Confusing market signals create a minefield for central Banks

Volatility and investors’ swings on the inflation threat complicates life for bankers unwinding stimulus

John Plender


Something curious is afoot in global funding markets, starting with the much-remarked recent surge in the London interbank offered rate. The difference between Libor and the overnight indexed swap rate has soared to its highest level since the financial crisis. A widening Libor-OIS spread, a seemingly arcane financial relationship, is important, not least because it usually implies stress in the interbank market.

One explanation offered is that US companies are repatriating cash from overseas subsidiaries. Some blame an expansion in Treasury bill issuance that followed the raising of the government’s debt ceiling. Perhaps most plausible is the existence of a wrinkle in the Trump tax reform legislation, which sets limits to the interest deductibility of inter-company financing for foreign banks.

Whatever the explanation, it is the consequence that matters. While it seems unlikely that the expanding Libor-OIS spread portends an imminent liquidity crisis in banking, it is undoubtedly true that Libor-linked borrowing costs on bonds, loans and mortgages are rising.

In effect, private markets are bringing forward the impact of future Federal Reserve tightening. What this underlines, among other things, is the difficulty central banks face as they retreat from ultra-loose monetary policy. Understanding the real economy is hard enough when tight labour markets fail to generate wage inflation and productivity performance is stubbornly poor.

Structural changes in financial markets that throw up confusing market signals are an unwelcome additional challenge. And those signals have been particularly confusing over the past few months on inflation, which is the central banks’ core concern.

From mid-December, investors started to demand increased compensation for taking on duration risk. Through January, rising US Treasury yields reflected a shift in concern away from deflation towards inflation and a demand for further compensation for what promised to be an earlier exit by central banks from unconventional policy. Then on February 2, a stronger than expected US labour market report caused a further rise in Treasury bond yields that had just reacted nervously, against the background of loosening fiscal policy, to the Treasury’s announcement of increased auction sizes for the government’s IOUs.

Equity markets across the world fell out of bed. Yet, paradoxically, the credit markets remained unperturbed with US and European corporate high-yield spreads staying at levels close to their pre-crisis lows. Strange signal.

Equities quickly recovered their losses. Then in March, bond yields started to fall again despite no marked change in the inflation outlook. What on earth, you might ask, was going on.

The turbulence of early February takes some unpackaging. With hindsight the key incident was the jump on February 5 in the Vix index, the measure of volatility implied by equity option prices. It was the biggest daily increase since the 1987 stock market crash.

The rise in volatility meant that traders in volatility exchange traded products had to buy more Vix futures to rebalance their books. As the latest BIS Quarterly Review points out in a revealing account of the episode, volatility increases have historically been sharp, so those betting on low volatility were collecting pennies in front of a steamroller.

There was then a spillover into the equity markets from Vix futures dealers who had hedged their exposures by shorting so-called E-mini S&P 500 futures, thereby putting downward pressure on equities. In addition, notes the BIS, normal algorithmic arbitrage strategies between exchange traded funds, futures and cash markets kept markets tightly linked. Forced sales by momentum traders added to the toxic mix.

In short, what appeared to be a full-scale inflation scare was a modest inflation scare combined with an immodest technical overshoot.

With government bond yields down since February, are investors now over-complacent about inflation? The risk of an overheating US economy remains real, labour markets are tight and commodity prices are up. In a recent speech Gertjan Vlieghe of the Bank of England Monetary Policy Committee put a cogent case that the Phillips curve, which charts the relationship between unemployment and wage inflation, is far from dead.

He highlighted a number of factors that have lowered wage growth for a given unemployment rate such as lower structural unemployment, public sector wage restraint, downward nominal wage rigidity, weak inflation expectations and weaker productivity growth. And he made a good case that several of these wage headwinds were now fading.

The volatility rise in February is probably a pointer to much greater future turbulence. Years of ultra-low interest rates and low volatility have dulled sensitivity to the leverage and currency mismatch risks inherent in ever more widespread carry trading. The exponential growth in derivatives trading means that the embedded leverage in these instruments is an ever greater threat to financial stability. So, too, is the increasing use of mechanistic, pro-cyclical trading strategies. All of which creates quite a minefield for beleaguered central bankers.


Whatever Happened to Saving for a Rainy Day?

Carmen M. Reinhart

The National Debt Clock is a very very large digital display of the current gross national debt of the United States

CAMBRIDGE – More than a decade ago, I undertook a study, together with Graciela Kaminsky of George Washington University and Carlos Végh, now the World Bank’s chief economist for Latin America and the Caribbean, examining more than 100 countries’ fiscal policies for much of the postwar era. We concluded that advanced economies’ fiscal policies tended to be either independent of the business cycle (acyclical) or to lean in the opposite direction (countercyclical). Built-in stabilizers, like unemployment insurance, are part of the story, but government outlays also worked to smooth the economic cycle.

The benefit of countercyclical policies is that government debt as a share of GDP falls during good times. That provides fiscal space when recessions materialize, without jeopardizing long-run debt sustainability.1

By contrast, in most emerging-market economies, fiscal policy was procyclical: government spending increased when the economy was approaching full employment. This tendency leaves countries poorly positioned to inject stimulus when bad times come again. In fact, it sets the stage for dreaded austerity measures that make bad times worse.

Following its admission to the eurozone, Greece convincingly demonstrated that an advanced economy can be just as procyclical as any emerging market. During a decade of prosperity, with output close to potential most of the time, government spending outpaced growth, and government debt ballooned. Perhaps policymakers presumed that saving for a rainy day is unnecessary if this time is different and perpetual sunshine is the new normal.

Fast-forward to the United States in 2018. Trillion-dollar deficits as far as economists can project are prima facie evidence that the arc of fiscal policy in the US bends in the wrong direction. An aging population should be husbanding resources for the future, not spending on itself now. Of course, democracies have a long history of over-rewarding current voters at the expense of future generations, but the current scale and scope of fiscal largess is mistimed to both the trend and cycle of the US economy. Most analysts believe the US is at or near potential output. Fiscal stimulus at such a time is plainly procyclical.

The previous round of fiscal stimulus dates to the 2009 American Recovery and Reinvestment Act, enacted in response to the Great Recession. The stimulus stretched past the immediate need, the ultimate price tag rose to $840 billion, and the net economic benefit remains debatable. Yet, even with these flaws, the legislation addressed the palpable cyclical reality of an unemployment rate touching 10%. This is what to expect in the exercise of discretionary policy, which is why the unemployment rate moves inversely with the federal budget déficit.

The Reagan tax cuts of the early 1980s came at a time when the unemployment rate was climbing to post-war highs, the economy was in recession, and the Federal Reserve battling inflation and keeping interest rates at or near record highs. The gross public debt at the time, at 31% of GDP, was small potatoes compared to today’s ratio of 105%.

The two main pillars of fiscal policy passed since December contravene the fundamental design principle of countercyclicality. The Tax Cuts and Jobs Act of 2017 and the Bipartisan Budget Act of 2018 are projected to put the deficit above $1 trillion by next year, even as most economists project the unemployment rate to move lower. Most Federal Reserve officials, for example, expect the unemployment rate to be just above 3.5% over the next three years, or almost one percentage point below their assessment of its natural rate.

This forecast of excess demand is an important part of the Fed’s rationale for raising the policy rate and shrinking its balance sheet. The net result of fiscal and monetary policy moving in opposite directions is that the Fed will make the government debt created by this legislation more expensive. The scale is not inconsiderable. The Center for a Responsible Federal Budget forecasts that interest costs will be the fastest-growing component of the budget, eating up 14% by 2028.

True, the federal tax code is in dire need of improvement, and last year’s reform, especially the reduction in the corporate tax rate, should boost output in the longer term. But such a gain is hard to bank on, and there is no plausible way that reform pays for itself. Rather, the preferable strategy would have been to pair costly tax policy changes with revenue-raising and expenditure-cutting initiatives. In fact, this year’s budget deal goes further in the wrong direction, making it likely that the public debt exceeds nominal income within ten years.

My concern about excessive government debt back goes a long way, both in terms of my research agenda and along the timeline of global economic performance. In work with Vincent Reinhart and Kenneth Rogoff examining a sample of advanced economies since the Napoleonic War, we found that periods of high debt were paired with long periods of weak economic growth. And in the current context, any adverse effect of debt on economic growth will intensify ongoing headwinds.

An aging US population implies lower participation in market activity. This, together with slower productivity, implies that rising entitlement spending will take a bigger slice of the income pie. Indeed, the Congressional Budget Office foresees increases in spending relative to GDP of about five percentage points in each of the next two decades.

Some officials argue that foreign investors’ appetite for US government debt – the rest of the world holds almost half of all outstanding Treasury securities, worth more than $6 trillion – insulates America from economic harm. Capital-account surpluses, mirrored in current-account deficits, summed to about $3.3 trillion from 2010 to 2017, compared to an $8 trillion aggregate federal deficit.

But those macroeconomic outcomes result from policy decisions abroad and the market-clearing movements of financial prices. Officials in important emerging-market economies chose to accumulate Treasury securities, because US yields, albeit low, were higher than in other advanced economies. A confrontational stance on trade, together with greater reliance on government debt, may well extract a higher toll to balance flows of goods and services and of capital. Moreover, the US will be paying for its current excesses with the promise of future payments, and inefficient stimulus now will not give future generations the productive resources needed to make good on it.


Carmen M. Reinhart is Professor of the International Financial System at Harvard University's Kennedy School of Government.


Marijuana Stocks Could Be a Buzzkill

By Bill Alpert  
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    Photo: Mark Sommerfeld 




A cold rain beat down recently on the boarded-up cinder-block homes and empty factories of Smiths Falls, Ontario, melting the last snows in this industrial town about an hour south of Ottawa. One parking lot was full, however. Inside a shuttered chocolate factory, it is artificial summer for the marijuana crop of the largest cannabis company in the world, Canopy Growth.

In brightly lit, high-tech “grow rooms,” Canopy is preparing for the expected legalization of recreational cannabis this year in Canada—the first industrialized nation to do so at the federal level. Workers in lab coats harvest, trim, and package Canopy’s Tweed-brand products, then store them in a giant vault whose heavy door would do a bank proud.

It is a scene being repeated by companies across Canada, which wants to become the Silicon Valley of recreational pot.

Canada’s experiment is being closely watched by other countries, including the U.S., where federal law still classifies marijuana as an illegal narcotic, but where more than half of the states allow prescription sales and nine have legalized recreational use. The visitor log at Canopy’s Smiths Falls facility shows delegations from dozens of countries.

As they often do, investors have celebrated this emerging business early by embracing Canadian companies that claim a cannabis connection. Traveling in Canada, cabbies, bankers, and even border guards will tell you their favorites in a bubble that has floated Canadian cannabis stocks to a collective stock-market value above $30 billion. That’s already about half the market capitalization of Canada’s gold mining industry.

But a Canada weed glut is a real risk. At current valuations, marijuana stocks are already too high for an investor tempted to join the party.

If other large nations follow Canada’s lead, cannabis could become a consumer discretionary business on the scale of the alcoholic beverage industry, in the view of Constellation Brands (ticker: STZ), the U.S. beer and wine giant that just plunked down $191 million for a 10% stake in Canopy. Constellation recently told analysts that global sales of cannabis products could reach $200 billion in 15 years.

Even under America’s conflicting regulations, Constellation says, U.S. cannabis sales already generate $50 billion annually, versus $60 billion for wine and about $75 billion for tobacco. Canopy’s chief executive, Bruce Linton, is confident that his product can compete against booze. “Mine doesn’t make you fatter or hung over,” he tells Barron’s. “And it leaves you feeling giddy afterwards.”

When Canada’s recreational sales start, Canopy Growth (WEED.Canada) will be ready with an Amazon.com-like e-commerce site called tweedmainstreet.com, featuring company brands like Tweed or Leafs by Snoop (yes, as in Snoop Dogg), as well as small-batch specialties from “craft” growers.



Linton and his rivals expect that nonsmoking forms of cannabis will fast become popular in Canada, as they have in markets such as Colorado. Extracts suited for vaping or munching can deliver the weed’s active ingredients like tetrahydrocannabinol, or THC (the source of a marijuana “high”), and cannabidiol, or CBD (which soothes pain in cancer patients). Food scientists at Canopy’s Smiths Falls plant are spending Constellation’s money to develop edible and potable products, including nonalcoholic, THC-fueled versions of beer, gin, and vodka. These consumable forms of cannabis, however, won’t be allowed until 2019 under Canada’s proposed law.

Along with Canopy, Canada is home to three other leaders in cannabis, all with sprawling greenhouses or high-tech grow houses like those in Smiths Falls. They are Aurora Cannabis (ACB.Canada), Aphria (APH.Canada), and MedReleaf (LEAF.Canada).

Vivien Azer of Cowen & Co. is the only analyst on Wall Street who covers cannabis stocks. After seeing Colorado’s legal cannabis dispensaries, she put out Buy recommendations for Canopy and MedReleaf. A longtime analyst of the beverage industry, Azer thinks that legalized cannabis could eventually substitute for much of alcohol’s role as “a social lubricant.”

Still, the price of Canada’s marijuana stocks might trigger vertigo. These companies trade for more than 100 times their 2017 sales, and several hundred times that year’s cash flows. Some have market values that are larger than estimated sales for Canada’s entire recreational marijuana market.

If Canada’s retail market can reach $9 billion in annual sales in a few years—as one bull estimates it will—that would yield only a couple of billion dollars in cash flow to wholesale producers like Canopy. So today’s investors are effectively paying 15 times the industry’s cash flow five years from now, a generous multiple. Moreover, there’s reason to believe these revenue forecasts are overly optimistic.

Most predictions fail to consider the dizzying price drops registered in states like Colorado and Washington after they legalized marijuana. In both states, supply gluts have pushed cannabis prices down more than 10% in each of the past two years.

Canada’s leading cannabis companies are “licensed producers” that make most of their money growing marijuana. Canadian investors have given them enough dirt-cheap capital to build more production than the world has ever seen, for a market already well-supplied by illegal growers. Once all the new greenhouses start budding, Canadian weed prices might tumble.

The Canadian companies will have to get through a price shakeout, says Jonathan Rubin, who has tracked U.S. spot prices for several years at New Leaf Data Services, a Stamford, Conn., pricing outfit that hopes to establish the cannabis benchmark. “You’ll hear folks who say that cannabis is different, that it’s not a commodity. Everyone wants to be the Coors of cannabis.”



Those Coors wannabes know that Canada’s recreational cannabis use is among the highest in the world. A 2013 report by Unicef said consumption by Canadian teenagers was the highest for that age group in any developed country. A 2015 report by Toronto’s Center for Addiction and Mental Health said that 45% of Ontario adults had used cannabis at least once, while about 15% acknowledged using it in the past year. And since 2001, Canada has let dispensaries sell marijuana by prescription. In British Columbia, Vancouver has so many dispensaries and lounges that some call it Vansterdam.

Nearly a year ago, the government of Prime Minister Justin Trudeau proposed a bill that would broadly regulate the production and sale of cannabis for recreational use by adults, with a target date of July 1, 2018. While the House of Commons approved the measure, Conservative members of the Senate have slowed its advance; it’s unlikely to become law before September.

The big four weed companies in Canada are gearing up for what they hope will be a large market for recreational use, but they all have gotten their starts as licensed producers of medical marijuana. Their customers get a doctor’s prescription and then register with one of the producers for mail-order delivery.

Neil Closner was an executive at Mount Sinai Hospital in Toronto when investors asked him to go into the medical marijuana business. “I was highly skeptical,” he recalls. But a visit with nursing home patients in Israel left him impressed with the ability of cannabis to relieve suffering from Parkinson’s disease, epilepsy, and cancer. In 2013, Closner helped start MedReleaf and became its chief executive. It now supplies more than 20% of Canada’s prescription cannabis.

In an industrial park near Toronto recently, Closner donned a surgical gown, mask, cap, and slippers to lead a tour of MedReleaf’s flagship plant. Except for the guard in a bulletproof vest, the building is typical of a conventional pharmaceutical operation, with air locks, vent ducts, and sealed doors. Step into a grow room, however, and you’re bathed in yellow light and a certain pungent smell. Green, jagged leaves rise like a forest of miniature Christmas trees, gently swaying under buzzing fans. After 10 weeks under the lights, the plants think it’s summer, and their thick buds turn the room into a two-foot tall jungle.

Licensed producers like MedReleaf are experimenting with cannabis cultivation on a huge scale. A greenhouse-grown crop yields 75 grams of dried flower per square foot, Closner says, but MedReleaf’s high-tech grow house yields 300 grams per square foot. Clean-room precautions keep out mold, mildew, and male pollen. That’s crucial, because every plant in the place is a cloned female and any pollen would make them all go to seed.

At its recent share price of C$17 ($13), MedReleaf’s stock values the company near C$2 billion. It had all of C$11 million in December-quarter sales, with losses of C$5 million, or five cents a share. Until the current fiscal year, MedReleaf had profits and operating cash flow (if you overlook the expense of stock options), but that is changing as it spends to gear up for legalization. The company is buying a million-square-foot greenhouse that will quadruple production.



MedReleaf hopes to establish medical cannabis production in foreign markets, including Germany, where pharmacies prescribe it and health insurers pay for it, unlike in Canada. The international opportunity is why the stock flies so high, CEO Closner says. “The valuation of our industry in the stock market reflects a level of enthusiasm and optimism about the world market,” he says, “which I think is warranted.”

Back in Smiths Falls, Canopy is doubling its output. Already the biggest producer in Canada, it got approval in February to build the world’s largest federally licensed cannabis site, in British Columbia. That will help expand its Canadian growing space to 5.6 million square feet. Over a February weekend, it flew 100,000 live plants to British Columbia in specially built crates.

At a recent stock price of C$33, the market values Canopy at nearly C$7 billion. Its revenue doubled in the December quarter, reaching C$22 million. Some 23% of those sales were cannabis oil and gel caps. Although Canopy showed net income of C$11 million, or one cent a share, the profits resulted from accounting gains. The company actually lost C$26 million on operations for the period and had negative free-cash flow exceeding C$100 million after all its investments for growth. CEO Linton says he wants to ensure that when recreational sales start, his products are on the shelves.

Investors are happy to help. At first, Canada’s biggest banks shunned the cannabis trade, so growers got loans from credit unions and sold stock through small brokers, such as GMP Capital of Toronto and Canaccord Genuity of Vancouver. But recently, the Bank of Montreal’s BMO Capital Markets joined GMP to help Canopy sell a C$200 million stock offering. Like most Canadian cannabis offerings, the shares were easily sold to both retail and institutional investors.

Investors’ money is funding a lot of production. Vancouver’s Aurora Cannabis brags that it grew to Canopy’s size in half the time. Aurora says it is building the world’s largest cannabis greenhouse, next to the airport in Edmonton, Alberta. And a joint venture will erect Europe’s biggest cannabis facility, in Denmark.

Revenue tripled in Aurora’s December quarter, to C$12 million. The company reported net income of C$7 million, or two cents a share, but that was a result of some investment gains. On operations, Aurora lost C$16 million. At a stock price of C$9, the market values the company at C$4.5 billion.

Aurora is sufficiently hungry that it began the industry’s first hostile takeover, in November, for a Saskatchewan producer called CanniMed Therapeutics (CMED.Canada). The board of CanniMed came around in January, after Aurora raised its offer from C$24 a share to C$43 in cash and stock—a total of about C$1 billion, 60 times unprofitable CanniMed’s 2017 sales.

The free-spending ways of other licensed producers is a favorite topic of Vic Neufeld, the chief executive of Aphria. In reporting quarterly sales of C$9 million, Neufeld noted that it had been Aphria’s ninth consecutive quarter with positive cash flow—in this case, C$1 million. The Toronto company says it aims to be a low-cost producer by sticking with greenhouses, instead of the more expensive indoor facilities.

That’s not to say that Aphria has stayed on the sidelines as its rivals spend investors’ money. It recently agreed to buy a company called Nuuvera (NUU.Canada) for about C$500 million in cash and stock. Nuuvera’s total sales over nine months were just C$30,000.

Like Canada’s other cannabis producers, Aphria has a market cap (C$2.4 billion) that seems out of proportion to its historical sales. To guess these companies’ fair value, it makes sense to look ahead to what the industry might look like after recreational sales kick in.

One analyst who has studied that opportunity is Daniel Pearlstein of Eight Capital, a tiny Toronto brokerage firm. He’s a bull, convinced that cannabis presents investors with a once-in-a-lifetime chance to get in on an industry that will boom like the internet.

“This is a market that is simply way bigger than a lot of people believe,” he contends.

How big? About $9 billion a year, Pearlstein estimates. Colorado has a sixth of Canada’s population, he notes, and the state’s cannabis sales reached $1.5 billion in its fourth year of legalization. So Pearlstein multiplies Colorado sales by six. And, of course, there are countries with potential markets bigger than Canada’s. Pearlstein believes that federal legalization gives the U.S.’s northern neighbor a head start to becoming the world’s preferred supplier.

Cowen analyst Azer is as optimistic as Pearlstein, although she worries about pricing, as legal weed finds a balance between supply and demand.

She’s right to worry.

Rubin’s New Leaf Data Services has a Cannabis Benchmarks index, which tracks weekly spot prices in more than a dozen markets, including Colorado, Washington state, and California. The volume-weighted index found that in states where weed is legal, spot prices dropped 20% over the course of 2016. The average in 2017 was 13% below 2016’s.

Prices were stable in the first year or so of legalization in Colorado and Washington, while supply caught up with demand. But then, cannabis behaved like other crop commodities; prices dropped in a supply glut. Canada’s market should also be well-supplied. There were four licensed producers when Health Canada began handing out licenses. Today, there are 94.

The potential for a supply glut is underscored by the claims of many producers that they are each building the world’s biggest grow house.

Neil Closner, MedReleaf’s chief executive, touring his company’s growing facility in Markham, Ontario. “The valuation of our industry in the stock market reflects a level of enthusiasm and optimism about the world market,” he says, “which I think is warranted.” Photo: Nathan Denette/The Canadian Press via AP


In February, Cronos Group (CRON) became the first Canadian grower to list shares on a U.S. exchange. At a recent $6.73, the Nasdaq-traded stock values the company at $1.1 billion, even though it had only C$3 million of sales in the 12 months ended September. That may explain why Cronos’ latest investor presentation shows no financial results--though it does say that it is building a 286,000-square-foot grow house that is “expected to be the largest purpose-built indoor cannabis production facility in the world.”

All these giant greenhouses won’t just compete with one another, of course. By some estimates, North America’s black market for marijuana is worth more than $50 billion a year. A study done for California by ERA Economics concluded that, in 2016, the state’s cannabis suppliers sold $1 billion worth to legal users and over $20 billion to illegal customers—mostly out of state.

One of Prime Minister Trudeau’s main legalization aims is to take sales from Canada’s estimated C$7 billion black market (and generate tax revenue in doing so). But that will take years, because black market incumbents won’t give up without fighting back by discounting their prices below those of the legal stuff.

Walk around certain neighborhoods of Vancouver or Toronto, and it’s hard to avoid passing a cannabis dispensary. Some require a prescription; some don’t. Strictly speaking, they’re all illegal. Websites also make it easy to arrange home delivery, and pop-up street fairs are common and hard to police, however illegal.

On an East Toronto street recently, the milling crowd made it obvious which door to try. Every minute or so, the dispensary’s manager buzzed in another group of young adults. A scruffy counter in the back of the undecorated space held the goods. The household furniture completed the low-rent look.

The shop’s manager, a cancer survivor, was furious that Ontario’s legalization plans leave out the pioneers of the cannabis trade. The manager, who asked not to be named because of past litigation, predicts that the black market will fight back by pricing its products at C$6 a gram, while the legal stores charge C$10.

Canada’s legal producers will have another pricing headache: The most populous provinces will allow retail sales only through government stores operated by provincial control boards. So in Ontario and Quebec, licensed producers will have just one large customer, which will dictate what they are paid.

Neufeld, the Aphria CEO, has warned that prices paid by these government stores will disappoint the industry’s high-cost growers. Talking on his last earnings call about his new contract with Quebec, he argued that “what they’re willing to pay licensed producers is absolutely going to force compression in pricing and therefore margins.”

From his study of the legal cannabis markets in Colorado and Washington, Rubin of New Leaf Data Services expects Canada’s recreational users to be uninterested in paying up for premium brands. He says the two questions he mainly hears in those states’ stores are: “What’s most potent?” and “What’s on special?”

Neufeld, in talking up Aphria’s focus on costs, scoffs at the exuberance he sees in his industry. Some licensed producers, he says, “are stating that it will be impossible not to make money once the recreational markets open up.”

But, he adds, “L.P.s that haven’t made profits while scaling up will continue to burn cash and ultimately disappoint investors.”

In February, Cronos Group (CRON) became the first Canadian grower to list shares on a U.S. exchange. At a recent $6.73, the Nasdaq-traded stock values the company at $1.1 billion, even though it had only C$3 million of sales in the 12 months ended September. That may explain why Cronos’ latest investor presentation shows no financial results--though it does say that it is building a 286,000-square-foot grow house that is “expected to be the largest purpose-built indoor cannabis production facility in the world.”

All these giant greenhouses won’t just compete with one another, of course. By some estimates, North America’s black market for marijuana is worth more than $50 billion a year. A study done for California by ERA Economics concluded that, in 2016, the state’s cannabis suppliers sold $1 billion worth to legal users and over $20 billion to illegal customers—mostly out of state.

One of Prime Minister Trudeau’s main legalization aims is to take sales from Canada’s estimated C$7 billion black market (and generate tax revenue in doing so). But that will take years, because black market incumbents won’t give up without fighting back by discounting their prices below those of the legal stuff.

Walk around certain neighborhoods of Vancouver or Toronto, and it’s hard to avoid passing a cannabis dispensary. Some require a prescription; some don’t. Strictly speaking, they’re all illegal. Websites also make it easy to arrange home delivery, and pop-up street fairs are common and hard to police, however illegal.

On an East Toronto street recently, the milling crowd made it obvious which door to try. Every minute or so, the dispensary’s manager buzzed in another group of young adults. A scruffy counter in the back of the undecorated space held the goods. The household furniture completed the low-rent look.

The shop’s manager, a cancer survivor, was furious that Ontario’s legalization plans leave out the pioneers of the cannabis trade. The manager, who asked not to be named because of past litigation, predicts that the black market will fight back by pricing its products at C$6 a gram, while the legal stores charge C$10.

Canada’s legal producers will have another pricing headache: The most populous provinces will allow retail sales only through government stores operated by provincial control boards. So in Ontario and Quebec, licensed producers will have just one large customer, which will dictate what they are paid.

Neufeld, the Aphria CEO, has warned that prices paid by these government stores will disappoint the industry’s high-cost growers. Talking on his last earnings call about his new contract with Quebec, he argued that “what they’re willing to pay licensed producers is absolutely going to force compression in pricing and therefore margins.”

From his study of the legal cannabis markets in Colorado and Washington, Rubin of New Leaf Data Services expects Canada’s recreational users to be uninterested in paying up for premium brands. He says the two questions he mainly hears in those states’ stores are: “What’s most potent?” and “What’s on special?”

Neufeld, in talking up Aphria’s focus on costs, scoffs at the exuberance he sees in his industry. Some licensed producers, he says, “are stating that it will be impossible not to make money once the recreational markets open up.”

But, he adds, “L.P.s that haven’t made profits while scaling up will continue to burn cash and ultimately disappoint investors.”

 What Do Higher Interest Rates Mean? Part 1: No More Refis

The developed world has lived with unnaturally-low interest rates for so long that it’s become hard to imagine what life in a normal financial system would be like.

But as rates finally start to rise, some of the necessary lifestyle adjustments are emerging. A big one is the fact that the days of refinancing one’s house every few years to extract free cash or lower the monthly mortgage payment are over. Now you pay what you pay, for as long as it takes.

That’s also bad news for the banks that have gorged on refi fees for the past decade:

Homeowners Ditch Refinancings as Mortgage Rates Rise 
(Wall Street Journal) – Refinancings make up a smaller portion of the mortgage business than at any time in the past two decades, posing a challenge for lenders who already fear higher interest rates and climbing house prices could eventually depress purchase activity. 
Last year, 37% of mortgage-origination volume was because of refinancings, according to industry research group Inside Mortgage Finance. That is the smallest proportion since 1995, and the number of refinancings is widely expected to shrink again this year. In 2012, refinancings were 72% of originations. 
While purchase activity has climbed steadily from a post-financial-crisis nadir in 2011, growth in 2017 wasn’t enough to offset a $366 billion decline in refinancing activity.  
The result: The overall mortgage market fell around 12%, to $1.8 trillion, according to Inside Mortgage Finance. 

 
What’s more, there are fewer homeowners eligible to refinance because of rising rates.  
The number of borrowers who could benefit from a refinancing is down about 37% from the end of last year, estimates Black Knight Inc., a mortgage-data and technology firm. At 2.67 million potential borrowers, this group is at its smallest since 2008. 

 
“The market has just gotten so very competitive because every loan matters,” said Ed Robinson, head of the mortgage business at Fifth Third Bancorp . He added that the bank is contacting homeowners who could be eligible for a refinancing in coming years to help maintain that business, and it is also instructing mortgage-loan officers to focus more on purchases. 
Freddie Mac said last week that the average rate on a 30-year fixed-rate mortgage was 4.45%, up from 3.95% at the beginning of the year. Increased mortgage rates can hamper refinancing activity because many homeowners have rates that are already lower than what lenders can now offer. In other cases, the higher rates cut into the savings a homeowner stands to reap by refinancing a mortgage. 
The Mortgage Bankers Association expects mortgage-purchase volume to grow about 5% in 2018 but refinancing volume to drop 27%. Refinance applications fell 5% in the week ended March 16 from the prior one, according to the group. 
To drum up business, lenders are emphasizing home-equity lines of credit, which let borrowers tap their homes for cash through a new loan that doesn’t affect the rate on their current mortgage. They are also pushing adjustable-rate mortgages, where initial rates are rising more slowly.

A few things

First, this is an obvious negative for bank earnings, which makes bank stocks an even more compelling short sale idea. Most analysts view the big banks as better capitalized than before the last crash, so another “death of Wall Street” scenario might be too much to hope for.

But there’s no escaping cyclicality — when the economy turns the banks follow. Here’s Citigroup’s stock in the Great Recession. If it falls even half as much in percentage terms it — and the other big banks — are still classic shorts.




Second, mortgage companies steering homeowners towards home equity credit lines and adjustable-rate mortgages is just what a dysfunctional system does when confronted with a return to historical normalcy. Keep your customers borrowing however you have to do it and let them worry about making the payments!

Third, higher rates are a sign that we’re finally starting to redress some of the past decade’s cultural bias in favor of borrowers and against savers. As interest rates rise, the relative handful of people who are putting part of each paycheck away – or who spent a lifetime doing that and now would like to retire with a bit of interest income – benefit, and the people who just borrow ever-larger amounts of money suffer.

That’s as it should be, though this trend is likely to last only until the next round of QE and ZIRP when the Money Bubble finally bursts.