By Matein Khalid
Citi has been a rollercoaster in the past year, plunging to 48 in last winter’s risk aversion spasm after having soared to 72 after CLSA bank analyst, Mike Mayo, predicted a double bagger potential for America’s scrappiest, most globalized money center bank that survived a catastrophic $50 billion loss, near-collapse and an Uncle Sam TARP bailout in November 2008. Citi shares had been under pressure even before Trump’s Mexican threats due to weak Chinese PMI data, the failure of Washington and Beijing to forge a credible trade pact, panic selling in emerging market currencies (Citi derives 45% of its global revenues from emerging markets) and an inverted US Treasury bond yield curve that hits bank net interest rate margins.
Citigroup trades at a slight discount to tangible book value at 61, far below the valuation metrics of J.P. Morgan or even Bank of America. I can well envisage the bank’s shares trade down to 56 – 58 if the Volatility Index rises to 25 and global equities continue to be slammed by negative political, economic and earnings data flow. However, as Citi falls, it becomes more attractive to me for three fundamental, game changing reasons.
One, Citigroup is unquestionably the biggest capital return story in the history of international banking. Wall Street bank analysts and senior management estimate a $50 billion windfall for investors as excess capital is returned to shareholders via a share repurchase program and dividends. Citi’s EPS will surge to $9 a share in two years as its share count shrinks and the bank’s profit growth engines deliver a 13.5% return on tangible equity, management’s strategic profitability target.
Two, Citigroup CEO Michael Corbat, a former Salomon Brothers bond trader who dismembered the epic Citi Holdings post 2008 “bad bank” empire, has held the top job since a boardroom palace coup ousted Vikram Pandit and John Havens. Despite failed Fed stress tests, complex management reshuffles and a fraud/scandal at Banamex, Corbat has earned the respect of Wall Street even if it is not reflected in Citi’s valuation metrics. Yet unlike human beings, financial markets discount the future, not remain obsessed by a traumatic recent past – like Chuck Prince’s horrific foray into ballroom dancing in toxic derivatives/subprime debt in 2008.
Three, Citigroup management targets a 13.5% return on tangible common equity by 2020. This target is entirely achievable as it is not dependent on a steeper US Treasury yield curve or another debt/equity capital markets underwriting new issue surge. Citigroup has also exited smaller, high risk consumer banking markets (eg. Turkey, Pakistan, Oman, Uruguay) and achieved its efficiency/cost control targets. Unlike Bank of America, Citi earnings are not historically highly correlated with shifts and fluctuations in the US dollar debt yield curve. While Mexican tariffs will hit Banamex’s 7% annual revenue growth, Citi’s vast Asian banking franchise benefits from the shift of Fortune 500 supply chains to Southeast Asia, Taiwan and South Korea. At a time when Europe’s banks are mired in the twilight zone of deflation and Chinese banks are under threat from the Trump White House’s sanctions/tariffs/tweets, Citigroup remains the ultimate safe haven bank for the world’s leading corporations, governments, pension/sovereign wealth funds. This bank literally operates the plumbing and custodian infrastructure of international finance.
Citigroup is also the natural counterparty for the Pacific Basin/GCC’s financial cognoscenti at a time when systemic bank risk is no longer a hypothetical issue. I believe it is premature to abandon the investment thesis/valuation rerating potential of Citigroup. In the Panglossian best of all possible worlds, I expect Citigroup shares to trade in a 56 – 78 range – and will design option strategies on the CBOE to optimize profits within my preferred trading range.
Making money in the US Treasury bond yield curve panic
The 100 basis point plunge in the ten year US Treasury note, 2.14% as I write, since last October is downright scary. Of course, Trump’s latest Mexican tariff salvo is the catalyst for the latest “safe haven” bid in Uncle Sam debt, the fact remains that weak global economic data, muted inflation pressures, a trade war with China and free falls in crude oil/emerging markets currencies have all contributed to the inverted US Treasury bond yield curve – and a shocking minus 20 basis point yield in the ten year German Bund, the latest reason to short Deutsche Bank. The bloodbath in global equities markets in May and the spike in the Chicago Volatility Index (VIX) to 19 all mean the macro trade de jour is to buy the long T-bond futures contract on the CBOT futures pits in Chicago’s La Salle Street. The two year T-note yield has plummeted to 1.90%, 35 basis points down in May, the most since November 2008. This is raw panic, the bond market crying out for Mommy Jay Powell!
The message from the Treasury bond market is crystal clear. A protracted trade war with China and now Mexico alarmingly raises the risks of a global recession. This message places the Powell Fed in an acute policy dilemma. A verbal monetary policy U-turn, as witnessed in the December and January FOMC conclaves, is no longer enough. Chairman Powell now faces an embryonic global financial panic in risk assets that can only be averted with an emergency 50 basis point rate cut this summer. This is now the consensus view implied by the Fed Funds/Eurodollar futures contracts in the Chicago Merc.
It is ironic that the US economic supertanker has not hit any macro iceberg despite the deflation SOS implied by the plunge in global bond yields. GDP growth in Q1 2019 was a stellar 3.1%. Consumer confidence, house prices and the labour market are all white hot. US money center banks, recapitalized, derisked and stress tested galore, are the safest, best managed, most profitable financial institutions on earth. Are the yield curve Cassandras predicting a US recession that will not happen? In my view, absolutely yes.
The impact of the US Treasury bond yield curve as an advance indicator of real economic performance has declined dramatically since Reagan’s second term in the late 1980’s. This was the era of Black Monday, the success of Chairman Volcker’s epic anti-inflation crusade, the savings and loan crisis, the LBO/high yield bond/Drexel Burnham debacle and the first Fed/Saudi bailout of Citigroup in 1991. Once the financial markets were convinced that the Volcker – Greenspan Fed had successfully executed inflation targeting, every uptick in the Fed Funds rate to combat inflation data noise could be dismissed as transient. Long term bond yields could then continue to decline. An inverted yield curve did not necessarily mean recession, even though it preceded the recessions of 2001 and 2008-9.
However, all the academic models I imbibed on the term structure of interest rates at Wharton became obsolete after the Bernanke Fed began its $3.5 trillion quantitative easing program in the depths of the global financial crisis. As the central banks of creditor nations like China, Japan, Taiwan, Saudi Arabia, Switzerland and UAE scramble to buy a scarce pool (and flow) of long duration US Treasury bonds, it became impossible to predict economic cycles via the term structure of interest rates alone. Sad but true.
Lord Rothschild said the best time to buy was when “blood ran in the streets”, as it does now in any segment of Wall Street correlated to bond yields or the US Treasury bond yield curve. Money center banks have been slammed by the flattening of the yield curve all summer. J.P. Morgan is now 105, Citigroup is 61 (though Banamex revenue growth will take a hit if Trump puts the mantequillas on the Texas/Arizona border out of business with his tariff magic wands). True, a full-blown risk spasm (Volatility Index at 35) means Citi could fall to 54 – 56 and the House of Morgan to 94 – 96 yet I can now project a risk-reward calculus I seek in the option market. Leveraged, closed end mortgage bond funds now offer fabulous dividend yields at dirt cheap prices and lovely net asset value (Yo mortgage REIT’s!) discounts.
There is no doubt in my mind that I can design 9 – 12% US dollar yield ideas that will get a high-octane price boost when the Powell Fed finally cuts rates. So, please Chairman Powell, do not soil your legacy by being a central banking Nero who fiddles while Rome (the hyper-volatile, networked, daisy chains of world finance) burnt. So Tweeter-in-Chief did not take you to have lunch with the queen at Buck House and bullied you rotten. Yet he has check-mated you with his Mexico tweet. So do the right thing. A 50 basis point cut in the Fed Funds rate at the July FOMC. Do it. Do it now!
Also published on Medium.