|By Matein Khalid| I had projected a bloodbath in the US Treasury bond market since late 2016, when it was obvious that Trump’s tax reform would double the US budget deficit at the same time as the Federal Reserve prepared to “normalize” or shrink its balance sheet by $470 billion. Fiscal stimulus is often a policy ballast amid a depression, as in the early 1980’s or 2009, not when US economic growth is accelerating and the unemployment rate is at its lowest in 25 years. The bloodbath in the bond market has now begun, as the yield on the US ten year Treasury note risen above 2.65% last week. Yields on Uncle Sam’s 5 and 10 year debt have violated post Desert Storm downtrend lines on the charts. Debt trading maestro Bill Gross views a 2.60% yield on the ten year US Treasury note as marking the start of a new bond bear market. This began last week and will change the world, as Lehman’s failure did that fateful September in 2008.
The world is in the first synchronized global economic recovery since the 2008 global financial crisis. Wage inflation has begun to creep higher, despite the deflationary thrust of technology and global supply chains. The Fed, Bank of England and even the ECB will replace printing money with quantitative tightening. Dr. Copper, a barometer of industrial cyclical demand, rose 32%. The US baby boom generation, the biggest in history, has begun its peak retirement years. The US Treasury bond yield curve is the flattish in a decade. Inflation will resurrect the bond vigilantes as the regime change in the Federal Reserve in March increases global angst on long dated debt. It is entirely possible that rising inflation forces four or even five Fed interest rate hikes in 2018.
I expect the Fed Funds rate to be 2.5% in the next twelve months. This is the overnight interbank borrowing rate targeted by the US central bank’s Federal Open Markets Committee. The Fed has a dual mandate to optimize jobs consistent with 2% inflation (price stability). The Fed has reached the limits of its dual mandate as the US economic supertanker creates 200,000 new jobs each month while services inflation in the CPI index is 3% (though goods is flat). This means the yield on the ten year US Treasury note will rise to 3.2% and lead to a spike in mortgage debt rates across the planet. As post (not revenue neutral!) tax reform US economic growth rises above 3%, demand for US Treasuries will fall even as the US budget deficit rises and stimulates more borrowing by Uncle Sam. Chinese, Japanese and Gulf petrodollar recycling demand for US Treasury bonds has now peaked. This means the world is on the eve of a major, secular rise in interest rates. This time the wolf is really here.
I am horrified by the surge in the London Interbank Offered Rate (LIBOR), the benchmark for literally trillions in floating rate corporate, sovereign, credit card and mortgage debt, since the last FOMC rate hike in December 2017. LIBOR is the rate at which the world’s leading banks lend to each other in the global interbank money markets. Note that the three month LIBOR rate was 0.5% in early 2016. It has now spiked to 1.6% as the Planet Forex realizes Fed monetary tightening is for real. The three month EIBOR rate has surged to 1.82% as I write. This is bad news for owners of mortgages, sukuks and corporate bonds in the UAE. Since almost all mortgages in the UAE are floating rate, homeowners should expect their monthly payments to spike higher in the next twelve months. Expect heavily leveraged corporates to face financing risks.
US tax reforms, Fed rate hikes and the upticks in global growth and inflation will only accelerate the rate of increase in LIBOR and credit spreads on $50 trillion in floating rate debt. The cost of capital for every homeowner, corporate borrower and government in the world has spiked higher since last autumn and is destined rise higher.
My call? A disaster in the US junk bond market is inevitable as stressed industries have more than a trillion dollars in speculative debt outstanding. Note retail (Amazon’s killer economics!) and hospital chain bankruptcies are at a higher rate than in 2008. Regulatory costs are killing specialty pharma. The surge in West Texas crude will not save offshore drillers and clean energy. Get real. Get short.
Macro Ideas – Brazil’s Bovespa fairy tale could well end in tears!
“Brazil is a country of the future and always will be”. General Charles de Gaulle so dissed Latin America’s largest economy, a vicious military dictatorship in his lifetime. The Rio and Sau Paulo I knew is the early 1990’s were mired in hyperinflation, banking crises and upper class social decadence – then President Collor was impeached, among other things, for his fondness for cocaine. The decade of Lula and Workers Party rule spawned an epic commodities driven boom, averted a sovereign debt default, consolidated the Real Plan (drafted by my Wharton finance prof Arminio Fraga, governor of the Brasilia central bank) and promised pension reform. Yet Lula’s sordid legacy was the Lavo Jato corruption scandal, Brazil’s worst recession in a hundred years and the resignation of his handpicked successor Dilma Rousseff. Now Brazil faces an election in October that could well seal its political and economic fate.
Brazil’s Bovespa stock market index was a license to make money in 2017, thanks to the 11% fall in King Dollar (the Brazil Real is the high beta anti green back), the frenzied inflows into emerging markets, the surge in commodities and the fall in Volatility Index (VIX). I have learnt the hard way that when things get too good to be true, the wicked witch of Wall Street casts her malign spell and, well, things fall apart, the center does not hold, mere anarchy is loosened upon the world (Forgive me, W.B. Yeats!). So will the Bovespa rise to 100,000 in 2018, as the bulls in the emerging market carnival insist or plunge to 62,000 as I fear, given my crystal ball gazing on the ten year US Treasury bond note, the Brazil Real exchange rate, sovereign debt risk premia, volatility curves and the Selic rate are remotely correct. After all, the Bovespa traded just above 60,000 a year ago.
I do not expect a bear market in Brazil, only a correction that is a classic “buy on dips” moment. After all, Brazil has emerged from its most brutal recession since the 1930’s. Corporate earnings could well rise 20%. Inflation plunged from 6 to 3% in 2017. Interest rates are at a record low of 7%. Petrobras is on a roll due to its US legal settlements and Brent crude’s spectacular rise from $45 to 68. The Rio Carnival, Copacabana Beach, samba, Gisele and Roberto Carlos make Brazil the hottest emerging market culture I ever encountered in my life – and a lodestar of El Torro in 2017.
However, there are Sophoclean signs of hubris in Bovespa 80,000. One, President Temer has failed to implement pension reform and could well lose in October. Two, Congress is polarized and fiscal black holes could well gut the Bovespa bulls. Three, Congress may well not approve social security reform. Four, the external debt and sovereign risk, as always, is the Achilles heel of Brazil. Five, Lula’s criminal conviction remains a political wound. If the Federal Appeals Court overturns his conviction, the populist Lulu could well become the next President of Brazil.
My biggest fear is that US wage inflation ignites a bloodbath in the US Treasury bond market and the yield on Uncle Sam’s ten year note could well spike to 3.2%. This mean the ten year Brazil dollar bond could well rise from 4.5% to as high as 6% given the scale of leverage embedded in the debt market.
I am a nervous bull on Brazil as its exchange traded fund (EWZ) trades at 44.50 in New York. So how does the carnival on the Sao Paulo Borse end? Lula gets a reprieve from his criminal conviction and the bulls go ballistic on the prospect of a Lulu II reign. A rise in the US dollar means the Brazil Real depreciates to 3.50. Foreign funds yank capital from Brazil equities as the yield on Uncle Sam debt spikes amid the Powell Fed’s monetary tightening. The bloodbath in the Wall Street debt markets triggers an emerging market contagion panic at the speed of light. I survived (barely!) Mexico 1994, Thailand 1997, Indonesia 1998, Turkey 1999, Argentina 2001, the Milky Way 2008. I know how these emerging market fairy tales bewitch the bulls and then kill them.
Political risks in 2018 include Trump/NAFTA, elections in Mexico and Colombia. Brazilian equities are now expensive at 13.7 times earnings, above their historical 11.6X level. Yet higher oil prices makes Petrobras a no brainer, as is Vale in mining, Gerdau in steel and Itau Unibanco in banking – at least for now!
Stock Pick – The thrills and risks of the Spotify IPO in New York
Not since the Beatles and the Rolling Stones swept America in the Swinging Sixties, has a Britain reinvented the world music scene as will happen when the Spotify IPO trades on the New York Stock Exchange. The Wall Street grapevine is that Spotify will be valued at $20 billion in the stock market. My teenage twins introduced me to the virtues of a Spotify music streaming subscription and a brilliant investor friend of mine in Bur Dubai textile market earned four times his money as the streaming music service hit 100 million subscribers worldwide. Welcome to the exponential mathematics growth curves of the Digital Age!
The Spotify IPO will not be a traditional book building effort led by an investment banking syndicate. It will be a direct listing on the NYSE. In essence, Spotify shareholders will sell shares directly to the public, not raise new capital from Wall Street’s institutional investors. Spotify is a global brand already so it does not need to IPO its shares on the Big Board as a branding exercise. This listing is just designed to provide liquidity to existing shareholders. This means that Spotify shares will be hyper-volatile after the IPO, with no underwriting syndicate to stabilize the aftermarket.
The Spotify IPO will have no roadshow, no 5% underwriting fees, no self-serving “cornerstone investors”, no conflict of interest riddled syndicate pots, insider sweetheart deals, no company mandated lock up periods. Since the Spotify IPO will be sold to retail investors in March, expect Bitcoin like “irrational exuberance” since the brand is now a global household name. Of course, the shares could also tank 50% or more if sentiment on the business sours. After all, Spotify’s competitors include global corporate colossi like Amazon/Apple as well as potentially the next Silicon Valley music startup. Spotify also faces legal risks from musicians displeased with its revenue sharing deals, as the current lawsuits by the agents of Tom Petty and The Doors (riders in the storm!) attests. Tidal, founded by Jay-Z, is also a potential rival since it is owned by musicians who will release their streamed content exclusively on its platform. My take? I would rather own musical copyright rights and earn royalties than pay royalties for content and sell subscriptions. Hence my fondness for Sony and Vivendi. Music streaming will exhibit cutthroat economics even if Spotify has won the Gorilla Game in this niche.
The private market values the Spotify “unicorn” at $16 billion. As Uber’s recent Softbank led financing round proved, it is entirely possible for a unicorn’s value to be slashed from prior peaks in the private market. Yet I doubt if this will happen to Spotify unless the entire tech share market tanks before March. Could the Spotify IPO turn into a debacle like the Facebook IPO in 2012? I doubt it but the risk exists if a deluge of early stage investors, founders and company employees sell shares. I would have preferred a stock market value nearer $12 billion or four times 2016 sales from 150 million odd active users. Yet there is no doubt that Spotify is the Big Enchilada, Numero Uno in music streaming and a 40% discount to a $20 billion post flotation value will only emerge when the Valley grizzlies finally emerge from hibernation, as they surely will.
Spotify has managed a twelve fold rise in its paying user base and is the dominant global brand in streaming music. It has the potential to continue 50% revenue hypergrowth and even turn profitable in the next two years, though it lost $600 million in 2016. Yet while the potential of music streaming is global, so are the ambitions of its archrivals Amazon Music and Apple Music. Spotify’s business model is also hostage to both artiste avarice and licensing negotiations with the world’s preeminent music labels. I do not expect the Spotify IPO to be a sad sack loser like Snap or even Twitter but the possibility of a 30 – 40% post floatation hit can never be ruled out. After all, hyper-growth startups must also demonstrate viable profitability and margins (unless they are Jeff Bezos!). Spotify can be hit by high royalty costs, a price war with Amazon/Apple Music and content wars with Jay-Z or even other startup rivals like the French Deezer. Caveat emptor!
Also published on Medium.