Corporate America is over-caffeinated

Let us hope our dependence on the fragile US consumer holds up

Rana Foroohar

Starbucks Economy Indicator
© Matt Kenyon

Starbucks isn’t just the world’s largest coffee chain; it’s a bellwether stock, one that tells us a disproportionate amount about the American economy and where it may be headed.

When Barack Obama was president of the US, he used to call Starbucks founder and former chief executive, Howard Schultz, for a read on the American consumer. The store sales figures coming out of thousands of communities around the country, four times a day, were much more sensitive than any Bureau of Labor Statistics data.

Last week, Starbucks told us something important and disturbing. The company’s stock took a dive after it signalled, during a presentation at a Goldman Sachs retail conference, that its recent 10 per cent rate of profit expansion wouldn’t carry into next year. In large part, this was because the benefits from President Donald Trump’s tax cuts were tapped out.

As Patrick Grismer, the chief financial officer of Starbucks, put it, “far and away the driver of our outperformance in fiscal 2019 relative to our original expectations was our effective tax rate”. Now that the tax boondoggle is over, so is Starbucks’ outperformance. The company also announced it was pulling forward $2bn worth of share buybacks it had planned for 2020 into the current year, as its sales and earnings are falling short of expectations.

Using equity repurchasing to bolster share prices is nothing new for Starbucks, which has seen its share price grow by some 80 per cent in the past year thanks not only to those Trump tax cuts, but to share buybacks (much of the company’s earnings per share growth comes from them).

The money raised from new bond issuances is often used to pay for those buybacks. Starbucks’ own debt load has roughly tripled over the past few years as it has pivoted to what it calls a “more highly leveraged model”.

Starbucks is of course by no means alone in its employment of such financial engineering. One of the biggest market stories of the past several years has been corporations capitalising on cheap money, using record low rates to issue bonds and then using the money raised to buy back their own equity in order to bolster share prices.

It’s a shell game that has always made my head spin, particularly when done at a market peak, rather than a trough, which tells you that the strategy isn’t a bet on a real, underlying growth story but an attempt to make headlines.

I thought we’d reached a peak in such Faustian financial wizardry a while ago, but no. In recent days, Apple, which has $200bn dollars of cash or cash equivalents on hand, announced a $7bn bond offering, part of a slate of $54bn worth of corporate debt issuances in the past week or so. Just when you think the bond bubble can’t get any bigger, it does.

Given the looming risk of recession, a spate of recent corporate trouble (involving heavyweights such as GE, Kraft Heinz, Boeing, PG&E, and now Johnson & Johnson, which is under fire for its role in the opioid crisis), you would think investors might steer clear of even “high grade” corporate debt. But the asset class seems to fill an existential need for something between equities, which many worry could crash, and the glut of negative-yielding government bonds.

In today’s bizarre and bifurcated market, any middle ground, it seems, is better than none. To me, all this says that corporate America is over-caffeinated and due for a crash. Starbucks would say the American consumer is not.

As Mr Grismer says, “we see in the US a very healthy consumer”. And it’s true that, while tax cuts and buybacks have been a big part of the Starbucks story over the past couple of years, they aren’t the only part. Consumer confidence in the US has, at least so far, been surprisingly resilient in the face of the US-China trade conflict, monetary policy uncertainty, and the sound and fury coming out of the White House. Starbucks same-store sales growth, a good measure of underlying demand, has been robust.

But policymakers worry that this resilience may not last. As New York Federal Reserve president John Williams put it recently, “the consumer is now carrying all of the weight, or much of the weight, for growth going forward.” Or, as Dallas Fed chief Rob Kaplan, who worries that bad macroeconomic data could shift consumer sentiment, says, “if you wait to see weakness in the consumer, you’ve likely waited too long”.

This reminds me of something Mr Schultz told me in February of 2015. Starbucks had just released impressive quarterly numbers. But Mr Schultz worried that economic bifurcation and political dysfunction following the 2008 global financial crisis had created a new and more “fragile” consumer, one that was quick to button up their wallet at the first real sign of economic trouble.

“There is no company you can point to that is as dependent as we are on human behaviour, the human condition,” he told me back then. In a nation divided between latte makers and latte drinkers, any small piece of bad news could trigger a downturn.

Economic bifurcation, political dysfunction, and our dependence on the fragile American consumer has only increased since then. For the sake of the markets, and the global economy, let’s hope they’ve had their double shot.

Fannie and Freddie Reform Plan Gets an Incomplete

Treasury Department’s plan for the housing giants is vague on key details such as how they will be recapitalized

By Aaron Back

The Trump administration is proposing reforms to the country’s mortgage-finance system. Photo: Steve Helber/Associated Press 

America’s mortgage-finance system isn’t going to change in a fundamental way for the foreseeable future. That is the inescapable—though to many parties deeply disappointing—takeaway from the U.S. Treasury Department’s housing reform plan issued Thursday afternoon.

Mortgage guarantors Fannie Mae FNMA -8.75%▲ and Freddie Mac , FMCC -8.21%▲ which have been wards of the state for 11 years, are likely to remain so for some time.

For years a debate has raged over how to deal with the companies that back most mortgages in the U.S. Some, especially holders of their volatile shares, want them recapitalized and released from government control as soon as possible. Others want a fundamental reform of the system, which would require new laws and likely include an explicit government guarantee for the mortgage-backed securities they issue.

The Trump administration is trying to straddle the two camps by recommending that Congress get to work on the more fundamental reforms while the executive branch gets started recapitalizing and releasing the companies. But exhortations to Congress are likely to fall on deaf ears. Meanwhile, the route to recapitalizing the companies outlined in the report is tentative and vague.

The report uses the term “Congress should” 40 times. It hardly seems likely that the Democratic-controlled House of Representatives will rally to implement the Trump administration’s detailed proposals between now and the next election, though—especially given the sensitivity of the issue.

As for what to do on its own, the Trump administration’s plan is in large part to keep thinking about it. The report states that it is time to bring the government’s conservatorship of the companies to an end. Then it lists several formidable preconditions, including that the companies should have raised sufficient capital to absorb losses on their own. According to an earlier report by the Federal Housing Finance Agency, it would likely require around $180 billion between the two companies for them to survive another 2008-magnitude financial crisis.

The fine print of Thursday’s Treasury report suggests even that amount might be insufficient.

The report lists several options for raising this money, including ending the “net worth sweep” whereby the companies surrender their quarterly net profit to the Treasury, or selling their shares through private or public offerings. It correctly notes, though, that “each of these options poses a host of complex financial and legal considerations that will merit careful consideration.” In the end, the Treasury’s plan is to consider all this and come up with a more detailed plan later.

Based on the language of the report, it does seem likely that the net worth sweep will end or be amended soon. Even so, it would take many years for the companies to build up sufficient capital through this alone: Over the last four quarters they had combined net income of just under $20 billion.

The Trump administration keeps insisting that it is willing to act alone, without Congress. But with the administration’s own plans still unfinished, it is far from clear it will have time to do so during the current presidential term. The future of Fannie and Freddie will likely remain unsettled until after the next election.

Family offices prepare for market downturn

Advisers who handle wealth of super-rich fret over threat of global recession

Chris Flood

Family offices have doubts about hedge funds’ ability to protect wealth during downturns, says UBS's Sara Ferrari © SEBASTIEN NOGIER/EPA-EFE/Shutterstock

Family offices, the advisers that invest the wealth of the super-rich, are preparing for a downturn in financial markets as concerns mount of a looming recession.

UBS, the Swiss bank, and Campden Wealth, a data provider, surveyed 360 family offices and found that 55 per cent expected the global economy to sink into a recession before the end of 2020.

Tensions between the US and China were cited as a concern by more than 90 per cent of those surveyed while almost two-thirds said Brexit would not enhance the UK’s appeal as an investment destination.

The 360 family offices generated an average return of 5.4 per cent over the 12 months ended May, weighed down by disappointing performances from their holdings of publicly traded equities in developed and emerging markets.

“Family offices have been navigating volatile markets and this is reflected in disappointing returns across most asset classes. The notable exceptions were illiquid investments which continued to perform well,” said Rebecca Gooch, director of research at Campden Wealth.

Alternative investments, such as private equity, hedge funds and real estate, already account for about 40 per cent of the average family office portfolio, a significantly higher share than among public pension funds.

Allocations to alternatives are set to increase further. A net 39 per cent of respondents said they anticipated a rise in direct private equity investments in 2020 and a net 28 per cent expected to increase their exposure via private equity funds. Real estate also remains an attractive proposition for family offices with a net 16 per cent aiming to raise direct property holdings in 2020.

“Family offices are looking to increase their allocations to real estate and private equity, particularly via direct investments which offer greater operational control. While family offices are concerned about the uncertainty in financial markets, they remain convinced that illiquid longer-term investments can deliver superior returns,” said Sara Ferrari, head of the global family office group at UBS.

The appeal of gold has also risen with a net 12 per cent expecting to increase their allocation to the precious metal next year.

Hedge funds, however, have continued to struggle to win new admirers among family offices. Allocations to hedge funds have been reduced for the past five years and no net new increase was anticipated in 2020 by the survey’s respondents.

“Family offices have doubts about hedge funds’ ability to protect wealth during economic downturns. They also dislike what some deem to be relatively high fees when compared to performance,” said Ms Ferrari.

At the same time, sustainable and impact investing strategies that attempt to deliver social or environmental benefits along with financial returns are expected to play a more significant role in family office portfolios.

Around a third of family offices already engage in sustainable investment strategies. These existing investors are expected to increase their average portfolio allocations from 19 per cent to 32 per cent over the next five years.

It’s Time for Massive Government Spending to Avert a Coming Economic Crisis

By Avi Tiomkin

The global economy is contracting, and deflationary trends are growing stronger. Left unchecked, they will lead to an economic, political, and social crisis, and the breakdown of frameworks carefully constructed over the past 100 years.

To forestall this looming crisis, policy makers must take steps that run counter to economic orthodoxy and prevailing practices. The required course of action involves massive government spending and higher interest rates. A failure to act could have disastrous consequences, leading to social mayhem.

The primary cause of the deflationary process of the past decade is expansionary monetary policy and ultralow (and negative) interest rates. In modern times, monetary policy has been the main instrument used to fight recessions, including the Great Recession that followed the financial crisis of 2008. Central banks lowered rates and infused capital into the markets, but this strategy has exhausted its usefulness and should no longer be applied.

Near-zero or negative interest rates, now popular throughout the developed world, not only fail to contribute to healthy economic activity but also are causing omnipresent damages. A global environment replete with energy surpluses and an almost unlimited workforce, complemented by expansionary monetary policy, increases supply, not demand, in the world.

Moreover, low rates lead to increased savings and reduce consumption, on which the economy depends. Demographics play a role here: The older the world population gets, the more it needs to expand savings as a substitute for diminished income generated by lower interest. Japan, with its aging population and negative rates, is a paramount example of this.

Today, negative interest rates exist throughout the developed world, with the exception of the U.S., although U.S. government bond rates are headed in that direction. While the U.S. economy continues to grow, further downward pressure on rates could cause a sharp decline in household consumption, as has happened elsewhere.

Savings and consumption habits don’t change overnight. The effect of zero or negative rates on consumer decision-making is likely to begin expressing itself in the next year or two, as bonds with long-term yields of 3%, on average, mature and are cashed in. At that point, zero-interest bonds could take their place in the savings cycle. When that happens, a decrease in spending and an increase in savings will inevitably occur.

More immediately, low and negative rates are harming banks, pension funds, and insurance companies, which can’t generate needed profits on invested capital. An index of European bank stocks has fallen almost 60% since early 2018, and stands below 2008-09 levels. Japan’s bank-stock index is down more than 40%, and U.S. banks trade at levels of almost two years ago, notwithstanding an estimated $100 billion of stock buybacks in the past two to three years.

If low rates are a bane to bankers and savers, they have been a boon to other corporations buying back stock and engaging in mergers and acquisitions. Since 2008, companies collectively have spent almost $25 trillion on buybacks and M&A. But companies have diverted and often exhausted their liquidity to buy in their own stock and do deals, skimping on research and development and business investment. Worse, many have borrowed heavily to fund these activities, which tend to destroy more value than they create.

In the case of buybacks and M&A, low interest rates have distorted economic considerations and turned Excel spreadsheets upside down. The distortion is based on the premise that the world economy is still expanding and that inflation persists, albeit at low levels. Not only is this premise wrong, but so are the explanations used by CEOs and boards to justify the policies.

The European economy offers the best example of how accommodative monetary policy and deflationary trends converge in a dangerous way. Following several years and nearly four trillion euros ($4.4 trillion) of monetary expansion, and negative interest rates, Europe now finds itself on the verge of a recession and a potential political crisis.

Persistent deflation, economic weakness, and inequality fomented by a low-rate regime invariably lead to political and social extremism. To stem and reverse these trends, governments, led by the U.S., the European Union, and the United Kingdom, must increase spending aggressively in the next few years to spur growth, directing outlays to infrastructure and public services, defense, domestic security, and more. Old and supposedly sacrosanct budget-deficit ratios—limiting budget deficits to 3% of gross domestic product, for instance—must be ignored. They are archaic and detrimental in light of today’s reality.

Practically, this means monetizing government debt, or flooding the market with government bonds that central banks will buy. By definition, excess supply of bonds should push long-term interest rates higher. Simultaneously, central banks should provide the commercial banking system with direct credit, which will be funneled to households

Governments also should place regulatory limits on stock buybacks and mergers, or impose taxes to deter such antigrowth activities.

It is important to recognize an inconvenient truth: The 2008 crisis never ended, and its impact hasn’t abated. Whether we like it or not, governments and central banks are the de facto solution. Without taking the necessary, if unorthodox, steps described here, economic, social, and political collapse are a near certainty, likely to manifest in the not-too-distant future.

Avi Tiomkin is an adviser to hedge funds. He previously managed money for several large hedge funds and specializes in global macroeconomic analysis.

The Hunt for Yield Could Still Get Fiercer

Falling interest rates have pushed money into corporate bonds, but there may be further gains to be had

By Jon Sindreu

The hunt for yield is back with a vengeance and corporate bonds look to be among the biggest winners.

Investment-grade credit has returned 13% this year, according to the ICE Bank of America Merrill Lynch index, putting it on course for its best performance since 2009—itself a 14-year record. Last week, agricultural manufacturer John Deere sold 30-year bonds at an initial yield of 2.877%, a record low for the U.S. corporate market.

Economic worries are mounting, with manufacturers around the world buckling under a slowdown in Chinese imports. But for financial markets this has been offset by the pre-emptive actions of Western central banks, which are slashing interest rates again. As a result, 10-year yields on Treasurys and German bunds have dropped by more than a percentage point over the past year and now trade at 1.6% and minus 0.6% respectively.

Corporate-bond yields have followed, falling so far that some investors fear for the sustainability of the rally. In a yield-starved world, though, demand for these bonds—particularly the higher-quality ones—may not have run its course.

In Europe, which is particularly vulnerable to the slowdown, investors returned from summer vacation hungry for more. Investment-grade credit issuance totaled €23.5 billion ($25.9 billion) in the last week of August, data by JPMorgan Chaseshows—the heaviest week in 18 months. Large companies were able to sell bonds at negative rates, including industrial conglomerate Siemens ,which is facing a likely recession in its home market of Germany.

John Deere sold 30-year bonds at a record low for the U.S. corporate market. Photo: rick wilking/Reuters

Indeed, the premium that new issuers usually pay relative to bonds that are already trading has practically been erased in 2019. At the end of 2018, when fixed-income investors panicked and started dumping corporate debt, it came close to 0.25 percentage points.

Once the impact of lower rates is stripped out, though, the corporate-bond market is still pricing in concerns about the economy. This could present an opportunity for investors.

The risk premium at which U.S. investment-grade corporate bonds trade in secondary markets has actually been rising, and is now close to its turn-of-the-year peak, which itself was the widest since 2016. In Europe, this measure has stabilized at higher levels than has been the norm in recent years.

This is likely a sign that there are still some gains left for these markets as investors keep reaching for returns amid ultralow sovereign debt yields. In particular, the safest corporate bonds—those graded AAA or AA by credit-ratings firms—have underperformed their riskier peers in 2019, even though they are likely to be the first that are bought instead of Treasurys.

The bonds of Southern European governments are also the easiest alternatives to German debt.

Of course, spreads on corporate bonds will appear small if there is an outright recession in the U.S. and Europe, which would likely hit the creditworthiness of companies. However, debt levels remain below previous peaks and central bankers seem eager to keep unleashing monetary stimulus.

Will investors be more motivated by economic concerns, or rather by their need for income?

For the next few months, at least, the odds seem better on the latter.