Finance – Page 3

Reviewing the past week

The past week was relatively interesting.

The 10-year bond yield went down about 0.25% from the beginning to the end of the week. Likewise, the long part of the yield curve also dropped (prices rose) and a whole flurry of the usual interest rate sensitive subjects got taken up VERY sharply. I’ll just give a few of them, but you get the idea – these four are from very different industries:

(But also take a look at REI.un.to, CAR.un.to, etc. – also dramatically up over the past few trading days).

REITs, lumber, sugar, and fast food. All of these are yieldly and leveraged. Don’t get me started on other components of the fixed income markets either, but I’ll throw in the 30-year US treasury bond yield:

There is a cliche that in bear markets, bull trap rallies are the sharpest. This is usually the case because short sellers are a bit more skittish than in the opposite direction.

My suspicion is that the bears on the long side of the bond market got a bit too complacent.

The calculation of the risk-free rate is a very strong variable in most valuation formulas. If you can sustain a 5% perpetual risk-free rate, there is no point in owning equities that give a risky 4% return. The price of the equity must drop until its yield rises to a factor above 5% (the number above 5% which incorporates the appropriate level of risk).

So what we see here is the strong variable (risk-free rates) moving down and hence the valuation of yieldy and leveraged equities rising accordingly, coupled with some likely short squeeze pressure on the most leveraged entities.

There are likely powerful undercurrents flowing in the capital markets – the tug-of-war with the ‘higher for longer, inflation is here to stay’ crowd competing with the ‘Economy is going bust, the Fed has to lower rates!’ group.

The last chart, however, I must say was not on my bingo scorecard for 2023 – Bitcoin is up over double from what it was trading at the beginning of the year:

I should have just pulled a Michael Saylor and gone 150% on Bitcoin. Go figure.

Negative amortization mortgages

Rising interest rates are going to break things, and this one in particular (Globe and Mail article on negative amortizing mortgages) is going to be interesting.

Snippets:

BMO disclosed that mortgages worth $32.8-billion were negatively amortizing in the third quarter ended July 31. That is the equivalent of 22 per cent of the bank’s Canadian residential loan book. For the second quarter ended April 30, the total was $28.4-billion, equivalent to 20 per cent of BMO’s loan book.

TD had mortgages worth $45.7-billion negatively amortizing in the third quarter, the equivalent of 18 per cent of its Canadian residential loan book. That was higher than the $39.6-billion, or 16 per cent of its loan book, in the fourth quarter of last year.

…

In this year’s third quarter, CIBC had mortgages worth $49.8-billion, the equivalent of 19 per cent of its Canadian residential loan book, in negative amortization. That was higher than the $44.2-billion, or 17 per cent of its portfolio, in the second quarter, according to its financial results.

It appears about 20% of mortgages presently are negatively amortizing. This is presumably due to the interest component of floating rate mortgages rising coupled with fixed payments being insufficient to pay the interest component. This would not apply to mortgages that have their payments vary with rising interest rates.

What will be even more interesting is when fixed rate mortgages renew. Five years ago the lowest rate you could get was 3.19%. Today this is 5.44%. By definition when people renew their mortgages they will continue amortizing their principal, but many of them will be facing increased payments. For example, somebody taking a $1,000,000 mortgage 5 years ago at 3.19% on a 25-year amortization would have a monthly payment of $4,830/month. If, after five years, they wish to renew the remaining principal (approx. $858k) at 5.44% with a 20-year amortization, that monthly payment goes up to $5,843/month. If they wish to keep their $4,830/month payment, the amortization on renewal goes to 29.6 years!

It is a valid point, however, that negative amortization is meaningless without the specific quantum involved. For instance, if your mortgage is negatively amortizing at 5% a year, while your property value is appreciating 10% a year, you are actually decreasing your loan-to-value ratio over time. This headline may be a little less ominous than it sounds without digging deeper into the data – which sadly was not provided.

The debt party will end very badly when real estate valuations collapse (if they ever do). Given the propensity of the Canadian government to functionally open their borders to anybody interested (especially in the form of student visas), the influx of population has provided an increasing level of demand for real estate on a very slowly rising supply base. As long as this remains the case, absent of any dramatic rise in unemployment, it appears unlikely there will be any deep downward catalysts on residential real estate valuations.

Long-term treasury yields

Bill Ackman has made the news about being short 30-year treasury bonds (buying puts on treasuries). You can play this trade at home too, by buying puts on TLT – at the money on long-dated options is trading at an implied volatility of about 16.5% right now. The below chart is the 30-year treasury bond yield.

There have been other prominent people in the Twittersphere piling in (e.g. Harris Kupperman) on the risks of long-term interest rates rising – it’s one way to flatten the yield curve with the short side going longer, it’s another thing completely for the long end of the curve to go up.

In general, when more people are conscious of a particular direction of trade, the riskier the trade becomes. Both Ackman and Kupperman are “talking their book” at this point, the question is whether they were at the beginning of this wave, or whether it’s mid-crest. I’m not sure.

My lead suspicion from a macro perspective is that the market is catching wind that the US Federal Reserve is not going to let up on short term interest rates anytime soon, coupled with the US Government’s Treasury issuing tons and tons of debt financing after Congress approved the rise in the debt ceiling – the US Government is raising a huge amount of cash. Economic data is too strong and employment is surprisingly resilient (with resultant wage pressures). We still see way too much speculative impulses in the market (for a good time, look at American Superconductor – AMSC on the Nasdaq).

What you’re seeing as a result of slow quantitative tightening, the US Government being the first claim on US currency (the treasury auction IS the price on money), and continually rising interest rates is a liquidity drain. As the liquidity gets sucked out of the system, the continual demand for money (the least of which to pay interest on debts) will result in a higher cost of money until the Federal Reserve decides to stop. Because so many have speculated about “the pause”, it blunts the effect of rising interest rates and hence the need to raise rates and tighten liquidity further.

Let’s take the Kupperman scenario of long-term rates going to 600bps, which means a risk-free P/E of 16.7 for significant duration. I’ve pointed out in the past that the risk-free rate is competing significantly against equities and this competition gap will continue to get wider and wider. We would surely see equities without earnings power depreciate. We would also see higher incumbency advantages in capital-intensive existing companies. I also think it would be the straw breaking the camel’s back with certain REITs which are already on the financing bubble (look at my previous post about Slate Office).

The question is whether the US Government, currently printing off massive deficits, would actually be able to taper their spending or whether this leads to another conclusion that we’re going to see massive levels of inflation, much more so than we previously have seen. Will we get to the point where we see defaults and a credit crunch?

Either way, it leads to a similar conclusion – keep a bunch of dry powder (cash) handy for buying into blow-ups that won’t go into Chapter 11 or CCAA. The 5.5% or so of short-term risk-free money is better than nothing, although I too even think this is a crowded trade. For large-cap investors out there, an example of an opportunistic miniature blowup was TransCanada (TSX: TRP) a few days back – although something makes me suspect you’re going to see it go even lower than $44/share in the upcoming months. There are going to be plenty of further examples like this going into the future of companies facing issues with debt.

Higher for longer, good news is bad news, etc.

I’ll just republish a CNBC article from mainstream media, noting this is the USA and not Canada we are talking about:

“Private sector companies added 497,000 jobs in June, more than double expectations, ADP says”

The sub-headline:
“Leisure and hospitality led with 232,000 new hires, followed by construction with 97,000, and trade, transportation and utilities at 90,000.”

ADP is a private sector payroll processor, so they have fairly good visibility on payroll data.

This much awaited recession is not yet happening, folks! It would be the oddest recession in economic history which still clearly had full employment.

As I wrote in yesterday’s article, “Essentially until we start seeing a gross contraction of employment demand, upward wage pressure should put a floor on inflation.”

So this “good news” (people working) is resulting in “bad news”, namely looking at the interest rate curve:

Canada, which is joined at the hip with the US in many things economically, also has a yield boost:

The far end of the yield curve (the 10 year point and beyond) is a core calculation for many asset management models. If that yield goes higher, more money gets allocated to fixed income than equities – for example, why bother buying the S&P 500 at 4% when you can buy its debt at 5%?

Here is the economic dynamic going on, based on this chart:

I don’t know how accurate this is, but essentially governments gave out a lot of surplus to consumers during Covid and they are still in the process of paring this surplus down. We are getting to the point where many people must pare back luxury expenditures (this would be leisure and hospitality spending, and those sectors have exhibited massive amounts of inflation – take a look at Expedia if you do not believe me) or earn more money (which they can through employment).

Either way, until we start getting reams of unemployment, those interest rates are going to stay higher for longer. I’d venture to say that broad market equity prices probably will peak out this summer. They are having difficulty competing against the returns in the bond market.

The ultimate silver lining, however, is that lower prices mean higher returns. If your companies are generating copious amounts of free cash flows, it doesn’t really matter. If, however, your companies are trading with a market value that is a very rosy projection of elevated future earnings, you may wish to check your risk.

The trick with obtaining these higher returns, however, is that you have the cash on hand to purchase at lower prices. If you’ve already spent the money, you’re out of luck.

The Bank of Canada will raise rates 0.25% to 5.00% on July 12th; the Federal Reserve will raise its funds rate from 5.00-5.25% to 5.25-5.50% on July 26th. There is also an outside chance that QT will be accelerated in an attempt to flatten the yield curve (selling long-term treasuries and buying the 2 to 9 year part of the curve). Buckle up!

Holding pattern

I’ve been on radio silence lately, as there has been little to update.

I will do a Late Night Finance quarterly review later this month, but putting a long story short, anybody that hasn’t invested in the top tier of indexes has likely underperformed such indices – with me no exception!

We are in a very strange market environment which is pricing huge multiples in the large capitalization companies – for instance, Apple is trading at 29 times next year’s projected earnings (TTM on September 2024). The equity at that rate of earnings, gives a total yield of 3.45% for an investor, while Apple’s unsecured debt, say their May 10, 2033 maturity is at a YTM of 4.35%.

It would be an interesting thought experiment whether Apple’s stock or its debt will give more of a total return over a decade. There is a lot of expectations baked into large cap equities.

Looking at something like NVidia and most “AI” related companies, the figures are even more expensive. Even if these stocks have a multiple compression of 50% (which would result in their share prices dropping by 50%) they look healthily valued. Higher prices means higher risk.

One conclusion I can make is that index investors probably will not perform nearly as well going forward. There’s probably some more room to go to give such investors a false sense of security, however.

While central banks are continuing to tighten and QT is progressing, there is still plenty of ample liquidity available for credit creation – it is simply more expensive. Companies borrowing money have to actually generate a return in order to justify the debt. It leads one to an ironic conclusion that investment leads will come from those companies that are taking out debt financing at current rates, opposed to ones forced to roll over debt.

While headline CPI figures continue to moderate, it is not evident that base economic factors (especially the cost and quality of labour) are at all easing. Essentially until we start seeing a gross contraction of employment demand, upward wage pressure should put a floor on inflation.

Also, as I alluded to in my previous post, the aggregate economic statistics also do not capture productivity very well.

There are other tail risks out there, namely social stability and the like. It is quite underestimated how close to a “flash point” things may be.

There’s a lot more swimming in my mind with respect to the future, but I will leave it here. Right now, I’m in a holding pattern.