Month: June 2018

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 27, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We continue our discussion of the problems for the U.S. Economy in the near future.  For this week and next (and probably the following week), the subject will be  Debt … its many forms, and its impact on our economic well-being.

Our responsibility … to our clients, colleagues, and friends … is to reveal the myriad ways that  Debt  creates complications for our economy.

As we noted last week, Debt  has been much too easy to amass over the last 20 years.  It has artificially boosted asset prices, and will become a serious drag on growth in the near future.

Making matters worse, many lenders (investors) are now more highly leveraged than they were ten years ago.  Many have bought their corporate bonds with borrowed money, confident that low interest rates and low defaults would keep risks manageable.

 

Covenant Quality

Last week, we touched on the subject of  Covenants  in the context of Bonds.  Remember that investment Bonds are Debt instruments.  Covenants  are the basic rules which govern the agreement between borrower and lender with respect to various Debt instruments, such as Bonds and Loans.   Covenants  enforce the requirements of the issuer … what the company can do (positive covenants), and what it cannot do (negative covenants).

A common example, with respect to a Corporate Bond, is the “restricted payments covenant.”  This provision protects the lender (investor) by limiting the company’s ability to make distributions and asset transfers which would hinder the borrower’s ability to repay the debt.  This can include restrictions on stock repurchases, prepaying junior debt, and dividends.  Other covenants may require certain debt-to-assets or interest coverage ratios.

Over the past few years,  Covenant Quality  has declined dramatically with respect to leveraged loans.  Leveraged loans are loans issued by companies with below-investment-grade ratings.  Traditionally, these loans have featured a number of Covenants  intended to protect the lender/investor.  On the other hand, a “covenant-lite” loan has fewer restrictions, therefore more risk.

U.S. corporations and investors obviously have very short memories.  Just 10 years after the most severe financial crisis since the Great Depression, Americans are taking on record amounts of risk, in the form of “covenant-lite” leveraged loans. Featuring fewer covenants … and weaker covenants … this form of Debt allows the borrowing company to favor its own agenda and shareholders, to the detriment of holders of its Bonds.

Today, according to S&P Global Market Watch, 77% of leveraged corporate bonds are “covenant-lite,” meaning that the borrower (issuer of the bond) doesn’t have to repay by conventional means.  Sometimes, they can even force the lenders to take more debt.

U.S. “covenant-lite” loan issues for 2017 were the highest in over a decade, a record $677 Billion.  This was almost double the $350 Billion in the previous year.  By comparison, the amount in 2007 was $150 Billion.

So far in 2018, American corporations are on pace to issue over $600 Billion in new “covenant-lite” Debt.

When the  Credit Cycle  turns over, Declining Covenant Quality will make things very difficult in the Bond space.  With interest rates continuing to rise, corporate borrowers will find it more and more difficult to pay off their Debt.

Because of the massive amount of Debt which has been amassed over a prolonged period of ultra-low interest rates, Corporate Bond Defaults will be the inevitable result.

 

A Looming Corporate Debt Crisis

As rates rise, government bonds will become a viable alternative to other assets again.  If an investor can earn an adequate return in a risk-free Treasury, riskier stocks and corporate bonds will become relatively less attractive. H igher interest rates create a stronger and stronger headwind for other assets.

The ultra-low interest rate regime of the last decade … created by the Federal Reserve and other central bankers … allowed thousands of companies to borrow money, including many which would have gone bankrupt without the infusion of “cheap loans.”  There are now several hundred publicly-traded corporations which will NOT be able to repay their debts in the coming crisis.

Several hundred American companies are destined for bankruptcy in the near future.

 

Consequences of the Debt Crisis

Here is a brief outline of the likely order of events in the Great Unraveling of the next few years:

Illiquidity will spread as lower-end corporate bonds fall to junk ratings.  Then, legal and contractual constraints will force institutions to sell, pressuring all but the highest-grade corporate and sovereign bonds.

Go back to our discussion of the  Credit Cycle  in the June 13 issue of  IntelDigest.  Instead of recession pushing asset prices lower, lower asset prices trigger the recession.  That will be the next stage as falling stock and bond prices hit borrowers.

Rising defaults will force banks to reduce their lending exposure, drying up capital for previously creditworthy businesses.  This will put pressure on earnings and reduce economic activity.   Recession  will follow … here, and around the world.

As always, a U.S. recession will spark higher federal spending and reduce tax revenue.  The federal government deficit will quickly rise to $2 Trillion per year.  Total federal  Debt  will reach $30 Trillion within four years.

Private capital markets will be constrained, and everyone will “enjoy” rising tax burdens.

American jobs will be endangered because of the massive amount of corporate  Debt.  As the weaker companies approach default, they will be desperate to cut costs.  Cutting human workers and moving to more automation … this will be a likely strategy.  Both manufacturing and service jobs are in jeopardy.

We will publish a new series on the prospects for the American Worker later this year.

More details on the coming  Debt Crisis  next week.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 20, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We have been  Looking Ahead  to the problems waiting over the horizon for the U.S. Economy.  After the currently-frothy markets play out … probably by the end of this year … complications await, in 2019 and thereafter.

We have warned of the prospects for  Stagflation, perhaps as soon as 2020;  and, discussed the evolution of  Credit Cycles  in the transformation of world economies.  This week and next, the subject will be  Debt … its many forms, and its impact on our economic well-being.

 

Credit Cycles

Our discourse on  Credit Cycles  revealed a fundamental change in economic cycles, attributable to central bankers, particularly the U.S. Federal Reserve (The Fed).  Over the last 20 years, American companies and individuals have learned from The Fed that running up  Debt  is easy and fun!

Unfortunately, Debt  eventually becomes a drag on growth. Debt-induced growth pulls spending forward, reducing a future recovery.  Debt  also artificially boosts asset prices.

The repercussions from the  Credit Cycle  of the last 20 years include a massive increase in  Debt … by the federal government, by many U.S. corporations, and by millions of individual Americans.  The ratio of  Debt  to gross domestic product is at record levels.

This environment sets up the American economy for financial instability.

 

Financial Instability Hypothesis

Professor Hyman Minsky of Bard College published his Working Paper on the  Financial Instability Hypothesis  in 1992. His basic point:  that over-exuberant companies become paralyzed when they take on too much  Debt, and this leads to a financial breakdown.

The hypothesis was clearly illustrated in 2008, when overexposure to subprime mortgages and their associated derivatives led to a breakdown in the banking systems, which almost brought down the U.S. economy.

Today, there is a much greater risk of financial crisis on the horizon because of the sheer amount of corporate debt now outstanding, especially high-yield bonds which will be difficult liquidate in a crisis.

 

Illusion of Liquidity

Economist Louis Gave recently published an article titled, “The Illusion of Liquidity and Its Consequences.”  In his research, he looked at corporate bond ETFs and compared the total Dollar amounts to the inventories of trading desks … this is a rough measure of liquidity.

Gave found that dealer inventories are not remotely sufficient to accommodate the bond-selling expected as interest rates rise.  The bond market has doubled in size in recent years, while the willingness and ability of bond dealers to provide liquidity under market stress has fallen by more than -80% in the same period.

Here is a likely scenario:  as interest rates rise, the value of bonds in mutual funds and ETFs falls.  The investors … often regular Americans and retirees seeking yield … all try to sell at once.  The funds must meet these redemptions, so they will sell at whatever prices are available.  In a bear market, you sell what you can.

Speaking of the investors, much of the Two Trillion Dollars currently invested in bond mutual funds and ETFs are NOT owned by “traditional” long-term investors in bonds, who would often hold the bonds until maturity.  Therefore, when bonds start to fall, there will be thousands of demands for redemption.

The funds may find that there will be no bids for the lesser bonds in their portfolios, so they will have to sell the best bonds in order to meet redemptions.  Remaining investors will be stuck with increasingly poor-quality portfolios, which will lose value even faster

The word “calamity” may not be too strong in describing the markets then.

Making matters worse, many lenders are now more highly leveraged than they were ten years ago.  Many have bought their corporate bonds with borrowed money, confident that low interest rates and low defaults would keep risks manageable.

According to S&P Global Market Watch, 77% of leveraged corporate bonds are “covenant-lite,” meaning that the borrower (issuer of the bond) doesn’t have to repay by conventional means.  Sometimes, they can even force the lenders to take more debt.

Buying such bonds may have been a good idea at the time … what happens when the times get tough?

 

Rolling Over the Debt

According to Wells Fargo Securities,  Four Trillion Dollars  of corporate bonds in the U.S. must be refinanced over the next five years.  This amounts to over 65% of all outstanding corporate debt in this country

As interest rates rise, that  Debt  becomes more expensive to extend.  Many companies will lose the ability to service their debt.

Investors would be justifiably concerned.  Combine unprecedented amounts of borrowing with interest rates rising steadily, and corporate balance sheets approach a
tipping point.

When companies can no longer service their  Debt, they have to cut back.  They will do so by laying off workers, reducing inventory and investment, or selling assets.  All of these actions reduce growth.  If reductions spread across the country, we get economic contraction, and  Recession  ensues.

More on  Debt  next week.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 13, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We have written, at length, on near-term prospects for The Economy and Markets in Spring issues of  IntelDigest.  We remain substantially invested in equities, expecting one final upward lurch in this nine-year-old Bull Market.

We expect high volatility in the markets as we go into August and September, so we want to prune the most volatile stocks from portfolios before August … trying to sell into strength by mid-Summer.

It is important to distinguish between the near-term period, which should last through most of 2018, and the recessionary period beginning in 2019.  The next three months will likely be the last opportunity for growth in equities for the next several years.  So, we face a balancing act in the near-term … how to find and secure growth prospects while the “Melt Up” in equities plays out its last few months … and when to get out with our gains before the market begins its slide into recession.

And, we fully expect that the Economy will fall into recession by some time next year, and perhaps result in an extended period of stagnation in the equities markets lasting for at least a few years.  Perhaps, stagnation will roll into a return of the Stagflation  of the 1970s … especially if political pressure is applied.

As we have written, the recession is inevitable, not imminent.

 

Looking Ahead

In recent weeks, we have moved forward to discussions of our Look Ahead at the Economy-To-Come … planning for the transition from this Bull Market to leaner times ahead.  We replayed our February 21 discourse on Inflation, Interest Rates, and Volatility;  then, moved on to the prospects for  Stagflation; and, reviewed the prudent approach to investing in a coming Bear Market.

We will discuss  Credit Cycles  today;  next week, we dive into the role of Debt … Government Debt and Deficits, Corporate Debt, Credit Card Debt, Student Loan Debt, Auto Loan Debt … in the Unraveling to come.

 

Credit Cycles

A seminal transformation in world economies has been occurring over the last 20 years, and right under our noses.  In essence, we no longer have old-fashioned business or economic cycles.

We now have  Credit Cycles, which ebb and flow with monetary policy.

When the Federal Reserve (The Fed) cuts short-term interest rates drastically, the only purpose is encouraging Americans to borrow a lot of money.  When The Fed reverses its policy and raises rates … thereby reducing liquidity … The Fed is discouraging us from taking on more debt.

This  modus operandi  goes back to the 1990s, when The Fed, under the leadership of Alan Greenspan, heavily promoted interest rates which were abnormally low at the time, even though the then-booming economy needed no stimulus.  This policy was attributed to the need for liquidity as we approached the potential crisis of Y2K, and a response to market turmoil following the near-collapse of the Long Term Capital Management hedge fund.

Again, in the early 2000s, The Fed loosened credit, which contributed to the 2008 mortgage crisis and the Great Recession.

So, for over 20 years now, companies and individuals have learned from The Fed that running up debt is easy and fun! But, over time, debt stops stimulating growth.  As debt accumulates, every additional point of GDP growth requires greater and greater amounts of debt.

Debt eventually becomes a drag on growth.  When growth is dependent on added debt, growth “borrows” from the future; in other words, debt-induced growth pulls spending forward, reducing a future recovery.

Debt also artificially boosts asset prices.  Stocks and real estate have done extremely well in an era of ultra-low interest rates. But, as rates rise over the next couple of years, and The Fed continues to unload Billions of Dollars of assets from its balance sheet, the values of stocks and real estate become vulnerable.

The value of an asset depends solely on the willing buyer.  As financing costs for future buyers go higher and higher, inflated asset prices will recede.

 

Recessions

In the good old days of the economic cycle, recessions triggered bear markets.  Economic contraction slowed consumer spending, corporate earnings fell, and stock prices dropped.

Things are different in the  Credit Cycle.  Lower asset prices are not the result of a recession … they cause the recession, because access to credit drives consumer spending and business investment.  When you take it away,  Recession follows.

 

Lenders and Borrowers

So, the repercussions from the Credit Cycle of the last 20 years include a massive increase in debt … not just by the federal government, but also by many U.S. corporations.  The ratio of Debt to gross domestic product is at record levels.

When interest rates rise, the resulting fall in bond prices will leave many lenders holding the bag.  Those lenders include Bond Funds and ETF investors and those of us who hold individual corporate bonds.

Who will buy when we want to sell?  It is not only Borrowers who have become accustomed to easy credit.  Many lenders assume they can exit at a moment’s notice.  The “Great Recession” caused by the 2008 Financial Crisis showed
what can happen when borrowers can’t roll over debt easily.

 

High-Yield Debt

The same situation exists today, except that the debt is in areas other than home mortgages, and much of the debt today is much riskier high-yield debt.  Total corporate debt, and especially high-yield debt issuance, has exploded since 2009.

 

Market-Making

It is important to understand how politics has had an effect on the market for corporate debt.  This will explain one of the primary reasons for the recent loosening of requirements of the Dodd-Frank banking law.

The major causes of the 2008 Financial Crisis are attributable to the Federal Reserve monetary policy (the Credit Cycle) and government spending during the Bush/Cheney Administration. Reacting to the Crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.  Dodd-Frank also authorized creation of the federal Consumer Financial Protection Bureau.

The law and ensuing regulations discouraged banks from making markets in corporate and high-yield debt. Traditionally, firms which “make markets” are willing to buy, sell, and hold securities.  They exist under rules created by stock exchanges, and are regulated by the U.S. Securities and Exchange Commission.

The tighter Dodd-Frank requirements reduced major bank market-making abilities by almost 90%.  Other entities picked up the slack;  bond market liquidity has been maintained in recent years because hedge funds and other non-bank lenders have filled the gap.  But, these “shadow banks” are not in the business of protecting your assets.  They are concerned with their own profits and those of their clients.

The problem is that these are not true market-makers.  Nothing requires them to hold inventory or buy when you want to sell. In this environment, bids can “dry up” when you need them most.

We will continue discussing Debt problems next week.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JUNE 6, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

In the June issues of  IntelDigest, we will continue our  Look Ahead  at the Economy-To-Come … planning for the transition from the 9-year Bull Market to leaner times ahead.  We will discuss  Credit Cycles, as well as the role of  Debt  in the Unraveling to come.

We will also examine the following topics over the course of the Summer:

* China, from several angles, over a series of issues

* U.S. Taxes – updates on changes in the law and regulations

* Work in America – a re-examination

* Robotics and Autonomous Vehicles

* Blockchain – new developments

Today, we’ll talk about Investing Fundamentals – important considerations when investing in a Bear Market.

 

The Unraveling

We pointed out, in our May 23 issue, that The Federal Reserve has been tightening the money supply since late last year.  The Fed’s unwinding of its massive bond portfolio has continued at a rate of $10 Billion per month in U.S. Treasury securities and $3 Billion per month in mortgage securities.

Equities markets rolled higher and higher over the last nine years on a tide of ultra-low interest rates and “Quantitative Easing” concocted by central bankers, including The Federal Reserve in the U.S.  The Fed has reversed course with the new regimen of tightening, draining liquidity from the system, along with the prospect of gradual raising of short-term interest rates.  With access to cheap credit drying up, the financial “tide” is now rolling out.

 

Investing in a Bear Market

We are transitioning from a historic Bull Market … when it was relatively easy to earn profits on stocks across-the-board … to a slowly unfolding Recession and Market Downturn.  Many will want to sell all their stocks and hide under the bed by next year.  Prudent investors, on the other hand, will want to hold onto the best, income-producing stocks in their portfolios.

However, investing in stocks during a Bear Market requires selectivity and discipline.  So, here are some important guidelines to anchor your portfolios in the coming lean years.

* Protecting Capital

When Selectivity is an important element of your investing approach, you should seek conservative stocks.  The time for speculation is past;  minimizing threats to your capital is paramount.

You want to own shares of companies which offer true value, and will pay you regularly for your ownership.  That means dividend-paying stocks.  As your payments add up, you can worry less about the price movements of the stock, especially when the markets in general are sagging.

This is a time to be patient with the markets, and avoid overpaying for any stock.  Don’t chase stocks higher;  set your price target, and wait for the stock price to come back to your target.

If you pay the right price for a company, there’s a good chance that the stock will trade higher when other investors realize the value of the company.

 

* Investing for Growth

Selectivity and discipline require research.  You (or your advisor) must explore the history of your target companies … have they grown profits, dividends, free cash flow on a consistent basis?  If a company’s cash flow and profits are not keeping up, it may have to cut the dividend.

Stock Prices during a Bear Market can be stuck in the mud for years, so you want companies which can make stable payments to you over several years, and continue growing those payments over time.

 

* Seeking Yield

We still live in a low-interest-rate world, so finding opportunities to earn a decent yield can be a struggle.  Bank deposits will continue to be low-yield for a few more years, and the corporate bond market is risky, especially as we head into a Credit Crisis in 2019-2020.

The best bets for a safe yield in the coming years will be (1) income-producing real estate, and (2) stable dividend-yielding stocks.  This is the safe middle ground.

Also, high-yield dividend-paying stocks will attract the attention of other investors, which would support the share price.  We want to be ready to move into high-quality stocks early in the Recession, after the initial breakdown of the stock market;  or, if we already hold them, be prepared to hold fast during the initial crash

By taking an early position in (or, holding on to) solid dividend stocks, we have a good chance of earning an attractive yield, from both a rebound in the stock price and regular payments from dividends.

 

* Understanding the Business

Just as you want to avoid speculating during a Bear Market, you should also avoid uncertainty.  You should not invest in a company if you don’t fully understand how it makes money.

Again, proper research is necessary.  It is well worth your time to learn about the products or services which a company offers, who are its customers and competition, how it earns its profits, and which units of a company are profitable or may be behind the competition.

If you understand a business well enough that you can clearly and succinctly describe the business to your friends or family, then you will be better equipped to make an investment decision.

 

* Finding Quality

After the research referred to above, you can make the threshold decision:  are you comfortable committing a portion of your net worth to a certain stock?  Are you convinced that the investment represents an exceptional opportunity?  You shouldn’t invest your hard-earned money in anything less.

You want to be sure that you’re buying a high-quality business, and its financial “attributes” make it a good investment.  That could mean that the company is highly capital-efficient;  has pricing power or dominance in its industry;  or, features a stock value which is low relative to its asset value.

If you have confidence that a company offers an excellent potential return on investment, then you will have the courage of your convictions when the markets are in a sluggish or declining mode.

 

* Settling In for the Long Haul

Warren Buffett famously wrote, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.  (Berkshire Hathaway 1996 letter to shareholders)

Investing in a Bear Market requires a long time horizon.  In that same letter, Buffett advised investors to “… Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

In a Bear Market, you should be ready and willing to commit to holding your stocks for 10 years.  Over the long run, stock prices are highly correlated with earnings growth.  Focus on durable, growing franchises.  You will want to hold businesses which you feel confident will be bigger and better in the years to come.

 

Following the Guidelines

The purpose of these Guidelines is to get you to concentrate on only the most stable opportunities during the lean times of a Bear Market … to eliminate marginal ideas from your portfolio. This is the mind set of private-equity professionals.

Thinking like a whole-business owner will help ensure that you own strong, enduring businesses … businesses which you know well and are comfortable holding through the storm.

Plan now to have your financial house in order so that you’re playing a strong hand during the lean times.  Pay off debts.  Build positions in Cash and Gold.  Follow the trailing stops in your portfolios over the remainder of this year.

When the storm hits, you will be in the best position to weather it.  This will allow you to sleep at night, focus on the big picture, and make better investment decisions in the years to come.