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It doesn’t get any better than this, according to a classic beer commercial of some years ago. The fly fishermen in the ad hooked a nice trout and cooked it over a campfire as the sun set in the background. In such an idyllic setting, the fishing buddies evidently overlooked the cheap suds being pitched.
If anything, the stock market is being extraordinarily critical of what it’s being served, notably earnings that are exceeding already high expectations. Take Caterpillar (ticker: CAT), which initially rallied Tuesday after reporting better-than-expected results. But on the post-earnings conference call, its chief financial officer called the first quarter the farm- and construction-equipment maker’s “high-water mark for the year.”
So, if it doesn’t get any better than that, the stock market’s response isn’t to savor the moment, but to sell it. CAT ended up losing 6.2% in reaction to that comment, leading a massive retreat in industrial and material names that helped the Dow industrials shed over 400 points in the trading session.
That isn’t an entirely irrational response, given data that show growth is slowing, while inflation is picking up. To those late-cycle symptoms add rising rates, both the ones administered by the Federal Reserve and those set by the bond market. On the latter score, the benchmark Treasury 10-year note briefly peaked just over 3%, a psychologically significant but otherwise not terribly meaningful number.
Arguably far more significant is that investors and savers can get 2% on six-month Treasury bills and almost 2.5% on a two-year note. (See our cash-comeback story.) Two years ago, dividend stocks provided investors a one-percentage point advantage over risk-free rates, says Danielle DiMartino Booth in her Money Strong missive. Now those places have been swapped. Adds David Rosenberg, chief economist and strategist for Gluskin Sheff, this ability to get a “safe yield” for the first time in a decade, with no risk from falling stock or bond prices, represents a “seminal shift and a huge source of competition for the dividend allure of the stock market.”
The prospect of higher rates may cheer savers, but poses greater risk to an economy never more dependent on debt, DiMartino Booth says. But that’s the direction the Fed is headed, given the rise in inflation and signs of slowing growth, an unpleasant combination that suggests stagflation; if not 1970s-style double-digit inflation and unemployment, then an economy expanding more slowly than prices are rising.
The Federal Open Market Committee faces that conundrum at its confab on Tuesday and Wednesday. That was underlined by economic numbers released on Friday. Gross national product grew in the first quarter at a 2.3% annual rate after inflation, according to the Commerce Department’s initial estimate. While a bit better than projections, it marked a deceleration of the pace of the preceding three quarters, which averaged around 3%.
More particularly, growth in real final sales, which strip out inventory changes, slowed in the latest quarter, to a 1.9% annual clip from 3.4% in 2017’s fourth quarter. Domestic final sales, which also exclude trade effects, decelerated to 1.6% in the latest quarter from 4.6% in the preceding period. A downshift in consumer spending, especially on autos, was partly responsible for the slowing, which likely represented some payback following the fourth-quarter surge in spending following last year’s severe hurricanes.
On the inflation side, the Fed’s favorite measure, the personal consumption deflator, excluding food and energy, rose at a 2.5% annual rate in the first quarter, up from 1.9% and 1.3%, respectively, in the prior two. Year over year, the core PCE deflator was up 1.7%, closer to the Fed’s 2% target. That will probably necessitate a rewrite of the FOMC statement on inflation, according to Michael Feroli, chief U.S. economist at JPMorgan, to note that inflation effectively has reached the panel’s goal.
No rate increase is likely this week, given the FOMC’s practice of making changes only at meetings at which a press conference is scheduled. Nevertheless, the federal- funds futures market puts a 34% probability of a hike in the Fed’s key rate target, from the current range of 1.5%-1.75%, according to Bloomberg.
The more likely timing for the next increase is the June 12-13 meeting, with a 93% probability for a range of at least 1.75%-2%. The futures market puts a 76% chance for the next hike at the Sept. 25-26 meeting, to 2%-2.25% or higher. As for the odds of a further increase at the Dec. 18-19 confab, the futures market says it’s a coin flip at this point.
A lot could happen by then. The effect of the fiscal stimulus, not yet evident in the first-quarter numbers, could boost growth or inflation, or both. That, in turn, could spur the Fed to lean more hawkish, further raising those risk-free rates that already are competitive with dividend yields. And that in turn could leave the stock market’s brew a bit flat.
The junk-bond market has come full circle. In the prehistoric era —that is, before the rise of Michael Milken and Drexel Burnham Lambert in the 1980s—high-yield bonds came by that status by dropping in price as a result of the issuer’s circumstances. The attraction of these so-called fallen angels was that they could provide both a high current yield and, if all went well, the prospect of capital gains from a recovery of their deeply discounted prices toward par at maturity.
Today’s breed of below-investment- grade bonds is the mirror image of that. They are being offered by hot new companies to fuel their growth. And far from having fallen on hard times, the new junk-bond issuers sport extravagant valuations. They could readily fund their expansion with equity at attractive terms, either via shares sold in the public market or from the overflowing coffers of private equity.
The latest example is WeWork, a provider of shared office space for entrepreneurs, which sold $702 million of seven-year notes at a yield of 7.875%. The offering was upsized from $500 million, to meet investor demand, despite the company’s growing losses and uniquely creative accounting.
As The Wall Street Journal reported, while revenue doubled last year, to $866 million, WeWork’s losses also doubled, to $933 million. But WeWork “earned” $233 million, based on a metric the company dubbed “community adjusted Ebitda.” That consists of earnings before interest, taxes, depreciation, and amortization—a widely used measure of operating cash flow—but also excludes basic operating expenses, such as marketing, general and administrative, development, and design costs. That’s not in any accounting textbook I’m aware of.
Equally puzzling is that WeWork is resorting to such creative accounting to do a debt deal, when it has an estimated $20 billion equity valuation after a recent funding by SoftBank Group (ticker: 9984.Japan) to the tune of $4.4 billion. That figures to a putative valuation over 85 times the fanciful community adjusted Ebitda metric. But it can’t be assumed that another round of private-equity funding would fetch that valuation.
The WeWork deal came after Netflix (NFLX) tapped the junk-bond market earlier in the week for $1.9 billion of 10½-year notes yielding just 5.875%. As noted on Barron’s.com, the video-streaming company also opted to borrow, rather than utilize its richly valued shares to fund its huge investment in content. The shareholders will reap the gains if those investments pay off—while the bond investors merely get back their money, with a relatively ordinary interest yield.
Still, the question of why these highly valued growth companies are taking on debt instead of issuing equity is a good one, says Martin Fridson, the veteran high-yield analyst who has followed the market since the early years. For one, debt doesn’t provide any tax benefit, given that companies such as Netflix or WeWork have little if any earnings against which to deduct interest expense, he writes in an email. Could it be that the existing shareholders might be resisting dilution from an equity financing? That’s plausible, Fridson says, especially if these investors expect still-higher valuations in the years ahead.
Back in the ebullient days of the 1990s, the era’s dot-com babies responded to the demonstrably irrational exuberance of investors by selling them stock before they burned out. Fridson adds that many of the TMT—technology, media, and telecommunications—companies of the time that issued high-yield debt opted for zero-coupon bonds. Such bonds have the added attraction of relieving issuers of paying out current cash flow to service the debt, a definite advantage for TMT companies that were burning cash at a prodigious rate.
“In both that case and the present one, it seems like the issuers are taking advantage of the underpricing of operating risk by the high-yield market,” he adds.
On that score, Stephanie Pomboy’s latest MacroMavens missive points out the spread between the yield demanded by the junk-bond market and the federal-funds target set by the Federal Reserve is four percentage points, the lowest since 2007, just before the financial crisis. The previous instance when the spread was that tight was, yes, in the 1998-99 dot-com era. In both of those previous episodes, however, the fed-funds rate was multiples of the current 1.5%-1.75% target band, so the absolute junk-bond yield was commensurately higher.
It would seem that the decision by highly valued growth companies to issue debt, instead of equity, says more about the state of the high-yield market than anything else. “Regardless of what corporate finance theory is involved, a company should take advantage of an opportunity to sell a security to an investor who’s paying too much,” Fridson concludes.
As for the WeWork bonds, by the end of the week, they had fallen in price from 100 to 97.50, according to one market pro—a sign of the market’s less favorable view of the credit and the wisdom of Fridson’s words.