Trend Changes

I revisited an interview with Harris Kupperman on Real Vision from November.  His comments on interest rates were not news (if you have been paying attention), but his delivery did a good job of succinctly clarifying the risk:

“I think the number one big-picture view right now is interest rates. If you look around the world, every currency, every yield curve, every duration component, they're all breaking out. There's a 30-year chart in the US it just broke out of. You look at shorter term charts, there are basically inverse head and shoulders everywhere. It's all breaking out.

And when you have so many different breakouts at the same time, it's probably a trend change. Interest rates go in generational cycles, 30-year cycles, and we just ended a 30-year cycle. No one in the markets right now, or almost no one, has invested during a time when rates go up. They've only seen rates go down.

I think you're going to see a huge change in what's happening in the markets. When rates go up, the value of everything else, every asset goes down because it's all value on cash flows. At the same time, cash flows go down because interest rate coverage goes up.

And I think you to see a loss situation where companies today look conservatively leveraged at 100 and 200 basis points more interest rate will actually lead to them being highly leveraged from a cash flow coverage side, that buybacks and dividends are going to end. Debt pay down is going to begin. And I think you will see a lot situations today where you have reasonably good businesses, where two, three years from now, what's to be left is an equity sliver on the enterprise value and a huge debt component…

I think it's a lot like the '70s when rates go up and values keep going down. And increasingly cash flow goes to interest service. And you're coming at this from such low interest rates that you don't need interest rates to go to 10%, 15%. To move from 0 to 300 BPS right now is an extreme. But you have interest rate floors in place, so you haven't really seen it companies.

The move from 300 to 500 BPS, that's going to go to stretch a lot of companies. And you don't really need the rates to go up that much. And yes, I think it's going to be a dramatic repricing because right now, equities price in the future, so equities are pricing in future earnings growth often funded by buybacks. And suddenly they're going to be pricing in earnings declines as everything goes to interest coverage. And when that repricing happens, it's going to be very dramatic.”

Red Flags

The subtitle is Why Xi’s China is in Jeopardy and the author is George Magnus (2018).

In the broad landscape of literature where analysts and economists opine in hyperbolic extremes about the future of China, Magnus tries to offer a balanced (tilting pessimistic) view of the country’s path forward.  And in erring to the negatives, his focus is primarily on the state-driven nature of the economy, which has led to feckless credit creation and rising credit intensity, weak institutions, and a risk-averse nature when it comes to truly disruptive experimentation that can trigger failure.

In looking at the meteoric economic rise of China over the past twenty or thirty years, Magnus points out that much of that growth stemmed from events that can only be booked once: joining the WTO, moving people from low-productivity rural life to high-productivity urban manufacturing, the massive real estate boom, the wave of globalization in the 1990s and 2000s, and enrolling all children in secondary schools.  All of those events are highly transformative, but not repeatable.

In addition, Magnus notes that much of that exponential advancement came under the relatively progressive and reformist leadership of Deng Xiaoping.  By contrast, the current leader, Xi Jinping, has shown a more autocratic and dictatorial tendency which hearkens back to Mao, where rules and processes become far less predictable.  Contributing to that, because it seemed that China was performing relatively well while the West struggled through the 2008 financial crisis, the continuing emphasis on reform was substituted with a misguided belief in the power and superiority of the Communist Party.  Thus, with more decisions and edicts made from up high, the underlying features which helped China to grow have become stifled.  None of which is promising as it tries to navigate its debt trap and still increase productivity.  And p.s., add to all of that, China is ageing more rapidly than any other large economy.

Still, in going through these realities, Magnus admits that the final story has not yet been written.  But, if we are honest, if China does manage to thread the needle and deal with these myriad issues in a way that avoids significant pain, their case study would be the first of its kind.  To be continued.

The Dollar

Another great interview on Real Vision with Luke Gromen.  He covered a lot, but I thought his summary below of Bretton Woods and how other countries are turning their backs on it, and the implications, is very useful.  Not for nothing, but part of the reason to prefer a Trump over Clinton was because of the belief that Clinton was prone to follow path one:

“…look, the deal was-- to be flip, the deal was, you take our jobs. You take our factories. You take our dollars. And then you lend us back the dollars, and we'll buy the stuff from you. And in third quarter '14, with the rollover in FX reserves, the world's saying, we're not taking the dollars anymore. And so I think what's ultimately happening is there's two paths for the US to go with that. Path one is, we'll invade your country and make you take the dollars. And path two is, fine. Deal's off. We'll bring the factories back. We'll bring the jobs back. If you don't want the dollars, you don't get to keep the factories. It's your choice.”

Sign Posts

Courtesy of Geopolitical Futures:

"According to the German Shipowners’ Association, German banks and investors own about 29 percent of the world’s container ship capacity. German lenders have been the biggest issuers of shipping loans. Based on Petrofin Global Bank Research statistics, German banks own one-fourth of all outstanding shipping loans made by large banks (about $90 billion). That makes them vulnerable to the shipping malaise."