Financial Review

Headwinds and Tailwinds

Sinclair Noe — January 14, 2016

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DOW + 227 = 16,379
SPX + 31 = 1921
NAS + 88 = 4615
10 Y + .03 = 2.10
OIL + .66 = 31.14
GOLD – 15.00 = 1079.50

Global stocks have lost almost $3.2-trillion in market value since the start of 2016, pushing all major US indexes into correction or bear market territory. Asian markets (except for China) and European exchanges were mostly lower. Even with a bounce, we’re trending lower, short-term.

The Bank of England this morning kept its key interest rate at a record low of 0.5% and made no changes to its $540 billion asset purchase program. Both decisions were widely expected.

The Hong Kong dollar sank by the most in more than a decade overnight and speculation mounted in the options market that the city’s 32-year-old currency peg will soon come to an end, as investors lost confidence in Chinese assets. Other currencies also took a hit. The loonie fell to its lowest level since April 2003, fueling speculation the Bank of Canada could cut interest rates as early as next week.

The average number of people who applied for jobless benefits in the past month climbed in early 2016 to the highest level since last July. Initial jobless claims for the first full week of January, meanwhile, rose by 7,000 to a seasonally adjusted 284,000; the four-week average rose to 278,750.

The prices the U.S. paid for imported goods fell 1.2% in December, and dropped 8.2% for all of 2015. Even if oil prices are set aside, import prices have been falling. The cost of all imports excluding fuel slid 3.4% in 2015, marking the only decline since the government began keeping track in 2001. At the same time, export prices sank 1.1% in December. For the full year, export prices sank 6.5%, the biggest decline since the government first began keeping records in 1983.

JPMorgan Chase said fourth-quarter profit rose 10 percent. Net income rose to $5.4 billion, or $1.32 a share, from $4.9 billion, or $1.19, a year earlier. Revenue rose 1 percent to $22.9 billion in the fourth quarter. Earnings rose as the bank cut expenses from litigation and employee compensation shrank. Now there’s a business model for you.

We didn’t see much in the way of positive surprises in the earnings report, unless you consider not paying the lawyers and the regulators more to be a surprise. Still, they beat estimates. JPMorgan was up .86 at 58.20 today. Flat is the new up in investment bank land.

JPMorgan kicks off a parade of bank earnings reports. Wells Fargo and Citigroup report on Friday. A few analysts think the big banks have already taken their licks and are so far into oversold territory that there might not be much downside left. The KBW Nasdaq bank index shows bank shares down 17% from their July 2015 highs, down 15% since December, and down almost 10% so far in 2016.

If the big banks are going to climb out of their hole, they’ll need a lot better news than JPMorgan delivered today. One of the bright spots was from advisory fees on M&A. Mergers and Acquisitions in the fourth quarter reached near record levels, capping a record year. Globally, M&A activity topped $4.9 trillion in 2015, outpacing the previous record of $4.6 trillion set back in 2007. In a rising interest rate environment, it is hard to imagine 2016 will be a better year for M&A.

JPMorgan’s advisory revenue was up 43% to $622 million. Not bad but not outrageously great; and it was about the only strong area and not a surprise. Meanwhile trading revenue fell 3%, equity trading fell 7%, and credit underwriting disappeared.

And the headwinds are more problematic than the tailwinds are helpful. There’s no question debt and credit trading was difficult in fourth quarter. High-yield debt in general hit the skids hard, and nowhere was that more prevalent than in the energy sector. The Federal Reserve’s most recent Shared National Credits exam noted that 74% of the increase in classified loans were oil and gas loans, “where near default loans increased four times.”

JPMorgan nearly doubled its loss provisions in the fourth quarter, mostly due to bad energy loans. Asked on the earnings call if the bank is setting aside too little, Dimon says he’d put up more if he could, but accounting rules dictate what can be done.

I’m not sure which rules Dimon was referencing but we do know that every 10 basis points of expense increases for loan loss provisions will knock about 4% off banks’ earnings. Bottom line: a decent report from JPMorgan but it doesn’t look like enough to lift the banking sector.

Following the collapse of the Third Avenue Focused Credit Fund last month, the SEC has launched a review of the entire junk-bond fund complex. Reuters reports the agency “sent detailed requests” to mutual fund and ETF managers following the Third Avenue liquidation plan in which investors could wait a year or more to get their money. Regulators are “seeking information about how they price less liquid securities, and whether certain parties have ever challenged those prices.”

Intel reported a small increase in quarterly revenue, reversing two quarters of declines, as growth in its data center business more than offset weak sales to PC makers. Net income fell to $3.61 billion for the fourth quarter, from $3.66 billion, a year earlier. Net revenue rose to $14.91 billion from $14.72 billion. On a per share basis, earnings were flat at 74 cents. The fourth quarter of 2015 marked the fifth consecutive quarter of worldwide PC shipment decline. Intel was up .83 at 32.74, but they are down over $1 in after-hours trade.

GoPro shares were clobbered, down 26%. The wearable camera maker said on Wednesday it expected revenue of about $435 million for the fourth quarter, well below the average analyst estimate of $512 million.

Renault shares dropped more than 20% after a union said French fraud investigators seized computers from the automaker, apparently as part of a probe into emissions testing. The French government said tests on nearly two dozen Renault models and other automakers found several that exceeded the country’s air quality standards but so far found no evidence of technology designed to cheat on emissions tests, except a couple of VW models.

Volkswagen and EPA officials remain at an impasse following yesterday’s talks between VW CEO Matthias Müller and EPA chief Gina McCarthy, casting doubt over a quick resolution of the automaker’s emissions cheating scandal. The two sides gave no indication of any progress during a meeting at EPA offices in Washington, D.C.

Trading in Fiat Chrysler was halted several times today in Milan Italy, as prices dropped by 10% or more on a report from Automotive News, saying that two Chicago car dealerships have filed a lawsuit alleging the company offered dealers large amounts of money to report US unsold vehicles as sold. A spokesman for Fiat Chrysler in the U.S. said the auto maker “has not been served with this lawsuit and cannot comment.”

West Texas Intermediate crude oil fell to $29.73 in overnight trade, its lowest level since February 2004; prices bounced from that low. Prices have already tanked 20% this year.  Not a big surprise that there was some support at $30. The question is whether support can hold in the face of a potential new source of supply. The United Nations’ nuclear watchdog is likely to confirm on Friday that Iran has curtailed its nuclear program as agreed with world powers, paving the way for sanctions to be lifted.

The past 18 months have been rough for the oil industry. The low price has caused layoffs in what had been a robust and growing shale oil extraction business. A new report shows the number of jobs in the United States in the solar industry outpaced those in the oil and gas industries for the first time ever. As of November 2015 there were almost 209,000 people who worked in the solar industry, 90 percent of whom only work on solar-related projects. There were only about 185,000 people working in oil and gas in the United States in December 2015, according to the Bureau of Labor Statistics.

The solar industry has seen prices drop, not quite as much as oil, but as the technology becomes cheaper, sales have remained solid. One other key difference for the economy, jobs in solar pay about half what jobs in the oil industry pay, on average.

Meanwhile, renewables just finished another record-breaking year, with more money invested ($329 billion) and more capacity added than ever before (121 gigawatts), according to new data released by Bloomberg New Energy Finance. Spending on clean power declined in Europe, but increased 17% in China, 7.5% in the US, and for the first time, more than half of the world’s annual investment in clean energy came from emerging markets.

And since clean energy is also getting cheaper, the world got more bang for each buck. Investment dollars rose 4 percent last year, while the new capacity added for wind and solar jumped 30 percent. Looking out still further, the International Energy Agency said last year that between now and 2020, renewable energy will be the largest area for growth, and predicts 700 gigawatts of added generating capacity.

Oscar nominations were announced this morning.  “The Revenant” led the nominations with 12 nods, including best picture, and best actor for Leonardo DiCaprio; while the action movie “Mad Max: Fury Road” landed 10 nominations.

Financial Review

Driving Down Third Avenue

Sinclair Noe — December 28, 2015

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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 9^th 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.