Just because the tech bubble didn't burst this year doesn't mean there isn't one.
During the dawn of the smartphone era, startups could raise money simply by pitching themselves as the mobile-first solution to any problem. However, with the hardware market almost fully saturated and software market overcrowded, companies are struggling to live up to prior valuations.
Since 2015, leading tech research firm CB Insights has counted 80 down rounds, or instances where startups accepted additional funding at reduced valuations. Roelof Botha, a partner with VC firm Sequoia Capital, says there is a "fog hanging over the industry" similar to what he felt after the dot-com boom.
Due in part to the overall unattractiveness of expected returns in public financial markets, private equity funding has been easy to come by. Venture capital firms raised $12 billion in the first quarter of 2016, a 10-year high. "The world has never seen an investment climate like this one. It's hard to express how much money is out there," said Bill Gurley, a partner with Benchmark VC firm benchmark, in a Bloomberg interview.
In addition to free-flowing money from the venture capital world, private companies have benefitted from a surge in capital available from so-called "tourist investors," i.e. hedge funds and mutual funds who don't usually occupy the space. Tourist money has papered over the cracks of lackluster financial performance for many private companies, but the worry is if earnings don't grow and economic conditions worsen, these fickle visitors will not hesitate to head for the hills.
Oil Rebound Sends Junk Bonds to 2016 Highs
Oil continued to rebound this week with crude prices hitting 15-month highs as stockpiles fell more than expected.
Saudi Arabia is outwardly confident other oil-producing countries will join OPEC in cutting production, but it could be just wishful thinking. In reality, the Saudis have little choice but to cut output. Political pressures at home are building due to a lower standard of living resulting from budget cuts. The kingdom will want to boost oil prices to maximize proceeds from the upcoming initial public offering (IPO) of state oil company Aramco. Lastly, it needed send a bullish signal to investors before this week's bond auction in order to maintain its credit rating.
To the last point, Saudi Arabia raised $17.5 billion this week in a record sovereign bond sale, eclipsing Argentina's $16.5 billion sale earlier this year. The kingdom reportedly sold $5.5 billion worth of five-year bonds at a 135 basis point premium to U.S. treasuries, $5.5 billion 10-year bonds at a 165 basis point premium and $6.5 billion 30-year notes at a 210 basis point premium. And with oil prices stabilizing above $50 per barrel, there wasn't any shortage of demand. Investors reportedly submitted $67 billion in bids.
The rebound in oil prices has also done wonders for the high-yield bond market, with junk bonds rallying to 2016 highs this week.
Junk bonds typically track the performance of stocks, but with equity markets largely unchanged in recent months the correlation has broken down. The rare divergence could mean one of two things: stocks could be poised for a rally or junk bonds could be set for a snapback.
At the same time, credit spreads have also compressed considerably. With oil's comeback also boosting headline inflation expectations, analysts are once again warning about duration risk.
With investors having moved further out on the curve to capture yield, Goldman Sachs says a 1% increase in interest rates - "far from a fat tail scenario" - could trigger $1.1 trillion in losses for U.S. bondholders. Average bond maturities worldwide are more than double the inflation-adjusted level of 2009 and three times that of 1994, creating elevated duration risk. Foreign central banks and sovereign wealth funds, large buyers of U.S. fixed income, would suffer the biggest losses in the event of an interest-rate spike.
While bond buyers are facing greater risks, debt issuers are enjoying a bonanza. Sprint this week became the latest junk-rated company to sell bonds at investment-grade prices. The telecom upstart is issuing $3.5 billion of bonds at rates similar to larger competitors Verizon and AT&T thanks to some creative maneuvering. To get around covenants on existing debt, Sprint is transferring 14% of its wireless spectrum holdings to a special purpose vehicle that will then issue the new bonds. Sprint will then pay $2 billion a year to lease back the assets. By virtue of this creative arrangement, the new bonds will occupy a senior position in the company's capital structure because lease payments would continue even in bankruptcy.
Maybe this discussion veered too far into the weeds, but it all goes to underscore the 1) rabid demand for corporate debt 2) lengths companies will go to take advantage of this historical period of rock-bottom interest rates.
Rise of Indexing Risk Destabilizing Markets
A combination of market forces and faulty regulation are accelerating the stampede into low-cost index funds.
Over the past three years, investors added nearly $1.3 trillion to passive mutual funds and exchange-traded funds (ETFs) while pulling around $250 billion from active funds, according to Morningstar (via the WSJ). The biggest beneficiaries have been Vanguard, which now manages around $3.5 trillion, and Blackrock, whose reported assets this week grew 14% year-over-year and topped $5 trillion in assets under management (AUM) for the first time ever. Around 93% of Blackrock's $55 billion in Q3 net inflows in Q3 were attributed to its iShares ETF unit.
A reminder: the rise of market-cap weighted indexing poses a couple of issues for markets 1) The lack of discretion in allocating capital causes indexed stocks to become overvalued and hurts the market's ability to price stocks efficiently, and 2) The fact a handful of large asset managers now own a significant portion of the stock market could reduce the incentive for corporate competition and impair the capitalist system.
While the simplified approach of index investing has outperformed active management in the post-crisis era, the rush into passive strategies near the tail end of a bull market cycle could lead investors to the slaughter. The Department of Labor's (DOL) fiduciary rule, which takes effect in April, threatens to exacerbate the problem. While not explicitly requiring retirement advisors to put clients in the lowest-cost funds, the rule exposes advisory practices allocating to active funds to significant litigation risks in the event clients feel their (loosely-defined) "best interests" haven't been represented. Given the choice between unknown litigation risk and cheap index funds, advisors are choosing the latter.
The Illinois State Board of Investment, which oversees a $20 billion, voted last month to convert their 401(k)-type plan to an all-index-fund lineup. Lawsuits over the underperformance of active funds in the portfolio influenced the decision, according to the board's Chairman Marc Levine. At a recent meeting, the board's attorney "walked us through the potential liability if there is harm to even a single participant," Levine said. "It was quite a wake-up call."
A financial advisor's job is to create a long-term asset allocation for clients that performs well over full business cycles. Of course indexing strategies will outperform in a zero-interest-rate-driven bull market, and yes historical long-term returns for passive beat those for active. But 1) not all active managers are created equal, and 2) there is no guarantee the past will look like the future, especially as the world faces a host of massive demographic challenges. When the pendulum swings so far to one side in the "active vs. passive" debate, it's usually time to play contrarian.
Don't Call It a Wall Street Comeback
Banks have gotten ensured earnings off to a great start, with residual gains coming from unexpected places.
The deaths of investment banking and bond trading have apparently been greatly exaggerated. Last week Citigroup and J.P. Morgan beat top and bottom-line estimates thanks to higher-than-expected revenues from fixed income trading and investment banking. Citigroup saw its bond trading revenues climb 35% while J.P. Morgan investment banking fees grew 14% year-over-year to $1.74 billion, the division's largest-ever third quarter haul.
The trend showed no signs of abating this week, with Bank of America, Goldman Sachs and Morgan Stanley topping estimates for similar reasons. Bank of America's corporate and investment banking revenue of $1.46 billion was its highest total since merging with Merrill Lynch in 2009, helping global banking revenue climb 22% from the year-ago period. Goldman Sachs' commitment to bond trading paid off in a big way as revenue from the business surged 49%. Morgan Stanley fixed income sales also turned around, while a record-breaking quarter for wealth management also contributed heavily to a top and bottom-line beat.
Low interest rates around the world have led to dire predictions for financial firms, which will now likely be tempered. However, not all banks are in the same boat. While firms like Goldman have stuck by languishing divisions, others are being forced to further concentrate the scope of their business due to financial stress - namely, Deutsche Bank (and Credit Suisse and UBS).
Just as investment banking revenues are rebounding, Deutsche Bank is looking to shrink its U.S. operations. Companies in better financial health are seizing the opportunity to grab more market share. HSBC, whose stock is up 16% year-to-date, recruited a Goldman Sachs executive to revitalize its investment banking division. Deutsche Bank shares are down nearly 40% this year, although the stock did rally this week back to levels last seen before the Department of Justice (DoJ) revealed plans to seek a $14 billion fine.
Brexit Gilt Trip Could Roil Markets
The pound - as floating currencies do - has absorbed the economic impact of Brexit, falling nearly 20% since the referendum. But another rebalancing could have a much more destabilizing effect on financial markets.
Bond yields typically (loosely) track inflation expectations. When a currency undergoes significant depreciation, inflation expectations increase - as they have recently in Great Britain. U.K. consumer prices rose 1% in September, more than expected, almost double August's 0.6% reading and the highest print since November 2014. Furthermore, in a Bloomberg survey published Tuesday, economists' median forecast expects inflation to hit 2.2% next year and 2.3% in 2018. Meanwhile, Bank of England (BOE) is expected to cut rates even further in early November.
Yield on the 10-year gilt have doubled in the past month, but the spread between U.K. government bond yields and inflation expectations remain at a historic high of around 240 basis points. Gilt yields would need to climb by another 150 basis points to revert to historical averages, a move that would cause significant pain for U.K. bondholders.
Elsewhere, the European Central Bank (ECB) decided to leave its stimulus measures unchanged, as expected, although a lack of forward guidance means Mario Draghi will need to more clearly set expectations at the December 8th meeting.
China Ready to get Serious About Reform
Wouldn't you know it, China's official GDP reading came in exactly in line with expectations at 6.7% (the government's 2016 goal was for growth between 6.5% and 7.0%). The transition to a consumption-based economy appears well under way as retail sales (+10.7%) led the charge while industrial output (+6.1%) lagged.
While the headline number is encouraging, the reality is the Chinese government has not adequately followed through on promises to curb debt and housing speculation. Credit expansion surprised on the upside in both August and September, while investment spending continues to emanate predominantly from the public sector. However, Beijing appears to be taking matters a bit more seriously so far in October, with more than 20 cities reversing a two-year trend by introducing more stringent mortgage lending standards and implementing purchase restrictions. Policy makers have also tightened short-term money markets in order to curb excessive leverage in bond investments.
Following the data, the yuan also fell to six-year lows past the government's stated year-end target. The dilemma for the Chinese government is while yuan hits new lows against the dollar, it's still strengthening against other global currencies (causing Chinese exports to fall 10% last month). Policy makers likely want to allow the yuan to depreciate further, but do not want to trigger more capital outflows as they did with a surprise devaluation in August 2015.