Month: June 2018

Back in November, still smarting from a year he would rather forget, Russell Clark and his Horseman Capital, i.e. the “world’s most bearish hedge fund” unveiled what he would be short next: according to Clark, the next major source of alpha would be shorting fallen angel bonds.

Citing a recent IMF Global Financial Report, Clark said that “US investment grade debt is very low quality, and could produce some large fallen angels. It then goes on to tell me that mutual funds are much larger in the high yield market than they used to be. It also tells me low rates means the capital losses are much higher than they used to be. And that investors in high yield mutual funds are much flightier than they used to be! Essentially the IMF are telling me that if you get a large enough fallen angel, the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me.”

One month later, in the aftermath of of Steinhoff fiasco, in which the ECB found itself long tens of millions of bonds in a company which went from investment grade to deep junk after it was revealed that it may have engaged in occasional fraud, crashing the bonds…

… Mario Draghi only made the bearish “fallen angel” case more explicit, by clarifying that going forward the ECB would likely liquidate bonds which were purchased as IG and subsequently downgraded to Junk (as we explained in detail in “The ECB Has Some Bad News For Junk Bond Buyers“)

Fast forward to today when one of the icons of credit and distressed investing, Oaktree Capital, joined the bandwagon of fallen angel hunters, saying that the fund expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds.

Speaking at the Bernstein Strategic Decisions Conference on Thursday, Oaktree Capital’s Chief Executive Jay Wintrob said that when the cycle turns it will be faster and larger than ever as “fallen angels” proliferate, and added ominously that “there will be a spark that lights that fire.”

Picking up on last week’s Moody’s warning, in which the rating agency warned of a junk bond default avalanche as rates rise, Wintrob said that the supply of low-quality debt is significantly higher than prior periods, while the lack of covenant protections makes investing in shaky creditors riskier than ever.

According to the Oaktree CEO, those structural flaws of the bond market mean debt will fall into distress quickly once conditions flip, and “Oaktree is prepared with about $20 billion saved for future investing opportunities” he said according to Bloomberg.

Of course, Oaktree could be simply talking its book: the fund fund which ranks among the world’s biggest investors in distressed debt, has been rather bored in recent years in which record low rates have made distressed opportunities an endangered species, and as we noted last wee, credit-rating firms are forecasting even fewer opportunities in the months ahead, although the tide will turn once rates rise higher enough.

But not just yet: for now, the total kept by S&P Global Ratings of potential “fallen angels”, or those investment grade companies in danger of being downgraded to junk, stood at just 45 in April, with $119.3 billion of debt outstanding according to Bloomberg.

This is where Oaktree came in, with the rhetorical question posed by Wintrob to lenders, who “should be asking themselves if the market can continue to lend and extend maturities of debt at very low rates.“

The abnormality in the lending market shows creditors should be “investing with an extra dose of caution,” he said. “We’re living in a low-return, high-risk world.”

The potential opportunity for Oaktree is so pressing that the fund has now allocated about a quarter of its assets to troubled issuers.

Amid slim pickings in the U.S., the firm has looked to spread its distressed strategies into China, India and other emerging markets.

To be sure, Horseman and Oaktree are not alone preparing for a surge in troubled issuers. The amount of “dry powder” held by fund managers to invest in low-quality debt has grown to around $150 billion, Wintrob estimated. Quoted by Bloomberg, he said this number has shown steady growth as the duration of bonds has increased, which could make the coming price drops even more significant than during the turn of the last credit cycle in 2008.

Which of course would be great news for America’s bankruptcy advisors: as a reminder, last weekend we quoted Moelis’ co-head of restructuring Bill Derrough who said that “I do think we’re all feeling like where we were back in 2007,” adding that “there was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time.”

All that is needed is the spark.

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During periods of market uncertainty, Morgan Stanley will deploy a vast army of artificial intelligence (AI) robots to tell its wealthy clients to remain calm and Hold On for Dear Life (HODL). The robots will craft personalized messages for each wealthy client about why they need to stay in overstretched, central bank driven markets.

When volatility rears its ugly head, Morgan Stanley advisors usually apply a great deal of time and energy in communicating with its clients base on various platforms, including phone and email about why they should HODL. Business Insider says the robotic email messages will “appear like a human wrote them.”

While complex algorithmic trading bots control much of the order flow in markets, it now seems as automation will be applied to sedate the investment bank’s clientele from selling at rich valuations.

Current Shiller PE Ratio: 32.28 

Robots are being combined with human advisors to complete just one task – calming customers during a financial storm, said Andy Saperstein, co-head of the New York-based bank’s wealth management unit.

Saperstein addressed an audience at the Deutsche Bank 2018 Global Financial Services Investor Conference on Tuesday, where he announced, Morgan Stanley is leveraging robots to create customized emails for its 16,000 advisors to send to clients during a stock market panics.

Saperstein said within the body of the email, a breakdown of the client’s account will show the impact of what a downturn could mean for their finances. This alleviates time and energy from the advisor and allows them to divert their attention to other things.

“It solves a big problem when clients call up really worried,” Saperstein added.

Saperstein also mentioned the robots will data mine the client’s social media platforms, public databases, and emails to craft the tailored “human-like” message.

“It could say something like “I just noticed that you joined the board of Safe Horizon, wonderful organization, congratulations on that,’” Saperstein said.

“And it appears that the FA took the time to research the effect that day had on every client in their book specifically, because in essence they did, aided by technology.”

Shares of Morgan Stanley have corrected down 15 percent from its 52-week high probed in early March. On Tuesday, the stock corrected down 6 percent amid a broader financial sell-off.

We wonder if the robots have already been triggered warning clients that Morgan Stanley’s stock is nearing a bear market?

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Authored by Frank Shostak via The Mises Institute,

According to the Austrian Business Cycle Theory (ABCT) the artificial lowering of interest rates by the central bank leads to a misallocation of resources because businesses undertake various capital projects that prior to the lowering of interest rates weren’t considered as viable. This misallocation of resources is commonly described as an economic boom.

As a rule businessmen discover their error once the central bank – that was instrumental in the artificial lowering of interest rates – reverses its stance, which in turn brings to a halt capital expansion and an ensuing economic bust. From the ABCT one can infer that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are only exposed once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no reason why businessmen should fall prey again and again to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Correct expectations will undo or neutralize the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence, it is held, the ABCT is not a serious contender in the explanation of modern business cycle phenomena.

According to a prominent critic of the ABCT, Gordon Tullock,

One would think that business people might be misled in the first couple of runs of the Rothbard cycle and not anticipate that the low interest rate will later be raised. That they would continue to be unable to figure this out, however, seems unlikely. Normally, Rothbard and other Austrians argue that entrepreneurs are well informed and make correct judgments. At the very least, one would assume that a well-informed businessperson interested in important matters concerned with the business would read Mises and Rothbard and, hence, anticipate the government action.1

Even Mises himself had conceded that it is possible that some time in the future businessmen will stop responding to loose monetary policy thereby preventing the setting in motion of the boom-bust cycle. In his reply to Lachmann he wrote,

It may be that businessmen will in the future react to credit expansion in another manner than they did in the past. It may be that they will avoid using for an expansion of their operations the easy money available, because they will keep in mind the inevitable end of the boom. Some signs forebode such a change. But it is too early to make a positive statement.2

Do Expectations Matter?

Now, a businessman has to cater for consumers future requirements if he wants to succeed in his business.

So whenever he observes a lowering in interest rates he knows that this most likely will provide a boost to the demand for various goods and services in the months ahead. Hence, if he wants to make a profit he would have to make the necessary arrangements to meet the future demand.

For instance, if a builder refuses to act on the likely increase in the demand for houses because he believes that this is on account of the loose monetary policy of the central bank and cannot be sustainable, then he will be out of business very quickly. To be in the building business means that he must be in tune with the demand for housing.

Likewise, any other businessman in a given field will have to respond to the likely changes in demand in the area of his involvement if he wants to stay in business.

If a businessman has decided to be in a given business this means that the businessman is likely to cater for changes in the demand in this particular business irrespective of the underlying causes behind changes in demand. Failing to do so will put him out of business very quickly.

Hence, regardless of expectations once the central bank tightens its stance most businessmen will “get caught”. A tighter stance will undermine demand for goods and services and this will put pressure on various business activities that sprang up whilst the interest rate stance was loose. An economic bust emerges.

Furthermore, even if businessmen have correctly anticipated the interest rate stance of the central bank and the subsequent changes in the growth rate of money supply, because of the variable time lag from money changes to its effect on economic activity it will be impossible to establish the accurate timing of the boom-bust cycle.

Due to the time lag, prior changes in money supply could continue to dominate the economic scene for an extended period. (Given that the time lag is variable, it is not possible to ascertain when a given change in the money supply growth rate is going to start to dominate the economic scene and when the effect of past changes in money supply is going to vanish).

We can conclude that correct expectations cannot prevent boom-bust cycles once the central bank has eased its interest rate stance.

The only way to stop the menace of boom-bust cycles is for the central bank to stop the tampering with financial markets.

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Earlier we showed that despite some significant cross-asset volatility, not to mention substantial declines especially across emerging markets and Italian stocks and bonds, in the month of May quite a few markets and asset-classes shrugged off the EM and Italian woes, and posted modest if steady returns, including the FTSE 100 (+2.8%), Stoxx 600 (+0.2%) and, of course, the S&P 500 which rose +2.2% in the month.

Yet what is far more remarkable is just how concentrated the S&P gains were in May, and how just one company was responsible for a quarter of the S&P500’s gains.

As Bloomberg’s Andrew Cinko calculates, it was all about Apple, which accounted for 23% of the S&P 500’s gains last month, its biggest contribution since August of last year.

As a reminder Apple hit a new all time high thanks to its latest, massive buyback plan and also thanks to the latest Buffett purchase of AAPL stock by Buffett who added another 75MM AAPL shares, bringing this total stake to 240 million shares, worth over $45 billion.

Whatever the reason behind Apple’s surge, without it the S&P’s gain would have been 1.65% instead of 2.16%, meaning that just AAPL alone was responsible for 0.50% of the S&P’s May gain.

This was AAPL’s biggest monthly contribution since last August, when AAPL alone accounted for over 150% of the S&P’s return. However, as Cinko notes, “in the intervening months, Apple’s effect on the broad market was small mostly because it’s move was paltry while other stocks bounded higher or lower. For example, in January Apple sank 1.1% while the index rallied 5.6% as Amazon surged 24%.”

However, in May, the tables were turned with Apple soaring 13.1% while the S&P 500’s second and third biggest stocks, Microsoft and Amazon, rose 5.7% and 4.1% respectively.

Meanwhile, AAPL’s contribution to the Dow was even greater, accounting for 35% of so-called “Industrial Average” last month, followed closely by Boeing with 34%.

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Authored by Nick Cunningham via OilPrice.com,

Global oil benchmarks are suddenly heading in different directions, upending what have consistently been close linkages between prices in various parts of the world.

To be sure, oil prices have declined everywhere over the past week on news that OPEC and Russia might agree to lift production levels. But regional differences are wreaking havoc on the oil market, dragging down some benchmark contracts more than others.

Western Canada Select (WCS), for instance, consistently trades at a discount to WTI, but the spread has widened recently. On May 23, WCS traded $17 per barrel lower than WTI, which is, to be sure, a very large discount. However, WCS has plunged this week, and by May 31 the Canadian heavy oil benchmark was trading at $41 per barrel, or $25 below WTI.

Pipelines are full and the bottleneck in Alberta is weighing on the Canadian benchmark. This has pushed Prime Minister Justin Trudeau to extreme lengths to get the Trans Mountain pipeline expansion built. But, the ceiling on midstream capacity is expected to persist, perhaps for several more years.

Pipeline problems are not unique to Canada. The Permian basin has continued to grow oil production, but the region’s pipeline network is not adding capacity fast enough. The most recent data suggests that the pipelines from West Texas to the Gulf Coast are full and Permian producers are scrambling to find takeaway capacity by rail or even by truck, which, needless to say, is expensive and inefficient, forcing producers to accept steep discounts for their oil.

For the last few weeks, Midland WTI has traded at a double-digit discount relative to WTI in Houston or Cushing. No new pipeline capacity is imminent, and in fact, the shortfall could grow over the next year. While the Midland discount is around $10 per barrel now, futuresfor November 2018 has Midland trading at a $17-per-barrel discount, a reflection of the fact that the pipeline bottleneck will only grow worse over the course of this year.

WTI, for its part, is trading at a multi-year low relative to Brent. As of May 31, WTI was down below $67 per barrel during midday trading, dropping to an $11-per-barrel discount relative to Brent.

Again the blowout in the spread is the result of surging shale production at a time when supply is restricted elsewhere in the world.

Brent, meanwhile, has lost ground relative to the Dubai benchmark. This is the result of tighter supplies in the Middle East, which has pushed up prices. Not only is OPEC keeping supply off of the market, reducing flows, but the scrapping of the Iran nuclear deal has also raised fears of supply outages from the Middle East. The discount for Dubai relative to Brent has shrunk to less than $3 per barrel, the lowest spread in months.

“The three benchmarks — Brent, WTI and Dubai — have been fluctuating based on a combination of domestic factors, as well as wider geopolitical risks,” Den Syahril, an analyst at industry consultant FGE, told Bloomberg.

“WTI is currently reflecting inland economics, as the U.S. struggles to bring oil to its coast. Brent and Dubai, on the other hand, are pricing in geopolitical tensions around U.S.-Iran sanctions, as well as uncertainties around the upcoming decision between OPEC and its allies.”

Obviously, American crude priced at more than $10 per barrel below oil found elsewhere in the world makes it highly attractive to buyers. That should result in an explosion in U.S. crude oil exports in the coming weeks. Export levels have already been trending up for the past year, but the price differential is now at its highest level in more than three years, likely sparking a stampede of purchases from Asian buyers, for example.

Bloomberg reports that refiners in South Korea, India, Thailand, China and Japan are scrambling to buy up as much U.S. shale oil as possible from where they can get it, including from the Eagle Ford, the Bakken and the Permian. Interestingly, Chinese buyers are cut purchases from Saudi Arabia for the second consecutive month, swapping them out with more American cargoes. Why buy oil from the Middle East for $10-per-barrel more than from the U.S.?

It is often said that the oil market is global, that oil is a “fungible” commodity, meaning that prices are largely the same everywhere. There are always regional discrepancies, but as a general rule, oil is globally priced. However, infrastructure bottlenecks, geopolitical fears, supply increases and outages are cropping up in various parts of the world, leading to an unusual divergence in the top benchmarks. With many of those factors not set to immediately go away, the price differentials may not dissipate anytime soon.

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