Sovereign Wealth Funds being tapped, Questionable Private Equity Valuations, and What Fixed Income?

This week three articles that stood out were 1) Bloomberg Businessweek’s “Petro States Shake Their Piggy Banks” discussing the impact petrodollars have had on the investment market and pointing out that they are being withdrawn to cover government budgets, 2) as a follow up to Michael Moritz’s article in The Financial Times about private companies that don’t look to be worth what investors are paying for them was The Wall Street Journal’s Tech Startups Feel an IPO Chill, and 3) Bond-Market Blues: Where Did My Income Go? in The Wall Street Journal illustrating how fixed income investments have shed the income characteristic.

*Note: bold emphasis is mine.

“Petro States Shake Their Piggy Banks” – Stefania Bianchi and Matthew Martin

According to the Sovereign Wealth Fund Institute, sovereign wealth funds investments total $7.3tn globally.  While TheCity UK, a lobby group, expects sovereign-fund assets to increase by 4% in 2015, to $7.4tn, that pace is well below the 12% average annual growth over the previous 5-years.

On Oct. 7, Norway said it expects to tap its $820 billion fund next year for the first time in its 19-year existence to balance the government’s budget.

“If the wealth funds of Norway and the Gulf countries begin to slowly pull out, it will have an impact on financial markets.” – Michael Maduell, President of the Sovereign Wealth Fund Institute.

To have a sense of the scale:

The amount of petrodollar investment in the five years through 2014 was on a similar scale to the amount of the Federal Reserve’s quantitative easing program spent on U.S. government bonds, according to analysts at Barclays.

“As the wealth funds switch to selling, the world has lost about $400bn in annual demand for financial assets” – Barclays

After falling for seven straight months, Saudi Arabia’s foreign holdings in August were $654.5bn down from a peak of $737bn in the summer of 2014.  Worse,

Russia expects to spend as much as 4.7tn rubles ($75bn) of the Reserve Fund, one of its two oil funds, this year and next to weather its first recession in six years.  The funds, which are invested in mainly U.S. and European government bonds, held the equivalent of $144bn on Oct. 1, according to the Finance Ministry.

$75bn of $144bn, that’s more than half…  But not all this is bad news for investment managers.  For countries that are drawing down reserves to cover shortfalls, they are also 1) looking to cut government expenditures – where they can politically – and 2) are and will look to chase higher returns in the market.

“Tech Startups Feel an IPO Chill” 10/19 – Rolfe Winkler, Douglas MacMillan, Telis Demos and Monica Langley

Several tech companies are seeing their valuations decline after public listings and in some cases private companies are lowering their valuations in subsequent funding rounds.  BlackRock Inc., which led the $350M deal that more than doubled Dropbox’s valuation to $10bn from $4bn, has cut its estimate of the company’s per-share value by 24%.

Many U.S. based companies that went public this year have seen their stock prices suffer, posting a median return of zero compared with their IPO price. Investors who bought shares after the IPOs began trading, often the first chance many individual investors get, are down by a median of 13%.

“We’re seeing financing rounds where founders are coming back and lowering the price over and over again” – Bill Gurley, partner at VC firm Benchmark

Among the 9 US listed IPOs since 2014 by venture-backed technology companies that were valued at $1bn in private fundraising rounds and have since reported annual results, only 3 have met or exceeded analysts’ consensus profit forecast for that year, according to FactSet.

“Bond-Market Blues: Where Did My Income Go?” 10/18 – Richard Barley

One of the drawbacks of declining interest rates, particularly zero-interest rate policy (ZIRP), is that yield is hard to come by.  Fortunately, for investors in yield assets over this time period, they’ve been more compensated with capital appreciation.

If there is one area where low interest rates have propelled growth, it has been in the fixed-income market. But increasingly, income is the one thing that is hard to find. Fixed income investments are now more an investment in capital gains rather than in steady income.

The Barclays Global Aggregate, a broad investment-grade bond index, now contains over 16,900 securities with a face value of $39.8tn, up from $25.3tn at the end of 2007 (an increase of 57.31%).  In December 2007 the Global Treasury index of government bonds contained $11.9tn of securities and generated $447bn in coupons in that year for an approx. 3.8% yield. By September 2015, the index is up to $21tn (increase of 76.47%), but coupon payments over the prior 12 months only totaled $535bn (increase of 19.69%) for an approx. 2.5% yield.

The problem now is how long ultraloose monetary policy has persisted: more and more low-coupon, long-dated debt has been and is being issued. If interest rates are permanently lower, that will change investor behavior.

HSBC forecasts 10-year US treasury yields at 1.5% at the end of 2016 and 10-year bund yields of 0.2%

With a lack of yield in safe assets, investors are likely to continue to move up the risk curve (despite its flattening trend).

Other Interesting Articles

Bloomberg Businessweek

• The Tycoon Left Out In the Cold
• Does Your Portfolio Lack a Theme?
• How Banks Funded the U.S. Oil Boom and (So Far) Escaped the Bust

The Economist

• Debt and alive – Oil companies in America
• Free exchange – Quantitative frightening

Bisnow: The 11 Largest EB-5 Projects in America 10/22

FT: The subprime ‘unicorns’ that do not look a billion dollars 10/16

FT: China-Brazil link is top threat to global economy 10/19

FT: Apple’s Tim Cook sees ‘massive’ tech-led upheaval in car industry 10/20

FT: Chinese bonds offer rare chance for capital gain 10/20

FT: Co-working becomes co-living 10/20

FT: Marriott checks in at the movies with a kiss and a heist 10/21

FT: Why the shift in Treasury bond ownership matters 10/22

FT: Difficulties in being a China bear 10/22

NYT: Few in Venezuela Want Bolivars, but No One Can Spare a Dime 10/18

PBN: Home builders haven’t felt this good about the housing market since 2005 10/19

Pensions & Investments: Worldwide real estate asset growth spectacular again 10/19

WSJ: For Hedge Funds, a Can’t-Miss Trade Goes Bust 10/19

WSJ: Developers in Australia Roll Out Red Carpet for Wealthy Chinese 10/20

WSJ: Pricey Gas Leads to Lower Home Prices 10/21

WSJ: China’s Better-Than-Expected GDP Prompts Skepticism From Economist 10/19

I’m sorry for the delayed post – returned from vacation yesterday.  The biggest items that stood out this past week are 1) that the IMF is projecting that Global GDP will decline in US dollar terms this year, 2) the implications of this for emerging markets, and 3) that central banks around the world are selling US government bonds at the fastest pace on record.  I will also cover briefly what I think to be an inflection point in high tech stock valuations (at least in the short-to-medium term for private tech companies).

First, as covered by James Kynge and Valentina Romei in The Financial Times, despite improved economic conditions in the US, the struggles in emerging markets coupled with a strengthening US dollar “…is set to plunge the world into its first outright US dollar recession since 2009, according to the IMF.”  Global growth forecast has been cut from 3.5% to 3.1%, but in USD terms, there will be negative global growth (a contraction of $2.7tn from 2014 – compared to a $3.3tn contraction in 2009, the steepest since records began in the early 1960s).  While the U.S., China and India are projected to experience GDP growth this year, Brazil’s projected 2015 GDP in nominal dollar terms is set to contract 19.1%, and Russia by about 36%.  Keep in mind desperate times lead to desperate measures, witness Putin’s aggression in Syria, Ukraine, Georgia, etc…

Second, and really an extension of the first point, in a follow up article by the Kynge and Romei two days later in The Financial Times, the IMF revised the projections to a fall in global GDP to $73.5tn in 2015, a $3.8tn fall from 2014, which would make it the largest annual decline in world growth since measurements began in the 1960s (in percentage terms this is a fall of 4.9% compared to a fall of 5.3% in 2009).

“Though the fall in US dollar GDP is primarily the product of an unusually strong dollar, it nevertheless helps to illuminate some important economic trends. It shows why some large multinational companies that calculate revenues in dollars but derive much of their business from emerging markets are suffering big earnings hits. It also helps explain why emerging market trade has been so weak this year.” 

“A blended rate of reported results and estimates shows third-quarter revenue for companies in the S&P 500 with less than 50% of sales in the US fell 13% year over year compared with a rise of about 1% for those with more than half of sales in the US, according to FactSet.” 

According to Charles Robertson, global chief economist at Renaissance Capital: “We expect external debt defaults to hit EM financials and corporates and higher import prices will feed into weaker domestic demand and hurt GDP.”

Third, as covered by Min Zeng and Lingling Wei in The Wall Street Journal, central banks around the world are selling US gov’t bonds at the fastest pace on record.  China, Russia, Brazil, and Taiwan have ramped up their selling (all among the largest buyers previously).  As a result, foreign official net sales of US Treasury debt maturing in at least a year hit $123bn in the 12 months ended in July (the biggest decline since data started to be collected in 1978). A year earlier, foreign central banks purchased $27bn of US notes and bonds and rose as high as a net $230bn for the year ended January 2013.  If global economic conditions continue to deteriorate (particularly for commodity exporting economies), it is possible that the FED may not need to raise the base rate to attain higher rates (loose correlation).  Rather, if central banks continue to drain their US government debt to shore up their own economies, rates may rise from the excess supply of reserves.  As the analyst at Deutsche Bank describe it “quantitative tightening.”

Lastly, a topic that is top of mind due to my travels in the Bay area for vacation and attending the Urban Land Institute’s Fall Meeting where the effects of the tech boom were clearly on display via the built environment.  Companies and developers have rationalized their space expansions and speculative offices as “recruitment tools” and are building excess space in expectation of growth needs.  However, not all of these tech companies (the more than 100 unicorns – private companies with valuations in excess of $1bn – among them) will attain long-term success and the participants in the built environment risk similar outcomes to the last development/tech boom in the Bay Area.  In the past week Mike Isaac of The New York Times reported that Twitter is opting out of a previously planned expansion of 100,000 SF across from its San Francisco headquarters and is going to reduce up to 8% of its employees (many of them engineers – the talent that is being so actively recruited).  Subsequently, a former tech blue chip (Dell) that is struggling to evolve with the changing cloud landscape has announced that it is acquiring EMC and the investment world is starting to see that things may not be so rosy at Bio-tech darling Theranos.  Be sure to read Michael Moritz’s, of Sequoia Capital, article in The Financial Times.

Other Interesting Articles

Bloomberg Businessweek

• Silicon Valley Leaps Across the Bay
• Metal Meltdown
• Investment Schemes Lure China’s Pensioners

The Economist

• Dominant and dangerous
• Buttonwood: The vultures circle

Washington Post: Scientist say a dramatic worldwide coral bleaching event is underway 10/8

REIT.com: When is the next recession?

FT: World’s economic slowdown is a hangover not a coma 10/9

FT: Renminbi outlook a puzzle for investors 10/8

FT: Americans spend majority of money saved at the petrol pump 10/8

FT: Further fall in China forex reserves points to more renminbi support 10/7

FT: US banks build defenses against downturn 10/11

FT: Beijing warns US against maritime challenge in South China Sea 10/15

WSJ: Cracks Emerge in Bond Market 10/12

FT: Dell-EMC deal latest sign old guard of IT world left behind 10/15

FT: Treasuries gain as growth worries persist 10/14

FT: China imports slump as growth expected to slide below target 10/13

This post will be a short one as I am on vacation and traveling.  Other than Russia’s escalating maneuvering in Syria and the U.S. Navy’s intent to sail some serious ships across through the Spratly Islands, four things that really stood out this past week were 1) the deteriorating credit condition of commodity companies (especially Chinese), 2) the delicacy of emerging market credit, and 3) that for the first time ever U.S. 3-month treasuries were sold at a yield of 0% on 10/5/15.

First ZeroHedge on David Stockman’s Contra Corner walked through Macquarie Bank’s report “Further deterioration in China’s corporate debt coverage.” Basically, looking at the entire universe of CNY22tn in corporate debt, the “percentage of EBIT-uncovered debt went up from 19.9% in 2013 to 23.6% in 2014…”.  In 2007 only 4 companies (all in the cement sector) had “uncovered debt (companies that can’t cover a full year of interest expense with profit).”  In 2013 approximately 1/3 of companies couldn’t cover their debt and corporate debt was at CNY4tn for just the commodity sector.  In 2014 “more than half of the cumulative debt in this sector was EBIT-uncovered and approximately CNY2tn in debt was in imminent danger of default and particularly for base metals companies.

Second, Gillian Tett of the Financial Times aptly highlighted why the Fed is right to be concerned about emerging markets in her article: The credit bubble, the bears and the central bankers.  There is the sheer size of the amount of emerging market corporate debt “as the IMF noted in its latest financial stability report, between 2004 and 2014 EM corporate debt increased from $4bn to $18bn, with much of the growth occurring after 2008.”  Further that “Citi has estimated the global private-sector money creation over this period and their conclusion is that 3/4 of all global private money creation in the past five years has occurred in EM. More specifically, since 2000 $8bn of flows have gone into EM – and this has generated $5bn of private EM credit each year.”  As Matt King, analyst at Citi, put it “the EM bubble is so big that it is far from clear central banks could plug the gap if (or when) this money creation slows down; the world is reaching a point of ‘credit exhaustion.’”

Third, as covered in the Financial Times by Patrick McGee on Monday, October 5, 2015, for the first time ever, US 3-month treasuries were bought for a yield of 0%. $21bn of zero-yielding three-month treasuries were sold.  Keep in mind that the lowest bid currently permitted for a US bill auction is 0%, “but ahead of the sale, four week and three-month bills have been trading at negative yields in the secondary market.”  By Tuesday, the four-week bill was quoted at -3bp and the 3-month at -1bp.  As a result, Wrightson Icap (a research company) is forecasting “that the debt limit will be raised in the first week of November and that the Treasury will start to ramp up issuance aggressively the following week.  We could see the four-week offerings return to $40bn within a couple of weeks after Congress acts.”  Also on Monday, the US auctioned 6-month bills yielding 0.065%, the lowest in 11 months.  Recall that before the financial crisis, 3-month treasuries routinely yielded more than 4%, but have been less than 0.2% since April 2009 reflecting the Fed maintaining an overnight borrowing band of zero to 0.25%. Until Monday the record low was 0.005%.  “Negative yielding bonds have become far more pronounced with Finland, Germany, France, Switzerland, and Japan all selling five-year debt at negative yields… Switzerland in April became the first government in history to sell benchmark 10-year debt at a negative interest rate.” Don’t forget that the U.S. 10-year still yields close to 2%, that’s practically stratospheric in relation to similarly rated debt in Europe and Japan.

Other Interesting Articles

FT: Rio Oil Trust: pensioned off 10/1

FT: Boutique banks: placement testing 10/1

FT: Renminbi overtakes Japanese yen as global payments currency 10/6

BloombergBusiness: Bruised Germany Is Canary in Coal Mine for Europe’s Troubles 10/7

CNBC: Recession buzz is heating up on Wall Street 10/7

What stood out the most over the past week was 1) the coverage of the increasing withdrawal of petrol dollars from the world investment markets, 2) the withdrawal of funds from emerging market securities, and 3) the rising spreads in corporate bonds.

First, it was only a matter of time with oil prices running below production costs for many of the world’s oil nations that their sovereign wealth funds (SWFs) would take a hit.  Surplus dollars are no longer being generated for many of the oil producing nations that ordinarily would then circulate those dollars into the world investment markets and asset classes. Rather, for many of these countries all of their oil revenues now must go towards paying for government commitments and in many cases countries are having to draw down from their SWFs.

As Simeon Kerr highlighted in the Financial Times, the Saudi Arabian Monetary Agency (Sama) which has seen its foreign reserves reduced by nearly $73bn since oil prices began their decline last year has pulled between $50bn-$70bn from global asset managers over the past six months.[i]  Sama is just one instance – consider that Saudi Arabia has the lowest marginal production costs per barrel at around $21 per barrel.[ii]  On a larger scale, consider that according to the Sovereign Wealth Fund Institute “nearly 60 per cent of the $7.3tn in global SWF assets is derived from oil and gas revenues.[iii]”  As covered by the Financial Times’ Lex column, “two-thirds of oil-dependent funds based outside North America expect outright withdrawals if the oil price stays below $40 a barrel for two years. Not just Saudi Arabia but Russia, too, has already raided its wealth funds to shore up an ailing economy.  Norway, the largest and most transparent of SWFs, expects its pension fund to have net outflows from next year as oil revenues go towards propping up the fiscal budget.[iv]”  Further, “a quarter of the remaining SWF assets belong to China,[v]” which is having its own economic issues with at least $150bn of capital leaving the country in August alone.[vi]  Global asset managers – hedge funds, private equity, etc. – will have challenges with redemption requests for sometimes illiquid assets and will experience a new dynamic with one of their primary funding mechanisms.  Granted, the withdrawn money doesn’t just ‘disappear’ from the world economy – it should find its way into consumer’s pockets via reduced energy costs – it is likely that this money will not be as accessible for asset managers if oil costs remained depressed.

Second, also related to SWFs withdrawing funds from global asset managers, they along with many other investors are pulling money from more volatile emerging markets.  China has the world spooked at the moment and most emerging markets are highly exposed to declining Chinese demand for raw materials.  As Carolyn Cui pointed out in the Wall Street Journal, global investors are estimated to have pulled $40bn from EM stocks and bonds during the current quarter, the most for a quarter since the depths of 2008.[vii]  Further, the world and many companies from developing countries are anxiously watching the FED and European Central Bank for changes in interest rates, especially considering that “companies from developing countries quadrupled their borrowing to well over $18tn last year from about $4tn in 2004, with Chinese firms accounting for a major share of that” and many of the borrowings are in dollars and euros.[viii]

Third, as covered by Mike Cherney in the Wall Street Journal, the “spread” between investment grade corporate bonds (rated BBB- and higher) and US Treasury securities have been steadily increasing.[ix]  For the first time since the financial crisis in 2007 and 2008 spreads have widened in two consecutive years.  As of September 24, US investment-grade corporate bonds yielded 162 basis points (bp) more than Treasurys.  That spread was at 131 bp at the end of 2014 and 114 bp at the end of 2013.  Worse, spreads in junk-bonds started moving sharply higher in 2014 as oil prices collapsed from 382 bp at the end of 2013 to 588 bp as of September 24, 2015.  As Krishna Memani – CIO at Oppenheimer Funds – so aptly put it “…the fact that spreads have been widening since the middle of 2014 is a very worrisome trend.[x]”  Further, as covered by Eric Platt and Nicole Bullock at the Financial Times, “as borrowing costs rise and defaults have accelerated, investors have withdrawn more than $14bn from junk bond funds since the middle of April. The yield on the BofA Merrill Lynch high yield index has climbed to 7.98% from 6.52% a year ago…  Already in 2015, more US companies have defaulted than at any time since 2009… S&P analysts expect the default rate to nearly double to 2.9% by June 2016 from June 2014.[xi]”  Capital (read debt) intensive companies are in a hurt, specifically companies whose fortunes are tied to commodities, which make up a meaningful portion of the US junk-rated companies.  US junk-rated companies EBITDA tumbled 39.3% in Q2 from a year earlier – the greatest decline in 15 years.  “The slide in earning has also elevated leverage to its highest level in almost 15 years. The debt burden of high-yield companies climbed to 4.82 times trailing 12-month earnings at the end of Q2.[xii]”

Other Interesting Articles

The Economist

• “China’s Consumers Doughty but not superhuman”
• “Buttonwood: Greys’ elegy”

BloombergBusiness: Macerich Sells Mall Interests to GIC, Heitman for $2.3 Billion 9/30

NYT: As Banks Retreat, Private Equity Rushes to Buy Troubled Home Mortgages

National Real Estate Investor: Borrowers Push for More Interest Only Loans 9/23

InvestmentNews: How Nick Schorsch lost his mojo

End Notes

[i] Kerr, Simeon. “Saudi Arabia Withdraws Overseas Funds – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[ii] Conca, James. “U.S. Winning Oil War Against Saudi Arabia.” Forbes. Forbes Magazine, 22 July 2015. Web. 02 Oct. 2015.

[iii] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[iv] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[v] “SWFs: Oil Be off Now – FT.com.” Financial Times. The Financial Times, Ltd., 28 Sept. 2015. Web. 29 Sept. 2015.

[vi] “Flow Dynamics: Capital Flight from China.” The Economist. The Economist Newspaper Ltd., 19 Sept. 2015. Web. 20 Sept. 2015.

[vii] Carolyn Cui. “Investors Pull About $40 Billion From Emerging Markets in Current Quarter.” WSJ. Dow Jones & Company, Inc., 29 Sept. 2015. Web. 30 Sept. 2015.

[viii] Carolyn Cui. “Investors Pull About $40 Billion From Emerging Markets in Current Quarter.” WSJ. Dow Jones & Company, Inc., 29 Sept. 2015. Web. 30 Sept. 2015.

[ix] Cherney, Mike. “U.S. Bonds Flash Warning Sign.” WSJ. Dow Jones & Company, Inc., 27 Sept. 2015. Web. 28 Sept. 2015.

[x] Cherney, Mike. “U.S. Bonds Flash Warning Sign.” WSJ. Dow Jones & Company, Inc., 27 Sept. 2015. Web. 28 Sept. 2015.

[xi] Platt, Eric, and Nicole Bullock. “US Junk Bonds Cracking after Debt Binge.” Financial Times. The Financial Times, Ltd., 29 Sept. 2015. Web. 30 Sept. 2015.

[xii] Platt, Eric, and Nicole Bullock. “US Junk Bonds Cracking after Debt Binge.” Financial Times. The Financial Times, Ltd., 29 Sept. 2015. Web. 30 Sept. 2015.