Category: Economics

As the whole world at this point knows, the US Federal Reserve reduced short term interest rates to a target rate of 1-1.25%, down 0.5% in response to economic concerns about the Coronavirus.

I’m not sure how changing a very low short term interest rate into something that is even lower will help matters.

The yield curve today looks like this:

1-month: 1.11%
3-month: 0.95%
1-year: 0.73%
5-year: 0.77%
10-year: 1.02%
30-year: 1.64%

Needless to say, these are low. Not European-style negative rate low (Germany’s bonds are trading at a -0.81% for 5-year and -0.63% for 10-year), but things clearly are at the point where if you’ve got reasonable credit, you can borrow money for nearly free.

QE4 is also alive and well, with $400 billion more in purchased securities on the federal reserve’s balance sheet from August 2019, most likely ending up in the stock market.

I’m guessing the Bank of Canada will probably announce a rate cut tomorrow to follow lock-step with the USA. The only question is whether they’ll drop a quarter point or a half point.

The analogy has been used many times before that lowering rates from current levels is like giving the metaphorical drug junkie another hit of heroin to keep high just a little bit longer – I can’t imagine on anybody’s financial spreadsheets how the incremental reduction in a 0.5% rate decrease from 1.5% to 1.0% will alter a capital investment decision, say to spend $10 billion dollars on a pipeline over the next 3 years, when there are so many other dominant variables that will take priority.

I also project there will continue to be a massive amount of government spending and deficits that will be incurred – when the cost to borrow is effectively free, why not?

This would explain why Gold is going crazy, but in theory, any assets that have the capacity to generate (inflation-adjusted) cash should also do relatively well.

Take a look at the S&P 500 over the past two months:

It is not entirely coincidental this aligns fairly well with the monetary loosening of the next phase of quantitative easing by the US Federal Reserve, which started in September:

Most of this excess capital tends to find its way pumping demand into the asset market. Right now, that demand gets centered around the large capitalization, large liquidity companies, but eventually that demand flows to parts of the economy that still offer morsels of yield.

The currency depreciation war is active and alive (below is a chart of the US Dollar to Chinese RMB exchange rate, showing a 3% devaluation over the past couple days which is historically quite volatile for the currency):

We’re entering into a strange topsy-turvy financial world where things are going to stop making much sense at all. We already have that in Europe, where a lot of sovereign bonds are trading at negative yields (which is the definition of financial insanity).

Interest rate futures for the US federal reserve already show that the fed funds rate will slip down to about 1% – the December 2020 fed funds futures are a full percentage point below the present values. The Bank of Canada will likely be forced to match to some degree – I would look for the Bank of Canada to drop their rates correspondingly.

In terms of investment themes, always keep in mind TINA – There Is No Alternative – as safe bond yields get pushed into the low single digit yields, in order to make any returns at all, the risk frontier continues to get pushed further and further into the equity realm. Dips in equity valuations will eventually be bought as pensions and institutions need to seek returns that they are not going to be receiving from bond portfolios. Specifically, domestic industries (i.e. no China exposure) with cash flow pricing power will remain king.

The allure of leverage (why not when you can borrow so cheap?) will also be tempting.

Unfortunately, a lot of these companies (e.g. most utilities) already trade rich, but there’s a decent chance that the escape for safety will continue to push asset prices even higher.

Also, with medium-term interest rates declining, those 5-year rate reset preferred shares will also likely take a hit. There may be some interesting opportunities coming up in this space as shares get sold off.

I talk much more about finance than accounting on this website, although I am a professional accountant. A good analogy is math and physics – people in both fields tend to understand the other, more so than the difference between chemistry and biology.

Effective this year, companies will have to adopt IFRS 16, which governs accounting for leases.

Other than enriching accounting consultants that will have to dig into the structures of leases of various firms, this will have a material impact of the reported assets and liabilities on a company’s balance sheet. New students of accounting will also have one more layer of complexity to memorize at exam time, while textbook manufacturers will undoubtedly be happy.

Specifically, the distinction between an operating lease vs. a capital/finance lease is removed and instead all leases will have an asset and liability component. The asset of the lease (the item which you are buying the rights to use) will be depreciated over time, coupled with an interest expense component for the financing cost of the lease, with a depreciation charge to reduce the asset value.

From an investment perspective this changes the character of “EBITDA”, where companies that heavily use operating leases would previously have expensed such costs (typically in operating expenses), while after IFRS 16 is implemented, they will suddenly find their EBITDAs increase because the lease cost will have strictly an interest and depreciation component. They are still expenses, but the characterization of the expense is now changed. This will be an accounting windfall for companies that traditionally are valued on EBITDA metrics.

So if you find it annoying how companies use EBITDA as a proxy of profitability (which it could be given the right assumptions – but most companies abuse the EBITDA number to inflate the perception of their profitability), after IFRS 16, good luck! Just remember, you can only live on after-tax cash flows and not EBITDA!

The other strange implication of the rule is that once a lease is initiated, it will initially be more expensive at the beginning of the lease, and less expensive later in the lease as the embedded interest expense of the lease declines. So let’s say you lease a million dollar jet for 10 years, your expense profile, depending on your cost of capital component, on year 1 would be $125,000 while on year 10 would be $75,000 even if you fork out $100,000/year to use it. Investors have to add one more layer of effort to separate what is happening on the income statement with what is happening on the cash side of things. (Even this example is not quite correct – the lease asset may be $1 million, but the liability is going to be bigger since nobody will want to lease a $1 million jet for a $1 million stream of cash).

You have to love these accounting standards that make life even more complicated for the layman in the name of increasing accuracy. Currently, an investor could look at the notes on the financial statements to understand what a company’s future lease commitments were. One-shoe-fits-all accounting sounds great in principle but it has the consequence of making financial statements more difficult to read and understand between companies even though the goal is to make them directly comparable.

If you haven’t picked up a (digitally – free!) copy of Ray Dalio’s Big Debt Crises, I would recommend you do so since what you are seeing right now is a playbook describing exactly what is happening right now. This book contains various examples of market reactions of historical debt crises which made for some very fascinating reading.

For the quarter, the TSX is down 9% and the S&P 500 is down 10% as I am writing this. These sorts of markets will be punctuated with higher volatility – rallies, in particular, will serve to draw cash from the market from people that are fearing “missing out”.

What’s happening is the cost of capital has risen to a point, coupled with the reversal of quantitative easing, where you are starting to see assets dragged into cash. Cash is starting to return a relevant yield again (e.g. 2-year US treasuries are yielding 280bps which is about 200bps more than it was a couple years ago). Yield proxies are no longer as attractive because cash is such an alluring alternative. It is a slow squeeze of a financial vice that will continue to reverse the inflation of asset prices and encourage demand for cash – “The phases of a classic deflationary debt cycle” is listed early in this book and what is happening in the USA is precisely this.

This means that the equity end of debt-heavy operations will be especially vulnerable. The last thing to hit in this part of the market cycle will be defaults as liquidity becomes much more valuable. One canary in the coalmine is General Electric – there is a very real valuation case to be made that they will go to zero unless if management is especially astute at managing the psychology of the marketplace. When reading articles like this (Reuters), hearing about “urgent” asset sales, especially in today’s market environment, smacks of desperation.

I won’t get into the malaise that Canadian oil producers are facing – putting it mildly, the damage done with the current Western Canadian Crude pricing situation, compounded with the general drop in West Texas Crude, coupled with overall financial market liquidity drying up (as most of the producers are heavily indebted) is going to cost a lot of people a lot of money. In these situations, timing the bottom is the key to making a lot of money, but I do not see signs of a bottom presently.