"Ah, lives of men! When prosperous they glitter - Like a fair picture; when misfortune comes - A wet sponge at one blow has blurred the painting." - Aeschylus
Multiple expansion through share buybacks have been driving indeed the stock market higher greater than earnings have. The S&P 500 has risen 26.7% YTD versus 16% for the trailing PE from 16.4x to 19.1x. Buybacks rose by 18% QoQ to $118 billion in 2013, up 11% YoY to $218 billion in 1H13. The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 129 CAPE reached 33x and in 2000 44x. The growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:
All that glitters ain't gold...
And it cannot be truer if either one looks into the rise of the S&P500 between High and Low Quality Stocks - graph source Bloomberg:
Or if one looks into the outperformance of the Small-Cap ratio versus the underperformance of the S&P 500 Utilities index - graph source Bloomberg:
Another sign of the real "Great Rotation" has been the continuous selling from Institutional clients while private clients have been stepping in as reported by Bank of America Merrill Lynch in their recent equity client flow trends report from the 26th of November entitled - "Little confidence in equities' new high":
"Institutional clients lead selling; retail clients return to buying
Last week, during which the S&P 500 climbed 0.4% to reach another new all-time high above 1800, BofAML clients were net sellers of US stocks for the fifth consecutive week, in the amount of $2.3bn. Net sales were led by institutional clients, who returned to net selling following a week of muted buying. Institutional clients remain the biggest net sellers year-to-date (Chart 1), with cumulative net sales of over $23bn—larger than in either 2008 or 2010.
As we noted last week, while much of institutional clients’ net sales post-crisis were likely due to redemptions, some outflows year-to-date could suggest a rotation out of US stocks and into global equities. Hedge funds were also net sellers for the second consecutive week, while private clients returned to net buying after a week of selling. This group has been a net buyer for 23 of the past 26 weeks. Large, mid and small caps all saw net selling last week." - source Bank of America Merrill Lynch
Another illustration of this "Great Rotation" comes from the same Bank of America Merrill Lynch report which displays BofAML institutional client cumulative net buys of US equities: pension funds and institutional ex. pension funds since 2008:
Of course, the credit markets have been also indicative of not only investors dipping their toes outside of their comfort zone but most of all the on-going "japonification" such as in the loan market as indicated by Christine Idzelis in her Bloomberg article from the 21st of November entitled "Loan Faults Seen in $250 Billion of Refinancings":
"The demand has helped companies issue $581 billion of loans to non-bank lenders such as hedge funds and collateralized loan obligations, up from $366.4 billion in all of 2012, Bloomberg data show. At the current rate, the record of $581.5 billion in 2007 may be broken as soon as today.
“I don’t think there’s much of a resemblance between now and 2007 other than it’s a borrower’s market,” A.J. Murphy, global co-head of leveraged finance at Bank of America Corp., the largest underwriter of leveraged-loans in the U.S., said in a telephone interview. Leveraged buyouts are smaller than they were six years ago, she said.
The top five LBOs this year averaged about $12 billion, compared with $30 billion in 2007, Bloomberg data show." - source Bloomberg.
We must say we have been quite amused by the above quote, we all know "this time it's different. One thing for sure, 2013 has been the biggest year since 2007 for CLOs as indicated by Kristen Haunss from Bloomberg in her article from the 26th of November entitled "Wall Street Props CLO Boom as Rules Lift Costs":
"The biggest year for collateralized loan obligations since 2007 is being propped by deals managed by Blackstone Group LP and Carlyle Group LP, which started funds that pledge to boost interest rates on the debt.
While $87 billion of CLOs have been issued globally this year based on JPMorgan Chase & Co. data, coupons on the highest-rated portions have risen to as much as 1.5 percentage points over the benchmark from at least a three-year low of 1.1 percentage points in May. Yields rose as GSO Capital Partners LP, the credit arm of Blackstone, Carlyle and other money managers sold at least $4.5 billion of CLOs with the promise of higher interest payments, typically after 18 months.
Money managers and banks are finding new ways to ensure investors keep buying CLOs -- which bundle junk-rated loans used to back buyouts -- after the Federal Deposit Insurance Corp. asked lenders in April to designate AAA rated portions of the notes as “higher-risk” assets. Regulators are now considering more rules targeting the funds, which helped push issuance of leveraged loans this year to a record $277.1 billion, according to data compiled by Bloomberg.
“AAAs continue to be the hardest to sell and banks have become creative in order to distribute the debt,” Ken Kroszner, a Stamford, Connecticut-based CLO analyst at Royal Bank of Scotland Group Plc, said in a telephone interview. At least 10 CLOs sold since June offered a so-called step-up coupon, where rates increase over the life of the deal, according to Kroszner." - source Bloomberg
If you think 2013 was a record year, wait for 2014. 2014 for us points towards the last inning of the game being played thanks to "easy money". Why so? You might rightly ask.
2014 will see the return of big LBOs so as a credit investor, you should switch on your LBO screeners we think. Anne-Sylvaine Chassany from the Financial Times in her article entitled "Private equity's dry powder' raises overcapacity concerns":
"Private equity groups are holding more cash for acquisitions than they had at the height of the leveraged buyout boom, in spite of a fall in the volume of deals being done – raising concerns about overcapacity in the industry. Data compiled by Preqin, the research group, show that the value of unspent commitments to private equity funds, known as dry powder, has surged to $789bn this year – an increase of 12 per cent since December 2012, after four years of decline. This compares with $769bn of unspent cash in 2007 – when the volume of private equity deals reached a peak – and the $829bn that went unspent in 2008, when deal volumes plunged 70 per cent as the financial crisis unfolded.
In 2007, private-equity houses led $776bn of deals, but the comparable figure stands at just $310bn in 2013, according to Thomson Reuters. Research by Hamilton Lane, a private equity investor that tracks 2,000 funds, says this combination of increased fundraising and decreased deals could lead to a record level of dry powder by the year end.
Buyout groups’ rising cash piles reflect the fact that they have taken longer to invest their funds since the crisis, as they have found fewer good opportunities. But the increase in the capital overhang has been largely fuelled by a renewed appetite for private funds from yield-starved investors.
After a steep contraction in the aftermath of the crash, buyout groups have been able to raise more money from investors, partly because they have found ways to return cash from previous vehicles – mostly through refinancings and initial public offerings. This has helped Advent International, Warburg Pincus, CVC Capital Partners, Carlyle and Silver Lake raise more than $10bn each for new funds.
According to Mario Giannini, Hamilton Lane’s chief executive, 2013 is on course to become “the fourth biggest fundraising year” of all time for the private equity industry, as investors are lured by its higher returns.
Private equity funds have attracted $279bn this year, more than the whole of last year, Preqin has found. Some industry participants warn that the cash overhang will drive asset prices up as groups feel the pressure to invest the money before the commitments expire, typically after five years." - source Financial Times - Anne-Sylvaine Chassany
The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business as reported by Mark Odell and Aja Makan in the Financial Times on the 27th of October in their article "Wave of private equity money flows into shipping":
"Private equity has been drawn to the sector as asset valuations for both new-build and second-hand ships have hit rock-bottom.
As a highly-fragmented industry with few large players, the need for capital could hardly have been greater. Traditional lenders such as Germany’s Commerzbank and HSH Nordbank and the UK’s Lloyds and Royal Bank of Scotland are either exiting the market or looking to reduce exposure, stung by heavy losses on loans made before the downturn.
Ship owners looking for fresh funds have found private equity groups willing to listen as they struggle to allocate capital in their more traditional markets.
Oaktree Capital Management, for example, last year took a large stake in Floatel, which owns and operates offshore construction support vessels, and injected equity into General Maritime, a crude and petroleum product tanker company.
Other groups are investing directly in ships. This summer Carlyle committed more than $100m to InterLink Maritime, allowing it to order ten bulk carrier ships, while in September Apollo Global Management committed to a joint venture with German freight line Rickmers Group to invest up to $500m initially in second hand ships.
Before that York Capital linked up with New York-listed Costamare, a container ship owner, in another $500m joint venture. “The reason they are here is high expectations about returns as they are entering at the low-part of the cycle,” says Greg Zikos, chief financial officer of Costamare.
These expectations have so far this year attracted more than $2.7bn, a quarter of the total investment in ships led by private equity since 2008, according to data compiled by Marine Money, a US-based consultancy.
Bankers and analysts say the money has targeted specific “hot” sectors of the market, especially product tankers, which carry refined products, and vessels to carry liquefied petroleum gas and liquefied natural gas. There has also been a renewal of orders for dry bulk carriers.
On top of the $11.2bn invested in ships and indirectly in shipowners since the start of 2008, private equity groups have also been investing in terminals, ship charterers and shipping containers. In August, KKR led $580m in funding for a specialist shipping bank." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"
Of course the investor profile in the shipping business has indeed changed with the arrival of dry powder and the buccaneers from the Private Equity business as indicated in the same article from the FT:
"But the presence of the “new” money has been noted. At a shipping industry conference in New York this summer a Greek shipowner, whose family had been in the industry for generations, took one look at the audience dotted with private equity executives, before asking the organiser: “Where are all the shipowners?”
His question was only part in jest, says Jim Lawrence, chairman of Marine Money, who organised the conference. Private equity executives not only look different – the Greek shipowner was shocked by the number of dark suits facing him – they act differently.
Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"
The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry.
The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012 - Evolution of Baltic Dry Index from 1990 until today - source Bloomberg:
Shipping has been our favorite deflationary indicator, so we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark. The container rate has been increased by $400 USD on the 15th of November on all US destinations with no impact so far for the "recovery" desired by Private Equity - graph source Bloomberg:
Hearing recently Alan Greenspan in the footsteps of Janet Yellen talking about the surge in equity markets not being a manifestation of "Cantillon Effects", namely bubbles, we reminded ourselves of our post "Cold Turkey", which in retrospect should have been called "three wise monkeys" given, including Ben Bernanke, these three "wise" central bankers cannot see, hear or speak no evil. By that point, you are probably wondering therefore why this week's chosen title.
Like many investors we have been "Singin' in the Rain", blessed by the Fed's liquidity "rain" for the last couple of years.
We have no doubt reaped some of the benefits of our "Generous Gambler", such as buying Junior Financial Subordinated bonds paying 12.5% coupon at 94.5 in cash price in 2011, seeing them soar past the 130 mark in cash price recently or buying Nikkei exposure hedged in Euro in 2013, and as we mused in our conversation the "Coffin Corner" we 've been indeed "singing":
"Like our credit friends, we keep dancing, but close to the door, knowing well enough, at some point the music will stop, and given the poor liquidity in the secondary space, the feeding frenzy on any new issues coming to the market, even with a miserable yield (Nestlé 7 year bond at mid-swaps +25 bps), when it will, it will no doubt be messy, like a NF104 Lockheed Starfighter falling from the sky."
So this week's chosen title is a musical reference to 1995 hit song "Gold" by Prince. When ones looks at some of the deals being thrown in the market, for instance in the convertible space, no wonder we think that some parts of Prince's lyrics are appropriate as our chosen title:
"Everybody wants to sell what's already been sold
Everybody wants to tell what's already been told
What's the use of money if you ain't gonna break the mold?
Even at the center of fire there is cold
All that glitters ain't gold" - Prince - Gold Lyrics
When we mention the convertible space there is a good reason. There is a surge in demand for bonds that converts into equities with zero interest, as reported in the Financial Times by Arash Massoudi in his article "Clamour for stocks sets "no-no" debt deal loose":
"A clamour for fresh opportunities to jump on board the equity market rally is providing some companies with cheap financing alternatives in the $200bn US convertible bond market. The most coveted of these are known as “no-no” bonds. Convertible bonds allow issuers to offer debt that pays investors a low monthly coupon and gives them the option to convert the security into the issuer’s stock if it climbs to a preset premium over the bond’s tenure. But as new issuance of the hybrid securities roars back to life after a multi-year slowdown, a number of companies are taking advantage of pent-up demand to pull off no-no deals that offer no monthly interest payments or discount to face value.
For investors, however, the return of these aggressively priced hybrid securities are the latest sign that issuers are exploiting a corner of the US capital markets for favourable terms. This month Yahoo and ServiceNow raised $1.25bn and $575m respectively by issuing no-nos, the first such deals since a $1.25bn Microsoft convertible bond in 2010. In the case of Yahoo, a conversion premium of 50 per cent means that investors need its stock to climb to above $53 a share to exercise the option of converting debt into equity.
David Puritz, who runs the convertible bond trading desk at BlueMountain, a $13bn hedge fund, says the recent deals leave investors with little margin for error. He says: “A no-no bond may look perfectly fine in a convertible model with interest rates and credit spreads at current levels . . . but given their longer duration, low or zero coupon securities are by definition more vulnerable to a move in rates or spreads.” Still, investors say the fact the deals were able to price with such favourable terms is a reflection of optimism over the state of the US equity markets and the attractiveness of indirect equity ownership. The conversion feature of the bond means that its value increases as the issuer’s share price goes higher, making deals for companies that have more volatile share prices such as technology stocks more attractive.
The Barclays US Composite Convertible index is up 21.6 per cent so far this year, not too far off the 26.4 per cent gains for the S&P 500. That compares with the Barclays High-Yield index, which is up 6.5 per cent, and a 2 per cent decline in the Barclays US Investment Grade index. But the resurgence of no-no bonds reflects just how distorted supply and demand in the convertible bond market has become, as the Federal Reserve’s stimulus efforts since the financial crisis have driven down interest rates. Lawrence McDonald, senior director at Newedge, says: “We see these types of deals when chief financial officers have more control over the capital markets and can dictate deal terms. That’s a trend across capital markets all year and it can be a very early indicator of an overheated market. It was in 2007 and it was in the dotcom bubble.”
The central bank’s efforts have allowed companies to borrow from traditional bond markets at historically low rates, leaving the overall size of the US convertible bond market to contract as new issuance has failed to keep pace with maturing securities over the past five years. Analysts at Barclays say the face value of outstanding US convertible bonds has shrunk by $120bn to $175bn since 2009, as some bonds matured and others were redeemed. But companies are once again turning to convertible bonds as investors and issuers brace for a possible rise in interest rates next year as the Fed looks to wind down its stimulus. This year companies are issuing convertible bonds at their fastest clip since 2009 and the pace has continued into November, which is set to be the most active for new issues this year. Companies have raised $42.75bn from offering 158 convertible bonds this year, according to Ipreo.
Joseph Hall, partner at Davis Polk, says: “When stock prices are as high as they are, the convertible bonds become a lot more attractive instruments for issuers. Companies are taking advantage of the opportunity to lock in financing in some cases at zero per cent.” Some warn, however, that the new deals could carry substantial risk if interest rates rise, especially for no-no bonds. Venu Krishna, head of equity-linked origination at Barclays, says: “Investors need to be cautious, especially if interest rates start rising, since these securities will be negatively impacted by heightened duration risk from having no coupon. “On the other hand, assuming no change in credit risk, if interest rates rise 100 basis points but the stock goes up say 30 per cent, investors will participate in the upside.” " - source FT.com - Arash Massoudi
Of course many will argue that until the music stops 'in true Chuck Prince fashion as an investor, you have to keep dancing: "As long as the music is playing, you've got to get up and dance" - Chuck Prince, CITI ex CEO.
So in this week's conversation we will look at these "glitters" we are seeing which definitely ain't gold and warrant caution as we move into 2014 which could mark the final innings of the long rally initiated in 2009 courtesy of central banks generosity.
So in this week's conversation we will look at these "glitters" we are seeing which definitely ain't gold and warrant caution as we move into 2014 which could mark the final innings of the long rally initiated in 2009 courtesy of central banks generosity.
The "Cantillon Effects" at play, the rise of the Fed's Balance sheet, the rise of the S&P 500, the rise of buybacks and of course the fall in the US labor participation rate (inversely plotted) - source Bloomberg:
In red: the Fed's balance sheet
In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.
“This does not have the characteristics, as far as I’m concerned, of a stock market bubble” - Alan Greenspan
A recent good illustration of the issuance of convertibles for buy-back purchases was NVIDIA's announcement on the 25th of November of an offering of $1.3 billion convertible senior notes to use the proceeds of the offering to fund capital return to shareholders via the repurchase of shares of the Company's common stock and for quarterly dividend payments pursuant to the Company's recently announced $1 billion fiscal 2015 capital return program.
Multiple expansion through share buybacks have been driving indeed the stock market higher greater than earnings have. The S&P 500 has risen 26.7% YTD versus 16% for the trailing PE from 16.4x to 19.1x. Buybacks rose by 18% QoQ to $118 billion in 2013, up 11% YoY to $218 billion in 1H13. The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 129 CAPE reached 33x and in 2000 44x. The growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:
And it cannot be truer if either one looks into the rise of the S&P500 between High and Low Quality Stocks - graph source Bloomberg:
Or if one looks into the outperformance of the Small-Cap ratio versus the underperformance of the S&P 500 Utilities index - graph source Bloomberg:
Another sign of the real "Great Rotation" has been the continuous selling from Institutional clients while private clients have been stepping in as reported by Bank of America Merrill Lynch in their recent equity client flow trends report from the 26th of November entitled - "Little confidence in equities' new high":
"Institutional clients lead selling; retail clients return to buying
Last week, during which the S&P 500 climbed 0.4% to reach another new all-time high above 1800, BofAML clients were net sellers of US stocks for the fifth consecutive week, in the amount of $2.3bn. Net sales were led by institutional clients, who returned to net selling following a week of muted buying. Institutional clients remain the biggest net sellers year-to-date (Chart 1), with cumulative net sales of over $23bn—larger than in either 2008 or 2010.
Another illustration of this "Great Rotation" comes from the same Bank of America Merrill Lynch report which displays BofAML institutional client cumulative net buys of US equities: pension funds and institutional ex. pension funds since 2008:
Of course, the credit markets have been also indicative of not only investors dipping their toes outside of their comfort zone but most of all the on-going "japonification" such as in the loan market as indicated by Christine Idzelis in her Bloomberg article from the 21st of November entitled "Loan Faults Seen in $250 Billion of Refinancings":
"The demand has helped companies issue $581 billion of loans to non-bank lenders such as hedge funds and collateralized loan obligations, up from $366.4 billion in all of 2012, Bloomberg data show. At the current rate, the record of $581.5 billion in 2007 may be broken as soon as today.
“I don’t think there’s much of a resemblance between now and 2007 other than it’s a borrower’s market,” A.J. Murphy, global co-head of leveraged finance at Bank of America Corp., the largest underwriter of leveraged-loans in the U.S., said in a telephone interview. Leveraged buyouts are smaller than they were six years ago, she said.
The top five LBOs this year averaged about $12 billion, compared with $30 billion in 2007, Bloomberg data show." - source Bloomberg.
We must say we have been quite amused by the above quote, we all know "this time it's different. One thing for sure, 2013 has been the biggest year since 2007 for CLOs as indicated by Kristen Haunss from Bloomberg in her article from the 26th of November entitled "Wall Street Props CLO Boom as Rules Lift Costs":
"The biggest year for collateralized loan obligations since 2007 is being propped by deals managed by Blackstone Group LP and Carlyle Group LP, which started funds that pledge to boost interest rates on the debt.
While $87 billion of CLOs have been issued globally this year based on JPMorgan Chase & Co. data, coupons on the highest-rated portions have risen to as much as 1.5 percentage points over the benchmark from at least a three-year low of 1.1 percentage points in May. Yields rose as GSO Capital Partners LP, the credit arm of Blackstone, Carlyle and other money managers sold at least $4.5 billion of CLOs with the promise of higher interest payments, typically after 18 months.
Money managers and banks are finding new ways to ensure investors keep buying CLOs -- which bundle junk-rated loans used to back buyouts -- after the Federal Deposit Insurance Corp. asked lenders in April to designate AAA rated portions of the notes as “higher-risk” assets. Regulators are now considering more rules targeting the funds, which helped push issuance of leveraged loans this year to a record $277.1 billion, according to data compiled by Bloomberg.
“AAAs continue to be the hardest to sell and banks have become creative in order to distribute the debt,” Ken Kroszner, a Stamford, Connecticut-based CLO analyst at Royal Bank of Scotland Group Plc, said in a telephone interview. At least 10 CLOs sold since June offered a so-called step-up coupon, where rates increase over the life of the deal, according to Kroszner." - source Bloomberg
If you think 2013 was a record year, wait for 2014. 2014 for us points towards the last inning of the game being played thanks to "easy money". Why so? You might rightly ask.
2014 will see the return of big LBOs so as a credit investor, you should switch on your LBO screeners we think. Anne-Sylvaine Chassany from the Financial Times in her article entitled "Private equity's dry powder' raises overcapacity concerns":
"Private equity groups are holding more cash for acquisitions than they had at the height of the leveraged buyout boom, in spite of a fall in the volume of deals being done – raising concerns about overcapacity in the industry. Data compiled by Preqin, the research group, show that the value of unspent commitments to private equity funds, known as dry powder, has surged to $789bn this year – an increase of 12 per cent since December 2012, after four years of decline. This compares with $769bn of unspent cash in 2007 – when the volume of private equity deals reached a peak – and the $829bn that went unspent in 2008, when deal volumes plunged 70 per cent as the financial crisis unfolded.
In 2007, private-equity houses led $776bn of deals, but the comparable figure stands at just $310bn in 2013, according to Thomson Reuters. Research by Hamilton Lane, a private equity investor that tracks 2,000 funds, says this combination of increased fundraising and decreased deals could lead to a record level of dry powder by the year end.
Buyout groups’ rising cash piles reflect the fact that they have taken longer to invest their funds since the crisis, as they have found fewer good opportunities. But the increase in the capital overhang has been largely fuelled by a renewed appetite for private funds from yield-starved investors.
After a steep contraction in the aftermath of the crash, buyout groups have been able to raise more money from investors, partly because they have found ways to return cash from previous vehicles – mostly through refinancings and initial public offerings. This has helped Advent International, Warburg Pincus, CVC Capital Partners, Carlyle and Silver Lake raise more than $10bn each for new funds.
According to Mario Giannini, Hamilton Lane’s chief executive, 2013 is on course to become “the fourth biggest fundraising year” of all time for the private equity industry, as investors are lured by its higher returns.
Private equity funds have attracted $279bn this year, more than the whole of last year, Preqin has found. Some industry participants warn that the cash overhang will drive asset prices up as groups feel the pressure to invest the money before the commitments expire, typically after five years." - source Financial Times - Anne-Sylvaine Chassany
What we found very amusing is that part of this "dry powder" is finding its way into shipping. There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".
We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business as reported by Mark Odell and Aja Makan in the Financial Times on the 27th of October in their article "Wave of private equity money flows into shipping":
"Private equity has been drawn to the sector as asset valuations for both new-build and second-hand ships have hit rock-bottom.
As a highly-fragmented industry with few large players, the need for capital could hardly have been greater. Traditional lenders such as Germany’s Commerzbank and HSH Nordbank and the UK’s Lloyds and Royal Bank of Scotland are either exiting the market or looking to reduce exposure, stung by heavy losses on loans made before the downturn.
Ship owners looking for fresh funds have found private equity groups willing to listen as they struggle to allocate capital in their more traditional markets.
Oaktree Capital Management, for example, last year took a large stake in Floatel, which owns and operates offshore construction support vessels, and injected equity into General Maritime, a crude and petroleum product tanker company.
Other groups are investing directly in ships. This summer Carlyle committed more than $100m to InterLink Maritime, allowing it to order ten bulk carrier ships, while in September Apollo Global Management committed to a joint venture with German freight line Rickmers Group to invest up to $500m initially in second hand ships.
Before that York Capital linked up with New York-listed Costamare, a container ship owner, in another $500m joint venture. “The reason they are here is high expectations about returns as they are entering at the low-part of the cycle,” says Greg Zikos, chief financial officer of Costamare.
These expectations have so far this year attracted more than $2.7bn, a quarter of the total investment in ships led by private equity since 2008, according to data compiled by Marine Money, a US-based consultancy.
Bankers and analysts say the money has targeted specific “hot” sectors of the market, especially product tankers, which carry refined products, and vessels to carry liquefied petroleum gas and liquefied natural gas. There has also been a renewal of orders for dry bulk carriers.
On top of the $11.2bn invested in ships and indirectly in shipowners since the start of 2008, private equity groups have also been investing in terminals, ship charterers and shipping containers. In August, KKR led $580m in funding for a specialist shipping bank." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"
"But the presence of the “new” money has been noted. At a shipping industry conference in New York this summer a Greek shipowner, whose family had been in the industry for generations, took one look at the audience dotted with private equity executives, before asking the organiser: “Where are all the shipowners?”
His question was only part in jest, says Jim Lawrence, chairman of Marine Money, who organised the conference. Private equity executives not only look different – the Greek shipowner was shocked by the number of dark suits facing him – they act differently.
Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover." - source Financial Times, 27th of October - "Wave of private equity money flows into shipping"
The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry.
Shipping has been our favorite deflationary indicator, so we give you the latest reading of the Drewry-Hong-Los Angeles container rate benchmark. The container rate has been increased by $400 USD on the 15th of November on all US destinations with no impact so far for the "recovery" desired by Private Equity - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 in the week ended Nov. 27, declining after last week's $400 general rate increase on containers from Asia to all U.S. destinations, which had boosted rates 14.4%. This marks the 20th week this year that rates are below $2,000. Even with seven increases in 2013, rates are 13.4% lower yoy and down 14.8% ytd, as slack capacity continues to pressure pricing." - source Bloomberg
While Private Equity's dry powder has indeed led the order book higher for shipping no doubt - source Bloomberg:
Creative destruction in the shipping industry is still slowly digesting the past excesses as illustrated by the number of bulk carrier scrapped vessels still rising - graph source Bloomberg:
Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by around 550% since June 2005.
The overcapacity is still heavily weighting on Asia-Originated Rates lower - graph source Bloomberg:
"The Shanghai Export Containerized Freight Index (SCFI) fell 4% yoy in the week ending Nov. 15. The SCFI is 27% below its May 2012 peak as excess capacity pressures rates, yet has risen 24% from its mid-October low. Similarly, the China Export Containerized Freight Index is 9.5% lower yoy and 22% below its peak, also in May 2012. Containerized traffic is driven by consumers, with changes in spending having a direct effect on global traffic volumes." - source Bloomberg
So we are sorry for Private Equity investors in the shipping space because the deflationary forces at play are alive and kicking as indicated by the 20% drop in Asia-to-Europe FEU Rates after three weekly declines - table source Bloomberg:
"Shipping rates for 40-foot containers (FEU) fell 7.6% sequentially to $1,765 for the week ending Nov. 28, the third straight decline, according to World Container Index data. Asia-Europe trade lanes continue to be the weakest. Rates between Shanghai-to-Genoa fell 14.7% sequentially, driven by a 12% decline in Shanghai-to-Rotterdam trade lanes. Asia-Europe rates have fallen 20.1% since carriers implemented a rates increase the week ending Nov. 7." - source Bloomberg.
Finally on shipping, deflationary forces and lack of shipping "velocity" in similar fashion to the impact QEs have had on velocity, higher costs have prompted shipping lines to slow vessels 18% over the past three years to an average speed of around 10.4 knots. Reducing the speed of container ships by 10 percent can pare fuel consumption by as much as 30 percent - graph source Bloomberg:
In similar fashion, companies have not invested in CAPEX due to ZIRP and weakening demand, preferring using "cheap credit" for buy backs purposes and shareholder friendly endeavors. Another manifestation of "japonification" in container shipping velocity? We wonder.
All that glitters in shipping ain't gold...
Apart from rising LBOs and increasing investment in shipping in 2014, you can expect another wave of M&A given companies in Europe have amassed almost $1 trillion through earnings, bond sales and by refinancing credit lines as reported by Stephen Morris in Bloomberg on the 28th of November in his article entitled "Record $1 Trillion Cash Haul to Spur Euro Growth":
"Companies in Europe have amassed almost $1 trillion through earnings, bond sales and by refinancing credit lines, foreshadowing a potential surge in acquisitions and investment.
Glencore Xstrata Plc, Siemens AG and Daimler AG are among at least 50 companies in the region that refinanced 143 billion euros ($194 billion) of credit facilities this year paying an average interest margin of 0.59 percentage point, the lowest since 2007, according to data compiled by Bloomberg. Lower debt costs have helped Stoxx Europe 600 Index members accumulate more than 600 billion euros in cash, adding an extra 200 billion euros since 2008, as companies hoarded profits and shied away from takeovers during the region’s longest recession.
Europe’s biggest firms now have ammunition for growth after almost five years of central bank stimulus measures and suppressed borrowing costs. Almost 70 percent of executives expect company mergers and acquisitions to increase in the next 12 months and more than half said growth is their primary focus, according to an October survey of 1,600 decision makers by EY, formerly known as Ernst & Young." - source Bloomberg.
Unfortunately consolidation does not amount to "job creation". It might be equity friendly but definitely not credit friendly if it means releveraging, so probably credit negative overall. While takeovers announced by western European companies have risen by 6 percent to $716 billion this year compared with 2012, according to Bloomberg data, it is still less than half the record $1.5 trillion of deals completed in 2007. It looks like credit wise, 2013 is more like 2006 and 2014 might end up looking a lot like 2007 we think. As noted by Matt Levine in his column from the 27th of October entitled "Welcome Back, Leveraged Super Senior Synthetic CDOs", the "fun" products from the past in this game of yield hunting are staging a come-back:
"You can tell that leveraged super senior synthetic collateralized debt obligation tranches are fun because they are called leveraged super senior synthetic collateralized debt obligation tranches, and anything with that many words in its name is up to something. And in fact LSS CDOs were popular prior to the financial crisis, got various people in various kinds of trouble, and more or less vanished.
But now Euromoney is reporting that Citigroup is trying to market them again, with a slight modification that might get people into less or at least different kinds of trouble, though it is far from clear that anyone will be interested." - source Bloomberg.
We believe 2014 will set another stage for the "japonification" of the credit markets as illustrated in the below chart from BNP Paribas, next year might indeed be "The big easy" as 2007:
We also agree with Peter Tchir from TF Market Advisors, namely that the spread between the 5 year CDS index Itraxx Main Europe (Investment Grade risk gauge based on 125 European entities) and the 5 year Itraxx Financial Senior index is moving towards zero - graph source Bloomberg:
2014 will also see Europe still facing the pressure from two tectonic deflationary plaques, which have been the US QE but more importantly in 2013 the outpacing of the Fed led by "Abenomics" which is indeed sending a tremendous deflationary force around the world which means that even the US is not immune to, hence our repeated doubts in seeing a "tapering" in 2014.
Make no mistakes the Bank of Japan's actions are highly deflationary. On that sense we agree with the recent note from Russell Napier - Solid Ground - entitled "An ill wind":
"The collapse of the yen from ¥115 to ¥143 to the US dollar from 1997 to 1998 played a key role in the Asian economic crisis as Japanese competitiveness surged. The YoY percentage change in the yen-dollar rate currently outstrips the peak decline of 1998 which cause so much pain for Japan’s competitors." - source CLSA - Russell Napier - "An ill wind".
You should focus on Japan and the pain which is already being inflicted to some Emerging Markets due to the Japanese deflationary "tsunami".
On the subject of the power of this Japanese "tsunami" we agree with the following comments from a head of derivatives trading at Bank of America Merrill Lynch:
"One lesson of Japanese culture: we are always hesitant to be the first one to take action but if one does, everyone will follow in the same direction.
DO NOT underestimate when all domestic are acting together!
As far as I know, there "was" only one big domestic winner in this year's equity market until Q3.
-What if the rally over last two weeks was mainly caused by domestics?
-What if Nochu is buying equities?
-What if other mega banks are buying?
-What if regional banks have started buying equities?
-What if Japan Post bank (Yucho) has been buying equities?
-What if Japan Post bank somehow shows up as "foreigner investor" on TSE's "Investment Trends by Investor Category" statistic?
-What if GPIF starts buying from next year?
-What if retail starts buying through NISA next year?
-What if lifers start considering "unwinding currency hedge" or "buying foreign asset without currency hedge"?
-What if US real money will start buying?
-Do you know how big Nochu is?
-What if Okinawa situation is settled soon?
-What if PM Abe leverages Okinawa settlement to settle TPP?
I heard that BoJ governor held a meeting on Tuesday to invite 25 investors. I heard the content was just repeating what he said before, but what was the subcontent of the meeting? Why did he hold the meeting in front of investors, though I don't think previous BoJ governor has ever done so?" - source Bank of America Merrill Lynch
Because we do not underestimate the Japanese "tsunami", we have been adding to our existing long Nikkei exposure hedged in Euro as well as our short Japanese yen stance.
In addition to Bank of America's comments, you should take into account the following article from Mayumi Otsuma and Keiko Ujikane from the 28th of November entitled "Japan's Tax-Free Granny Gifts Unlocking Retiree Savings":
"Shoko Iwasaki looked for years for a tax-free way to pass down a lifetime of savings to her grandson. Prime Minister Shinzo Abe has offered the 71-year-old an answer with a program now helping unlock pensioners’ hoarded wealth.
“I’m so grateful for this tax measure, which enables me to hand over my money all at once,” said Iwasaki, who lives alone in Ashiya, about 300 miles west of Tokyo. She plans to endow 15 million yen ($147,000) for the education of her grandson under an initiative introduced this year exempting tax on lump-sum gifts to children for schooling expenses.
Potential transferable assets to the younger generation under the program that lasts through 2015 amount to 117 trillion yen, according to estimates by Goldman Sachs Group Inc. Gifts of just 10 percent of the total could see 4 trillion yen a year trickling down -- an amount equivalent to 1.7 percent of annual consumer spending in the world’s third-largest economy.
With a shrinking and aging population leaving Japan’s companies reluctant to invest at home, added impetus to consumption would help Abe’s campaign to strengthen domestic demand. Any bump in spending resulting from the act also could diminish the blow from sales-tax increases that start in April.
“This tax exemption is a significant idea in terms of tapping seniors’ money -- which is mostly in a dormant state,”said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance Co. in Tokyo. “This is one policy that will support the success of Abenomics.” "- source Bloomberg
So forget the US "tapering" and focus on Japanese "tapping". There is a Japanese "tsunami" coming your way and it represents $8.5 trillion in savings as indicated by Masaki Kondo and Hiroko Komiya in Bloomberg on the 19th of November in their article entitled "Yen Bears Return as Japan Taps $8.5 Trillion Savings":
"The Nippon Individual Savings Account program will allow individuals to invest in stocks and mutual funds starting Jan. 1 without facing taxes on profits, freeing up savings that exceed China’s gross domestic product and complementing the Bank of Japan’s $70 billion of monthly bond purchases. Strategists say low domestic interest rates may force part of the new money offshore, helping weaken the yen and end deflation.
“The NISA will spice up yen-bear sentiment,” Daisaku Ueno, the chief currency strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo, a unit of Japan’s biggest financial group by market value, said by phone Nov. 15" - source Bloomberg.
As we said back in our conversation "Cold Turkey" regarding Japan on the 17th of November:
"While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket"
We also added:
"As we posited in the "Coffin Corner" back in Europe, the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe and we think the US will as well withhold its tapering stance, spelling more trouble ahead".
On a final note, the link between Japan's stocks and yen is the strongest on record as displayed in Bloomberg's Chart of the Day from the 27th of November:
"The link between Japan’s stocks and yen is the strongest on record as its central bank stands ready to ease monetary policy while the U.S. Federal Reserve prepares to pare stimulus, according to SMBC Nikko Capital Markets Ltd.
The CHART OF THE DAY shows that the correlation between the U.S. dollar's strength against the Japanese currency and the Nikkei 225 Stock Average rose on Nov. 26 to the highest on record, based on data compiled by Bloomberg since January 1978.
This indicates a growing tendency for equities to rise when the yen weakens, and vice versa. The Japanese currency fell 1.1 percent against the dollar last week, while the Nikkei 225
gained 1.4 percent.
“Japan’s monetary base is expanding and the expansion in the U.S. monetary base is slowing, which would tend to suggest, all things being equal, that the dollar will strengthen against the yen,” Jonathan Allum, London-based strategist at SMBC Nikko said in a telephone interview. “That’s a reason to think the stock market in Japan will go up.” Prime Minister Shinzo Abe and the Bank of Japan have signaled they’re willing to add to unprecedented easing measures to reach a 2 percent inflation target, while the U.S. Federal Reserve is contemplating reducing its record $85 billion in monthly asset purchases as the world’s largest economy rebounds.
The policy divergence helped the yen lose 15 percent against the greenback this year as the Nikkei 225 surged 49 percent to rank first among major developed markets.
The 130-day correlation coefficient between the yen and Nikkei 225 rose to 0.49 on Nov. 26, from as low as 0.28 on March 21. A weaker local currency boosts earnings for Japanese exporters such as Toyota Motor Corp. and Panasonic Corp., while increasing the cost of imported goods, adding to price pressures.
“The other possibility why the correlation is suddenly so strong is because there is a correlation between a weak yen and inflation,” Allum said. “If Japan gets into a more self-sustaining inflationary mode and people expect it to continue to rise, then perhaps you won’t need the currency to stimulate stocks.”" - source Bloomberg
Houston, we have lift-off...
"Fortune is like glass - the brighter the glitter, the more easily broken." - Publilius Syrus
Stay tuned!
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