Financial Markets

Oi vey Australia! Time to develop innovation

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While the Australian school system seems obsessed dealing with LGBT awareness, gender fluidity and social causes, a day in the most up to date Israeli cyber park in the Negev Desert shows just how seriously the small nation deals with the real world and preparing future generations for it.

It should come as no surprise that Israel lives under constant threat. The Jewish State is happy to leave LBGT 20yr celebrations to rainbow flags on the beachfront in Tel Aviv. When it comes to education it is all about working kids hard to be competitive, hungry and innovative. Primary school students learn computer coding and mathematics. They don’t hold cross dressing presentations or participate in Family Day as a replacement for Mothers Day to show inclusiveness for minorities. Survival matters.

Those same primary schoolers learn even more skills when they hit high school. The government monitors 13yo kids for their cyber acumen to screen the best possible assets for the future. By 16yo the weeding out process is all but done.

The notorious IDF cyber unit 8200 is relocating to this cyber centre in Negev where over a dozen buildings are being erected to gather the finest innovators in the world. It’s a $50bn investment. Even the Israeli Defence Force standard cyber units will relocate there. As Israelis have compulsory military service from 18 years of age, the best and brightest get automatically assigned to these cyber teams.

The universities are collaborating with corporates and government. They work on real solutions that matter rather than shoot for research on questions nobody is asking. Companies like Intel are setting up R&D centres in Israel because the talent is there.

Australia may have a Department if Innovation & Science which has a billion dollar budget. The Israeli tech infrastructure organizers in places like the Negev encourage start ups. They award grants thru competitive processes based purely on merit. Instead of cutting grant cheques to all for participating in the Aussie “everyone wins a prize” mentality, the idea is that only the “best” idea out of 500 wins. The rest are forced to make more compelling arguments and work to secure alternative funding. That weeds out waste. If Australia just divvies out with fairness in mind, resources are misallocated and it is more likely the capital allocators are clueless.

The system is impressive beyond words. Listening to a dozen presenttions ranging across medical, cyber and agricultural fields, one cannot be thoroughly in awe of an early-thirties doctor from the neighboring university who has racked up 20+ patents for his inventions.

Then there is the tale of a 17yo intern who was given an asssignment to hack the vulnerability of a mobile phone manufacturer whose PR department lied through its back teeth to cover up a flaw in the system they boasted was secure. They cited the original hack wasn’t done over a secure VPN. In 3 days the 17yo kid hacked that too. Take about a face plant.

The same group told a large American corporate that it’s video streaming had a bug. Instead of admitting the lapse, the tech giant hunkered down and dug in its heels. They put a bandaid on it and were hacked again. They have managed to make a computer that is next to another but not connected in anyway, even via WiFi to make functions purely based on heat.

The answer is simple though. There are many cultural reasons why this type of education system works in Israel. While Australia has no hope of holding a candle to the Israelis there are huge lessons to be learnt about fostering a culture of individual excellence rather than move down the slippery slope that fails to prepare our kids for the future. It maybe too late.

Priorities, priorities…

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Maryland (MD) – 2018

  • High school graduation rate: 87.6% (12th highest)
  • Public school spending: $13,075 per pupil (19th highest)
  • 8th grade NAEP proficiency: 34.7% (math), 37.4% (reading) (11th highest).
  • Adults with at least a bachelor’s degree: 39.3% (3rd highest)
  • Adults 25-64 with incomes at or above national median: 61.6% (2nd highest)
  • Violent crime 4.72/1000 residents (national average 4.0/1000) (9th highest)
  • Crimes per square mile 57 (national average 31.9)
  • Baltimore, MD most dangerous city (out of biggest 50) in America.
  • Opioid death rate 29.7/100,000 (3rd highest) – national average 13.3/100,000

Good to see where things are ranked among the worst, Democrats wish to put the least focus and vice versa. Rather telling. Where is the focus on healthcare and climate change? Even more telling.

Xi and Trump summit In Singapore

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On May 25th, CM wrote after the spat between Trump & Kim, “It will be China sending Kim back to the meeting table with Trump because it will ultimately be managing the protectorate after any peace is signed for its own geopolitical aims. China does NOT want US friendly forces on its border. Best keep the buffer by getting Kim to accept a lesser deal where he gets to keep his life. For a man in his early 30s he can either choose to go down fighting or see out his days with the embezzled billions and bevy of beauties in his concubine.

Shouldn’t the fact that China provided Kim Jong Un with a “private” jet to get to the summit speak volumes about who his interests represent? While the US State Dept might quibble over minibar expenses at his hotel in Singapore, President Xi is showing he’s truly behind the outcomes from North Korea’s side. The Chairman is but a puppet.

China only wants reunification if that means US Forces leave the South. That is unlikely to be on the cards so Kim can de-nuclearise and clutch to the bosom of Xi.

As CM wrote back in August 2017, China will turn North Korea into a puppet state. Kim knows it is best to hitch his wagon to the world’s most ruthless regional power in coming decades. He only needs to bear 6.5 years of Trump. President Xi will be around for decades.

Kindergarten level agenda behind Kinder Morgan buyout

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The Canadian Liberal government is paying $4.5bn for a 60yr old pipeline that was sold a decade ago to Kinder Morgan for $377m for an asset RBC values at $2.5bn. Another $7.5bn will be spent to “create jobs”. Apart from Canadian tax dollars going to fund a US company’s ability to expand and compete against Canadian suppliers, the real truth of Trudeau’s intentions probably don’t become any clearer when examining the sponsored summer jobs programme (where businesses could only get greenlighted if they shared “his” values). Yes, taxpayer dollars were approved by Trudeau to help activists protest a pipeline he’s just bought. This was an ad posted by Dogwood:

“As an organizing assistant through the Canada Summer Jobs program you will work directly with a Dogwood Provincial Organizer and the field organizing team to help our organizing network stop the Kinder Morgan pipeline and tanker project, as well as help us strengthen the public call for stronger, more accountable and transparent democracy.”

He has already been crashing in the polls. This will help to no end. So much for transparency.

Jan 2008 again?

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Back to Jan 2008 10yr Treasury – 3mth Treasury Bill spread levels of 0.84% overnight. Shaded areas are previous recessions. I’m sure it is nothing. The friend who sent me the link also sent a Barron’s article last week which interviewed Kiss legend Gene Simmons who believes the Dow is poised for 30,000. He may well be proved right, although I wonder just whether algo trading is linked to Twitter followers. Maybe if Katy Perry starts jawboning about Dow 40,000 we should shut up and buy the trend. More useful than some Goldman Sachs nerd with a PhD in nuclear fission to read the runes…

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GE’s Angolan Kwanza exposure

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Sell-side analysts rarely read through the fine print of an annual report. Hidden away in the prose, one can find some pretty eye-opening paragraphs. From GE’s 2017 Annual Report,

“As of December 31, 2017, we held the U.S. dollar equivalent of $0.6 billion of cash in Angolan kwanza. As there is no liquid derivatives market for this currency, we have used Angolan kwanza to purchase $0.4 billion equivalent bonds issued by the central bank in Angola (Banco Nacional de Angola) with various maturities through 2020 to mitigate the related currency devaluation exposure risk. The bonds are denominated in Angolan kwanza as U.S. dollar equivalents, so that, upon payment of periodic interest and principal upon maturity, payment is made in Angolan kwanza, equivalent to the respective U.S. dollars at the then-current exchange rate.”

On that basis the marked to market figure is actually another $250mn hole in 2017. One wonders what the exchange rate will be in 2020? Furthermore at what level will Travelex or Thomas Cook exchange that for? It would be safe to assume the ‘bid/offer’ spread will be horrendous. GE might find it more useful to run a Nigerian mail scam to hedge the expected losses. For a company as large as GE, potentially losing $850mn should look like a rounding error unless the company is bleeding as the monster is. GE took a pretax charge of $201mn on its Venezuela operations.

We shouldn’t forget that “GE provides implicit and explicit support to GE Capital through commitments, capital contributions and operating support. As previously discussed, GE debt assumed from GE Capital in connection with the merger of GE Capital into GE was $47.1 billion and GE guaranteed $44.0 billion of GE Capital debt at December 31, 2017. See Note 23 to the consolidated financial statements for additional information about the eliminations of intercompany transactions between GE and GE Capital.

As 13D Research noted, “GE spent roughly $45 billion on share buybacks over 2015 & 2016  despite the shares trading well above today’s levels all the while ignoring the $30 billion+ shortfall in its pensions. Management disclosed in a recent analyst meeting that it would have to borrow to fund a $6 billion contribution to its pension plans next year, as well as chopping capex by 26% in 2018.

As mentioned yesterday, there are some who have faith in the sustained turnaround in medical. Indeed it has seen some top line and margin improvement but management seems more concerned with focusing on cutting costs than pushing innovation. Efficiency drives should be part and parcel of all businesses but one must hope CEO John Flannery has far bigger hopes for its market share leading product line (which GE admits facing pricing pressure in some segments) than trimming the staff canteen cookie tin.

GE remains a risky investment. Flannery has it all to prove and to date his performances have been anything but inspiring. GE feels like a business suffering from the divine franchise syndrome synonymous with former CEO Jack Welch. That dog eat dog culture seems to be biting its own tail.

 

 

GEzus Priced super far?

US Corp prof.pngIt is not rocket science. Generally higher interest rates lead to lower profitability. The chart above shows that quarterly pre-tax US profitability is struggling. We took the liberty of comparing the profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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With the Fed moving toward a tightening cycle, we note that the spreads of Baa 10yrs to the FFR has yet to climb out of its hole. During GFC it peaked at 8.82%. It is now around 3%.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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Corporate America binged on cheap credit over the last decade and given the spreads to Aaa ranked corporate bonds were relatively small, it was a no brainer. In 2015, GE’s then-CEO Jeff Immelt said he was willing to add as much as $20 billion of additional debt to grow, even if it meant lower bond grades. We can see that the spread today is a measly 0.77%. Way off the 3.38% differential at the time of GFC. Still nearly 50% of corporate debt is rated at the nasty end.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper its balance sheet. So as an investor, would you prefer the safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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In any event, the 4.64% 10yr Baa corporate bond effective yield is half what it was at the time of GFC. Yet, what will profitability look like when the relative attractiveness of US Treasuries competes with a deteriorating corporate sector in terms of profitability or balance sheet?

Take GE as an example. Apart from all of the horror news of potential dividend cuts, bargain basement divestments and a CEO giving vague timelines on a turnaround in its energy business things do not bode well. Furthermore many overlook the fact that GE has $18.7bn of negative equity. Selling that dog of an insurance business will need to go for pennies in the dollar. There is no premium likely. GE had a AAA rating but lost it in March 2009. Even at AA- the risk is likely to the downside.

Take GE’s interest cover. This supposed financial juggernaut which was at the time of GFC the world’s largest market cap company now trades with a -0.17x interest coverage ratio. In FY2013 it was 13.8x. The ratio of debt to earnings, has surged from 1.5 in 2013 to 3.7 today. It has $42bn in debt due in 2020 for refinancing.

By 2020, what will the interest rate differentials be? There seems to be some blind faith in GE’s new CEO John Flannery’s ability to turn around the company. Yet he is staring at the peak of the aerospace cycle where any slowdown could hurt the spares business not to mention the high fixed cost nature of new engines under development. In a weird way, GE is suffering these terrible ratios at the top of the cycle rather than the bottom. Asset fire sales to patch that gaping hole in the balance sheet. Looks like a $4 stock not a $14 one.