Valuentum Exclusive Analysis for the Discerning Investor

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Bloomberg recently reported that U.S. banks’ record-breaking earnings have likely peaked for this cycle. We’ll get the team’s thoughts on this, and we’ll also cover views on the corporate credit cycle, China GDP, and the US election cycle. We don’t think the US-China Phase One deal amounts to much, other than removing the uncertainty that it, itself, created.

Let’s kick things off with our views on a recent Bloomberg piece, U.S. Banks’ Record-Breaking Earnings Streak Has Probably Peaked, “which notes that “global interest rates remain stubbornly low and geopolitical tensions (remain) high.” Matt Warren is Valuentum’s Independent Bank and Economic contributor, and we’ll start there.

Matthew Warren:

The views expressed in the article seem a bit overly bearish assuming the economy continues growing at 2% or so. Net interest margins (‘NIM’) will continue to be under pressure but the banks should lap that pressure in a couple quarters (assuming rates don’t continue lower). Balance sheet growth has been decent. Investment banking and trading is always a wild card. The fourth quarter is an easy comp, and then it gets a little tougher but not that tough. Share buybacks are amplifying what modest growth there is. If the economy turns down, then I would expect earnings to also be down.

Here are our latest notes on the six biggest banks.

Morgan Stanley Expecting Substantial Improvements >>

Goldman Hit By Charge Related to 1MDB >>

Bank of America Gaining Share >>

Citigroup Succeeding at Cross-Selling >>

Wells Fargo Remains an Inefficient Bank Despite Regulatory Overhang >>

JPMorgan's Quarter Shows Higher Sustainable Growth Potential >>

Callum Turcan:

Tying this in with the latest US employment report covering December 2019, the one real risk to the US economy, in my view, is a weakening manufacturing sector spreading to the rest of the economy. Manufacturing employment grew just ~46,000 in December 2019 versus December 2018 levels. The US Labor Department noted that the US shed 12,000 manufacturing jobs in December 2019, indicating softness as we head into 2020. While economists and financiers note there are plenty of job openings in the manufacturing sector and the US economy at-large, what isn't noted in a lot or any of these discussions is that many of those job openings come with low starting wages and lackluster benefits.

Often, a lot of the new manufacturing jobs in the US aren't what one would consider "traditional" manufacturing jobs in terms of offering a salary that's comparable to the national median average (around ~$62,000 per year according to the US Census, as of 2018). The Bureau of Labor Statistics notes that as of May 2018, the mean and median annual salary for 'Production Occupations' (a definition that covered 9.1 million US employees at the time) was $39,190 and $35,070, respectively.

Reductions in US auto manufacturing output and problems at Boeing's (BA) 737 MAX airplane take away the kind of manufacturing jobs with higher pay that lead to more dynamic positive effects on the economy (which goes away when those jobs are lost and vis-versa when those jobs are created). 

Brian Nelson:

Since the beginning of 2019, as measured by the Select Sector SPDR Trust (XLF) the largest banking stocks have lagged the broader stock market be a few percentage points. Since 2011, that spread of underperformance expanded to about 25-30 percentage points, so owning banks through this upswing hasn’t been a great proposition. An investor almost had to call the exact March 2009 bottom to have generated outperformance relative to the broader S&P 500 with diversified banking entities.

It’s hard to believe that banking stocks haven’t bounced back as much as they probably should have – for example, on a price-only basis, the XLF is about back to its highs set in May 2007 before the Great Financial Crisis, while the broader stock market has more than doubled since then. Investing in banks hasn’t been rewarding this past decade, but we still think some exposure makes sense. One of our favorite banks is Bank of America (BAC), which we include in the Dividend Growth Newsletter portfolio.

I came across a rather interesting piece from Moody’s of late, “Overvalued Equities Increase Corporate Credit’s Downside Risk.” In the book, Value Trap, I talk a lot about how equity analysis and credit analysis are inherently linked, and also how many income-oriented equities are capital-market dependent, meaning that they are reliant on external capital to support the payout. Here is an excerpt from the Moody’s piece:

An overvalued equity market increases the risk of a deep sell-off of equities that will damage corporate credit. Ironically, corporate credit may eventually suffer to the degree that debt-funded equity buybacks and dividends lifted equity values up to unsustainable heights.

A sinking equity market also increases the cost of corporate debt by making it much costlier, if not impossible, to replace debt capital with equity capital. Moreover, equity weakness reduces the amount of cash that can be raised via the sale of business assets.

All else the same, a broadly distributed equity price plunge lowers the market value of the business assets that collateralize outstanding corporate debt. The consequent drop in the market value of the net worth of businesses and a likely increase in the volatility in the market value of business assets will increase the likelihood of default.

It should not be a surprise that any sort of dislocation in the equity markets could make things bad on the credit side, and Moody’s may have it right that when this bull market and stock market party is over, we could have one very, very bad hangover. We’re definitely keeping an eye on some of our leveraged ideas in the newsletter portfolios. What do you think Callum?

Callum Turcan:

Good piece, and it ties into why we like AT&T Inc (T) and Philip Morris International Inc (PM) in the High Yield Dividend Newsletter portfolio. Both companies have a substantial amount of debt (and as such need to retain access to capital markets to refinance that debt), but their strong investment grade credit ratings and stellar free cash flow profiles enable both companies to pay juicy yields without being dependent on equity markets in a meaningful way.

AT&T is in the process of buying back its stock, and Philip Morris International doesn't issue equity outside of any share-based compensation (dilution historically has been minimal/non-existent). As of this writing, Philip Morris International is breaking out towards the high end of our fair value range estimate, a trajectory supported by its strong technicals and positive fundamentals (such as the recent launch of its IQOS product in the US supporting its free cash flow outlook). 

Back to the Moody’s piece--what I found particularly striking was by just how much the yield spread for investment grade and high yield bonds grew when US equity markets dipped significantly lower from May 2015 to February 2016. High yield bond spreads jumped over 85% while investment grade bond spreads jumped over 45% in the matter of less than a year, according to the piece. The surge in the expected default frequency rate and high yield bond spread during this period indicates just how dangerous some of these low quality high yielding companies are out there for investors. 

Sure, a double-digit yield might sound tempting, but not if that yield comes with the risk of (and oftentimes, eventual) material capital depreciation. That can be due to bankruptcies in the events credit markets seize up on low quality firms that are dependent on capital markets for refinancing needs (usually this decimates equity holders), or serious capital depreciation can be the result of dividend cuts/suspensions as dividend obligations weren't properly funded by free cash flows (future payouts required the company to maintain access to capital markets for funds). 

Corporates that find themselves overly reliant on equity markets are not in a good position this late in the business cycle, as things can turn south quick in this environment.  

Matthew Warren:

It does seem to me like many bond investors are “picking up nickels in front of a steamroller.” There just isn’t much yield or sound covenants on some of the issuance, particularly as it relates to junk issuance and levered loans. I think it will end very badly for some of these investors when the next downturn comes. Of course, one could have been saying that for 11 years now.

Switching gears a bit--what do we think about the comeback in GE? The stock is still down considerably since late 2016, but it has come roaring back off the bottom.

Callum Turcan:

GE's (GE) problems still look tough to navigate given its exposure to the natural gas power generation space (a market that has really cooled off in the US, Europe, and elsewhere) and the 737 MAX debacle (given GE is a partner in a JV that makes the LEAP engine). While there are ways for GE to navigate some of these problems, such as growing its wind turbine business and pivoting away from the 737 MAX towards other airplane models (GE and its JV partner did a deal with Airbus (EADSY) recently to increase shipments to the European aerospace giant), I'm still concerned with its large net debt load, weak outlook, and need to divest assets to cover its deleveraging plans. 

Brian Nelson:

I generally agree.

While GE could bounce back to the teens, the move is still within the wide range of fair value outcomes for a company that has endured so much the past decade or so, not the least of which are three dividend cuts. One can probably count out income or dividend growth investors as those interested in GE, and for those looking for industrial exposure, Honeywell (HON) may be a better fit, a stock that has a lot less "hair" on it. Shares of Honeywell are a bit pricey, but its Dividend Cushion ratio of 2.5x speaks to considerable strength in the payout. Honeywell yields about 2% at the moment.

What does the team think about developments in China (FXI, MCHI)?

Callum Turcan:

China's preliminary assessment of its GDP growth in the fourth quarter of 2019 indicates the Middle Kingdom's economy grew by 6.0% in the quarter, allowing for full year GDP growth of 6.1% which was below 2018 levels of 6.6%. While there are plenty of questions concerning just how "managed" these figures are, what matters most is Chinese authorities are communicating to businesses and investors that Beijing will accept a slower rate of growth than the historical norm. 

The country did enact stimulus efforts to offset the US-China trade war. For instance, China cut its reserve requirement ratio ('RRR') in a bid to boost lending by allowing domestic banks to hold less cash in reserve relatively speaking, with the RRR last cut by 50 basis points at the end of 2019, bringing it down to 12.5% (a move that was made effective January 6, 2020). China had cut its RRR a few months prior in September 2019, also by 50 basis points (which at the time brought the RRR down to 13.0%). Other stimulus measures include allowing local governments to boost their bond issuances to fund ambitious infrastructure programs and rolling back environmental targets in certain areas (particularly as it relates to thermal coal mines and power plants). 

Adding on to the thermal coal related subject, China's central government has not been pushing natural gas as hard as it has been in the recent past. That's largely because China imports a lot of its natural gas supplies, either by pipeline from Russia, Turkmenistan, and elsewhere, or through liquefied natural gas re-gasification import terminals (those supplies can come from such sources as Qatar, Australia, Russia, and elsewhere, even the US if tariffs on US LNG supplies are scrapped as potentially planned). When times get tougher (i.e. US-China trade war), priorities change.

Now that the US and China have signed their "Phase One" trade accord, which effectively is a partial trade war truce, it will be interesting to see if China pivots back to focusing on keeping debt levels contained. On the other hand, if the US-China trade war flares up again, Beijing likely still retains the ability to launch even more aggressive stimulus packages, but that will severely stress its debt levels.

Brian Nelson:

It seems like the US-China trade war has been more of a superficial economic peace treaty between two superpowers. I think it was to be expected that we’d get some kind of deal before the Trump administration hits the campaign trail, and I’m hard pressed to believe Phase One really changes much. Here is what our team said in September, months before the signing of the Phase One pact:

I think Trump is going to do whatever he can to cut a deal soon. It may not be exactly what the US is looking for, but I think whatever the deal will be, he will “declare victory” as he builds talking points for the upcoming debates. I think he knows China can just wait him out, so I expect a much more amenable President Trump at the next round of talks.

While others find this Presidential administration to be unpredictable, it seems that the moves are somewhat predictable as each move seems very politically motivated, in my view, almost entirely focused on getting re-elected in 2020. Perhaps this may be the case with each first-term President, but it seems so obvious to me the past few years: The Trump administration has a political playbook to get reelected in 2020, and that playbook is what we’re going to see.

That means that I doubt we see much movement on Phase Two at all because the political talking points have already been achieved in landing a Phase One accord. Same with Iran. It doesn’t seem like the Democrats are making the assassination and the downing of passenger airplane in Iran a big deal on the campaign trail, here and here, (I don’t even think it has come up in the Democratic debates of late), so we might see ongoing easing of tensions in the Middle East. The impeachment process continues, but it is almost expected that Congressional authorities won’t cross party lines.

Though China’s economic growth is slowing, that it handled a “trade war” with the US and is still growing at a 6% clip is noteworthy. In some ways, this is a big win for China, and I doubt that the US will be able to press as hard as it did to achieve much more. Though there was a celebration at the signing of Phase One, again, it’s largely superficial, in my view, and China’s economy continues to hum along at a breakneck pace, even if that pace may be slowing. Trump continues to show both economic and military restraint in his international dealings, even as he comes close to tipping over the global economy and sparking increased tensions in the Middle East.

Matthew Warren:

While I think that the Phase One deal does cool tensions a bit and prevents further escalation of the trade war for now, it seems like a shaky truce, with the tariffs still in place and the US demanding more than it is willing to give. At some point, isn’t this likely to come back to a boil, even if it is after the 2020 US general elections? In the meantime, I think we will see a further balkanization of economies and technology ecosystems. It has all the makings of a cold war, where you have two powers competing and trying to pull other countries into their orbits. Some countries will choose a leader, while many will simply try to play both sides. I think what is lost is a lot of growth opportunities for companies trying to grow their sales into China.

Further, I remain a long term (and unrequited) bear on China. I simply don't believe that centralized management of a large economy works. It's been proven otherwise several times in history. I think the state-owned companies are my case in point. They are bloated organs of the state, with too much debt, and extremely political mandates. One day, there will be a lot of bad debt as a result. There is simply too much leverage and real estate speculation in the system. That will also come home to roost.

It's funny, I think people believe in the party's ability to manage economic outcomes just like the West believes in the Federal Reserve, European Central Bank, and Bank of Japan. These forces are indeed extremely powerful in the short run and you can lose your career by betting against them. Longer term, it is more like the Wizard of Oz. Printing money or building new ghost towns in central China are simply not long term fundamental growth drivers. Please don't ask me when these will flip over, because your guess is as good as mine.