The fundamental concerns surrounding the financial health of China-dependent companies across the globe are tangible, and the risk of a currency crisis and eventual credit crunch are real, if they aren’t already happening.
Fortescue Metals Group (FMG), the fourth-largest iron ore producer in the world, announced over the weekend, that profits were nearly completely wiped out (down nearly 90%) for the fiscal year ending June 30, even as the firm shipped 33% more tons of iron ore during the period over last year’s mark. The largest iron ore producers, BHP Billiton (BHP) and Rio Tinto (RIO), are only adding to production overcapacity, conditions that are wreaking havoc on the commodity price. Iron ore prices are to remain under pressure as long as the global glut of supply continues to outstrip waning demand. Balance sheets across the mining sector are particularly overleveraged, and such malign conditions of sustainably low iron-ore prices may cause default rates to soar. Credit spreads across the mining industry have already widened considerably.
Crude oil prices continue to tank, as the battle between OPEC and US independents rages on. At last check, West Texas Intermediate crude oil is trading just north of $39 per barrel, as crude oil inventories are the highest they’ve been for this time of year in over 80 years. OPEC is fighting tooth-and-nail for market share at the expense of the price of the black liquid, and the rig count continues to rise in the US. Baker Hughes (BHI) announced Friday that the number of active rigs in the US advanced to 674 as of August 21, a modest increase, but one that came under conditions of ever-lower prices of crude oil. Though the US oil rig count has dropped dramatically since the height in 2014, last week marked the fourth consecutive week of increases as producers, in our view, continue to deny the reality of sub-$40 per barrel crude oil. As with the mining space, credit spreads across the energy sector have “exploded,” and if the price of the black commodity continues to drop, we expect default rates to soar in this area as well.
With the Shanghai index completely wiping clean its 60% gain for 2015 and now trading in the red for the year, consumer spending in the country is likely to take a significant hit as investors undergo the equivalent of a negative wealth effect. The largest auto makers in the country are in for a substantial shift in demand, something Volkswagen (VLKAY), GM (GM), and Ford (F) have already acknowledged. China auto sales fell more than 7% in July, marking the fourth straight month of declines and the longest downturn in 5 years. With consumers reeling from the collapse in wealth, autos won’t be the only sector impacted either. The gaming markets–already hurting from anti-corruption initiatives–and the ultra-luxury markets will likely feel the most pain, but consumer electronic sales won’t be spared either. Smartphone sales dropped in China during the second quarter for the first time in history. Government interventionism is doing nothing to stem the vast declines, and a temporary closing of the Chinese markets may be the only answer to retain some semblance of order.
We maintain that the fallout from the collapse in Chinese equity markets is real and not sentiment-based, and in light of anecdotal evidence, the Chinese economy may actually be contracting–a far cry from expectations of ~7% growth. We anxiously await the reported GDP “growth” number for the country’s third quarter, however.
The tangible, fundamental reasons supporting a collapse in Chinese shares and the corresponding demand concerns across global multinationals are only partly responsible for the vast declines in global markets, however. The risks to forward earnings estimates for global multinationals are significantly heightened, of course, but it is also our contention that we are only starting to see the “popping” of the debt-inflated stock bubble caused by Fed actions that only delayed (not cancelled) the fall-out from the Financial Crisis in 2008-2009. Many fixed-income yields have been driven to insufficient lows after rounds and rounds of quantitative easing, and retirees and near-retirees were reluctantly lured back into the equity markets for income needs, with many chasing unsustainably high-yielding equities in hopes of generating an income stream large enough to support a standard of living that had been jeopardized as a result of the capital losses suffered during the credit crunch of late last decade.
Upstream exploration and production entities have been feeling the pain for some time, but their share-price drops have accelerated as of late. Investors are simply abandoning bellwethers Chevron (CVX) and ConocoPhillips (COP), despite their lofty dividend yields, as both continue to burn through free cash flow and as leverage on their balance sheets balloon. These two may be survivors over the long haul, but the value of their equity in an environment of sub-$40 per barrel oil is still substantially less than their current prices. Betting that an energy stock’s equity will survive over the long haul does not mean that its price has to increase from today’s levels. By our estimates, current equity prices in upstream oil and gas entities assume a rebound in crude oil prices to $70+ levels on a normalized, mid-cycle basis, something that may not be realistic in light of recent events. It has only been 17 years since crude oil prices were ~$12 per barrel, and average cash costs to bring a barrel to the surface are less than $14. OPEC is not yielding, and neither is US oilfield production.
Under the promise of ongoing and growing distribution payments, retirees and near-retirees have also been lured to the MLP-heavy energy arena. The MLP structure, which is heavily dependent on access to incremental new capital from the external capital markets, has come under attack as collapsing energy resource pricing has, in our view, put their business models at risk. Most MLPs are not self-sustaining entities–they do not generate traditional free cash flow (cash flow from operations less total capital spending) in excess of their distributions/dividends paid–and many are leveraged several times over, some as high as 6-7 times their annualized EBITDA. As commodity prices and equity prices continue to fall, the risk to MLP payouts has increased exponentially as the cost of equity-financing, and by extension, debt funding soar. We would not be surprised to see distributions of most energy MLPs tested in this environment.
Under the event that default rates across the upstream arena surge, midstream pipeline companies are not immune to contractual re-negotiations should customers file for Chapter 11 reorganization. The fall-out across the energy complex is likely to spare very few, and as distributions and dividends are cut, the not-so-virtuous cycle of ever-lower equity prices becomes an eventuality, as most midstream shares are tied to an artificial valuation paradigm surrounding their financially-engineered payouts. A few months ago, we warned of the collapse in Kinder Morgan’s (KMI) shares when shares were trading north of $40, and Plains All American (PAA) and Summit Midstream (SMLP) have already warned about the risks to their distribution growth in coming years. We expect an avalanche of other distribution and dividend warnings across the space in light of the current financial and commodity-price climate.
As the mining and energy sectors near implosion as commodity prices plunge, the currency markets are feeling the ramifications. The devaluation of the Chinese yuan has only been the latest event across the currency markets, as the dollar has been strengthening significantly against a broad basket of currencies since the middle of last year. Multinational corporations have been experiencing material currency headwinds for some time, but the recent fallout in China is now bringing comparisons to the currency crisis in the late 1990s, infamous for leading to the demise of hedge fund, Long Term Capital Management. Some currencies such as the Malaysian Ringgit have reached late-1990s crisis levels, the South African Rand just hit an all-time low against the US dollar, and other African currencies are reeling as well. Even if the Fed decides not to hike interest rates this year, a flight to the strengthening US dollar has become ever-more attractive in light of the current global malaise. The 10-year Treasury yield is now below 2% after rallying significantly since April in anticipation of a rate hike.
What remains to be seen, from our perspective, is whether the collapse in the mining and energy sectors and the crisis in emerging-market currencies will eventually lead to yet another credit crisis, similar to the one that shocked the world in 2008-2009 and brought some well-known names to their knees across the financial sector (XLF). Though we’d like to rule out such a scenario, we can’t. The Fed’s stress-tests have offered investors greater transparency into the impact a global calamity may have on bank balance sheets, but even if we do not witness the demise of another “Lehman,” it doesn’t mean that equity returns are going to be strong in coming years. For example, the equity prices that correspond to levels of “survival” for Bank of America (BAC), JP Morgan (JPM), and Goldman Sachs (GS) would be much different than those that correspond to levels of “healthy and thriving.” This distinction is paramount across the banking sector, which relies on confidence more than any other arena, save the MLP space.
The 1,000-point drop on the Dow Jones (DIA) at the open Monday has likely cleared out many sellers and the bounce back from those levels could have only been expected during intra-day trading. The question, however, is not what happens this week or next week or even for the remainder of this year, for that matter. The real question is whether the 6+ year bull market is finally over. From our perspective, it is. Valuations are still not attractive, technicals are “broken” on most major indices, dividends and distributions are at risk for most “ultra-high-yielders,” sentiment is still negative, and uncertainty as measured by the VIX is soaring. We’d expect a flight to safety and to financially-sound, cash-rich (debt-light), and capital-market-independent entities to ensue–companies such as Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), which also happen to have outsize organically-derived dividends to boot.
The Dow may bounce the next couple days, but we hope you have your gear on. The rough sledding lower has just begun, in our view.
Related Firms: SPY, KBE, ETP, BABA, BIDU, FXI, USO
Image Source: Martin Thomas