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.