The push and pull of financial regulation continues on Capitol Hill.
As part of their ongoing effort to make big banks too dull to fail, the Federal Reserve wants to take the Volcker Rule a step further by putting an end to merchant banking (the practice whereby banks purchase stakes in companies rather than lending them money). The move would act as another disruption to financial sector economic expectations while addressing a "problem" not seen as having any role in causing the global financial crisis.
Private equity firms, not wanting to suffer the same fate as big banks, are fighting back against Dodd-Frank. The industry, citing the lack of systemic risk it poses, is lobbying the House of Representatives (with apparent success) to roll back some of the more stringent reporting obligations included in the controversial bill.
Bank of America, meanwhile, assigns a 20-50% probability humans are living in a matrix-like alien simulation, which makes arguing about interest rates and financial regulation feel a bit trivial.
Markets Plummet to Snap Out of Summer Slumber
The S&P 500 finally saw its streak of 51 straight trading days without a 1% move in either direction (dating back to June 27) come to an emphatic end Friday as the index fell nearly 2.5%. When the market rallies investors hardly require an explanation, but when stocks fall financial pundits always need a narrative. The blame Friday was placed largely at the feet of Boston Federal Reserve President Eric Rosengren.
A typically-dovish member of the rate-setting committee, Rosengren said in prepared remarks "a reasonable case can be made for continuing a gradual normalization of monetary policy" while suggesting persistently low rates may be doing more harm than good. His comments, however, were not particularly hawkish nor did they bear any mention of rate hike timing, making the rationalization for the selloff look tenuous. More likely is investors simply took risk off following a historically-quiet August when stocks hovered near all-time highs despite four straight quarters of earnings contraction and lackluster GDP growth in the first half of the year.
Expectations for a September Fed rate hike are still low, climbing from 18% to 24% on Friday, while odds for a hike by December grew modestly from 51% to 55%. Sitting bond king Jeffrey Gundlach and European Central Bank (ECB) President Mario Draghi also got some credit for bringing the bears out of hibernation. Gundlach warned about complacency regarding a potential hike surprise in September. Draghi and Co. elected to keep all key interest rates unchanged while providing no indication about expanding their quantitative easing (QE) program. In fact, the only change from the ECB's July policy statement was the date line, suggesting that like many traders the ECB may have just gone on holiday for the last few weeks.
Talk of a rate hike had an even more profound effect on safe havens. Utility stocks, as tracked by the Utilities Select Sector SPDR ETF (XLU), fell 3.72% to their lowest level since late May. A selloff in U.S. treasuries saw the 10-year yield climb six points to 1.67%, its highest reading since mid-June. With doomsday fears over Brexit dissipating, Germany's 10-year bund yield climbed into positive territory to levels not seen since before the British referendum, closing at 0.04% (yield bottomed out at -0.20% in early July). The move in longer-term bunds was even more violent, with the 30-year making a five standard deviation move (19 basis points from 0.42 to 0.61) in just two days (Thursday and Friday).
There has also been a "quiet riot" in Japanese government bonds (JGBs) over the past month, pushing the 10-year yield briefly back into positive territory Friday (it closed the week at -0.01% having hit a low of -0.29% in early July). The move was tempered by comments from Bank of Japan (BoJ) Deputy Governor Hiroshi Nakaso, who insisted the central bank would not rule out pushing rates even deeper into negative territory. The BoJ is turning its attention back to the interest rate front because it's simply running out of bonds to buy. At the current purchase rate of $750 billion worth of bonds per year, analysts estimate banks will run out of bonds to sell the BoJ within 18 months - and perhaps earlier if they want to maintain appropriate levels of safe debt collateral for everyday transactions. Ultimately, Japan's inability to engineer its way out of a demographic death spiral serves as a cautionary tale to Europe, which faces a similar crisis over the coming decade.
The ECB is similarly running up against the limits of monetary policy due to self-imposed rules limiting its ownership of Eurozone government bonds. As a result, the ECB began buying corporate bonds in June, with suggestions its next step could be outright stock purchases or helicopter money. As a result of the program, European corporate bonds have seen record issuance. Yields plunged to record lows Wednesday before retreating with the rest of markets Friday, although the sell-off was muted in comparison.
French drug-maker Sanofi thus became the first non-financial private company in Europe to issue bonds with a negative yield. Distortions have gotten so out of hand that despite deteriorating fundamentals, some junk-rated companies are even issuing short-term debt at zero percent interest. Many investors are still buying this stuff with expectations the ECB will continue its corporate bond-buying scheme, but the more prevailing wind has been a migration into U.S. and emerging bond markets. U.S. high-yield mutual funds have seen net inflows of $6.4 billion so far in 2016 compared to net outflows of $47.7 billion over the past three years, according to data from Thomson Reuters Lipper cited by the Wall Street Journal. As a result, credit spreads in the U.S. are getting uncomfortably tight.
Yield-hungry investors betting on a goldilocks economy would be decimated by a surprise rate hike, which is among the many reasons one will never come to pass. Larry Summers thinks Janet Yellen is crazy to be even talking about a rate hike at all. Central banks have put markets in an endless feedback loop where any positive trend in economic data leads to a series of hawkish statements from policy officials that ruin the conditions necessary for an actual policy tightening. Barring an election surprise, expect the economy to bounce along the bottom long enough for the Fed to continue its annual holiday tradition: the December hike.
Oil Oversupply Concerns Aren't Going Away
Contributing to Friday's sharp sell-off was 4% decline in the price of crude oil. Crude prices spiked early in the week following discussions between Saudi Arabia and Russia at the G20 summit over potential output limits. Leaders of the two oil-rich countries triggered excitement when they teased a "significant announcement" but the loosely-worded agreement that followed offered no meaningful cooperation, with Iran's reluctance to participate in a freeze remaining the major sticking point. Saudi Arabia said there is no current need to limit production despite the kingdom canceling $20 billion worth of projects over budget considerations caused by persistently low oil prices.
If the Saudis are still hoping to quell the U.S. shale revolution, Wednesday brought some depressing news: Apache (APA) announced a surprise discovery in the Permian Basin that could yield up to 3 billion barrels (worth conservatively $8 billion) of oil and gas equivalents (BOEs). Oil exploration and production companies had long written off the area in question near the mountains of West Texas as inhospitable for hydraulic fracturing (fracking) due to the soil's high clay content. However, a team of researchers led by Apache's Steve Keenan (formerly of EOG Resources) approached the problem with a fresh set of eyes. None had ever worked in the basin, which Keenan credits for allowing them to have an open mind. Rejecting existing dogma and preconceived notions about the quality of the soil, Apache gleaned favorable results from its own proprietary 3D seismic data analysis and then proceeded to systematically test various drilling concepts. After ultimately finding the clay content to be very low, the company gradually snapped up leasing rights for remaining land near the site, which they are calling Alpine High.
Perhaps the most compelling part about the discovery is that based on early tests Apache believes harvesting the resources could be economical at $40 oil and $2.50 natural gas prices on a full-cycle (all-expenses-included) cost accounting basis. If such estimates hold, it would mean a 30% profit margin rarely seen in the oil and gas business. In addition, Apache expects to be able to source much of the water it needs for fracking from deep brackish formations in the Permian Basin, which minimizes common environmental concerns about the pollution of underground fresh water.
In addition to having significant implications for global oil and gas supply (not to mention Apache shareholders), the discovery provides a fun metaphor for investing and entrepreneurship. Just because others say something's impossible doesn't mean with fresh, contrarian thinking it can't be done.
Record Pipeline Deal Highlights M&A Wave
Mergers and acquisitions (M&A) activity shows no signs of letting up.
Sticking with the energy sector, Canadian oil pipeline giant Enbridge (ENB) announced an all-stock takeover of natural gas pipeline operator Houston-based Spectra Energy (SE) creating a $128 billion infrastructure behemoth, the largest in North America. Both stocks rallied on news of the deal, which is not expected to face significant antitrust scrutiny because of the lack of overlap between the two businesses. By making it an all-stock merger with limited premium, the companies are hoping to avoid the commodity exposure risk, debt burden and complexity that eventually doomed the proposed Energy Transfer Equity-Williams linkup. Elsewhere, EOG Resources struck a deal to acquire Yates Petroleum for $2.5 billion.
Hewlett-Packard (HPQ) announced plans to spin off its software business to create a new $8.8 billion entity in cooperation with UK tech company Micro Focus. Intel is spinning out Intel Security with help from private equity firm TPG in a deal that values the business, to be renamed McAfee after the antivirus software Intel previously acquired, at $4.2 billion. General Electric announced acquisitions of two leading metal-based 3-D printing companies, Germany's SLM Solutions and Sweden's Arcam, for a combined $1.4 billion as it looks to win the future of automated industrial manufacturing.
Bayer raised its offer for Monsanto to more than $65 billion ($127.50/share), with Fox Business reporter Charlie Gasparino reporting the deal nears completion.
Liberty Media agreed to buy international motorsports business Formula One for around $8 billion. Environmental testing company Danaher agreed to acquire molecular diagnostics firm Cepheid for around $4 billion.