#bubble

Seen this all before

What is it with the US auto market that throws up so many canaries in the coal mine? Several years back CM wrote about the growth in sub-prime auto loans. What triggered this boom? Easier access to finance? That was one reason. As it happens the largest factor was driven by the ability for finance companies to shut down a vehicle by remote and repossess the vehicle should the buyer be unable to afford the monthly payments. This lowered risk and allows these long-dated loan products to thrive. Average subprime auto loans carry 10% p.a. interest rates. More than 6 million American consumers are at least 90 days late on their car loan repayments, according to the Federal Reserve Bank of New York.

About a 1/3rd of all US auto loans issued today are stretched out to seven years and beyond, according to the WSJ. A decade ago, the seven-year loan only made up about 10% of all loans. Even 10% of 2010 model year bangers are being bought on 84-month term loans.

After the tech bubble collapsed at the turn of the century do you remember the ‘Keep America Rolling’ programme, which was all about free financing for five years? While sales were helped along nicely, the reality was it stored up pain. As new car sales became harder to achieve, new financial products offered sweeter upfront incentives and buyback guarantees (because cheap finance was everywhere and not a differentiator) helped keep the fire stoked.

However, as front end incentives kept getting juicier, the cars on guaranteed buybacks were starting to return to the market at prices well below the ‘guarantee’ leaving automotive finance arms in a whole world of hurt and huge losses. Goldberg & Hegde’s Residual Value Risk and Insurance study in 2009 suggested on average 92% of cars returned to leasing companies recorded losses on return of up to 12%. Any company can guarantee the price of its used product, in theory, the question is whether used car buyers will be willing to pay for it.

In the last decade, auto loans have ballooned from $740bn to $1.3 trillion. Auto dealers are now making a majority of their money on the finance deal as opposed to the sale of the actual car. Even worse, the US car market is experiencing a third of trade-ins in negative equity meaning the gap is being added to the price of the new car, hence the push out of the loan period to keep a lid on the size of monthly payments. This was 17% in 2008.

CM is sure there is nothing to worry about. It is consistent with nearly everything else that has occurred in finance since the GFC. Just double down, spend more, close your eyes and hope nothing bad happens. Ultimately it will be someone else’s problem.

Serious auto-loan delinquencies – 90 days or more past due – in 2Q 2019, jumped 47 basis points year-over-year to 4.64% of all outstanding auto loans and leases, according to New York Fed. This is equivalent to the delinquency rate in Q3 2009, just months after GM and Chrysler had filed for Chapter 11 bankruptcy. The 47-basis-point jump in the delinquency rate was the largest year-over-year jump since Q1 2010. Actual outstanding delinquent 90 day + delinquencies stand at $60bn in 2Q 2019, almost double the amount of 4Q 2010.

Did CM mention gold?

The Grim Repo

What a surprise to see markets show little reaction to the negative repo (repurchase agreements) market in the past week. So much nonchalance and complacency remain in financial markets. It is as if there is this false belief that the authorities can keep the ship afloat with magical modern monetary theory. Not a chance. The tipping points in the financial markets are quantum levels bigger than any that Sir David Attenborough could conjure up in his wildest pessimistic dreams. If we want to cut carbon emissions, the coming economic slump will take care of that.

On average there are $1 trillion of overnight repo transactions every day, collateralised with US Treasuries. Yet many missed that the repo market seized up late last week. Medium-term repos surged from the normal band of around 2.00~2.25% to around 5.25% on Monday. Some repo rates hit 10% on Tuesday.

Essentially what this said was that a bank must have seen that it was worth borrowing at an 8% premium overnight in return for pledging ‘risk-free’ US Treasuries at 2%. In any event, it allowed that particular bank to survive for another day. Banks use the repo market to fund the loans they issue and finance trades that are executed. It is like an institutional pawn shop.

Looking at it another way, why weren’t other banks willing to lend and take an 8% risk-free trade? A look at the global bank’s share price action would suggest that these bedrock financial institutions that grease the wheels of the economy are not in good shape. We just pretend they are. We look at the short term performance but ignore the deterioration in underlying balance sheets. The Aussie banks are future crash test dummies given the huge leverage to mortgages. As CM has been saying for years, the Big 4 risk whole or part nationalisation.

This recent repo action is reminiscent of that before the GFC. The Fed stepped in with $75bn liquidity per day to stabilise markets by bringing rates into the target range. The question is whether the repo action is a short-term aberration or the start of a longer-term quasi QE programme which turns into a full-blown QE programme.

The easiest way to look at the repo market action is to say the private markets are struggling to be self-funding, requiring central bank intervention. Bank of America believes the Fed may have to buy upwards of $400bn of securities to back the repo market this year alone.  This is another canary in the coal mine.

CM wrote a long piece back in July 2016 titled, “Dire Straits for Central Bankers.” In that report, we described how the velocity of money in the system was continuing to drift. As of now, central banks have printed the equivalent of $140 trillion since 2008 but have only managed to eke out $20 trillion in GDP growth. That is $7 of debt only generates $1 of GDP equivalent.

This is the problem. Companies are struggling to grow. US aggregate after-tax profits have gone sideways since 2012. We have been lulled into a false sense of security by virtue of aggressive share buyback programs that flatter EPS, despite the anaemic trend.

Despite the asset bubbles in stocks, bonds and property, pension funds, especially public sector retirement schemes, are at risk of insolvency given the unrealistic return assumptions and nose bleed levels of unfunded liabilities in the trillions.

Also worthy of note is the daily turnover of the gold derivatives market which has hit $280bn in recent months, or 850x daily mine production. This will put a lot more pressure on the gold physical market and also to those ETFs that have promissory notes against gold, as opposed to having it properly allocated.

We live in a world of $300 trillion of debt, $1.5 quadrillion in derivatives – until this is expunged and we start again, the global economy will struggle. That will also require the “asset” values to be similarly wiped out. Equity markets will plunge 90-95% relative to gold. That suggests a 1929 style great depression. The debt bubble is too big. Central banks have lost control.

Buy Gold.

Ford downgraded to junk

This week, Ford Motor Co’s credit rating was downgraded by Moody’s to junk. $84bn worth of debt now no longer investment grade. It will be the first of many Fortune 500s to fall foul to this reality. In 2008, there was around $800bn of BBB status credit. That number exceeds $3.186 trillion today.

CM has long argued that the credit cycle would be the undoing of the economy. For too long, corporates binged on easy money, caring little for credit ratings because the interest spreads between AAA and BBB were so negligible. The market ignored risk and companies went hell for leather issuing new debt to fu buybacks to artificially prop up weak earnings to give the illusion of growth.

Sadly this problem is likely to cause widespread sell offs by companies/investors which must stick to products (as woefully yielding as they may be) with an investment grade, exacerbating the problem of refinancing debt close to maturity. The thinking during easy credit times was simple – refinancing could be done with low interest rates because there was no alternative.

This is problematic for three reasons:

1) under the Obama era, much of the newly issued debt was short term meaning $8.4 trillion arrives for refinancing in the next 2.5 years, crowding out the corporate market.

2) more than 50% of US corporates are one notch above junk status. Refinancing will not be a simple affair.

3) more and more investment grade debt will be driven to zero or even negative yields as a result further exacerbating the problems for insurance companies and pension funds dealing with massive unfunded liabilities.

Last year, in relation to unfunded liabilities at US public pension funds, CM wrote,

California Public Employee Retirement System (CalPERS) lost around 2% of its funds in 2015/16. The fund assumed an aggressive 7.5% return. Dr. Joe Nation of Stanford Institute for Economic Policy Research thinks unfunded liabilities have surged to $150bn from $93bn in the last two years. He suggested the use of a more realistic 4% rate of return last year. At that rate, CalPERS had a market based unfunded liability of $412bn (or the equivalent of 2 years’ worth of California state revenue). At present Nation now thinks the number is just shy of $1 trillion using a 3.25% discount rate. He expects that the 2017 data for CalPERS will be out in a week or so which should give some interesting perspective as to how much deeper the pension hole is for Californian public servants.

N.B. California collects $232bn in state taxes annually in a $2.3 trillion economy (around the size of Italy).”

This is just California, which in the last 8 years has seen a 2.62-fold jump in the gap between liabilities and state total expenditures.

Unfunded liabilities per household. In California’s case, the 2017 figure is $122,121. In 2008 this figure was only $36,159. In 8 years the gap has ballooned 3.38x. Every single state in America with the exception of Arizona has seen a deterioration.

Switching to Illinois, we have a case study on what happens when pension funds go pear shaped.The Illinois Police Pension is rapidly approaching the point of being unable to service its pension members and a taxpayer bailout looks unlikely given the State of Illinois’ mulling bankruptcy.

Local Government Information Services (LGIS) writes, At the end of 2020, LGIS estimates that the Policemen’s Annuity and Benefit Fund of Chicago will have less than $150 million in assets to pay $928 million promised to 14,133 retirees the following yearFund assets will fall from $3.2 billion at the end of 2015 to $1.4 billion at the end of 2018, $751 million at the end of 2019, and $143 million at the end of 2020, according to LGIS…LGIS analyzed 12 years of the fund’s mandated financial filings with the Illinois Department of Insurance (DOI), which regulates public pension funds. It found that– without taxpayer subsidies and the ability to use active employee contributions to pay current retirees, a practice that is illegal in the private sector– the fund would have already run completely dry, in 2015…The Chicago police pension fund held $3.2 billion in assets in 2003. It shelled out $3.8 billion more in benefits to retired police officers than it generated in investment returns between 2003 and 2015…Over that span, the fund paid out $6.9 billion and earned $3.0 billion, paying an additional $134 million in fees to investment managers.”

Therefore Ford’s downgrade to junk will have the effect of repricing over a decade of misplaced central bank policy across all markets. The dominos are only beginning to fall. The market can absorb Ford’s downgrade but not if it has to deal with the panic of dozens like it.

CM has long been warning of GE. Despite being the world’s largest stock in 2000, it is 1/5 the size today, trades in negative equity, wasted $45bn on share buybacks in 2015/16 and were it be classified as junk would increase the pile of junk by 10% on its own. Broadcom and American Tower are other monsters ready to be hurled onto the ratings scrap heap.

Buy Gold. The US Fed will likely embark on QE. It requires an act of Congress to approve the purchase of equities but don’t be surprised if this becomes a reality when markets plunge.

This will be the reset of asset prices which has been long overdue thanks to almost two decades of manipulation by authorities. It has 1929 written all over it. Not 2008.

WeWorked

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WeWork has delayed the IPO. According to Zerohedge, the initial appraisal value of $47 billion appears to be entering the realm of $10 billion. This has ‘canary in the coalmine‘ written all over it. The kaleidoscope of razzle-dazzle in the free money world looks to have stopped spinning.

The company looks toxic. Most people point fingers at the co-founder Adam Neumann,  who, according to WSJ,  reportedly sold $700 million in a mixed debt and equity transaction. CM may be a contrarian, but even he sees the pre-IPO sale as somewhat suspicious. Selling part of your stock as part of an IPO is one thing. Doing it prior doesn’t pass the pub test.

How can IWG plc (better known as Regus) make profits (albeit sideways) with the same concept? 2018 IWG revenue and profit after tax increased 51% over 2014 levels. Revenue increased 13.5% since 2016, but post-tax profit slumped 24%.

WeWork seems like the Tesla of the office space world. Huge promises but the numbers are struggling to stack up. Maybe WeWPresumably, due to a combination of intensifying shared office competition, start-ups spoilt for choice or simply failing to grow.ork should leap into insurance as a way to generate cash flow like Tesla has started to do?

Banker Buster?

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Before the GFC in 2008, bank shares across the globe were flying. Financial engineering promised a new paradigm of wealth creation and abundant profitability. They were unstoppable.

However 12 years later, many banks look mere shadows of their former selves. We are told by our political class to believe that our economies are robust and that a low-interest rate environment will keep things tickety-boo indefinitely. After all the wheels of the economy have always been greased by the financial sector.

If that were true, why does Europe’s largest economy have two of its major banks more than 90% off the peak? Commerz has shrunk so far that it has been thrown out of the DAX. Surely, Japan’s banks should be prospering under Abenomics so why are the shares between 65% and 80% below 2007 levels?

Ahh, but take a look at those Aussie beauties! How is it they have bucked the global trend? How can Commonwealth Bank be worth 6x Deutsche Bank?

Although we shouldn’t look at the Aussie banks with rose-tinted glasses they have mortgage debt up to the eyeballs. Mortgages to total loans exceed 62% in Australia. The next is daylight, followed by Norway at 40%. Japanese banks, before the bubble collapsed, were in the 40% range. CM wrote a comparo here. There is a real risk that these Aussie banks will require bailouts if the housing market craps out. It carries so many similarities to Japan and when anyone ever mentions stress tests – start running for the hills.

If you own Aussie banks in your superannuation portfolio, it is high time you dumped them. Franked dividends might be an ample reason to hold them, but things in finance turn on a dime and this time Australia doesn’t have a China to rescue us like it did in 2008-09. More details contained in the link in the paragraph above.

In closing, Milton Friedman said it best with respect to the ability of central banks to control outcomes,

“… we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.

 

The depression we have to have

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In his 1967 presidential address to the American Economic Association, Nobel laureate economist Milton Friedman said, “… we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.

What we are witnessing today is not capitalism. While socialists around the world scream for equality and point to the evils of capitalism, the real truth is that they are shaking pitchforks at the political class who are experimenting with economic and monetary concoctions that absolutely defy the tenets of free markets. As my learned credit analyst and friend, Jonathan Rochford, rightly points out, central banks have applied “their monetary policy hammer to problems that need a screwdriver.

Never has there been so much manipulation to keep this sinking global ship afloat. Manipulation is the complete antithesis to capitalism.  Yet our leaders and central banks think firing more cheap credit tranquillizers will somehow get us out of this mess. IT. WILL. NOT.

BONDS

As of August 15th, 2019, the sum of negative-yielding debt exceeds $16.4 trillion. That is to say, 30% of outstanding government debt sits in this category. Every single government bond issued by Germany, The Netherlands, Finland and Denmark are now negative-yielding. Germany just announced a 30-yr auction with a zero-interest coupon.

Unfortunately, insurance companies and pension funds are large scale buyers of bonds and negative interest rates don’t exactly serve their purposes. Therefore the hunt for positive yield (that ticks the right credit rating boxes) means the pickings continue to get slimmer.

Put simply to buy a bond with a negative yield, means that the cost of the bond held to maturity is more than the sum of all the coupons due and the receipt of face value combined. It also says clearly that controlling the extent of the loss of one’s money is preferable to sticking to strategies in other asset classes (e.g. property, equities) where TINA (there is no alternative) is the rule of thumb.

CM believes that there is a far bigger issue investors should focus on is the return “of” their money, not the return “on” it.

Rochford continues,

Central banks have hoped that extraordinary monetary policy would kick start economic growth, but they have instead only created asset price growth. In applying their monetary policy hammer to problems that need a screwdriver they have created the preconditions for the next and possibly greater financial crisis. The outworkings of many years of malinvestment are now starting to show with increasing regularity.

Argentina’s heavily oversubscribed issuance of 100-year bonds in 2017 was considered insane by many debt market participants at the time. The crash to below 50% of face value this month and request for maturity extensions is no surprise for a country that has a long rap sheet of sovereign defaults. Greece’s ten-year bond yield below 2% is another example of sovereign debt insanity…

…There have been three regional bank failures in China in the last three months, likely an early warning of the bad debt crisis brewing in China’s banks and debt markets. Europe’s banks aren’t in much better shape, there’s still a cohort of weak banks in Germany, Greece, Italy and Spain that haven’t fixed their problems that first surfaced a decade ago. Deutsche Bank is both fundamentally weak and the world’s most systemically important bank, a highly dangerous combination.”

What about equity markets?

EQUITIES

We only need look at the number record number of IPOs in 2018 where over 80% launched with negative earnings, you know, just like what happened in 2000 when the tech bubble collapsed.

Have people paid attention to the fact that aggregate US after-tax corporate earnings have been FLAT since 2012? That is 7 long years of tracking sideways. Where is this economic miracle that is spoken of?

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The only reason the markets have continued to remain excited is the generous share buyback regimes among many corporates which have flattered earnings per share (EPS). The “E” hasn’t grown. It is just that “S” has fallen. Credit spreads between AAA and BBB rated corporate paper has been so narrow that over 50% of US corporates now have a BBB or worse credit rating. Now credit spreads between top and bottom investment-grade bonds remain ridiculously tight. At some stage, investors will demand an appropriate spread to account for market “risk.”

Axios noted that for 2019, IT companies are again on pace to spend the most on stock buybacks this year, as the total looks set to pass 2018’s $1.085 trillion record total. Pretty easy to keep markets in the clouds with cheap credit fuelling expensive buybacks. Harley-Davidson is another household name which suffers from strategy decay yet deploys more cash to share buybacks instead of revitalising its core franchise. Harley delinquencies are at a 9-yr high.

Companies like GE embarked on a $45bn share buyback program despite a balance sheet which still reveals considerable negative equity. GE was the largest company in the world in 2000 and now trades at 20% of that value almost 20 years later.

Should we ignore Harry Markopolos, who discovered the Bernie Madoff Ponzi scheme, when he points to the problems within GE? GE management can protest all they like but ultimately the company is not winning the argument if the share price is a barometer.

Valuations are at extreme levels. Beyond Meat trades at 100x revenues. Don’t get CM started on Tesla. A largely loss-making third rate automaker which is trading at outlandish premiums. The blind faith put in charge of a CEO that has lost over 100 senior management members.

Bank of America looked at 20 metrics to evaluate current market levels of the S&P500. 17 of them pointed to excess valuations relative to history including one metric that revealed S&P500 being 90% overvalued on a market cap to GDP ratio. Never mind.

Then witness the push for diversity nonsense inside corporate boardrooms. CM has always believed if a board is best suited to be run by all women based on background, skills and experience, then so be it. That is the best outcome for shareholders. However, to artificially set targets to morally preen will mean absolutely nothing if a sharp downturn exposes a soft underbelly of a lack of crisis management skills. Shareholders and retirees won’t be impressed.

It was laughable to hear superannuation funds ganging up on Harvey Norman last week for not having a diverse enough board. Even though Harvey Norman is thumping the competition which focuses too much on ESG/CSR, the shortcomings of our retirement managers are only too evident. Retirees want returns and their super managers should focus on that, rather than try to push companies to meet their ridiculous self-imposed investment restrictions. Retirees won’t be happy when their superannuation balances are decimated because fund managers wanted to appear socially acceptable at cocktail parties.

PROPERTY

It was only last month that Jyske Bank in Denmark started to offer negative interest mortgages. That is the bank pays interest to the mortgage holders. Of course, the bank is able to source credit below that rate to make a profit however net interest margins for the banks get squeezed globally. What next? Will people be able to sign up to a perpetual negative interest mortgage? Shall we expect a Japan-style multi-generational loan?

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The RBA’s latest chart pack shows net interest margins at the lowest levels for two decades. With the Hayne Banking Royal Commission likely to further crimp on lending growth, we are storing up huge pain in property markets despite the hope that August clearing rates signal a bottom in the short term. Yet more suckers lured in at the top of a shaky economy and financial sector.

Of course, central banks will dance to the tune that all is OK. Until it isn’t.

Don’t forget former US Treasury Secretary Hank Paulson, said “our financial institutions are strong” right before plugging $700bn worth of TARP money to save many of them from bankruptcy in 2008.

CM has previously investigated the Big 4 Aussie banks who have equity levels that are chronically low levels. Our major banks have such high exposure to mortgages that a severe downturn could potentially lead to part or whole nationalisation. Of course, between signalling the importance of factoring climate change, APRA assures us the stress tests ensure our financial institutions are safe.

Back in 2007, Sydney house prices were 8x income. In 2017 Demographia stated average housing (excluding apartment) prices were in the 13-14x range. The Australian Bureau of Statistics notes that 80% of people live in houses and 20% in apartments. Only Hong Kong at 19x beats Sydney for dizzy property prices. In 2019, expect that price/income rates remain at unsustainable levels.

In 2018, Australia’s GDP was around A$1.75 trillion. Our total lending by the banks was approximately $2.64 trillion which is 150% of GDP. At the height of the Japanese bubble, total bank lending as a whole only reached 106%. Mortgages alone in Australia are near as makes no difference 100% of GDP. Where there is smoke, there is fire.

At the height of the property bubble frenzy, Japanese real estate related lending comprised around 41.2% (A$2.5 trillion) of all loans outstanding. N.B. Australian bank mortgage loan books have swelled to 64% (A$1.8 trillion) of total loans.

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Sensing the bubble was getting out of control, the Bank of Japan went into a tightening rate cycle (from 2.5% to 6%) to contain it. Unfortunately, it led to an implosion in asset markets, most notably housing. From the peak in 1991/2 prices over the next two decades fell 75-80%. Banks were decimated.

In the following two decades, 181 Japanese banks, trust banks and credit unions went bust and the rest were either injected with public funds, forced into mergers or nationalized. The unravelling of asset prices was swift and sudden but the process to deal with it took decades because banks were reluctant to repossess properties for fear of having to mark the other properties (assets) on their balance sheets to current market values. Paying mere fractions of the loan were enough to justify not calling the debt bad. If banks were forced to reflect the truth of their financial health rather than use accounting trickery to keep the loans valued at the inflated levels the loans were made against they would quickly become insolvent. By the end of the crisis, disposal of non-performing loans (NPLs) among all financial institutions exceeded 90 trillion yen (A$1.1 trillion), or 17% of Japanese GDP at the time.

The lessons are no less disturbing for Australia. As a percentage of total loans outstanding in Australia, mortgages make up 65%. The next is daylight, followed by Norway at around 40%. US banks have cut overall property exposures and Japanese banks are now in the early teens. Post GFC, US banks have ratcheted back mortgage exposure. They have diversified their earnings through investment banking and other areas. That doesn’t let them off the hook mind you.

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Japanese banks have 90%+ funding from domestic deposits. Australia is around 60-70%. Our banks need to go shopping in global markets to get access to capital. Conditions for that can change on a dime. External shocks can see funding costs hit nose bleed levels which are passed onto consumers. When you see the press get into a frenzy over banks passing on more than the rate rises doled out by the RBA, they aren’t just being greedy – a large part is absorbing these higher wholesale funding costs.

Central banks need a mea culpa moment. We need to move away from manipulating interest rates to muddle through. It isn’t working. At all.

Rochford rightly points out,

Coming off the addiction to monetary policy is going to be painful, but it is the only sustainable course. It is likely that normalising monetary policy will result in a global recession, but this must be accepted as an unavoidable outcome given the disastrous policies of the past. Excessive monetary and fiscal stimulus has pulled consumption forward, the process of unwinding that obviously requires a level of consumption to be pushed backwards.”

Rochford is being conservative (no doubt due to his polite demeanour) in his assessment of a global recession. It is likely that this downturn will make the GFC of 2008 look like a picnic. CM thinks depression is the more apt term. 1929, not 2008. Central banks are rapidly losing what little confidence remains. If the RBA think QE will be a policy option, there is plenty of beta testing to show that it doesn’t work in the long run.

It is time to have the recession/depression we had to have to get the markets to clear. It will be excruciatingly painful but until we face facts, all the manipulation in the world will fail to keep capitalism from doing its job in the end. The longer we wait the worse it will get.

“It’s not what you don’t know that gets you into trouble…..it is what you know to be sure that just ain’t so! – Mark Twain.

Beauty is in the eye of the beholder

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To all those budding first home buyers – knock yourself out with this beautiful 27m2 wonder for sale at $535,000 in Elizabeth Bay. Reminds CM of a garage that was for sale in Park Lane, London for GBP900,000. At least the real estate agent can still spin it…

Highlights
* For renovators: your own fitout
* A blank studio space for revamp
* Views via wall-to-wall windows
* Outlooks over Rushcutters Bay
* Dual aspect sunlight/circulation
* Neat kitchen/bathroom with tub
* Main studio room gutted for reno
* Set in Harry Seidler building, lift access
* Intercom entry, scrambled parking
* Council $1,109p.a., water $717p.a.