Tag Archives: money

bracing for higher interest rates

August 5, 2015 By in bond market, Constructing a Portfolio, Current Market Thoughts, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

Long-time readers may remember that in an embarrassingly premature fashion, I began writing about the upward path away from non-crisis interest rates toward normal several years ago.  It looks like liftoff day has finally come, however.

The consensus expectation, informed by judicious leaks by the Fed, is now that the Fed Funds rate will rise by .25% next month, and by another .25% before yearend–meaning short rates will exit 2015 at .50%.  A highly stylized view of the Fed’s intentions is that it will continue to raise rates at the same 1/4% clip at every second Fed meeting next year–meaning another 1.0% increase during 2016.  The goal of rate normalization is an endpoint for Fed Funds of around 3% (but probably lower).

This is a potentially important change of direction for two reasons:  rates have been at emergency lows for an extraordinarily long time, and the thirty-five year war against inflation has been long since won.  The secular trend of ever lower nominal interest rates–for many financial market participants, the only trend they have ever seen in their working lives–is over.  Barring another world financial disaster, nominal rates may be higher in the future, but there’s no chance they’ll ever be lower.  So the thought habits of a lifetime are about to be shaken up.

What does this mean for stocks?

Past tightening cycles have been bad for bonds, but stocks have been flat to up.  The generally accepted explanation for the latter phenomenon is that the negative effect of higher rates is offset by robust profit growth.  Said another way, positive earnings surprises (more than) offset the negative effect of price earnings multiple contraction.

Personally, I think this explanation is the right one.

Critics of the applicability of the idea to the present situation point out that this time rates will be rising long after the business cycle has turned.  Therefore, they argue, the chances of a surprisingly large corporate profit surge are slim.  In consequence, the “normal” protection for stocks against Fed tightening is absent.

Four thoughts:

–the reason rates are still at 0% is that the “normal” cyclical profit surge hasn’t happened yet.  Maybe surge isn’t the right word for today’s situation, but world economies certainly aren’t firing on all cylinders yet.

–profit rises and Fed tightening aren’t independent events.  The Fed has made it clear that it intends to tighten only to the extent that economic strength allows.  The agency has often referred to the repeated disastrous mistakes Japan has made over the past quarter-century by tightening too soon.  If profit growth doesn’t permit, tightening will go more slowly than many expect.

–for the S&P 500, half the index’s profits come from abroad.  The EU (25% of profits) will likely be stronger next year than this; China may be, too.

–where else will money go?  Certainly not into bonds.  Cash is the only safe haven.  It’s possible there will be a large outflow of money from stocks into cash.  I don’t think so.  That’s partly (mostly?) because I like stocks.  More substantively, institutional investors may shade their portfolios a bit toward cash, but their large size means they can’t maneuver quickly, so the risk to them of betting against stocks in a major way and being wrong is enormous.  In addition, my sense is that a defining feature of the bull market that began in 2009 is the lack of retail participation.  If so, retail has already bet heavily–and incorrectly–against stocks.

A final point:

–yielding 0%, cash isn’t an attractive alternative to me at.  However, given that the period of zero interest rates is coming to an end, I’ve got to ask myself at what level would it be?

If we assume that inflation will be steady at 2%, I would find 3% cash and a 4%+ long bond very attractive.  That may be evidence that we’ll never get there.

Still, what I’m trying to get at is that there will come a point in the tightening cycle where even an equity fan like me will have to reallocate toward fixed income.  We’re nowhere near that now, in my opinion.  But I think this, not the start of tightening, will be the real showstopper for stocks.  This is not an idea to act on, but it is one I think we should keep in the back of our minds.

ZipCap

May 21, 2015 By in Banks, Industry Analysis, internet, Investment firms Tags: , , , , Leave a comment

ZipCap, short for Zip Code Capital, is a San Diego-based startup alternative lender featured in the Business section of today’s New York Times.  It provides low-cost loans to local businesses that aren’t able to get credit from traditional banks–presumably either because they’re not (or not very) profitable or because they don’t have a good enough financial handle on their enterprise to know whether they make money or not.

ZipCap helps a client business form an “Inner Circle” of customers who pledge to buy a minimum amount of stuff from the client over a specified period.  ZipCap lends against that commitment.  In the case of the restaurant/coffee house featured in the NYT article, 130 entities pledged to spend $475 each ($61,750 in total) over the following year.  That got Beezy’s Cafe a $10,000 loan at 3.99%.

If all of this were new spending, my back-of-the-envelope guess is that it would bring in $40,000 or so in fresh operating income, far in excess of what would be needed to repay the debt.  For Beezy’s to be better off simply from forming the Inner Circle, a quarter of the pledges would have to be new spending, or about $2.50 a week per Inner Circle member.  That figure would need to be adjusted up if not everyone keeps his word.

 

It seems to me, from the limited data in the NYT and on the ZipCap website, that ZipCap isn’t really about lending.

It’s not a social service, either.  Chances are that Beezy’s would be better off getting, say, business students from a local college to create financial tracking to help figure out what makes money for the cafe and what doesn’t.

What ZipCap does do, I think, is provide a socially acceptable, non-toxic way for a struggling business to proclaim that, though it might appear to be thriving, it isn’t   …and, at least implicitly, that it won’t be around for long unless it gets more community support.

Of course, there may be unintended consequences of the Inner Circle creation.   Assuming the extra spending doesn’t come out of thin air, IC creation at Cafe A may force Cafe B to close its doors.  Or it may make it extra hard for a new Cafe C to get started.

It will also be interesting to see how ZipCap deals with rising interest rates, as and when they occur.

 

thinking about the oil price

March 26, 2015 By in Energy, Industry Analysis, shale oil Tags: , , , , , , Leave a comment

I’ve been reading lately that many US oil companies are continuing to drill for shale oil, despite the fall in the price of crude.  However, while they are finishing drilling holes in the ground, they’re not yet “completing” the wells.  That is, they’re not fracking the underground deposits by pumping in water/sand/chemicals to create a path for the hydrocarbons to get to the well.  Nor are they installing the equipment a working well requires.

There’s even a name for these already drilled but not completed wells–fracklog.

The decision not to complete is easy to understand.  There’s already too much oil sloshing around in the world.  Why spend money to add to the problem–maybe even pushing prices down enough to make your own efforts unprofitable.

Why continue to drill, though?

Lots of potential reasons.

A drilling rig may be under contract, so the oil explorer has to pay for it whether used or not.  Drilling a certain number of wells may be necessary to keep mineral rights to specific acreage.  In the case of companies with too much debt, the bankers may be calling the shots (although such wells will surely be completed as fast as possible).  Some exploration firms have also made it clear that they consider today’s oil price to be a purely temporary dip.  So they’re going to continue to drill no matter what.

What’s important for investors, though, is how the fracklog may affect any rebound in the oil price.

My picture is that oil is bouncing along at or near the bottom, waiting for high cost production to leave the market.  As/when that happens, and as world GDP growth gradually increases demand for petroleum, the oil price will begin to rise again.

I think the fracklog creates a ceiling above which oil will find it difficult to rise.  It implies that when these backlogged wells become profitable enough, a rush of new output will hit the market.  Maybe the appropriate price is $70 a barrel.  $60, anyone?  It’s almost certainly below $100.

If I’m correct, an eventual oil price rise will be unpleasant for consumers but not devastating.  Also, the buy/sell decision for any oil producer becomes much more a sharp pencil exercise than a thematic call on the possibility of boundless price increases for output.

 

 

yesterday’s Fed meeting announcement

March 19, 2015 By in bond market, currency markets, Federal Reserve, securities markets, stock market Tags: , , , , , , , , Leave a comment

My experience with Fed meetings is that the stock market usually heads off in the wrong direction on the release of the Fed statement and accompanying documents, but then quickly reverses course and moves in the way one might reasonably have predicted by actually reading the Fed materials.  This is not just computers trading.  The US market has operated this way for as long as I can remember.

Not this time, though.  Instead, the S&P made an immediate strong upward move   …and never looked back.

What’s different this time?

I think it’s the PDF where the Fed shows, among other things, where its voting members believe the Fed Funds rate will be at the end of this year, next year and in the longer term.

The previous release, in December 2014, showed the median estimate for 2015 at 1.0%.  For 2016, the figure was 2.5%.

Yesterday’s, in contrast, suggests the rate will be between 0.5% and 0.75% this December, and at 1.75% as we enter 2017.

That’s a big haircut for just three months.

The factors involved in the change are:

–the rise in the US$,

–moderation in domestic economic growth over the first quarter, and

–the lack of any sign of inflation.

Stocks and bonds spiked on the news.  The US$ came off its highs.

my take

Investors continue to be fixated on the numbers the Fed releases, and to be distrustful of any qualitative statement by the Fed saying it has taken the tragic 1990s example of Japan seriously and will err on the side of caution in raising rates.  Doesn’t make a whole lot of sense to me that the market doesn’t believe this, but it’s the way it is.

My stocks were having an unusually strong day yesterday before the Fed announcement.  They lost a bit of their relative strength afterward, though.  Arguably, this shows I was preparing for faster rate increases than the market now thinks will occur. I have no desire to become more aggressive, but I will be interested in how my stocks fare today.

I’ve been mulling over whether to try to play a potential rally in domestic-oriented EU stocks.  My experience is that this isn’t safe until the domestic currency in question has stopped falling.  I wonder if yesterday was a turning point?  Again, more data today.

a dollar shortage?

March 17, 2015 By in currency effects, currency markets, securities markets Tags: , , , , , , Leave a comment

response to a reader’s question

A reader asked me to comment on this post on the Zero Hedge website about a potential US$ funding shortage.  The post was sparked by (is a rehash of) this recent commentary by JP Morgan’s currency strategist.

Let’s be clear that this is not my area of expertise.

Nevertheless, here goes:

the blogger

The Zero Hedge post, following the JP Morgan piece, observes that it has become unusually expensive to buy large amounts of US dollars.  The last time this happened was just as Lehman was failing, signalling serious problems with the world financial system.

The post author concludes that because dollars are again pricy we’re warming up for another round of severe banking problems.

JP Morgan

I don’t think the blogger is correct.  It seems to me he’s mixing up cause and effect.  Also, this is not what JP Morgan is saying.

history

Back in 2008-09, the main issue  was counterparty risk.

Bear Stearns, whose financial statements showed assets–mainly bonds, loan participations…worth about $80 ended up bankrupt, with those “assets” really worth close to nothing.  Lehman’s value was coming under similar questioning.

The conclusion the financial markets drew was that maybe all the banks’ financials were similarly not worth the paper they were written on–and that therefore anyone you lent money to, even for a few days or weeks, might go under before you were repaid.  So the wisest–and only–course was to lend to no one.   The world financial system froze up.

An important leading indicator of this mess was the increasing cost of borrowing dollars to finance trade.

today

Today’s situation is very different.  Two factors are involved in the current high cost of finding dollars:

–it’s cheaper to borrow in euros, hedge currency exposure and convert the loan proceeds into dollars than it is to borrow directly in dollars. (Similarly, in recent years it’s been cheaper for a Mets fan to fly to San Francisco to see the Mets play there than buy a premium seat at Citi Field.) Enough American corporations are doing so to dramaically up the cost of obtaining dollars.  They will presumably continue to do so until do so until this arbitrage makes no sense.

–today’s carry trade is sell euros (or just about any other currency)/buy dollars.

my conclusion

Today’s situation, unusual as it is in post-WWII history, doesn’t signal the onset of a new banking crisis.  Rather, it’s a function of differences in central bank monetary policy between the US and EU caused by differences in the relative economic health of  the two areas.

an aside

JP Morgan mentions one thing for which it has no hard information but that may prove important.

The corporate borrowing situation described a few lines above makes no net impact (in theory, anyway) on the fx value of the euro.  The currency hedging contract exactly offsets the effect of the purchase of dollars.

Suppose, though, US companies aren’t hedging.    After all, multinationals have tons of money in overseas banks and lots of physical assets in foreign countries.  Currency losses on both are currently ripping gaping holes in firms’ income statements.  Companies might consider that having, say, euro-denominated liabilities would neutralize some of the damage (I feel confident that the JPM strategist has either made, sat in on, or at least heard about, financing pitches arguing US companies should do precisely this).

If so, their dollar-buying isn’t  being offest by hedging contracts and  is putting upward pressure on the US$.

equity implications

If so, once converting euros into dollars becomes expensive enough, US companies will presumably stop doing it.  This could cause a significant bounce in the euro.  This would likely switch European stock market preferences away from dollar earners toward (beaten down) domestic issues.