Wednesday, 5 August 2015

Leverage and hope - Twins of the financial apocalypse

Yesterday we saw Fonterra announce another 10% drop in milk prices. So you can slice another 10% off this chart updated last month from their website

Once again the antipodean dream of never ending Chinese demand is turning into more of a nightmare. It’s a simple rule of business. Never expand production reliant on one client unless you are sure the contracts are binding. New Zealand is just experiencing what any UK dairy farmer has experienced at the hands of the large UK supermarkets. China is behaving like a UK supermarkets who promise the earth then backtrack and pin the suppliers down once they have no other buyer.

I went into this in last week’s post with regards to China’s next logical step being to buy distressed commodity companies and infrastructure rather than the commodities themselves so was reassured to see this mornings headline that a Chinese state owned company is looking to buy into Australia’s Fortescue.

Shares in Australia's Fortescue Metals Group jumped 9 percent on Wednesday, boosted by a report that China's Hebei Iron & Steel Group and Tewoo Group could invest in its infrastructure and mining assets.

Well there you go then. The greatest asset the Chinese system has compared to the West is long term planing unclouded by 5yr leadership rotation.

The outlook for equities is confusing me. On one hand I am looking for a move lower as growth and data disappoints, but I am very wary of a bearish sentiment that is getting worn down by lack of moves lower.

Sector rotation has kept the indices fairly intact with commodities being offset by tech but it leaves me wondering how long the ‘make up a number’ world of tech stocks can withstand the latest slew of soft data instead just absorbing sector switching from hard ’stuff’ to investment in hope backed by a reverse justification that as it’s at relative highs it’s ok.

My core concern is that we have seen a compression in credit that still sees real default risk miss-priced through the price anchoring effect of low global yields. I am particularly struck by the very low yields demanded on financing deals. There have been very few notable company failures recently and knowing how pricing models work, lack of past defaults is normally priced as lack of future defaults. Ooo err.

Most balance sheets have been wrung dry through accountancy tricks normally sponsored by private equity buy-outs NPVing future cash flows based on current optimism, borrowing against it and walking away with the borrowings leaving the less savvy lender, who by definition doesn’t understand the company as well as those running it, with the risk. Much as CB monetary policy has little ammo left, should things turn for the worse, these corporate buffer zones are wafer thin. If there is a turn down or a hint of a problem the disasters could be March 2000 re tech and Sept 2008 re financing leverage unwinding.

Of course we are absolutely fine until borrowing rates increase. For the past two years I have doggedly been putting ‘March 2016’ against any survey for the first Fed move higher. I may well be baled out by recent data, expecting expectations in the most time wasting game of this decade (Fed hike guessing) to once again be pushed back. But I am much more concerned about swings in credit related spreads than the core CB 25bp here or there. As anyone with a poor credit history knows, the base rate is the least of their financing concerns.

Where will the tip come? As regular readers would have noticed I have an inherent loathing for arguments based on past event arguments (normally expressed through clever scaling of past and present charts) BUT, I am willing to agree that some of this is looking very 1999. Commodities through the floor and tech through the roof. So my money is on stupid tech being the weak point, not Apple cash cows, but the 99% of the start-up portfolio that has been bought on the assumption that the 1% mega-winner will compensate for the loser rest. Tie my 'tech hope' and financing concerns together and I worry that if there is a turn down or a hint of a problem the disasters could be both March 2000 re tech and Sept 2008 re financing leverage unwinding. Don’t get me wrong, i’m not calling this as a high delta outcome but it is a fat tail.

But back to the shape of equity markets and I am till fascinated by the tech/commodity spread and find a glut of extreme commentary particularly interesting. to the point I am going to stick two fingers up at popular opinion and buy some oil and commodity stocks. Nice low geared big ones.


hipper said...

"Well there you go then. The greatest asset the Chinese system has compared to the West is long term planing unclouded by 5yr leadership rotation."

Well said. And if you extend it further the Western system might not any longer currently even live up to its historically stated benefits, democracy for one. Political power = $$$ = corporate power and just wait until TTIP and TISA get waved through under the flag of democracy. Pick your poison and choice not being clear should tell quite a lot by itself.

In foreign policy and geopolitically the Chinese, Russian etc. system definately should trump the Western systems though. Only one moving part (one guy using the real power) compared to a million parts (committees) all just thinking what not to do, say or vote to don't loose your job. And the rest just thinking how to maximize the paycheck from Mr/Ms Mystery Lobbyist.

Antipodean said...

Jeeze Hipper... I assume you are taking the piss

hipper said...

Noticed and got a bit carried away from the focal point, sry. Pure clairvoyance.

And Chinese starting to snatch up commodity stuff. They actually tried the same in tech with Micron too a couple of weeks ago on the cheap but it didn't seem to fly very well and if it did then it would've probably hit the impenetrable wall of political no-nos anyway.

Unclear Wessels said...

Hipper, mate, you certainly did surprise me with the bit about trumping... have you been to Russia (outside Moscow)? Don't know enough to comment about the Chinese, but Mr P is certainly not too clever at playing the long game.

hipper said...

Unclear Wessels, what I kind of meant was when you think of the system theoretically having certain attributes, and exclude leadership quality. In the one man show decisions can potentially be made quickly, there are less susceptible parts to be corrupted, and there are less opportunities for the decision to get distorted out-of-shape before it reaches where it was going. Where as democracy seems to be somewhat opposite. Here where Polemics "unclouded 5yr leadership rotation" is in play and potentially with the right set of circumstances can be a very effective management system.

Of course then when you add back "leadership quality", in the one man show it's a lot more important, since not many factors along the way to influence possible bad decisions to better. But if there's a capable and understanding leader, then the dictatorship type might actually be beneficial (like Singapore) where as if there isn't, then democracy as decisions might have an increased likelihood to be distorted from worse to better. But that's why democracy is somewhat suspicious, you just never really know on what basis the effective net outcome is being delivered. The term "representative" is very shivery. Representative to whom? It would certainly be nice to see some kind of periodic ventilation taking place preventing the same set of ppl be in control for too long, thus letting decades of accumulated dust blow out from the administration chambers.

Of course there's a lot more going on in the real world. Mr. P might not be very succesful playing this game , but then again I for one don't have reliable info to tilt either way to say why they're doing what they're doing in Ukraine and who was provoking who to begin with. Don't know how things would turn out with fully implemented democracy either. The geopolitical position is what it is. One who certainly doesn't seem to be very clever here either is the "democratically elected" EU leadership who have thus far proved to be quite incapable of handling any intra-Union crisis and regardless are still aiming for further expansion.

Sorry for the deviation guys. I had a dream of blowout 297k but it's so ridiculous I'm ashamed to even have dreams anymore.