The Supplementary Leverage Ratio (SLR) exemption – will it be extended?

Recent gyrations in global equity markets has stem from the gradual (is it gradual?) steepening of the US Treasury curve. Steepening started in November 2020. In our view, the steepening stems from:

1. Upcoming new supply (Biden’s US$1.9trn stimulus package) and the US Treasury’s new supply extended their weighted average maturity.
2. Upcoming data around inflation and GDP growth points to a ‘hot’ economy, one in which a potential rate hike is on the horizon (rather than being on the verge of infinity).
3. Potential narrative around the Fed’s tapering of quantitative easing, which creates fear of a subsequent Fed Funds Rate hike. [QE would need to end before any rate hike.]

That said, there are several other theories floating around:

1. China government not buying (or buying less) long-end Treasuries [low likelihood], while Japanese investors have (reportedly) been buying long-end Treasuries [medium likelihood]. Looking at the relative spread between US and Japanese 10-year bonds, the UST10yr provides a decent yield / carry pick-up of ~150bps over Japan’s, yet still not as wide as pre-Covid (200-300bps) as historical context (shown below);

2. Convexity hedging (which we covered in 26-Feb-2020 update) results in MBS investors selling their long-end Treasuries (which were hedging the negative convexity of MBS), and as long-end yields rise, the incentive for homeowners to refinance their mortgage (likely at a higher rate than previously) decreases and therefore the duration of such MBS (holding the current, non-refinanced mortgages) would increase (given lower early repayments), which reduces the MBS investor’s need to hedge duration using long-end Treasuries. [medium likelihood];
3. US banks (JPM, C, BAC) concerned about the Supplementary Leverage Ratio (SLR) exemption renewal and reducing their USTs holdings before a potential non-extension announcement by the Fed [medium likelihood, discussed below].

The SLR is a leverage capital constraint on banks regulated by the Fed. The SLR was adopted by the Basel Committee, under the Bank of International Settlements, as part of the Basel III revisions. The SLR deals with capital adequacy, which is a bank’s ability to absorb unanticipated losses and declines in asset values that could otherwise cause a bank to fail. This in contrast to the traditional view of bank leverage, which is bank capital divided by total assets.

The SLR is more encompassing and calculated as:

• SLR = Tier 1 Capital / Total Leverage Exposure, where:
• Tier 1 Capital = CET1 + AT1, as defined by U.S. Basel III
• Total Leverage Exposure = on- and off-balance sheet exposures, which includes Treasuries & Fed Reserves.

The SLR views bank leverage by combining on- and off-balance sheet exposure:

Source: Federal Financial Institutions Examination Council [Data Point: FFIEC101]

The minimum SLR for G-Sib banks is 5%. Below 5%, the Fed will put restrictions on the bank’s ability to make capital distributions to equity shareholders (dividends, share buybacks) and restrict discretionary bonuses to bank employees. On the flip side, a SLR above 6% would be considered “well capitalised”. Thus, the margin between “good” and “bad” is relatively tight. In terms of sensitivity, the SLR ratio is effectively a cap rate whereby your denominator continues to grow faster than your numerator, compressing your ratio and risking a breach below the 5% threshold.

On 1 April, 2020 the Fed announced a temporary exemption by excluding Treasuries & Fed reserves from the TLE calculation, effectively shrinking the SLR’s denominator and providing US banks with a (temporary) buffer to the leverage capital constraint. However, no update has since been made regarding this exemption, which is scheduled to expire on 31 March, 2021. The Federal Reserve may discuss the SLR issue in its upcoming FOMC announcement scheduled for 17 March, 2021. If not, we would expect a clarification shortly thereafter and before the exemption’s 31 March 2020 expiry date.

The SLR exemption allowed US banks to expand their balance sheets by participating in (i) US Treasury auctions, as a primary dealer, and (ii) the Fed’s quantitative easing programme, which without the SLR exemption would have required them to increase their Tier 1 Capital. During the pandemic, the banks played a vital role in ensuring sufficient liquidity in the financial system (recall that a solvency crisis is preceded by a liquidity crisis) and continued to make loans. This ensured that sufficient liquidity in the system prevented widespread solvency issues.

If the SLR exemption is not extended by the Fed, either in full or in part (UST or reserves), US banks would need to hold more capital against the USTs and reserves (after selling USTs & MBSs into the Fed’s QE programme) accumulated in the last 12 months and on a forward looking basis. Therefore, absent any exemption, one would expect to see US banks lower their demand for USTs as they would need to increase Tier 1 Capital to maintain compliance with SLR, before considering any further increases to their TLE.

Therefore, the SLR exemption enables primary dealers to accumulate and sell USTs into the Fed’s QE, which has been predominantly the short-end tenors the Fed NY (whose ‘Trading Desk’ is responsible for open market operations) is looking to purchase. From this perspective, the impact of SLR on long-end USTs is minimal.

Looking ahead at the Fed’s FOMC announcement, we expect SLR exemption being extended as “hopeful”, however the exemption would likely apply to Fed reserves only, rather than include USTs as well.

Several reasons for this view: part theory, part practical.

1. Theory (Part A): when the Fed conducts QE and buys an asset (UST, MBS) from a bank, the bank receives a Fed Reserve Deposit (effectively a digital token of equivalency to cash, against which can only be used in the Fed Funds Market) in return for selling the UST/MBS to the Fed. As explained above, a bank’s TLE includes both Treasuries & Fed Reserves. Therefore, as banks enlarge their balance sheets (shown in below table from Bloomberg) when participating in the Fed’s QE, they will need an extension to the SLR exemption to continue participating in the QE programme (unless their numerator grows proportionately, though this is unlikely). Put another way: from the bank’s perspective, Fed reserves are a negative externality from participating in QE.

2. Theory (Part B): customer deposits held with banks can either be used to underwrite loans or held as USTs or Fed reserves, all three of which generate positive carry. However, without SLR exemption being extended, the additional deposits coming from (i) President Biden’s US$1.9trn fiscal package and (ii) US$1.2 trillion decline in the Treasury General Account (TGA), will mean banks will either need to (a) charge negative interest on deposits (to maintain their ROTCE) or (b) turn away deposits, which will mean the only place left are (i) depository institutions (State Street, Bank of NY Mellon) or (b) money market funds, which are capped to US$30bn on direct inflows into the overnight RRP facility. In fact, uncapping direct inflows (from $30bn) on overnight RRP facility and hiking the overnight RRP rate to just above 0% would go along way towards alleviating the balance sheet pressure on commercial banks with or without extension to the SLR exemption. The mechanics of the US$1.2trn TGA drawdown is shown in the below table from Credit Suisse, and illustrates the reserve constraint that banks will face.

3. Practical (Part A): banks simply have no practical use for Fed reserves on their balance sheet (except for the Fed Funds Market) given the Fed eliminated the reserve requirements in March 2021 (and hence IORR = IOER). Reserves can be turned into loans but isn’t a prerequisite for credit creation (when loans are ‘created’ as assets, corresponding ‘deposits’ are created as liabilities). As reserves are truly agnostic (as liabilities of the Fed), their exemption from the SLR calculation would make sense given they carry no risk (and in reality, limited reward of 0.10% per annum). Whereas for Treasuries, assuming they are still considered risk-free assets, have a component of interest rate risk.
4. Practical (Part B): the market forecasts a sharp economic recovery in the US, thanks to the continued rollout of vaccines and stimulus checks supporting consumption. However, the Fed needs to ensure there is sufficient liquidity (via ample reserves) in the system, which means keeping the FFR pinned within the ZLB and short-end curve (0-5yrs) on our path to ‘recovery’. That path will require the Fed to continue (and eventually taper) the quantity of QE (currently US$80bn for Treasuries & US$40bn for MBS), which requires the banks’ primary dealers to have balance sheet room for reserves expansion.
5. Practical (Part C): the Fed needs excess reserves in the banking system to facilitate the financial system’s liquidity. While we currently face an opposite constraint to the Sep-2019 cash crunch (Bloomberg article extracts below), the Fed will be mindful so as to maintain an ‘ample’ level of reserves in the system as it eventually tapers QE (with a view to normalising via FFR hikes). From a simple perspective, as the financial system’s value has grown, the amount of reserves in the system that would constitute ‘ample’ would also have risen against previous levels.
   1. “The repo market is where the cash-rich of the financial system lend to the cash-poor, with banks, money-market funds, hedge funds, broker-dealers, asset-managers, and others borrowing and lending to each other short-term. While borrowers in this system have plenty of longer-term assets, on a day-to-day basis they may not have the liquidity they need. Repo lets them borrow cash against those assets to tide them over.”
   2. “After the financial crisis, the Fed began stimulating the economy by buying bonds. The money it spent to do so added to the excess reserves held by banks. After years of QE, big banks became accustomed to always having cash to lend in the repo market—they were swimming in excess reserves. But then the Fed began tapering off QE, buying fewer bonds and reducing the excess reserves in the system. There’s still a lot, but this is where the regulatory experiment comes in. To prevent a repeat of the 2008 crash, bank watchdogs have tightened rules in such a way that the biggest lenders feel they have to keep more reserves on hand. So falling reserves and banks’ desire to hold on to more began to pinch.”
   3. “In September [2019] all these forces combined with a few other quirky events—such as corporations needing cash to settle quarterly tax bills—to create a brief systemwide shortage of ready cash.”
6. Practical (Part D): common stockholders of the big US banks are (arguably) being unfairly treated as any dividends and/or share buybacks would dilute the CET1, the larger component of the SLR’s numerator. In fact, the other numerator, AT1, is also dilutive to CET1 since it carries a non-deferrable coupon. The denominator (as discussed above) continues to rise as the big US banks ensure ‘smooth functioning’ and ‘orderly market conditions’ via the quantitative easing programme. This is where US politicians have (in our view) unfairly targeted the ‘big banks’ which have, since the Fed’s Dec-2020 stress test (on page 143), been permitted banks to “pay common stock dividends and make share repurchases that, in aggregate, do not exceed an amount equal to the average of the firm’s net income for the four preceding calendar quarters”. The position of US (democratic) senators has been to urge the regulators to “reject the coordinated lobbying efforts” in regards to extending the SLR exemption.

Therefore, the Fed extending SLR to exclude reserves would ensure banks have sufficient space on the balance sheet to take up & store Fed reserves, while also excluding Treasuries would likely prevent a selloff (in order to comply with the SLR rule + a management buffer).

Given the above, it’s clear that the SLR, in its non-exempted form, doesn’t suit the practical nature of how the Fed relies on banks’ primary dealers to operate monetary policy. Instead of an SLR exemption extension, we could even see a revised SLR threshold, although this would be extremely unlikely in the near term, as the SLR forms a buffer (or an early indication of stress) over a bank’s minimum capital requirements, as Randal Quarles, a Fed Governor, highlighted in November 2018,

“As the Federal Reserve has long maintained, leverage requirements are intended to serve as a backstop to the risk-based capital requirements. By definition, they are not intended to be risk-sensitive. Thus, I am concerned that explicitly assigning a leverage buffer requirement to a firm on the basis of risk-sensitive post-stress estimates runs afoul of the intellectual underpinnings of the leverage ratio, and I would advocate removing this element of the stress capital buffer regime. Of course, leverage ratios, including the enhanced supplementary leverage requirements, would remain a critical part of our regulatory capital regime, and we will maintain the supervisory expectation that firms have sufficient capital to meet all minimum regulatory requirements.”

An alternative view on a non-extension of the SLR exemption is that the Fed may have (preemptively) determined its QE tapering schedule. Recall that excess reserves are required in the banking system to supply short-term funding. If the Fed expects to taper (e.g. by 2022), the accumulation of USTs & Fed reserves pushing the banks’ SLR ratio thresholds would be alleviated. The SLR relief would have limited / no impact on the TGA decline and fiscal stimulus checks.

In any case, Bloomberg’s Weekly FIX sums up the Fed’s dilemma nicely,

“Fed policymakers have largely been mum about their plans — and probably for good reason. Senators Elizabeth Warren and Sherrod Brown said in a letter to U.S. regulators this month that extending relief to banks would be a “ grave error.” As my Bloomberg Opinion colleague Brian Chappatta notes, this puts the Fed in a somewhat impossible position — the central bank can renew the exemption and appear beholden to the banks, or let it lapse and risk destabilizing the $21 trillion Treasury market.”

Looking ahead at the FOMC announcement on 17-March-2021, we expect the following:

1. No change to the Fed’s FFR or QE volume (nor any commentary on ‘twist’).
2. 5-10bps hike to IOER (a technical adjustment to pull the effective FFR towards its mid-band)
3. Uncap the o/n RRP inflow limit (current: $30bn per MMF), with possible hike by 5bps (to ensure GC / SOFR doesn’t go & stay negative)
4. SEP revised steeply higher, with inflation running just above 2%
5. Immaterial changes to dot plot in pointing to a rate hike
6. Revision to dot plot median of longer-run projection to 3% (raising the UST30yr yield threshold from 2.5%)

Clearly, our focus is on whether the Fed extends the SLR exemption.

If the Fed doesn’t extend the exemption, we believe this would be hawkish. The SLR exemption rollover debate deals with US bank balance sheets accumulating reserves (and USTs) and being included in the SLR’s denominator. If the Fed plans to taper sooner, rather than later, the accumulation of reserves on the bank’s balance sheet will begin to end. Recall: Fed QE needs to taper to $0 before rates can hike. However, if the recovery is choppy & uneven, we may see a ‘twist’ (like the Bank of Canada) or ‘taper and twist’ with the Fed lowering QE size but focus more on long-end – this could also be a technical hike as short-end would rise gradually.

The TGA’s drawdown ($1.2rn by Aug-2021) can be solved without SLR relief. If the Fed uncaps the o/n RRP inflow limit, the incoming deposits can be absorbed by MMFs, rather than bank balance sheets. In fact, this would draw more deposits away from bank balance sheets, which would alleviate their SLR constraint (since deposits are included in the SLR denominator).

Of course, we would need to hear from the Fed on its reasoning for / against extending SLR exemption before drawing concrete conclusions.

Implications?

1. UST long-end continues to steepen: UST10yr to 2.25%, UST30yr to 2.85%;
2. DXY recovers from 90-92 and stabilises ~95;
3. Value continues to outperform growth; and
4. Fund flow prefers DM over ex-China EM.

Market Wrap – 27th June, 2020

Market Wrap for 2020.06.27

Main theme for 2020Q3=>2021Q2 will be diversification, specifically out of the US equity markets and into particular CEEMEA, North Asia. The week started with Asian & European markets trading ‘wide and flat’ as uncertainty loomed over pretty much everything.

The market’s narrative started strong with Blackstone’s Schwarzman & Pershing Square’s Ackman both indicating at Bloomberg Invest’s virtual conference that a ‘V’ shaped recovery was on the cards as recovery would begin year-end 2020 and normalisation by 2H2021. Meanwhile, grounded comments were pushed by Kynikos’ Chanos that ‘easy money’ tends to lead investors towards funding questionable business models, from which financial fraud tends to arise.

Tuesday Asia morning saw consecutive medium-sized red moves, followed by a few large green move as the Navarro, White House trade advisor, indicated in a Fox News interview that US-China Phase 1 trade deal was over – this sent S&P futures down 60 points (from 3,120 to 3,060) and quickly reversing upon the clarification, all while the UST curve, especially on long-end, tightened & reversed 4-5%. Futures recovered and traded 1% higher into the European open as positive PMI data from Europe-wide outperformed expectations at or near expansionary levels.

Futures moved weaker into Wednesday as markets showed uncertainty over, what looks like, a second wave of Covid-19 on the brink of an outbreak in the US, while LATAM continued to see a rise in new cases. Thursday was the weakest point with Friday trading flat / slightly up. EU & UK markets closed off the week slightly lower (around -2%, for the week), while US markets closed -3% to -4%. The UST curve closed the week tighter particularly in the belly, as the steepener trade maintains relative value.

China vs. the World

China seems to be on a vendetta against pretty much the whole world, except for North Korea and Russia. Beijing’s latest act on implementing a national security law undermines Hong Kong’s autonomy from mainland China, which has underpinned its status as a global financial center, given it bypassed the elected local legislature – the traditional route of passing laws in Hong Kong. Geopolitical tensions between China and, frankly, rest of the world will weigh on equity markets given China’s position in manufacturing & supply chain management and the tail-risk this exhibits.

Hedging against US dollar Inflation

Like Charlie Munger, I’ve always been skeptical of using gold (or gold futures) as a portfolio hedge, until you discuss inflation. The case for an inflation hedge is growing, which is when gold investment demand typically grows on concerns around debasement (of the USD, which gold is priced in) and (sustained) lower real rates.

The base level of uncertainty encompasses (i) additional fiscal stimulus measures (by developed market governments) and (ii) whether monetary policy will remain loose. The concern will be around a potential increase in taxes (whether income, sales, or trade) to offset the lower revenues in the face of a growing deficit. Ultra-loose monetary policy will make it difficult to raise rates to restrain runaway inflation.

Bridgewater forewarned that the current wave of fiscal & monetary stimulus is “Monetary Policy 3” – you can find material on this using their research library or watch their recent video. The additional layer of uncertainty concerns the ramifications sustained fiscal stimulus, in the form of MP3 and how the resulting deficits will translate into fiscal policy (in the next few years) and whether loose monetary policy can be sustained if inflation refuses to abate.

Remember, the Fed shifted onto an “ample reserves” policy, from “scarce reserves” policy so that a liquidity crisis (risk of which was reduced using ample reserves) doesn’t kickstart a solvency crisis – precisely why the Fed dropped rates, on a Sunday in March 2020, and established USD liquidity swap lines with global central banks. Had the Fed not taken this action, the rise of DXY would’ve crushed emerging market currencies (and their nation’s balance sheet), from the lack of US dollar (safe haven) supply.

A second wave of Covid-19 causing another round of lockdown will push DM government response into unrecoverable territory. Would you, as a lender, continue lending money to a debtor with debt-to-EBITDA projected to continue increasing? The current wave of MP3 has re-ignited the bogus theory of ‘Modern Monetary Theory’ (discussed below), where (unsustainable) fiscal printing of debt is fine so long as it’s within your nation’s currency. MMT is being pushed at a period of social unrest, political uncertainty and volatility, and rising geopolitical tensions (towards de-globalisation).

Therefore, the case for inflation is part logical and part scary. Post-World War II, governments tolerated higher inflation to help drive pent-up demand, this combination helped ‘de-lever’ the government’s balance sheet, as inflation erodes the (present) value of debt, while higher demand means greater consumption => improved debt-to-GDP. This is the logical part. The scary part is how much pension liability is tied against the value of securities in the capital markets. The notional amount of liability is unchanged, since it’s pre-committed, so a decreasing value in capital markets increases the payout burden on corporates & governments => this would be a compression on corporate earnings and government budgets.

The short-version of a case for gold as an inflation hedge. Looking at 2008, gold traded relatively flat ~18 months post-GFC. However, a high level of uncertainty on economic outlook will typically push gold higher as the business cycle finds ways to exit its trough. However, the difference in 2020 is that the US dollar carry trade (positive carry spread of USD vs. G10 currencies) has effectively been squeezed out => this strengthens EM currencies (a trade recently discussed) and boosts their purchasing power of gold (since its relatively cheaper now that the USD is weaker).

For gold to trade materially higher (e.g. above US$2,500/oz), the reported inflation would need to deviate from the Fed’s expectation (of its 2% target) AND monetary policy remains ultra-loose (with EFFR at ZIRP, or ‘boxed-in’). This would signal that the Fed has lost control of the US dollar and thereby justify the rising value of Gold.

Looking forward, FOMC minutes released in September could provide a better understanding of how its members view the current progress and its dovish vs. hawkishness, via the Dot Plot.

In USD funding terms, Treasury Inflation-Protected Securities (TIPs) would provide the best inflation hedges, pending US monetary & fiscal policies in dealing with the economic recovery. Removing inflation risk, you still deal with interest rate & credit risk of the US economy and government. A quick read of Bridgewater’s All Weather strategy will give you an indication on desired allocation between growth vs. inflation allocation.

A synthetic exposure in commodities (denominated in Yuan/Euro/Franc) would provide an additional layer of hedge, in non-USD terms. Contrary to conventional wisdom, freehold ownership of real estate in (i) a democratic nation, (ii) with a rule of law and (iii) low-to-moderate household debt-to-GDP would provide an inflation hedge with portfolio diversification.

Between 1942 and 1951, the Fed instituted yield curve control (YCC), which eventually caused inflation to peak at 20% (with real interest rates troughing at -15%). The clock on DXY weakness is ticking and could unfold like this:

1. Firstly, beginning in March 2020, the Fed established its central bank liquidity swap lines and flooded the global markets with US dollars, mainly to settle (i) international trade, (ii) withdrawals from US capital markets, and (iii) capital flight from emerging markets (back into US dollars).
2. An extension of above, weaker GDP growth exacerbates a widening current account deficit (from which, exporting nation receiving US dollars aren’t reinvesting these proceeds into US Treasuries given the lack of relative, and absolute, value in terms of yield) which suggests a natural devaluation over time, absent TINA (safe haven holding during risk-on).
3. Secondly US fiscal policy saw ~$4.5trn issuance from the Treasury (excluding Fed’s QE purchases), flooding the US domestic market with US dollars. As a result, the global markets see a (relative) excess of US dollars in the financial system, at a time when global trade is near decade lows.
4. Lastly, currencies are relative prices (as Stephen Roach pointed out, highlighted in last week’s review) and given covered interest parity, the Fed’s commitment to keep its term structure (via the Dot Plot) lower for longer (and further exacerbated if YCC is instituted), the relative strength over the Yuan and Euro (as the largest currency trading partners) abates as real US yields move increasingly negative (as inflation expectations tick higher).

Just on a side note, the remaining arguments consist of (i) oil price weakness (lowering demand for the US dollar-denominated commodity), (ii) greater fiscal policy cohesion within the Euro states (previously a headwind to Euro’s rising dominance), and (iii) qualitatively speaking, the erosion of domestic economic and sociopolitical strength, on a relative basis.

A gradual (or steep) weakening of the US dollar points toward a perfect storm of higher inflation coupled with weak economic fundamentals during a period of sky-high market valuations. The US-China trade discussions will need to be carefully managed so that the net neutral effect on cost-push / imported inflation is managed for US consumers. While the US may represent a higher cost of production, a larger share of incomes generated from US manufacturing would alleviate the (downward pressures on DXY from its) current account deficit, either through lower dependency of imports or greater share of exports.

The traditional method of dealing with inflation is a hike in interest rates, however with the Fed remaining at the ZIRP, higher interest rates would render US debt unserviceable (as the cost of debt monetization falls apart) as long-term interest rates steepen (the cost of managing duration rises).

MMT: Mainstream Monetary Theory?

Officially dubbed Modern Monetary Theory, MMT has taken hold of US politicians seeking an alternative method of sustaining government expenditure absent of (i) additional borrowing and (ii) tax hikes. MMT hinges on a nation’s ability to print money denominated in its own currency – quantitative easing quashes concerns over inflation, given its deflationary nature. However, the concern over MMT results from US Democrats push towards the ‘Green New Deal‘, a US$93 trillion project!

Proponents of MMT include Bernie Sanders, a self-proclaimed ‘democratic socialist’, who is (intellectually) backed by Stephanie Kelton, a professor at Stony Brook University. Kelton believes in a goldilocks scenario for MMT, where deficits can be (a) too big if they lead towards inflation but (b) risk being too small and risk “robbing the economy of a critical source of income, sales and profits.” However, Kelton remains within the theoretical realm.

Before you indulge on MMT fantasy, I suggest you read Robert Murphy’s review of Kelton’s ideas.

Market practitioners, like BlackRock’s Larry Fink calls MMT “garbage” as “deficits are going to be driving interest rates much higher and it could drive them to an unsustainable level.” Remember, when you print money faster than GDP grows (as in, debt-to-GDP rising), the quantity of money chasing a set number of goods & services causes inflation. What the theorists seem to miss is that, unless governments ‘print’ money directly from government and into the end-users bank accounts, the credit creation system relies on bank balance sheet and underwriting standards.

In recent years, consumer prices have experienced deflation (resulting from restrained commodity prices, from higher competition, and technology, efficiency leads to lower prices) while asset prices have experienced inflation (greater supply of financial money from low interest rates, limited options for capital / operational investment expenditure => cash hoarding, financial asset purchases). Therefore, the risk of higher inflation stems from higher interest rates to constrain money supply, which during a period of high leverage (debt-to-GDP, debt-to-EBITDA) presents an avalanche of risk.

Lastly, good luck to all you PMs this week.

Market Wrap – 20th June, 2020

Market Wrap for 2020.06.20

Markets started Monday weaker on accounts of (i) 2nd wave of Covid-19 cases in the US and (ii) imported cases of Covid-19 to China (based on European food imports) => this pushed US cash & futures equity into red erasing some of last Friday’s recovery. However, at 2pm on Monday, during US trading hours, the Fed announced it would begin buying (directly, instead of indirectly through corporate bond ETFs) corporate bonds with the New York Fed’s Secondary Market Corporate Credit Facility (SMCCF). This spiked new vigor (or fear?) into US equities and pushed transport names 5-10% higher on the day.

The Fed’s SMCCF will begin buying corporate bonds based on its term sheet, which includes (i) 1.5% portfolio exposure to any eligible issuer, (ii) eligible issuer rated BBB-/Baa3 (as of 22 March, 2020) but greater than BB-/Ba3 (as of the SMCCF’s proposed purchase date), (iii) eligible issuer’s business with significant operations in the United States, and (iv) purchasing on leverage at 10:1 for investment grade and 7:1 for (eligible) high yield. While the Fed’s announcement moved US cash and futures higher, this tailed off on Tuesday with geopolitical tensions rising.

However, moving forward to Wednesday, we see higher shutdown risk (insert tailrisk-on) with (i) New Zealand calling in the military to enforce border controls (over managing Covid cases), (ii) Beijing shutting down all of its schools and sealed off particular residential compounds to stem the Covid spread, and (iii) US cases picking up in six states (Arizona, Florida, Oklahoma, Oregon and Texas) with an expectation for hospitalisations to subsequently rise, as a result.

On Thursday, US equity futures began to show weakness after a relatively mixed Wednesday cash trading performance (NQ outperformed RTY & transportation) on the back of rising tail risk of lockdowns => VIX trading 4% higher to ~35 (in risk territory) post US cash close. Concerns over a second lockdown are warranted => China’s official data suggests it quashed the spread of Covid-19 back in February, however with recent lockdown and work-from-home measures being instituted, it’s risk-on for the US where daily infection count is rising in California and Texas, followed by Arizona and Florida <= this could represent the tail-end of ‘outbreak 1’ or the start of ‘outbreak 2’, pending hospitalisation data.

AUDJPY (L/S) was tipped as one of the key trades for 2020 (on the back of rising inflation concerns), however this may be weakened as Australia’s unemployment rate reached 7.1% (in April vs. 6.4% initially disclosed). Additional risks from (i) a BLM protestor in Melbourne has tested positive and (ii) Qantas has cancelled most international flights until October (as Australia’s Gov indicates its borders won’t be open any time soon). Still, focus will be on the commodity-driven nature of Australia’s economic recovery and Japan’s weakness in exports (amidst weaker global demand) and (relative) increased cost of importing energy. We should not discount the risks that Covid presents, especially on the ‘upper echelon’ of decision makers – Honduran President was hospitalised and diagnosed with pneumonia a day after he tested positive for Covid-19.

On Friday, the UK demonstrated a borrowing spree (under Rishi Sunak) of GBP55.2bn (taking the trailing 3 month total to ~GBP125bn) to stem the impact of Covid-19 on the UK’s economy. NA/EU markets closed lower with Apple announcing store closures given the spike in Covid-19 cases, a decision that brought heightened volatility on the day of ‘quadruple-witching’. Healthcare, specifically biotech, was the only positive performing sector.

My perspective on equity markets

Given the current level of risk vs. reward (read: every market commentator saying ‘distorted’), I remain out of any US & UK equity market positioning (sold out 9-10 June 2020) and will remain underweight both markets until we see greater clarity over (i) US political developments, in particular the social unrests, passing of $1 trillion in additional stimulus, control over Covid-19 spread, and (ii) UK developments on Brexit, clarity over BOE’s monetary policy coordination with its fiscal response (e.g. Project Birch, furlough budget)

US equity markets have sustained an impressive rise on account of improved equity risk premium (from a lower cost of capital), which I believe will represent a short-term ‘blip’ on the long-term equity chart. Given talks of the Fed considering yield curve control and its SMCCF (& PMCCF), in addition to broader QE (including corporate bond ETFs), the cost of debt remains artificially suppressed with (i) risk-free rate and (ii) corporate spreads completely distorted and not reflective of their underlying credit risk. Coupled with this is a general view of US dollar weakness => better relative value trades will present in Asia & Europe.

The US market has been driven purely on the ‘Fed Put’, without accounting for the economy’s underlying drivers: jobs, GDP, and inflation. The Fed’s forecast on the US economy’s underlying drivers underwhelms. The imminent systemic issue arising from inflation will wreck havoc on equity markets and monetary policy (to contain runaway inflation), both of which already sit on their ‘upper limit’ as we face record dislocation in valuation vs. fundamentals. The S&P 500’s concentration in F-A-A-M-G has yet to abate from ~22%.

The consequence of monetary and fiscal response creates a systemic concern over whether credit rating agencies will shift their credit rating spectrum on a fundamentals basis. This would see a weakening on financial thresholds for investment grade => high yield credit (e.g. 4.0x Debt/EBITDA => 5.5x Debt/EBITDA), on account of the system wide leveraging UP and suppressed (i) risk-free and (ii) credit spreads. Credit is always priced on a ‘relative’ basis, not on an absolute basis. If credit rating agencies loosen their financial thresholds (at the same time investors accept looser protective covenants), there will be increased pressure on well capitalised companies to increase their debt holdings (while keeping net debt at 0 or negative). This effectively worsens a key theme from 2019: zombie balance sheets (for investment grade) and zombie companies (for high yield).

Key events from the week are highlighted below:

India vs. China

Clashes on the border between India & China has resulted in ~100 fatalities (on both sides) and tension remains high. Confrontation has brewed for a while over India’s building of a new road in Ladakh which runs along the ‘Line of Actual Control’ which divides the two countries. Understandably, this puts into jeopardy the signing by China & India of the Regional Comprehensive Economic Partnership, which also involves Australia, Japan, Korea, and New Zealand. As India has shifted its geopolitical relations towards the US, at a time US-China relations have soured, puts India’s eggs ‘all in one basket’. India’s alliance with the US is expected to pay-off as Trump & Biden are essentially campaigning over how strict the US policy will be on China post November 2020 elections.

On the other side of China’s land mass, North Korea blew up its North-South Korea liaison office and moved its military police into the DMZ. Meanwhile, Beijing has shut its schools and urged people to work from home in order to extinguish the spike in Covid-19 spread. Questions over China’s growth are at the forefront of how a global economic recovery will be achieved, given China represents the second largest GDP in the world. However, with China escalating geopolitical tensions with pretty much every nation in Southeast Asia (Vietnam, Philippines, Malaysia over O&G and fishing resources, and Taiwan over WTO inclusion) and escalated geopolitical tensions with the West (United States, Canada, United Kingdom, Australia).

China’s Economic Outlook

China’s economy, previously driven by (i) external demand for its manufacturing and (ii) internal production debt-fueled often leading to an overproduction of ‘unproductive projects’ (e.g. ghost cities, roads to nowhere). Infrastructure upgrade has fueled asset wealth and introduced the idea of land ownership to the Chinese. However, what resulted from a decade of high growth was lifting a relatively poor population (on a GDP per capita) into ‘new’ wealth, which spurned global travel & foreign asset purchases. Southeast Asian economies and destination regions in Europe shifted their economic model towards serving the Chinese tourist. A global slowdown dampens China’s growth potential – this places further downward pressure on the ability to recover for already weak & tourism-dependent economies.

Looking inwards, China’s high growth has sustained its debt-fueled growth, something which comes into question if high growth slows, even if still double (the growth rate) relative to the global economy. Gross domestic debt is estimated to reach ~300% of GDP by 2022, a figure which puts into question how they will either (i) service the debt or (ii) deleverage its position. Deflation (if sustained) would exacerbate economic issues so we’d expect a stronger fiscal policy to support credit creation and money supply (via monetary policy, lowering bank reserve requirements and interbank rates) => however, skeptics are rightly concerned over China bank NPLs, particularly as China AMC NPLs are not inconsequential.

China 2H2020 Stimulus

Yi Gang (PBOC Governor) indicated on Thursday that China’s credit creation in 2020 will likely rise to RMB20trn from RMB16.81trn in 2019 and TSF to reach RMB30trn, accounting for ~30% of China’s GDP. PBOC measures to cut bank reserve requirement ratios and lower reverse repo rates has helped boost credit creation. However, the excess liquidity in the system (designed to stem issues of solvency problems) will need to be released in coordination with global economic recovery, in order to reduce the likelihood of demand-pull inflation:

The interaction between China’s economic recovery and global economic recovery continues to be mistimed in 2020:

• In January & February: China shut down its economy, this caused a ripple effect on Western economies as the reduced flow of goods & threat of Covid spread created a massive tail-risk on the economic cycle;
• In March, April, and May: China began (almost full) recovery from Covid spread and began opening its economy, however the rest of world was beginning to enter & remained in lockdown mode, slowing China’s ability to kickstart a recovery from exports.
• In May: Western economies have begun to show signs of lockdown easing, mostly partial but a trend toward re-opening their economies shines light on a potential for V-shaped recovery.
• Since mid-June: Covid cases continue to rise in the US, remains elevated in Brazil, and China contained a recent outbreak in Beijing (via partial lockdown measures) reinstitutes tail risk given chance of further lockdown.

China’s ability to institute lockdowns has been (drastically) more effective than the West. I see elevated risk of a second lockdown given Western government’s inability to institute quick measures to contain a potential new spread. A second lockdown would result from a foreseeable, uncontrolled spread. Given the limited knowledge governments (seem to) know about the virus, this overhang remains unpriced into the markets (given their focus on a higher equity risk premium).

China Financial Market Reform

New rules for Shenzhen’s ChiNext (a tech-focused board), whose constituents feature in benchmarks like FTSE China A50 and CSI 300 index, will be allowed to move upto 20% (either direction) in a trading session. This will impact broker risk-control systems regarding margin financing, share pledging, and ETF inclusion (given potential volatility of premium/discount to NAV). The reform by China Securities Regulatory Commission is meant to ‘open’ its financial markets, away from the volatility-reduced policy measures taken in 2015. Enhanced potential for volatility may increase southbound trading to Hong Kong as funds seek greater stability within the Hong Kong exchange mechanism.

Equity risk for China Big4SOE banks remains the upcoming TLAC issuance (and potential Basel reforms) which indicates a 5-20% dilution to CCB, BOC, ICBC, ABC (in order of dilution).

TINA: There Is No Alternative

The USD’s importance and value often ascribed with ‘there is no alternative‘ is still a currency which carries a relative price => this represents the currency nation’s value proposition (economic, financial, social, and political factors) in comparison with another nation. Some observers expect a 20-30% decline in the USD’s value, primarily against its main trading partners. Five countries account for 72% of total trade weights in the broad USD index: China (23%), Euro (17%), Mexico (13%), Canada (12%), and Japan (7%). Therefore, a weaker USD would require a coordinated strength in China and Euro area, given a combined 40% contribution to the index.

For China, structural reform whereby a shift from (i) manufacturing to services, (ii) investment- and export-led to consumer-led growth, and (iii) financial liberalisation of the financial system would underpin a strengthening RMB, especially in the face of increase US-China trade risk. For the Euro area, fiscal policy coordination between Germany, France and Italy has raised confidence in the area’s ability to maintain unity. Therefore, USD weakness hinges on RMB & EUR strength, which would solve China & Europe’s concern over its sustained current account surplus.

Furthermore, USD’s share of official foreign-exchange reserves has declined from 70% to 60% in the last 20 years. If this trend continues, TINA doesn’t hold in the face of sustained devaluation from increasing debt issuance and weakening of the “Dollar Smile” framework, which describes gains in the USD from EM positioning on (i) US growth > RoW and (ii) safe haven currency. In the near-term, regions able to establish a sustained reduction in nationwide coronavirus cases, of which the US has not established, will give it a ‘leg up’ on its peers.

Given the Fed has effectively locked-down the front-end of the UST curve, until 2022, the flattened yield curve has compressed out any premium from the swap rate between USD vs. G10 currencies. In the medium-term, the Treasury’s sustained debt issuance in the face of weak economic & political structure erodes its (comparative) ability to run a large current account deficit while maintaining low borrowing costs.

US-China Trade War 2.0

Trump is set to meet his advisors ahead of this Sunday’s deadline on the next round of US import tariffs on Chinese goods, while Pompeo has met with Yang in Hawaii which resulted in a pledge of cooperation. Trump’s decision will be to implement (a 15% tariff on $160bn of Chinese imports) or delay the proposed measures. While these measures are designed to improve their respective current account imbalances, heightened geopolitical tension remains a cause for concern over potential for escalation.

Myth of Imported Labour

As raised (to his own contradiction), Mark Zandi, head economist at Moody’s, responds to the question of “shutting down immigration”, in an interview with CNBC, that sectors like “agriculture, construction, leisure and hospitality” as needing ‘those workers’ as ‘being necessary’, being immigrants, and then flows the discussion towards “immigrants being key to innovation and ultimately technological change and productivity growth and growth in standard of living. They are, by definition, risk takers.”

Importing low-quality labour into the US has effectively deflated prices, since your input cost (labour) is lowered, however to then branch the discussion into (what I would assume as children of) immigrants being risk takers and promoting innovation and change is somewhat farfetched given the current economic outlook for the US. If unemployment in the US remains ~10% by end-2020, a US citizen should question whether the chance of getting a jobs is being diluted by immigration policies.

Covid vs. Fossil Fuels

The energy sector has (arguably) been the hardest hit from the coronavirus pandemic, as (i) domestic energy consumption (in the form of electricity & fossil fuels), (ii) global trade volumes, and (iii) leisure travel has been wiped out. As demand for electricity plunges in the West, the East will be looking towards ways to improve its cost of goods sold (as manufacturing hubs). Putting downward pressure on wages pushes deflationary outcomes, therefore lowering production hour costs (electricity, hydro) and easing pollution controls will provide a slight tailwind to fossil fuels => coal.

Asia makes up 75% of global coal consumption, obtaining most of its coal from China, Indonesia and Australia. Coal will become an even larger Asia story as weaker consumer demand in the US has forced US coal plans to shut => they may struggle to re-open as coal prices have dropped to 3-year lows. A similar story is playing out in Indonesian where ICI coal prices are at or close to their cash costs (including government royalties). With the US expected to burn just 394mn MT of coal in 2020 (26% lower than initial forecasts in January), a rebound in the US coal sector will be unlikely as utility companies in the US shift away from coal and into cleaner energy inputs.

For China, which burns and mines ~50% of global coal, coal plays an important part in keeping the cost of living low for Chinese residents. In fact, China is expected to add upto 10% of new coal-fired generating capacity by 2024 (to reach 1,200GW), at which point coal will dominate China’s energy mix for household consumption and factory production. For the remaining BRIC, India’s state-owned Coal India is expected to produce 710mn MT in 2019 while keeping its eye on the 1,000mn MT target by 2024 in anticipation of sustained (coal) demand. Thematically, coal will play an increasingly integral energy source for China and India moving forward as their economies seek greater independence from reliance on global trade while looking at ways to stimulate its domestic consumption levels.

This coincides with an IEA report (on Thursday) suggesting that 2019 will represent a peak in global emissions but will cost the global economy a $1 trillion investment from public and private capital, on top of the existing investment allocated to clean energy. Potential job gains from the new investment could help offset a subset of the inevitable job losses in the fossil fuel sectors. 

Indonesia Growth Concerns

Indonesia decided to cut its RRR rate by 25bps (to 4.25%) and lacked the ability to demonstrate strength (to other EM central banks) that remaining steadfast on their monetary policy will play an important role in preserving capital flows. Mizuho expected rates to remain steady at 4.5% in order to provide stability among global uncertainty. Remember, back in 2019, the Bank of Indonesia was doing everything it could to strengthen and keep the Rupiah under 15,000:USD.

The Indonesian rupiah has strengthened from its weakest point at ~16,500:USD back to 14,200:USD area (similar to the intervention levels in 2019, amidst a strong DXY). A stronger IDR boosts importers of raw materials & goods while weakens its exports (crude palm oil, coal, O&G) => given where commodity prices are (weak and at near cash cost levels in US$ terms), a stronger rupiah reduces risk of imported inflation. However, Indonesia’s economic recovery hinges on China’s recovery (given its placement within Asia’s supply chain) and remain a ‘cheap’ production house, an incoming issue given the outlook of a weakening DXY (discussed below).

Walter Bagehot’s Principle

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Walter Bagehot’s principle was to lend freely at high rates (of interest) against good security (collateral). The principle seeks to alleviate a liquidity problem so that it doesn’t create a solvency problem. But, the cost of stemming the liquidity problem must outweigh the benefit(s) of preventing the solvency problem. This is precisely where central banking (in the West) has failed Bagehot’s principle.

There is one recent example (that has come to my attention) that meets Bagehot’s principle (but, in principle only). Hong Kong Government’s restructuring package for Cathay Pacific Airways, a company listed on the stock exchange in Hong Kong. Cathay Pacific’s announcement:

https://www1.hkexnews.hk/listedco/listconews/sehk/2020/0609/2020060900356.pdf

In summary, the restructuring plan is HK$39.0 billion (or HK$40.95 billion, if the warrant is fully utilised), with the Hong Kong Government (HKGov) providing (upto) HK$29.25 billion or 75% of the restructuring proceeds. HKGov’s package is as follows:

1. HK$19.5 billion in preference shares, which carry a step-up coupon (paid semi-annually, deferrable (compounded) but cumulative in arrears) of:
   • 3% in first 3 years;
   • 5% in 4th year;
   • 7% in 5th year; and
   • 9% in 6th year and beyond).
2. HK$1.95 billion in warrants (detachable, to subscribe for Cathay Pacific’s ordinary shares), which would give the HKGov a 6.08% equity interest in the company (following the proposed 7-for-11 rights issue, below);
3. HK$7.8 billion of bridge loan (drawdown available up to 12 months after 6 June 2020) carrying an interest rate of Hibor+150bps AND security “granted over certain aircraft and related insurances”, with a maturity of 18 months.

The remainder of Cathay Pacific’s restructuring plan is 4. HK$11.7 billion 7-for-11 rights issue, of which “Irrevocable Undertakings” have been made by Swire Pacific, Air China and Qatar Airways to take-up their allotment in the rights issue. Their three combined shareholdings (pre-rights issue) is 84.98%, which means that HK$9.95 billion of the HK$11.7 billion rights issue proceeds have been committed.

From Cathay Pacific’s analyst briefing presentation: https://www.cathaypacific.com/dam/cx/about-us/investor-relations/announcements/en/2020_analyst_briefing_webcast_en_locrechk.pdf

The Preference Shares and Warrants are both transferrable. The Preference Shares (including its fully deferrable (compounded) and cumulative dividends) are transferrable “at any time subject to limited exceptions”, however details of which are not disclosed. I hope this will be clarified in due course, especially as HK LegCo’s submission on the recapitalisation plan suggests the warrants are included within and detachable from the Preference Share allocation. This would bring the total recapitalisation plan to HK$39.0 billion (and not HK$40.95 billion as some analysts suggest). The (detachable) Warrants are transferrable but contain a restriction on non-transferability to (subject to Cathay Pacific’s consent) (i) a competitor and (ii) substantial shareholder, of Cathay Pacific.

There are a few additional details but not material to this article’s point. So how does Cathay Pacific’s restructuring plan demonstrate Bagehot’s Principle?

Cathay Pacific (as opposed to US or European airline stocks) has a controlling shareholder: Swire Pacific. Given Swire Pacific’s diversified business model, large asset base (as controlling shareholder of Swire Properties), and strong credit rating (A3), Cathay Pacific is well ‘backed’ by its controlling shareholder. Read: good security.

Add to this, Swire Pacific has undertaken to remain a controlling shareholder of Cathay Pacific so long as the HKGov’s preference shares or (any amount of) bridge loan remains outstanding. This means that HKGov’s financing (or investment) of Cathay Pacific is backed by a strong creditor => Bagehot’s Principle, “against good security”.

Therefore, while Cathay Pacific may not represent “good security” (as direct borrower), it’s controlling shareholder (Swire Pacific, as indirect backstop) certainly does. However, when you consider the financials, it’s a grim picture => hence why I mention, this is Bagehot’s Principle “in principle only”.

Cathay Pacific’s cash flow from operations (CFO) in 2019 was HK$15.3 billion. Even if 2020 to 2023’s CFO is equivalent to 2019’s (which is 100% impossible), accounting for expansionary & maintenance capex (~HK$20 billion per year) we’ve got negative FCF, not even accounting for finance lease costs (~HK$7.5 billion per year).

The more likely scenario is that the HK$39.0 billion restructuring package will keep Cathay Pacific operating for another 12-24 months (maximum). Therefore, Cathay Pacific will likely need to conduct another restructuring within the next 18-24 months, considering:

1. Sharp drop and slow recovery in global consumer travel (CX ~163.3 billion ASK with ~82.3% load factor in 2019);
2. Cargo flow (~17.5 billion ATFKs) dragged by a worsening load factor outlook (has averaged ~65%), given (i) weaker external demand for China’s exports and (ii) push towards de-globalisation;
3. Limited ability to ‘squeeze’ and drag out its working capital position; and
4. 2019 year-end cash (& equivalents) of HK$14.9 billion vs. a cash COGS of ~HK$75 billion (in 2019).

Swire Properties generate ~HK$8-10 billion in CFO per year (expected to revert downwards given weaker economic outlook => lower headline rents, higher lease incentives, lower collection), Swire Pacific does not have the stand-alone means to refinance the HK$19.5 billion (and HK$7.8 billion bridge loan) within the next 3 years UNLESS Swire Properties conducts asset disposals.

Swire Properties had HK$277 billion in investment properties, mostly in Hong Kong, with a relatively small loan book (HK$30 billion).

Swire Properties 2019 annual report: https://www1.hkexnews.hk/listedco/listconews/sehk/2020/0406/2020040600596.pdf

Therefore, I would expect Swire Properties to begin diving into their IP portfolio with a view to improving each potential IP disposal’s WALT & tenancy profile. Real estate guys call this “repositioning”. This would be a perfect time for Swire Properties to conduct asset sales before we hit (what I consider will be) a ‘perfect storm’ of inflationary depression to kick-start the deleveraging process, given:

• Hong Kong’s IP value held on balance sheet is HK$238.2 billion covering ~12.7 million square feet => ~HK$19,000 per square foot; while
• China’s IP value held on balance sheet is HK$32.2 billion covering ~7.8 million square feet => ~HK$4,000 per square foot.

Obviously, the value of Hong Kong real estate has been questioned in the past, however with Hong Kong’s real estate market under pressure, with decade-high vacancy rates, the Hong Kong IP portfolio will provide the obvious candidates for repositioning then disposal:

From SCMP’s article: https://www.scmp.com/business/companies/article/3088487/hong-kongs-office-market-hollowing-out-vacancy-rate-hits-10-year

However, the issue Swire Pacific may face in the case of a subsequent equity injection, which causes Swire Pacific’s shareholding to increase by more than 2% (i.e. breaching the creeper rule), to trigger a mandatory general offer would complicate the existing cross-holding with Air China (29.99% stake in Cathay Pacific).

Now, back to Cathay Pacific’s restructuring plan.

20% (HK$7.8 billion) of the restructuring plan is committed via debt (in the bridge loan), while the remaining 80% (HK$30.15 billion) is committed via equity (preference shares, warrant, rights issue). As a large chunk of HKGov’s financing is in the form of preference shares (HK$19.5 billion, or ~50% of the total restructuring plan), the rationale would be to improve Cathay Pacific’s (i) debt/equity ratio and (ii) prevent any potential breach of financial covenants on its existing loan book.

Satisfying Bagehot’s Principle: the embedded step-up coupon of the preference shares (highlighted above) means that Cathay Pacific has EVERY incentive to redeem (either via cash flow or refinancing) and cancel HKGov’s preference shares by the 4th year, really within the 3rd year. While the preference shares are redeemable in (full or) part by Cathay Pacific, they would carry HK$1.755 billion per year in coupon, or equivalent to ~10% of Cathay Pacific’s CFO in 2019, if fully outstanding by year 6 (assuming dividends are paid and not in arrears from years 1 to 5).

While the 3-4 year mark is in-line with how IATA, General Electric / Rolls Royce, Lufthansa view the global consumer travel recovery period (3-4 years), the financials of Cathay Pacific simply imply a ‘kick the can down the road’ to refinance the HK$19.5 billion of preference shares in 2-3 years, given the lack of internal cash flow generation (excluding asset sales) of Cathay Pacific (& Swire Pacific) to redeem within 3 years.

If we look at the ‘duration’ of Cathay Pacific’s restructuring plan, we’ve got:

• 20% committed as debt (via bridge loan) for a period of 18 months (drawdown <12 months from now);
• 50% committed as medium-term equity, in the form of preference shares, which most likely will get redeemed by the 4th year; and
• 30% committed as long-term equity, in the form of ordinary share subscription.

There certainly is a geopolitical angle to the HKGov’s financing but let’s not get into that today, although briefly highlighted above on Air China’s cross-holding. The point is, HKGov is providing ample funding to alleviate any liquidity concerns that could exacerbate into a solvency problem.

HKGov’s financing package is designed to be fully repaid within 3 years. In fact, the interest HKGov would receive over the first 3 years (assuming bridge loan fully drawn) would be HK$2.00 billion (HK$19.5 billion @3% over 3 years + HK$7.8 billion @Hibor+150bps over 1.5 years), which is roughly equivalent to the HK$1.95 billion warrant issued to HKGov.

Therefore, should HKGov exercise its warrant, from the Hong Kong citizen’s (& taxpayer’s) perspective, any equity exposure (from the warrant’s exercise) would be fully covered (to zero) by the interest received on the preference shares & bridge loan over the first 3 years. A pointless analysis as the preference shares would be (basically) worthless if the ordinary shares drop to zero, but anyways.

So, the above should serve as a warning on investor’s positioning in ‘value’ vs. ‘growth’ in the next 6-18 months. Don’t chase ‘value’ for the sake of value – consider whether it’s return on equity will remain higher than its cost of capital. Two things to consider:

1. Equity dilution is real and it will come. Governments need to look at individual (strategic) companies and restructure them with equity, not debt.
2. If the restructuring package is provided with a non-ordinary / common share method, analyse the risks (e.g. whether company stand-alone or with extraordinary support can repay financing) and HOW repayment is possible.

For an overview on how to analyse ‘value’ vs. ‘growth’, given the Fed’s ‘assurance’ of zero-lower bound interest rates, it’s worth reading Morgan Stanley Counterpoint Global’s recent piece on “The Math of Value and Growth”.

https://www.morganstanley.com/im/en-ch/intermediary-investor/insights/articles/the-math-of-value-and-growth-en.html

Disclaimer: the above is not investment advice.

I’m back

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Where have I been? Working…

For those catching up on this blog, for whatever reason that may be, I’m going to try and share a few more thoughts on how to navigate the economic recovery or downfall we will see in the coming 6-18 months.

Here goes.