On the back of buoyant M&A activity, stock market optimism continues, undeterred by the risk of America’s slowdown developing into a recession; instead buying into the soft landing scenario.
The growth of the private equity bubble
M&A activity burgeons, financed by mountainous debt, delivered with growing laxity. In spite of a series of risk warnings by such as Wilbur Ross, the well known specialist in leverage buy-outs, who said “The concept of risk-adjusted return has been replaced by risk-ignored return”. One of the latest deals, the largely debt-funded £11.1bn Alliance Boots bid by KKR is unsurprisingly a covenant-lite deal where many of the usual banking covenants have been waived. The deal makers are dictating the terms, not the finance providers. That same deal also includes “bridge equity”. The FT described this as a risky path to debt syndication. They said that although many banks do have principal finance arms which look for opportunities to invest equity in big takeovers, the size of the new bridges required in such deals is far greater than they would normally seek. They also say the bridges are provided on terms that do not begin to reflect the risks involved. If all goes well, the equity will be sold on in the market. If it goes badly, the banks will be left holding it and they say that their fees for doing this are inadequate – it’s a case of far too much money chasing deals!
The situation has developed to such an extent that Jeremy Grantham, in his recent quarterly letter (also reported in the Financial Times), was driven to say that the new global money flows had probably created the first truly global bubble, “almost everywhere, in almost everything”. In the years to come, he says this huge bubble may well be termed “the private equity bubble”.
The spread of lax lending practices that we have discussed in recent issues, was referred to by Larry Fink, CEO of BlackRock, who said to the Financial Times that lending to highly indebted companies was becoming lax in ways similar to those that have undermined the US sub-prime market making the leverage loan market tomorrow’s problem.
What about the property bubble?
For the time being, this loose credit driven boom will continue until it pops, in much the same way as the Spanish property market this week popped. It is calculated that last year 800,000 Spanish houses were built, far more than required. The Spanish property boom has now ended in panic. So far that panic is reflected in the share prices of the property businesses and, to some extent, banks. To give an example, Spain’s biggest property group Sacyr fell 8.15% whilst developer Astroc Mediterraneo has seen its share price fall in a week from €43 to €16 and even at that price is still at a forward price-to-earnings multiple of 20 times.
The housing market in the UK, on the surface, is still very buoyant; nonetheless it faces challenges. According to propertyfinder.com the number of first-time buyers a year ago was 33%, today it is only 22%. The buy-to-let market is still booming in spite of the fact that the math doesn’t really work. Rental yields do not compensate for mortgage interest and other ownership costs, leaving buyers relying entirely upon future capital growth. They don’t think it’s a problem but such situations make no sense whatsoever and rest assured, if such fundamental principles are ignored, then a heavy price is usually to be paid.
The stock market is less sanguine about UK housing. The stock price of the Paragon Group, who are buy-to-let mortgage specialists, is down 20% over twelve months and looks very vulnerable to the downside. The Kensington Group, specialists in sub-prime lending in the UK, has seen its stock price more than halve in twelve months.
We continue to review our four Financial Horsemen of the Apocalypse.
Update on the key market indicators
The white horse – false peace – The Volatility Index (VIX)
Investors have regained their appetite for risk. The Volatility Index is somewhat becalmed but in technical terms is still above 11.2, the level we referred to in the previous issue. From just reading the chart, the recent pullback looks no more than that, and to our eyes set for another move up. That will remain the case whilst 11.2 is untested.
The red horse – war and destruction – The Philadelphia House Market Index
Optimists are bottom fishing the housing stocks, the news however is not very good. Mortgage applications were down for the fifth successive week but worse than that; existing home sales in March were down 8.4% to 6.12 million – the steepest fall in 18 years and well below the 6.4 million which had been confidently expected. The inventory of unsold homes rose to 7.3 months’ supply; in February it was at 6.8 months’ supply. Overall across the USA, year-on-year sale prices have suffered their eighth consecutive monthly decline.
Reality is setting in, consumers who have happily used mortgage equity withdrawal to subsidise their spending are coming under pressure. MarineMax, America’s largest recreational boat dealer, has recently said that earnings would come in at 45 to 65 cents per share. Back in January they had estimated $1.40 to $1.50 per share and only five months ago were forecasting $2.05 to $2.15. We thank the Daily Reckoning for that bit of information. A great number of boats have, in the past, been bought using money extracted from houses, it’s not happening on such a large scale now.
The black horse – famine and unfair trade – Dow Theory
We have a positive signal, both the Transports and Industrials have made new highs, an indicator that the market feels pretty happy about things; however, two recent interesting bits of news that casts some doubt on that signal.
UPS sounded a warning on the sluggish US economy saying that it has caused a drop in earnings for the first three months of the year. UPS is considered to be a reliable economic bellwether for the American economy. If their business is quiet, goods are not being delivered. It was also reported in the Wall Street Journal that the stubborn slowdown is squeezing US freight transportation companies generally. Such news puts in question the reliability of the higher Transportation index.
The pale horse – sickness and death – The Inverted Yield Curve
In the US, 3-month money is at 5.25% whilst the 30-year yield is at 4.8%. In the UK the figures are 5.6% for 3-month money, 4.87% for 15-year yields. Such circumstances are not optimistic for future business conditions because inverted yields are predictive of recessions to come. Stock market lows usually occur before recessions are confirmed.
Portfolios still have some exposure to UK bear funds, we still expect these to pay off although we are watching current stock market action carefully.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/