Whatever Happened to Junk Bonds?

The great QE-driven paper chase is on in earnest now. With the average yield on so-called junk bonds now under 5% on Barclays US High Yield Index, risk pricing seems totally out of kilter.

Indeed, Apple just closed a $17billion book build (with $50 billion of demand) at a microscopic yields:

Apple’s debt sale included $4 billion of 1 percent, 5-year notes that pay 40 basis points, or 0.4 percentage point, more than similar-maturity Treasuries (USGG10YR); $5.5 billion of 2.4 percent, 10-year securities with a relative yield of 75 basis points and $3 billion of 3.85 percent, 30-year bonds paying an extra 100 points, data compiled by Bloomberg show.

With the rally in defensive equity names in the US and Australian banks being consistently  described as run for yield rather than reflective of valuations, the parade of unintended consequences of QE is swelling in numbers.

The real winners here are institutionalised borrowers, the junk bond names now able to borrow at under 5%. Main Street businesses, starved of oxygen, aren't so lucky as Federal Reserve liquidity is restricted to the narrow confines of Wall Street banks and their clients.

Moody's has released a note warning of misspricing in the high yield space:

The lackluster state of the world economy has curbed the growth of business sales. The US high yield bond spread has shown a strong inverse correlation with the JPMorgan/Markit global composite PMI index of world economic activity. Ordinarily, the high yield bond spread widens as the global composite PMI falls. 

Nevertheless, despite how April 2013’s global composite PMI of 51.9 is well under its long-term median of 54.6, May 7’s high yield bond spread of 411 bp was well under its comparably measured median of 583 bp. Moreover, the statistical record suggests that the high yield spread ought to be closer to 700 bp, as opposed to approaching 400 bp. In fact, when the high yield spread last narrowed to 411 bp in December 2003, the global composite PMI approximated 60.0.

Now perhaps this was the intention of central banks all along - to force investors to readjust their risk profiles. And the talk of potential negative rates in Europe following Mario Draghi's comments last week seems like more of the same stick even though the carrot is looking rather withered and blotchy. However, as Barnejek explains, central banks have had very little success  in what happens to liquidity after they create it.

I don’t question the fact that such a move will persuade banks to search for higher-yielding assets, ie loans but what I’m trying to explain is that the liquidity in the banking system is like a hot potato. The central bank controls how much money there is in the system (using various ways, eg printing money, changing the reserve requirement etc) and the market only needs to decide the price of this money. The only way that lowering rates to the negative territory impacts the amount of cash in the system is because the central bank will be returning 99% of the money placed in it back to banks. But then which of the major central banks could even contemplate shrinking its balance sheet at the time when the global economy remains exceptionally fragile? 

What I think discussions like the ones taking place in Europe will lead to is significant re-pricing of interbank rates (BOR-OIS spreads could decline massively as banks start passing on the potato) and an increased demand for government or quasi-government bonds by banks’ assets and liabilities management desks (ALMs). Perhaps this is the point of the whole exercise. Then again, isn’t it yet another version of crowding out and actually forcing banks to play the carry in government bond markets? Hard to see how that should please politicians but perhaps this is the only path to rejuvenate the credit action. I really don’t like growth implications of such a process. Unless of course the ultimate beneficiaries, ie the governments, use the extra demand for their papers to increase public spending… But I will spare you, Dear Reader, yet another discussion about consequences of austerity. There’s this chap in the US who does that several times a day.

Fear of missing out now has a new acronym companion in the investment world: FOBOR - Forced Buyers of Risk. 

Towards A Cashless Society

From the Department of Staggering Statistics: worldwide spending on Visa cards was over $1 trillion in Q1, an 8.8% increase. The inexorable rise in electronic payments is part of the long march towards a cashless society. In my opinion, it can't come soon enough.

In Kenya, Google in partnership with Equity Bank has launched an NFC-enabled payment system called BebaPay for buying goods and service. Kenya already has M-Pesa, and extraordinarily successful money transfer system that operates via SMS on mobile phones. 70% of Kenyans use M-Pesa, and East Africans have therefore remained amongst the most underbanked people in the world. Overall, only 20% of African families have bank accounts.

The ideal of a cashless society has much greater chance of occurring in countries which lack basic banking and electronic payment services. The same holds for high-speed mobile internet and the end of fixed-line telephony. WiMAX was originally chosen by MTN Uganda because the infrastructure for wired data delivery simply didn't exist outside of the city. It makes much greater economic sense to build cellular networks into rural areas with zero fixed-line penetration.

Already Africa has grid-less communities operating with low-tech electricity solutions like this one. Econet Solar is owned by Zimbabwe's richest man, Strive Masiyiwa, and power is prepaid via a Econet Wireless (of course) SIM card in the unit. The social benefits are immediately apparent in education - the ability to study after dark is hugely beneficial. 

Now a communications network relying entirely on mobile telephony is as much a bridging measure as a solar-powered community  but they are born out of necessity. And in a continent where governments have failed spectacularly at providing infrastructure, they may persist longer than one might expect.

As for the overbanked in the developed world, payments via mobile phones (whether NFC or otherwise) have been long-promised but slow to arrive. We are still carrying these quaint little things around called wallets that are filled with archaic legal tender - an analogue frustration but not one that creates a pressing need for change. However, as long as Visa and Mastercard have their point of sale hegemony, we'll still need wallets carry around their bits of plastic, too. 

On Poverty and Standing Still

The World Bank has released some pretty sobering poverty figures this week that are encouraging or embarrassing depending on whether you hail from Asia or Africa. As of 2010, Sub-Saharan Africa had the highest share of the world's extreme poverty. The divergence between China and SSA is extraordinary.

Sub-Saharan Africa, as the following charts show, is clearly mired in a black hole of stagnant development, corruption, and misspent international aid. Foreign exchange from oil extraction in countries like Nigeria, Angola, and Equatorial Guinea has had little effect on the lives of ordinary citizens.

Sadly, not only have much of Sub-Saharan people been mired in extreme poverty, they have also been getting poorer.

The number of extremely poor individuals has more than doubled in Sub-Saharan Africa since 1981 whilst declining in every other region.

And in absolute terms, extreme poverty now seems pretty immovable in Sub-Saharan Africa. An improvement from 51 to 48% over the past three decades is abysmal. 

As the commodity super-cycle turns, Africa's poor have missed out on the benefits. Political risk, bureaucracy and cronyism have all prevented large scale application of capital in the resources sector over the last ten years. With the mining majors now looking to extricate themselves from projects, the future looks dim. 

An alternative source of economic growth is not obvious, and a lack of prescient and capable leadership has left a vacuum where income inequality will continue to grow and social mobility remains impossible. 

But you said it would be a non-event!

Whatever agreement the EU comes to with Cyprus regarding its levies on deposits, it is clear that parliamentary function is as broken as it is in Australia. A last-minute plan is not going to stop massive withdrawals when the banks open. So there are technical problems that must be considered in reference to these capital outflows, if not outright capital controls.

This article is very discouraging, it simply looks like one big f*ckup with bureaucrats desperate to show that they have their heads above water.

(Reuters) - Euro zone finance officials acknowledged being "in a mess" over Cyprus during a conference call on Wednesday and discussed imposing capital controls to insulate the region from a possible collapse of the Cypriot economy. 

In detailed notes of the call seen by Reuters, one official described emotions as running "very high", making it difficult to come up with rational solutions, and referred to "open talk in regards of (Cyprus) leaving the euro zone". 

The call was among members of the Eurogroup Working Group, which consists of deputy finance ministers or senior treasury officials from the 17 euro zone countries as well as representatives from the European Central Bank and the European Commission. 

The group is chaired by Austria's Thomas Wieser. Cyprus decided not to take part in the call, a decision that several participants described as troubling and reflecting the wider confusion surrounding the island's predicament. 

"The (Cypriot) parliament is obviously too emotional and will not decide on anything, if Cyprus does not even feel that they can attend the call it is a big problem for us," the French representative said, according to the notes seen by Reuters. 

"We have never seen this."

Again the EU is faced with the problem of how to ring-fence Cyprus, especially mitigating the effects on Greece. Back to unscrambling eggs, then 

Rio Tinto's Age of Austerity.

As much as they will protest otherwise but it seems like Rio Tinto are trying to walk away from one of their bigger commitments:

RIO Tinto has threatened to freeze work on the $US10 billion ($9.7bn) Simandou project in Guinea if the government there does not quickly sign an investment agreement and secure its share of funding for the project. 

Yesterday the company denied news reports it had already frozen work on the big project in the poor West African nation. 

But the message delivered in a meeting between new chief executive Sam Walsh and Guinean President Alpha Conde was that Simandou could be mothballed if Guinea could not get funding and agree to terms under which Rio could sink more cash into the development.

Back in the halcyon days of iron ore expansion, it would seem preposterous relying on a small West African nation to secure total funding for a big mine like Simandou. After the disastrous purchase of Riversdale Mining's Mozambique operations, West African projects with operational and sovereign risk in might suddenly seem reckless.

The slowing of Simandou comes as Rio also deals with new-year troubles in the two other developing nations it invested heavily in under Mr Albanese. In Mozambique, inability to get government approval to barge coal down the Zambeze River, and a big downgrade in reserves, led to a writedown on its Riversdale Mining acquisition and the removal of Mr Albanese in January. 

At the same time, in Mongolia, where Rio has nearly completed the $US6 billion first stage of the Oyu Tolgoi copper and gold mine and is considering a second stage, tensions have risen as parliamentarians demand a greater share of the spoils from the project. 

Oyu Tolgoi is operating under an investment agreement similar to the one Rio wants with Guinea but this has not been enough to stop demands to change the ground rules.

The assumption underlying the counterparty government funding of all these projects was debt either directly from China or underwritten by Chinese demand. The trouble with assumptions is that they are often mistaken for data-driven forecasting. 

Sovereign Risk

If you've been following the turbid story of Elliot & Associates, Argentina and in the Second Circuit court of appeals in New York, you'll be unsurprised by the following news from Vale:

BRAZILIAN mining giant Vale has shelved its $US5.92 billion ($5.74 billion) Rio Colorado potash project Monday, the latest and biggest casualty in a company-wide austerity effort prompted by slumping iron-ore prices and billion-dollar write-downs.  

The mine was expected to pump out 4.3 million metric tonnes of potash per year, making Argentina one of the world's leading producers of the potassium-based fertilizer. But it has been under review since last year for cost-related reasons, and Vale suspended work on the mine in late December. 

"In the current macroeconomic environment, the economics of the project are not in line with Vale's commitment to discipline in capital allocation and value creation," Vale said in a statement. The company left the door open for the venture to resume sometime in the future, however, saying it plans to keep "searching for alternatives that enhance the economics of the project."

Now the big miner doesn't specifically mention sovereign risk, but after Christine Kirchner's nationalisation of Repsol's Argentinian assets, and the above-mentioned debt default issue, who could blame any company from avoiding sending capital to the country.

Argentina's economy has always been hostage to populist politics, not unlike Venezuela under Chavez. If the anaemic recovery continues in the US and other developed countries, expect emerging markets and currencies to continue to suffer from a lack of faith this year.

On Complexity

I now know it's not just me. That inescapable feeling I have when I turn on the computer each day - that there is less time, more relevant data, and more investment ideas to assimilate - is universal. The complexity of the investment universe, that macroeconomic global events dominate markets, is an inescapable reality of the networks we build. I know, too, that this doesn't matter as much as I think it does. The trouble is that my attention span, battered by media of every stripe, is becoming more unsuited to long-form writing, applied thinking, and reading that isn't encumbered by non-contextual stimulus and some news feed or another.

*in case you are wondering, I have checked twitter and my various email inboxes multiple times whilst writing the first paragraph of the first draft*

We now have apps, which boldly claim to have an altruistic mission to simplify, codify and organise our lives. Yet they fail to acknowledge the added layers of complexity, the endless trips beyond the boundaries of practicality, and the simple answer that the newest ideas needn't supplant the old. "There's an app for that", seems to have become axiomatic.

The New York Times has a wonderful piece by Evgeny Morozov the author of “To Save Everything, Click Here: The Folly of Technological Solutionism.”

Or, if you tend to forget things, Silicon Valley wants to give you an app to remember everything. If you occasionally prevaricate in order to meet your clashing obligations as a parent, friend or colleague, another app might spot inconsistencies in your behavior and inform your interlocutors if you are telling the truth. If you experience discomfort because you encounter people and things that you do not like, another app or gadget might spare you the pain by rendering them invisible. 

Sunny, smooth, clean: with Silicon Valley at the helm, our life will become one long California highway. 

LAST month Randi Zuckerberg, Facebook’s former marketing director, enthused about a trendy app to “crowdsource absolutely every decision in your life.” Called Seesaw, the app lets you run instant polls of your friends and ask for advice on anything: what wedding dress to buy, what latte drink to order and soon, perhaps, what political candidate to support.

To Silicon valley, there are few problems that cannot be solved by social networks or applications. Morozov calls these people the "solutionists". Memory and attention seem to be in the cross-hairs for creative destruction. And even when it seems otherwise, memory and vivid experiential moments need to be endorsed not just by the camera - which in itself can be an ally and foe if recall - but by photo sharing. Some of this is boastfulness, but mainly sharing has become one of the most pervasive human actions enabled by mobile technology.

Some of the presenters at TED, "the meme-hustlers" as Morozov calls them, present a world that looks quite dystopian to me - it is full of wonderful technology solving all the world's problems, but there is scant mention of human beings. Even problems as resistant to technology as politics are presented as easily scalable hillocks. Technology will happily hurdle climate change and scarcity; memetics will supersede religion. Conflict will simply fall by the wayside and a future of abundance and leisure will resolve today's petty peculiarities of race, gender, and culture.

Please don't mistake me for a Luddite, and I do enjoy a lot of what TED has to offer, but we are mistaking technological complexity for productivity growth. Indeed we are mistaking the social layer that is interwoven in Web 2.0 with the actual mechanics of anthropogenic problem solving. Certainly many social networks act as exponential mechanisms for ordinary human interactions, but they are not going to solve the world's ills. Mark Zuckerberg suggests that we should all share more. And who can argue against that? However, there are many geopolitical and economic problems that cannot be counteracted by Silicon Valley aphorisms.

The Kony 2012 viral hit was a classic example or mistaking awareness for a successful terminus. Hashtags, whilst neatly providing context to a 140 character message, can't possibly engage the full scope of the problem. And outside of Uganda and the DRC's big urban centres most people don't have the faintest idea what YouTube and Twitter are.

Geoffrey West, a theoretical physicist, has been prolific in the realm of scaling phenomena and the complexity of networks - both biological and man-made. His metabolic theories of ecology, an extension of Kleiber's Law, show an amazing consistency in metabolic rate and scalability in living organisms. Basically if you plot the metabolic rate against mass you get a straight line - from a shrew to a blue whale (that's 8 orders of magnitude!). Also, each animal, independent of size, gets about a billion heartbeats in its life. The plot of this line is sublineal (about 3/4), which means that larger animals have economies of scale over smaller ones - each increase in lifeform size requires a proportional increase in energy to maintain it.

Now the problem is that the built environment, our cities, operate on a superlineal scale (about 1.15/1). Cities speed up as they get larger, the rates of productivity and output increase. And the technological ecosystem is no different. If you feel like city life is passing you by, that's because it is. Complexity, therefore, increases and naturally society's demands are not sustainable. The system requires leaps in innovation, like the industrial revolution, the internal combustion engine, pesticides etc. Without these leaps in innovation, societies collapse, they hit finite time singularities. And there are plenty of examples of this.

Biological life is sigmoidal bounded growth. You are born, your growth accelerates, it plateaus, and then you die.:

This is unbounded growth becoming super-exponential up to a finite time singularity and then collapse:

And here is Geoffrey West's chart with these leaps of innovation which are required to sustain societies:

You will notice that as the system grows, the frequency of technological leaps increases. This is the danger we face as a society. The chart above is what you might feel.

Socioeconomic time, the time we live by, is accelerating, compared with the time as defined by the earth travelling around the sun.

On the average between now and 2050 a  million people a week will be urbanised. and this is all time, it is happening in time. We are in this expanding universe and this is simply not sustainable  The strain on resources and the speeding up of time is going to have a profound effect. 

 Geoffrey West, Copenhagen October 2011.

I think the next century will be the century of complexity.   

Stephen Hawking, January 2000

As an aside, Geoffrey West and his team have studied nearly 25,000 companies and deduced that they also have sublineal growth like biology. They will too die someday.

Beware the neat, reductionist thinking of gifted public speakers on TED - the world's problems cannot be solved in 15 minutes or less. They believe they have order and simplicity, but the result is entropy. Morozov:

All these efforts to ease the torments of existence might sound like paradise to Silicon Valley. But for the rest of us, they will be hell. They are driven by a pervasive and dangerous ideology that I call “solutionism”: an intellectual pathology that recognizes problems as problems based on just one criterion: whether they are “solvable” with a nice and clean technological solution at our disposal. Thus, forgetting and inconsistency become “problems” simply because we have the tools to get rid of them — and not because we’ve weighed all the philosophical pros and cons. 

To square the circle back to finance, the benefits of twitter and indefatigable data streams are negated if they stifle the long view. If we're all operating in the realm of immediacy, the dangers of group think and the blindness to tail-risk become baked-into the ecosystem. If we take a contentious viewpoint, one that perhaps relies on an altered view of time i.e. how socioeconomic time impacts "real" time, new opportunities might present themselves. I don't believe that the consumer Internet start-up machine can provide the leaps in innovation that we need. These must come from real hardware innovations, from unpredictable marvels in energy, transportation, and factors of production.

 

One painful lesson that I have learned is that despite the reassurance that following multiple data streams provides to my perception of my current macro knowledge, I am an outsider. And outsiders occasionally need to turn off the noise and take view; a lasting, structural view on investing. I'm not suggesting having no cyclical or momentum exposure at all, but not enough that obsessing about current events becomes consuming. To whit, here is one of the Interloper's rules for outsiders:

Outsider Rule #2: Secular over Cyclical. Reducing economic sensitivity in a portfolio can drastically reduce portfolio risk and the labor involved in investment decisions. Investors in construction equipment, for instance, will be forced to white knuckle every dubious Chinese economic data report for the foreseeable future, three or four times per month. There are, however, investable trends that will happen, at varying speeds, regardless of the economy. 

Once you have an understanding of the complexity of networks, that socio-economic growth is superlinear, then it is possible to step back from the Sisyphean chore of trying to stay abreast of everything. It was ever thus. Trying to be a person who perfectly informed is as ludicrous as China accusing Japan of keeping its currency artificially low.