shifts over the holiday to help manage the surge in online shopping and the severe weather plaguing the South. FedEx’s major air hub is located in Memphis, an area affected by the heavy storms. Meanwhile, UPS seems to have avoided holiday trouble this year, stating it had established detailed operating plans to ensure available capacity.

Amazon typically plays its customer data close to the chest, but it has released several figures about its Prime service and holiday season. More than 3 million people joined Prime in the third week of December alone, and 200 million items were shipped to Prime subscribers, and more than two-times as many Amazon devices were sold compared to the 2014 holiday season, the company said in a statement. So how many Prime members does the retail giant now boast? The exact figure is still not known, but Amazon said it’s in the “tens of millions.”

Star Wars: The Force Awakens crossed the billion-dollar mark on Sunday, accomplishing the feat in just 12 days, and it hasn’t even opened in China, the world’s second largest movie market. Prior to The Force Awakens, the fastest movie to cross the $1 billion threshold was Universal Pictures’ Jurassic World, which took just 13 days after its release in June.

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