Financial Review

Mind the Gap

Sinclair Noe — June 22, 2016

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

Subscribe: iTunes | Android | RSS

DOW – 48 = 17,780
SPX – 3 = 2085
NAS – 10 = 4833
10 Y – .01 = 1.69%
OIL – .82 = 49.03
GOLD – 1.70 = 1267.00

Tomorrow, UK citizens will vote on whether or not they want the UK to remain a part of the European Union. This is the referendum, also known as the “Brexit” vote. While opinion polls suggested the vote was too close to call, betting parlors in the UK put the odds of a vote to remain in the EU at 76 percent. Nevertheless, the whole process has been a source of great uncertainty.

The euro currency hit its lowest level vs. the dollar in 12 years. Politicians on both sides of the debate will be making their last arguments today ahead of polling stations opening tomorrow at 7:00 AM London time. We probably won’t know the final vote count until Friday morning, although there might be a decision based on exit polls and early voting trends.

The major issues for Britons who want to leave: sovereignty, regulation, and migration. The major issues for Britons who want to remain in the EU: free trade, investment, unity, and peace. And while the greatest impact will be felt in the UK and the Euro Union, the vote will impact the US as well. The UK is a major trading partner with the US, our seventh largest trading partner last year.

Beyond economic ties, the US government is most concerned about the political instability a Brexit could portend for Europe on the whole. There has been tremendous speculation about how the vote will affect financial markets; everything from a complete crash, to a minor blip, to a big rally. The truth is we don’t know. No states have ever left the EU before, so this is uncharted territory.

Fed chair Janet Yellen was back on Capitol Hill this morning. Yesterday, Yellen delivered her semi-annual Humphrey-Hawkins testimony before the Senate Banking Committee; today she testified before the House Financial Services Committee and she repeated her dovish outlook for the economy. Yellen cited “considerable uncertainty” about the economic outlook, and the potential for a Brexit vote to shake up the markets, she said the employment picture should improve, but she basically took a July rate hike off the table.

Yellen once again stressed the word “patience.” The Q&A session following the prepared remarks revealed a few interesting points: Yellen opposes legislation that would force the Fed to reveal the design of its stress tests, she does not think Fed regulations pose much a headwind for business, the Fed plans a conference on student debt, and she said it is not the Fed’s job to boost the stock market. Yellen did ask Congress for help to boost productivity but she wasn’t very forceful; as if she knew there was no chance of Congress doing anything worthwhile.

Sales of previously owned homes increased in May to the highest level in nearly a decade. The National Association of Realtors said existing-home sales rose 1.8% to a seasonally adjusted annual rate of 5.53 million, the fastest pace since February 2007. Constrained inventory continues to dog the market, pushing prices higher. The median price in May was $239,700, 4.7% higher than a year ago.

In a separate report, the Federal Housing Finance Agency said home prices rose 0.2 percent on a seasonally adjusted basis from March, and 5.9 percent in April from a year earlier. Prices rose from a year earlier in all regions, led by the Pacific — including California, Washington and Oregon — with an 8.6 percent gain. The FHFA says the national median price of an existing single-family home was $233,700 in April.

The rent is too high. A new report from Zillow shows that rents across the U.S. are increasing, and not just in the expected regions of New York City, San Francisco and Boston. Overall, rents increased 3.3% year-over-year as of January. In Phoenix, rents are up 5.3% year-over-year.

Puerto Rico is being sued in New York by a group of hedge funds claiming it’s illegally using an emergency fiscal-crisis law to dodge payments that are supposed to be guaranteed by the island’s constitution. While Governor Alejandro Garcia Padilla has not yet implemented a temporary debt moratorium, many speculate he will soon because the territory is expected to default on a payment of nearly $2 billion on July 1.

Elon Musk’s Tesla is buying Solar City from…, Elon Musk. Tesla Motors, made an offer to buy his solar installation firm SolarCity in a stock deal worth as much as $2.8 billion. Tesla shares plunged more than 13 percent in extended trading – amounting to a loss in value of about $4.3 billion, or more than the value of the offer for the other company. Shares of SolarCity rose about 18 percent.

After the volatility caused by the news settles down, we’ll be able to see how investors really feel about it. But the move is classic Musk; the chairman of SolarCity, CEO of Tesla and the largest shareholder of both companies, described the deal as a “no brainer”; the company could sell customers an electric car, a home battery and a solar system all at once.

But talk about synergies is just short-term. In the long-term, Musk is trying to build a fully vertically integrated energy company, from energy installation to storage to application. It would be a company that generates power from the sun, stores energy in batteries, and uses those batteries to power cars and buildings. On a conference call this morning, Musk said that the cost of sales for SolarCity and Tesla could drop by potentially half, or perhaps by 30% to 40%. On the solar and battery installation set up side, there would be one crew instead of two to three visits. For ongoing maintenance, there would be one point of contact instead of two to three. The cost of hardware would also be lower.

The plan is not without risk. SolarCity is building a massive solar panel factory in upstate New York; this at a time when energy prices have dropped substantially. Tesla has brought many of its development needs in house, moving away from suppliers as much as possible. With the Gigafactory, its massive battery factory under construction outside of Reno, Nev., Tesla will soon be making its own batteries, too, by bringing that core technology in house.

Tesla has taken reservations and deposits for nearly 400,000 Model 3 electric vehicles and now they need to figure out how to manufacture all those cars. And in his spare time, Musk launches rockets into space and plans a mission to Mars. Musk said the deal doesn’t really add debt because SolarCity should be cash flow positive before the end of the year. Still, SolarCity comes with massive debt burdens, and Tesla itself is not cash flow positive.

The SolarCity deal, and for that matter everything about Elon Musk, is risky. Many Wall Street veterans and hedge fund activists seem to hate Musk. At the same time, many Wall Street veterans think the best way for companies to create shareholder value is to scrap spending on research and development and innovation, borrow money on the cheap and buyback their own shares; an obsession with delivering short-term returns to shareholders while ignoring the future of the business.

From 2009 to the end of 2013, corporate investments rose by $400 billion. But those investments were dwarfed by shareholder payouts, which increased by $740 billion. During that same period, companies borrowed $900 billion. The financial system is no longer an instrument for getting money into productive businesses and then increasing profits through growth, but has instead become an instrument for getting money out of them.

Consider the differences between two well-known companies, Apple and Amazon. Apple’s stock has lost about a quarter of its value over the last year, despite a bunch of stock buybacks at the urging of former shareholder and billionaire investor Carl Icahn. Apple needs another billion-dollar product, and no one sees one coming down the pipeline.

Apple spends 3.5% of its revenue on R&D; Google spends 15% of revenue on R&D; Facebook spends 21% on R&D; Amazon consistently denied shareholder profits in order to reinvest in the business. Now, through that constant reinvestment, Amazon has found itself on the cutting edge of not just e-commerce, but also the cloud computing it developed.

Consider Michael Pearson, the former CEO of Valeant Pharmaceuticals; he cut R&D to single digits. He once said that the unfortunate thing about curing cancer was that there was no money in it. And his philosophy on drug pricing was to charge as much as the market could bear. As a result, he drove the price of two lifesaving heart medications up hundreds of percentage points. In 2014 Pearson said, “there’s only one metric that really counts, and its total return to shareholders.” Valeant shares lost 90% of their value. Pearson was fired.

Now consider Elon Musk; he dreams big, he makes the most innovative cars we have seen since the Model T, his products are environmentally friendly, and massive disruptors across several industry sectors (auto, energy, space); and now he faces one of his biggest challenges.

Institutional investors own more than 63% of Tesla shares. Tesla is not following standard procedures on this deal. Musk owns 21% of Tesla and 22% of SolarCity; his cousin, Lyndon Rive, is a founder and the CEO of SolarCity. There are already charges of a potential conflict of interests. It does not appear that Tesla or SolarCity truly formed an independent committee or hired independent counsel. It is a good bet that shareholder lawsuits will be forthcoming.

Whether the deal falls apart or not, you should appreciate that we are watching one of the most compelling characters and one of the most remarkable business stories. Musk, Tesla, SolarCity, and the deal could be the next great thing, or it could all come crashing down harder than a SpaceX Falcon rocket, but it is hard to take your eyes off whatever unfolds.

Financial Review

While the Sun Shines

Sinclair Noe — March 26, 2015

 

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

Subscribe: iTunes | RSS

DOW – 40 = 17,678
SPX – 4 = 2056
NAS – 13 = 4863
10 YR YLD + .09 = 2.01%
OIL + 2.22 = 51.43
GOLD + 9.00 = 1205.10
SILV = .15 = 17.20

Saudi Arabia and its Gulf allies started bombing targets in Yemen as the country slides closer toward civil war. A Saudi military spokesman said there were no immediate plans to launch ground operations in Yemen. Importers say the Saudi attack is not expected to disrupt oil supplies, but the threat of spreading war in the region could likely impact oil flows. Yemeni President Hadi reportedly fled the country yesterday. The White House says the US will provide “logistical and intelligence support.”

Yemen is a fairly small oil producer, but still the news helped push oil prices up almost 5% today, and there are several reasons. First, if things go wrong, this could turn into a proxy war between Shiite Iran, which is backing the rebels, and Saudi Arabia and other Sunni monarchies that supported the Yemeni regime.  The Saudi action could exacerbate tensions in Libya, Syria and Iraq; in other words, this could be part of a trend in the region.

Yemen is also geographically strategic, at the chokepoint of the Red Sea; so there might be the possibility the rebels could disrupt oil tanker traffic; 3.8 million barrels a day are transported through a 25 mile wide stretch of water between Yemen and Djibouti. Foreign ships have been warned not to get to close to Yemen ports.

The flip side of the bullish case for oil is that the Saudis will now need to pay for their military actions, and that means they can’t afford to cut back oil production.

Another consideration is the strong US dollar, which would only get stronger if the Fed hikes rates. This has been a light week for economic data which means it has been a good week for Federal Reserve policymakers to make a case for hiking interest rates. St. Louis Fed President James Bullard says now may be a good time to start normalizing US monetary policy, “so that it is set appropriately for an improving economy over the next two years.” Bullard says there is a concern that prolonged low interest rates could feed into asset price bubbles over the next few years. Atlanta Fed President Dennis Lockhart was interviewed on CNBC today; he says the strong dollar is something that he has upgraded in terms of importance, and that it could have “some dampening effect,” still Lockhart see a rate hike coming “mid-year or a little bit later.” Fed Chairwoman Janet Yellen wraps up the week with a speech tomorrow, just in case the Fed heads haven’t hammered home their point.

When the Fed talks, people listen, and then economists write papers. Laurence Ball economics professor and monetary policy expert at Johns Hopkins University, in a paper to be published next week by the Center for Budget and Policy Priorities says the Fed could create more jobs by letting the unemployment rate fall lower. It should seek to push the rate “well below 5%, at least temporarily,” he writes. That could help bring some discouraged workers to reenter the labor market, as well as help the long-term unemployed find work and involuntary part-time workers find full-time jobs. Mr. Ball allows that a low unemployment rate might result in a temporary jump in inflation above Fed targets but he considers that an acceptable side effect. In other words, it would be easier to fight inflation down the road with rate hikes than it would battling persistently low inflation or deflation with rates already close to zero.

The number of people who filed new applications for benefits at their state unemployment offices, known as initial claims, fell by 9,000 to a seasonally adjusted 282,000 in the period stretching from March 15 to March 21. New claims have tracked below 300,000 for three straight weeks after a weather-induced spike in February that pushed them to the highest level since last spring. And they are running about 9% lower now compared to one year ago.  Layoffs remain near a 15-year low.

A rebound in home prices is good news in the wake of the housing crash — but there can be too much of a good thing. Home prices are rising 13 times faster than wage growth nationwide, according to a report from RealtyTrac. From 2012-2014, median home prices climbed 17% while median wages rose 1.3%.

The House of Representatives today passed a bill to revamp Medicare’s payment formula for doctors. The bill would end the temporary patches known as the “doc fix” that lawmakers approve to prevent payment cuts to doctors. Part of the $214 billion measure is paid for by raising Medicare premiums on wealthy seniors. Passed on a vote of 392 to 37, the bill now goes to the Senate.

The Consumer Financial Protection Bureau has released a plan to rein in payday lenders. The CFPB proposal would require lenders either to ensure borrowers are able to pay back loans or to provide affordable repayment options or other protections such as capping the number of times borrowers can roll over debt. Four out of five payday loans are rolled over or renewed within two weeks. The CFPB’s proposals under consideration also would restrict payday lenders from some questionable practices by preventing repeated and unexpected withdrawals from consumers’ bank accounts. Most payday lenders can access borrowers’ checking accounts and withdraw the funds they are owed, often resulting in high fees when the withdrawal exceeds the checking account balance. In most cases, regulation for payday lenders largely falls to the states, which determine such factors as the maximum interest rates lenders can charge. Annual percentage rates on payday loans, which are offered in 36 states, are typically just shy of 600% in Idaho, Nevada, Texas and Utah, according to a report by the Pew Charitable Trusts. The CFPB proposals will now be opened for feedback from payday lenders and other before putting forward a plan.

Labor Secretary Tom Perez announced plans to travel to Seattle to sit down with workers and employers to discuss “how flexible workplace policies can help support families and businesses.” Perez said only 12% of private sector workers have access to paid sick days. It’s a big problem for low-wage workers. Two thirds of workers at the bottom 25% of the pay scale, the country’s lowest earners, do not receive paid time off for illness, according to the Labor Department. Three quarters of part time employees are not paid when they miss work due to illness. In some cases, they lose their jobs. In a video statement, Perez said: “We are way behind the rest of the world on this. You shouldn’t have to choose between the family you love and the job that you need.”

Of course, Seattle is the headquarters of Microsoft, and today Microsoft announced a new policy requiring suppliers with at least 50 employees to offer workers either 15 days of unrestricted paid time off, or 10 paid sick days and 5 paid vacation days. Microsoft works with a variety of businesses that supply goods and services, ranging from building maintenance and food service to management consulting and “software localization.” The new requirement will apply only to workers at suppliers who do “substantial work” for Microsoft and who have been with the supplier for at least nine months. Microsoft concluded that mandating paid time off for suppliers would ultimately benefit the company and employees by contributing to a “happier and more productive workforce.”

The Commerce Department reports that corporate spending on research and development rose 6.7 percent in 2014, almost twice the previous year’s gain and the biggest advance since 1996. The pickup was capped by a 14 percent fourth-quarter surge that signals additional increases are on the way. More research may help rekindle business investment in equipment that has been bogged down since late last year. Orders for non-military capital goods excluding aircraft, a proxy for future spending on new gear, slumped 1.4 percent in February. It marked the sixth straight decrease, the longest stretch since mid-2012. Investors are now rewarding companies looking to the future rather than those using their horde of cash to buy back shares. Shares of the 190 companies in the S&P 500 that disclosed R&D spending in 2014 outperformed the overall index by 6.1 percentage points. One of the benefits of increased spending on R&D is an increase in productivity, although productivity gains lag R&D spending, sometimes by several years.

The U.S. Energy Information Administration has just released data showing that in just one year, California has increased solar power from 1.9 percent to 5 percent of the state’s total power generation. California isn’t just producing the most utility-scale solar electricity of any state; it’s producing more than all the other states combined. And that’s only what the major electricity producers are generating; it doesn’t include rooftop solar, in which California is also leading the nation. In small-scale solar, capacity for another 2.3 gigawatts has been installed, according to the California Public Utilities Commission. California now accounts for about half of the country’s solar power capacity.

The surge in California’s solar output was driven by a handful of massive new plants, including the Topaz Solar Farm in San Luis Obispo County and Desert Sunlight Solar Farm in the Mojave Desert. Each has a capacity of 550 megawatts, making them among the largest solar plants of their kind in the world. With those plants and others, California added nearly 1,900 megawatts of new utility-scale solar capacity in 2014, raising the state’s overall solar sector to nearly 10,000 megawatts — or enough to power some 2.4 million homes.

Renewable energy, including hydro power and rooftop solar, now constitutes about a third of California’s electricity. And remember that California is going through one of the worst droughts in its history, which has resulted in hydroelectric power being cut in half. The annual increase in California’s solar generation in 2014 offset 83 percent of the decrease in hydroelectric generation. When you don’t have rain, you have to harvest sunshine.