Credit Suisse Cheese

Holey balance sheet! Over the course of March, Credit Suisse has lost what could be double-digit billions of dollars in capital once all the dust has settled and losses are fully accounted for. The company has been mum about the numbers thus far, but they had a spectacular quarter end finish when a large family office collapsed under outsized leverage and Credit Suisse drew the short straw in the prime brokerage community and now appears to be one of the more serious casualties. The details are still being sorted out and so the following is an attempt to give some idea of the two major events to rock Credit Suisse. The details are likely to change as more reporting is done on the matters. Note these events are not isolated to Credit Suisse but the bank is key to both.

Greensill Capital was a supply chain lender. They were considered best in class and Sir Greensill was tied into influential names among the UK government. His firm lent into the global supply chain and sold the debt to investors. Its most recent investment partner was Credit Suisse, who had a series of investor funds that bought the loans. Since the loans were of various quality supply chain companies, they were covered by credit insurance to protect in the event of default. Sometime in February, it seems, the various counterparties began to realize something was amiss. The insurers pulled coverage (did not renew) and the loans turned out to be questionable if not outright fraudulent. So as much as $10 billion in loans have gone very sour. Now begins the very long process of investigation and courtroom battles to see who is left holding the bag. What is clear is that Credit Suisse will experience a loss, how much remains to be determined. The $10 billion figure is very big and is bound to hurt whoever’s lap it lands on.

Archegos Capital was the family office of a convicted criminal former hedge fund manager that was recently unleashed by the SEC and allowed to trade again. Some of the reported numbers suggest he had grown his capital to $15 billion and that various banks gave him 5-6x (maybe more) leverage using derivative contracts (essentially equity swaps). He was a well-regarded guy and so the big investment banks gave him the leverage without perfecting their security interest in his collateral. He over-pledged his collateral. Sometime towards the end of March the banks realized that there was not enough collateral to go around. At this point, Archegos Capital was defaulting on margin calls. Credit Suisse, realizing the gravity of its own situation attempted to broker a truce with the other prime brokers. Some of the other brokers, sensing advantage, were able to seize collateral and sell it off in size with minimal pain before markets became fully aware of what was happening. This came at the expense of the other prime brokers. Over a chaotic weekend in which prime brokers were trying to shop the rest of the collateral, related asset prices were falling and creating bigger holes in the balance sheets of any prime brokers left trying to close positions. Credit Suisse is thought to be among the worst hit and they have yet to disclose any details. The highest rumored amount was up to $7 billion loss. Since we just passed the quarter end mark we are bound to see a news release from them soon.

Note that Credit Suisse reported $3.85 billion income in 2020 and $3.67 billion income in 2019 (both converted to USD). The losses described above are much more than an earnings event, they are a balance sheet event. It was a terrible, horrible, no good, very bad month for Credit Suisse.

Suez Canal

The canal channels some 10% of global trade, providing key passage between west and east. The day travel savings for seafarers is approximately 9 days if you used Singapore and Rotterdam as end points (WSJ). That is the additional time it takes for a trip around Africa’s horn. Not to mention extra savings realized from reduced pirate exposure. These time and safety savings were available until a massive cargo shift caught wind and hydrodynamics took over, driving the bulb (part of the ship beneath the bow) of the ship through the canal wall and the stern of the ship embed into the opposing wall. Traffic through the canal stopped immediately. While the canal was blocked other ships were queueing – sitting ducks, if you will – and faced the tough question of waiting an unknown period or recharting travel. Crews worked feverishly for days tugging, dredging, and digging to free the ship. The ship first became stuck on March 23 and was freed on March 29. The damage to trade is untold, but at this point is par for the course with all the supply chain problems rippling through from COVID shutdowns. Into April now, there are some preliminary reports of losses in the reinsurance market.

WeWork

We back! WeWork, after a failed IPO in 2019 and a tough pandemic filled year in 2020, is seeking to become a publicly traded company through the SPAC market, which has entered a craze of sorts. Last time, WeWork didn’t.

How fitting would it be for this group to mark the market top again with a failed/pulled SPAC offering. We are highly skeptical of anything commercial office space in large city centers right now. We are no less skeptical of WeWork considering it is effectively an office space wholesaler – they lease large amounts of space from landlords on long lease terms and sub-lease these spaces on short lease terms – month-to-month in many cases. Further, WeWork entered most of their leases during peak office space demand and now face a weak office space outlook. This would be akin to buy high and sell low. However much one might view their product offering as marginally benefiting during an economy rotating from centralized office and work to remote work and on-demand office space it is hard to see a lease-up here that covers needed economics.

WeWork lost $3.2 billion last year. But hey, that gets you a $9 billion valuation nowadays. At least we are not talking the $47 billion valuation from two years ago. Step right up, folks!

GameStop

More of the same here. GameStop’s stock price has ebbed and flowed. Below is a price chart of GME during March. Notice the month’s trading range. The price moved from a low of $99.97 on March 1 to a high of $348.50 on March 10 to a quarter close of around $189.82. Look at March 10 alone; the price ranged from $172 to $348.50. That is $176.50 of range in one day, or 65.5% of $269.43 open price that day. Clearly there is something more to this stock than just retail investors buying and selling. We look on and feel like the markets are being gamed. Derivatives play a big part. Just look at the Archegos story above. No thanks.

Intel

In another pivot, Intel is investing $20 billion (surely with government assistance) to build new manufacturing plants in Arizona with the aim of manufacturing more chips for other companies. Previously, as we noted here and here, Intel signaled it would give up on the US and begin outsourcing chip manufacturing. While the former is no longer true, the latter remains the plan, at least in part. We viewed a shift to completely outsourced chip manufacturing as national security risk, and it seems Intel does too. Now Intel needs to focus on execution.

Infrastructure

A theme we have been focused on since politicians and central banks responded to the pandemic has been infrastructure. It has been years in the making. The Trump administration was working on it. Now the Biden administration is rolling out stimulus packages geared towards infrastructure spending. We will see what comes out of the Washington legislative sausage factory. There will be pork in there, but how much may make the difference in getting this country back to productive.

Railroads

Speaking of infrastructure. Kansas City Southern (KSU), the fourth largest US-based railroad has agreed to be acquired by Canadian Pacific (CP). In hindsight, it is a clear match made from the USMCA (NAFTA 2.0). The merger would perfectly link Canada (CP) and Mexico (KSU) rail lines through the heart of the United States – straight through the Midwest. The deal must be approved by respective governments.

Aircraft

Speaking of railroads. General Electric agreed to sell its airplane leasing unit to AerCap, the largest aircraft leasing company in the world. AerCap acquired insurance giant AIG’s aircraft leasing unit, ILFC, during AIG’s dismantling after the great financial crisis to become one of the largest such companies in the world. Now AerCap picked over the dismantling of GE Capital. AerCap has transformed into a true market force.

It may not be smooth travel for them with the globe still on pandemic alert, but the power of air flight now rests in their hands. See it this way: most of the airlines are now nearly financially ruined whereas they previously had healthy credit standing. The aircraft manufacturers lost their might too because their end market is financially weaker and currently do not have much need for new aircraft (airlines have surplus capacity for the foreseeable future as they parked their fleets in the desert). Boeing faced financial ruin from various missteps, including two-year grounding of its main aircraft, the 737 MAX. All of this should mean that aircraft lessors, which have maintained financial strength, have greater power over the airlines and the manufacturers. AerCap is consolidating the market at a pivotal moment.

There are surely other aircraft lessors on the radar now. Carlyle Group, a large alternative investment group, announced it would acquire Fly Leasing and merge it into Carlyle’s existing group Carlyle Aviation. Brookfield, another large alternative asset manager, just announced it has appointed former Air Canada CEO as advisor. I wonder what they might be interested in.

Crypto

Non-Fungible Tokens (NFTs) are all the rage right now. They are being sold for eye-popping prices. NFTs are the rights to something digital recorded on the chain – that is the blockchain. The something is tokenized on the chain which then represents indisputable ownership of that item. The something is an original of sorts. An original photo, an original video, et cetera. Some of it is being described as like playing cards of a different era; you wanted to get a rare rookie card. It was collectible and the price appreciated for the right stuff. There is a lot of roar and some eye-popping prices are being realized. We do not understand. What good is an original JPEG, for example, when there are infinite exact digital replicas available on the web?

We think Peter Schiff put it well when he tweeted, “Using overpriced Ether to buy overpriced [NFTs] reminds me of the old joke about a guy who tries selling his pet dog for $10,000. Since he can’t find any buyers actually will pay $10,000 in cash for his dog he ends up trading his $10,000 dog for two $5,000 cats.” Link

Rates

Treasury yields continued to back up at the long end of the curve. 10 year and 30 year reach recent highs. Unfortunately, credit spreads seem to be going the other direction so there still is not much to capture for carry. The market is caught between two huge forces: a monetary and fiscal push to reignite the economy and a labor force that remains severely underutilized. Given the historic size of each side this tug-of-war, any movement on either side will continue to lead to volatility in various asset classes. If the labor market does not improve sufficiently then capital markets may go back to disinflationary positioning. If the labor market does improve the capital markets may rip with inflationary views. But that only addresses the US. Much of the rest of the world is still dealing with COVID. Global forces are also driving the dollar and the US capital markets.

US Treasury Curves Steepening:

US Credit Spreads Tightening (Bloomberg Barclays US Agg Corporate Avg OAS):

COVID

While the rest of the world goes into hard lock down as COVID variants take hold, the US continues to benefit from vaccine rollout and the relative immunity this brings. There is still a race to head off COVID resurgence in the US with vaccine deployment. The last thing this country needs is a setback, but things are looking bright in the US. Israel is perhaps the brightest spot on the globe. Israel went into hard lock down and vaccinated much of the country’s population. Israel is now basically wide open. For the rest of the world, it is not looking as bright. Some examples:

• Canada entering new lockdown in Ontario region
• France entering new lockdown
• Germany resisted lockdown but urges citizens to stay home over the holiday
• Italy entering new lockdown
• UK slowly coming out of lockdown
• Chile taking measures to close boarders and control case surge
• Brazil, perhaps the scary of cases, is seeing the virus rip through communities that already saw high levels of infection in previous waves
• Peru continues to battle COVID with the Brazilian variant circulating
• Philippines is grappling with surging cases

There are many more examples around the globe. Add to this confusion and fighting in the EU over safety and availability of AstraZeneca’s vaccine. This virus has been and continues to be a real slog.

The point here being that even if the US leads in vaccinations and finds itself immune from the virus, the economy will not be immune from global recession if the virus continues to roll around the globe. Simply put, sickness and death reduce productivity. (We are empathetic and sympathetic to the hardships and losses from this pandemic. Here we make purely an economic and financial point as pertains to viewing the current investment environment.) It is our opinion that the general, near-term outlook remains bleak despite what US stock market prices may suggest otherwise. We may feel elation from going to restaurants or whatever your celebrated normality may be (if indeed you find yourself getting back to normality), but maybe that should not translate to capital market enthusiasm quite yet.

Stay safe.

We must be getting into late stages of a cycle given the fervor and frenzy of certain topics in the market.

Bitcoin

The price of Bitcoin (vs USD) started February around 32,600, reached a high of 58,350, fell to as low as 43,060, and began a new rally to close out the month. A lot of things happened within this month. Some argue Bitcoin is now set up for a spectacular collapse while others will argue the foundation is set for a surge. It is a highly speculative situation.

Starting with the collapse perspective, the New York Attorney General’s office announced a settlement reached with Bitfinex, the group that created Tether, a stablecoin that is used by cryptocurrency investors that cannot find conventional access to the market. Amongst many astonishing findings was that its dollar-for-dollar reserves policy was a lie to the tune of billions. The NYAG settlement stipulated that Bitfinex could no longer conduct business in New York, something that is generally viewed as the kiss of death since New York is often considered center of the financial universe.

On to the surge perspective, it is argued that the Tether saga is now behind Bitcoin, no collapse has occurred, and institutional investors continue to enter the water – BNY Mellon and BlackRock to name a few. Tesla also jumped in by announcing the company had acquired $1.5 billion of Bitcoin and may accept Bitcoin for car sales. Notably, most of this “institutional” participation is simply productizing or enabling retail investors to invest in the market – they are not putting their dollars at risk, they just want fees from crypto craze.

MircoStrategy, an operating company with dotcom-era origins, appears to have completely pivoted strategy to being at the center of the crypto craze. Under the leadership of an audacious CEO, MicroStrategy made the bold move of investing the company’s “reserve” assets in cryptocurrencies – namely Bitcoin. The company has now issued debt to buy more Bitcoin – not only did it seek to issue $600 million, but the debt deal was upsized to $900 million on high demand. The CEO is now considering another debt raise…

All these activities contributed to Bitcoin achieving a milestone $1 trillion market cap. Interestingly, the narrative around Bitcoin has slowly shifted from a new, disruptive currency to now Bitcoin should just be viewed as a smarter and better gold – a digital gold. That is probably a more accurate description, but we still think most buyers of the cryptocurrency are speculators, not long-haul owners – buying something to sell it higher. If that is true, then it seems to us that Bitcoin is a bubble – people buying for no other reason and with no other basis then “price goes up”. But if the activities of this month keep pace in months to come then this bubble could blow larger before it pops.

Bitcoin:

Tesla

Tesla and Tesla-adjacent stories during February:

• Nikola internal review
• Nikola vehicle lineup
• Another round of price reductions
• Fisker and Foxconn team up
• Live by the sword, die by the sword
• Fremont shutdown
• China regulator
• Buys Bitcoin

GameStop

Last month we highlighted the frenzied trading of stocks like GameStop. This activity subsided as the stock prices slowly declined. There was a congressional hearing that included Robinhood’s CEO, Citadel’s CEO, Melvin Capital’s CEO, and a retail investor, Keith Gill, who went by several online names. We did not watch the hearings, but we understand there was little to be gleaned from the grilling by representatives with little understanding of markets. What is fascinating is that by the end of February stocks like GameStop were rallying again – after falling back to $38.50, it surged to more than $180. What else is fascinating is that for all the narrative around retail investors “sticking it to the suits” (hedge funds, Wall Street, et cetera) there are now stories of several hedge funds making large sums of profit during the run up. All we can say is that something appears to be deeply broken with this market and we wish for it to be fixed. In the meantime, prepare for things to get crazier.

Silver

Following the GameStop gambit, Reddit users turned their attention to the silver market. The price of silver was driven higher but given the depth of the precious metals market the price of silver did not rise like GameStop and the others. Instead, curiously, gold has broken through technical support levels to the downside while silver remains somewhat buoyed. We continue to watch precious metals with interest in select investments.

Silver:

Gold:

Rates

The long end of the treasury curve has been on the rise – the treasury curve is steepening. The central prognostication is that inflationary pressures are driving investors out of bonds. Just look at commodity prices, for example: lumber, copper, iron, oil, corn, etc are all up big year-over-year. But then there is the curious case of gold trading lower and treasury TIPS breakeven trading inverted – this is generally interpreted to mean that expectations are for transitory inflation, rising near-term and settling lower long-term. Some from this camp are calling it a “head fake”. Perhaps more plausible still is something quite technical: 1) Bank SLR (supplementary leverage ratio) was temporarily excluded as part of Federal Reserve COVID policy and is set to expire March 31, 2021. Among other reasons, the SLR exclusion has allowed banks to soak up increased treasury issuance since the pandemic began. The Fed does not yet know what it will do with the exclusion despite the deadline looming, but, in the meantime, banks are shedding assets in anticipation of compliance should the SLR exclusion not be renewed. This means treasury bonds are being sold. 2) The Treasury has inexplicably decided to shift the mix of new issue treasuries – on net, shifting from shorter to longer. This is causing reduced supply of T-bills (and shortages in the repo markets as seen by rates literally at 0.0%) and increased supply of bonds, driving rates higher and the curve steeper. Adding fuel to the fire, convexity hedging (mortgage investors), and risk parity unwind must sell into the market in response to the recent move in rates.

Curve steepening:

Breakevens:

Bloomberg commodity index:

Brazuela

Brazil president Bolsonaro ousted the CEO of the country’s stated owned petroleum company, Petrobras. The CEO was replaced by a Bolsonaro loyalist general. As you could imagine, the general does not have petroleum or mining experience. We wonder if Brazil’s oil production has taken a step in the direction of Venezuela, an oil rich neighbor to the north with diminished technical ability to extract the oil after years of malinvestment under communist mismanagement. We will see, but we think Petrobras has little investment appeal now.

Boeing

After two long years scrambling to get its 737 birds back in the air Boeing grounds another bird. This time, the 777s are having engine problems. Luckily, there were no deaths, but if you watch the video it must have felt terrifying to be on these flights. The culprit appears to be a particular breed of Pratt Whitney engines exclusive to the 777s. And, in the case of Boeing, these are fortunately very old aircraft – it will not shutdown production of newly airworthy aircraft.

Junk

Junk bonds have achieved record low borrowing costs according to FT (note, this site requires subscription). In the piece FT notes that Centene Corporation borrowed $2.2 billion for 10-years with a 2.5% coupon, matching the low set by homebuilder MDC Holdings in January. T-Mobile now holds the record for lowest coupon ever for a junk issuer with its 5-year note that pays 2.25%. Ford borrowed seven years with 2.9% coupon. The list is growing…

Warren Buffet said in his latest letter to Berkshire Hathaway investors:

Some insurers, as well as other bond investors, may try to juice the pathetic returns now available by shifting their purchases to obligations backed by shaky borrowers. Risky loans, however, are not the answer to inadequate interest rates. Three decades ago, the once-mighty savings and loan industry destroyed itself, partly by ignoring that maxim.

We could not agree more. Investors currently appear desperate for yield as risk premiums across the investment universe have been driven lower by central bank largesse.

Now is the time to be paying attention to fundamentals. Know what you own.

GameStop Saga

You name it – Robinhood, Reddit, GameStop, AMC, BlackBerry, et cetera – they were all there. January ended with a lot of buzz around these names. It was described as a battle between retail investors and the “suits”. Retail was sticking it to the man. Retail investors were taking down billionaires – hedge fund managers. It started with some forum posts on Reddit where individual investors were trying to rally around GameStop stock. The messages said GameStop was heavily shorted by a top-shelf hedge fund and the retail investors wanted to squeeze that fund out of the position. From there the price went into the stratosphere as investors piled on and not only created a short squeeze, but also created a gamma squeeze by buying out-of-the-money call options that cause more stock buying by triggering the options dealer hedging mechanism. Yet more buyers piled in. They went after other stocks too – AMC, BlackBerry, etc. 

In the financial universe, it is now considered common knowledge that many recipients of federal stimulus checks have deposited their money into retail brokerage accounts as a free-money flier on the stock market. Many had a successful 2020 since it was an up-trending market. The favorite retail broker for the above trading and speculative stimulus deposits was Robinhood, a Johnny-come-lately that offers commission-less trading. Robinhood has notoriously lax restrictions compared to peers like E*Trade, Schwab, and Ameritrade. In one example last year, some Robinhood investors discovered a loophole that gave them infinite leverage – a very combustible proposition for even the most experienced investor.

If inflicting harm on major hedge funds was the mission of these retail investors, it was a success. At least one hedge fund has closed in the aftermath and several others have reported major losses since the start of the year. One hedge fund – the initial target, Melvin Capital – received a rescue package of $2.75 billion in loans (from Citadel and Point72) to help it survive the turmoil and it still was down 53% in the month.

There is a secret here though. Robinhood (and others like it) can offer commission-free trading because they sell order flow. When investors buy and sell securities on their platform, their order has been sold by the platform to executing brokers – the likes of Citadel Securities and other market makers. Using their larger book, technology, partners, and, perhaps, questionable means market makers earn profit by capturing value between bid and ask prices. They are the middleman between buyers and sellers. In general, if trading volume goes up, they make more money – lots of it.

By mid-week retail brokers – mainly Robinhood and Interactive Brokers – began limiting activity in the hot stocks. Soon the brokers were forcing investors out of their positions. This was upsetting to many retail investors who thought they were unjustly having their positions taken from them. They viewed this as an act of billionaires (hedge funds) calling in favors. The reality of the situation could probably just be found in their retail margin account agreement (if you have not read one, to put it simply, brokers reserve a lot of leeway with your account. Example). Maybe this was the first experience with margin and margin calls for these retail investors. But the cold hard reality, it turns out, was much worse than silly retail investor margin calls. Robinhood, with its lax controls managed to sink itself into a major liquidity hole. Even though Robinhood’s CEO did his patriotic duty of lying about liquidity on mainstream network interviews, the company’s needs were dire. At about the same time or shortly thereafter, Robinhood drew its credit line, raised more equity, and is now contemplating raising debt.

Alas, the whole situation was rich with irony. Maybe hedge funds received scars to be sure, but retail got margin called just like the hedge funds, and retail may very well have imperiled the very venue that enabled their democratized investing. Robinhood required a big rescue package and might be insolvent when all is said and done, and the “billionaires” likely just got richer from the market frenzy – higher volumes are a boon for high frequency traders, market makers, and predatory investor hedge fund-types.

Contrary to current sentiment, it does not appear that government or billionaire intervention was at play here, just simple market mechanics. Big losses accrued throughout the system. On the other side of it big gains accrued. Net-net, we think retail investors were dollar losers and this was likely a big, expensive learning experience for them. It will be telling to see where the next round of stimulus checks goes.

In investing, it pays to be early. Otherwise, it pays to be a good middleman. That is the quickest take on the GameStop saga.

Tesla

Elon’s payday is coming again. This time to the tune of $7 billion. Talk about grift. Tesla produced shy of 500k cars in 2020, which was Elon’s target for the company. The company produced another quarter of profit, thanks again to regulatory credit sales. Amazingly, Tesla is worth more than all other car manufacturers in the world as measured by market capitalization, but only produces a fraction of one of the other major car manufacturers.

Life Insurance

Is this the start of chronic pandemic pains in the life insurance industry? The year 2020 was a major mortality year for any carrier selling death benefit coverage. Now the industry has at least two other problems looming: 1) more deaths will likely follow, either directly or indirectly from virus infection, and 2) what to do with the pre-existing condition – whether asymptomatic or symptomatic the long-term health effects can dramatically change the results of life insurance and so the industry is making changes. Premiums are on the rise, underwriting is screening for COVID-19, and applications now come with waiting periods. Low fixed income yields, high mortality experience, and other problematic products like long-term care and long-term disability present an enduring challenge for the industry. We will be watching for opportunities.

COVID-19

The virus has been burning red-hot around the world. Such places previously thought to have herd immunity are experiencing new waves – Sweden, Brazil. Countries among the most diligent in rolling out vaccines are shutting down as new variants flare – Israel and China. There are at least three new variants of concern. They are nicknamed after the region of initial prevalence: UK (B.1.1.7), Brazilian (B.1.1.248, or P.1), and South African (B.1.351). All three have been identified within the US. Each has reached community spread level in the US – those infected have no known travel or acquaintances who have traveled. This could be the setup for a repeat of March 2020. All three variants are more transmissible but the question remains about whether they are more lethal and whether they evade vaccines. It is a race against the clock to deliver vaccines before vulnerable become ill and more variants emerge, putting further strain on vaccine efficacy. This comes at a time when everyone is exhausted of precautions and shutdowns. Be careful out there.

Intel

Activist investor Third Point announced a new position in Intel and has begun dialogue with management. Under pressure Intel’s CEO, Bob Swan, has resigned and he was replaced by Pat Gelsinger, former CEO of VMWare. Intel’s stock promptly rallied on the news but has since retreated a bit. The new CEO is expected to restore focus by selling fabrication plants and ancillary businesses. He will also accelerate the push to outsourced manufacturing. This comes at an important juncture for the country. Much of the highest quality chip manufacturing is done in Taiwan. If you have not been paying attention to geopolitical news, China is increasingly taking provocative moves against Taiwan, which runs decidedly against US interests. It is a major global tension potentially coming to a boil. Neither Trump nor Biden matter – China wants to tuck Taiwan back under communist party control much like it has done with Hong Kong. This would pose serious national security risk for the US.

Bitcoin

The cryptocurrency Bitcoin continued to amaze. During January, Bitcoin – and many others – reached new all-time highs. It has peaked for now, it seems. We stumbled upon an anonymously authored piece by a former Bitcoin market participant that puts forth reason and supporting evidence for why Bitcoin is a bubble about to burst. To our surprise it is not Bitcoin directly, rather another cryptocurrency called Tether that is the lynchpin to the whole thing. If you are up for an amusing read on the matter, the anonymously authored piece can be found here. We find it compelling and continue to believe Bitcoin is a speculative frenzy that should be avoided by anyone not prepared to write-off the position.

Boeing

It has been a turbulent start to the year. Beginning with Boeing announcing a $2.5 billion settlement to resolve criminal case relating to two 737 MAX plane crashes 2 years ago. Boeing reported earnings that missed expectations. More 737 orders have been cancelled from the order book and the company was hit with more delays in delivering its 787s. Despite leverage massively out of sync with similarly rated credit, Boeing remains investment grade.

What a year 2020 was! Ballast completed our fourth year of operation, with goals of providing clients with security, stability, and innovative investment strategies. The year took everyone on a wild ride – we found some of it to be investable – and we tried to comment in our newsletter and blog on things we found more noteworthy. As the year closes, we wanted to take the opportunity to reflect more wholly on what we did during the year.

Activity

Core Investment Strategy

Among other client constraints, return requirement remains top-of-mind as we build and maintain investment portfolios. The bedrock with which Ballast portfolios are built upon is core, yielding investments. The average investor requires a well-diversified portfolio, and so, investment positions within are numerous. These core holdings provide relatively low-risk return and cash flow for clients in fulfilling their investment objectives.

Credit – Credit provides the bulk of the yield allocation for achieving desired cash flow and return within an investment portfolio. The risk premium, or credit spread, may be higher than comparable maturity securities due to risk considerations like collateral, degree of leverage, management, credit ratings, et cetera. Nevertheless, with a little bit of analysis and monitoring, there are high-quality credits worthy of investment. Here we list some examples of core yielding bonds put into many Ballast clients’ portfolios during 2020: FedEx, Molson Coors, Ralph Lauren, and Ross Stores. Our clients may recognize these as high-quality, household names. Other high-quality names enter the portfolio through one-off market events to contribute incremental yield within what Ballast views as core:

 

Mylan Laboratories –Mylan (now Viatris, as you will read shortly) is a name less familiar to people. Mylan is a global pharmaceutical that focuses on generic drugs, though its best-known product is a non-generic product called EpiPen. As health care costs rise and receive due attention, Ballast believes generic drugs will remain of strategic importance. Already one of the largest generic pharmaceutical companies in the world, Mylan just got bigger by combining with Pfizer’s established pharmaceutical division called Upjohn, which was spun-out of Pfizer into a new company for the purpose of merging with Mylan. The combined group has been renamed Viatris. During the turmoil earlier this year we had the opportunity to buy Mylan bonds at a level we thought was attractive for a company with constructive prospects and especially considering it was set to merge with Upjohn. We viewed this latter point as credit positive and expected credit rating to migrate higher over the near-term (S&P Ratings has since moved their credit rating outlook to positive). In short, our expectations were that the bonds provided good value as stand-alone (as Mylan) and better value as combined (as Viatris). We feel good about this position.

 

RMBS – Residential mortgage-backed securities (RMBS) come in agency (guaranteed) or non-agency (non-guaranteed). The latter is underwritten by Ballast on various factors including loan pool credit score, diversification, structural support, and LTV. RMBS is not a large component of most accounts and our clients are more likely to see agency RMBS.

 

ABS – Asset-Backed Securities provide yield with substantial risk protection through strong collateral or structure. United Airlines and American Airlines are examples of investments many Ballast clients would recognize. The bonds are highly rated and secured with the airlines’ aircraft. With the substantial pullback in air travel during 2020 we have given extra scrutiny to our aircraft-backed bonds, monitoring the aircraft collateral and their flight activity. While the airline industry is not yet free and clear, after reviewing underlying aircraft activity we remain confident our bonds have appropriate support.

 

CMBS – Commercial Mortgage-Backed Securities are used by Ballast to generate incremental yield for short-term, or cash-like, allocations within client accounts. CMBS are pools of loans backed by properties such as Office, Multi-family, Retail and Industrial properties.  These securities are structured to provide short-term or long-term cash flow, as well as credit characteristics for buyers.  Ballast acquires the short-term (“front-end sequential”) to acquire attractive yield without much principal or credit risk. This last point is critical when considering the year 2020 and the impact of retail and office space. As relates to short-term investing we are highlighting, we intentionally invest in the senior piece (“top of the stack”) where there is sufficient support to protect principal against severe loss scenarios.

Non-core Investment Strategy

For many clients, especially in the current market, core investments do not provide enough yield alone. Ballast adds incremental yield to client portfolios by investing in non-core opportunities. These include credits of high (and some low) quality, as well as strategies of high yield and total return. What is common of these non-core opportunities is that they require Ballast’s vigilance, patience, and analysis. Here we list some examples of investments made during 2020:

Continental Resources (CLR) – a shale oil and gas exploration and production company. Despite what the pandemic did to the energy sector, we believe the company’s short-term outlook is good, supported by modest cash flows and backstopped by a large credit facility. As one of the stronger (thinking in terms of size and credit rating) in the shale exploration and production sector the company also stands to benefit from consolidation, opportunistic acquisitions of distressed assets, and tailwind of any recovery in oil prices. We found an opportunity during the market turmoil to add Continental to many accounts.
 

EQT Midstream (EQM) – a midstream pipeline natural gas pipeline in the northeastern US that is sponsored by EQT, one of the largest shale natural gas exploration and production companies in the US. Though natural gas prices have been under immense pressure from the competition in hydraulic fracturing, EQT remains among the stronger in the sector and the natural gas market, like its shale oil counterpart, is set to rationalize given the level of distress experienced throughout the energy industry during 2020. Natural gas is a primary and growing power generation input and is also a growing export in the form of liquid natural gas (LNG). A combination of factors – above and other – combined with an attractive opportunity gave us confidence to add EQM to many accounts.

  

National General Holdings Corp (NGHC) – a mid-sized insurance company in the property and casualty market. The company has been moderately successful as characterized by growing, stable, and profitable insurance underwriting. This gives the investment a solid base. AllState, a well-known and high-quality insurance company, agreed to acquire NGHC during 2020. While the common stock and bonds of NGHC responded to the news as you would expect, we found an attractive opportunity to add NGHC preferred stock to many accounts.
 

Warrior Met Coal (HCC) – a metallurgical coal company based in the US. HCC has mining assets primarily in Mississippi. In 2015, with interest in distressed investing opportunities of the energy and mining industries, we followed the bankruptcy of Walter Energy, a metallurgical coking coal miner that failed spectacularly during the broad global economic pullback. During that cycle, savvy distressed debt investors recovered credit losses by taking over Walter’s core mining assets in Alabama. Those assets became HCC. Warrior Met management, with bankruptcy burned into their recent memory, is running the company conservatively with a large liquidity position. The company’s bonds have first lien on the mines, which we view as high quality and validated by the recoveries of the distressed investors just a few years ago. Further, we view the mines as strategic to the US considering global political economy turmoil. More trade wars would further underscore the value of the US-based mines. Although we did not find opportunity with Walter in 2015 the prior experience benefited us in 2020. We found an attractive opportunity to add HCC to many accounts.

Other Interests

Each day, investing is busy and brings a new rock to turn over. With all the things Ballast examines and thinks about during the year, it is difficult to note them all, but there were a couple of areas we found interest in during 2020. Although we have not acted on them, we continue to monitor each.

The energy sector has suffered greatly due to a confluence of factors – capital flowing into the sector allowed shale operators to bring new supply on at levels that were probably not healthy for long-term economic health of the sector; the pandemic took demand offline at a particularly vulnerable time; and public interest in electrification of vehicle fleets have driven energy prices lower and have turned investor expectations sour. We hold another view – that the sector is facing capital rationing, which brings with it greater discipline, or supply constraint; that we will emerge from this pandemic with rejuvenated “energy” to go about and live, thereby increasing demand; and that vehicle electrification may be the future but we believe the adoption timeline is exaggerated. Thus, we look to the energy sector with great interest in the new year.

Another area of interest but with less of a formed view is real estate. Several sector have fallen into distress. As an investment group emphasizing basis, market dislocations such as happened in 2020 provide attractive opportunities. Two noteworthy sectors of real estate are office and hospitality. Both have use in the unknown future, they just face a great deal of uncertainty. Therefore managing basis – or entry price – is critical but second to analyzing and knowing what it is you are buying. We continue to evaluate opportunities here.

 

The new year always brings more challenges and opportunities. This new year brings continued coronavirus spread and economic closures. It continues as two economies – those that survive and thrive partial shutdowns and those that do not. With capital market valuations at high levels despite what could clearly be economic sinkholes investors may need to tread carefully. With more insight into what Ballast did during 2020, clients can expect the same commitment in the year ahead. We look forward to navigating the challenges and providing our clients with security, stability, and innovative investment strategies in 2021.

  
A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

Tesla

• Third equity raise of the year ahead of index inclusion: link 
• Tesla was added to the S&P 500 index: link
• Elon asks about Bitcoin: link
• Snubbed: link
   

Cybersecurity

A hack exploit of cybersecurity firm SolarWinds’ software that allows access to various Microsoft systems left many enterprises exposed. The Russians are alleged to have conducted an operation that lasted months and involved several US government agencies including the US Treasury, Commerce Department, and Energy Department. The operations are assumed to have gained access to critical organizations and enterprises around the world. Damage remains untold but it is another cautionary tale in cybersecurity. Even with the best protocols and software in place, attacks may still come.

Our non-expert advice to readers would be to change passwords frequently – including now, if you were not aware of this news – and to enable multi-factor authentication on any particularly sensitive accounts. 
 

Cryptocurrency

The SEC has begun to weigh in on cryptocurrencies. It has charged Ripple with unregistered securities offerings. As a result, associated cryptocurrency XRP crashed lower. Several crypto exchanges suspended trading of XRP. Elsewhere, cryptocurrencies have surged during December. Bitcoin, for example, started the month around 19,000 and finished the month at around 29,000. Interest in this topic has surged and so has its price – as if its self-fulfilling, or a mania. Our position remains the same – that this is a highly speculative area. Experienced traders may find profit from the rising prices and volatility, but we are dubious of investors making money by holding long-term. Even if it were so, what if the investor is hacked and their digital wallets are emptied or what if the SEC weighs in like they did on Ripple? These are dangerous investing waters so wade carefully.

Airbnb

Markets remain surprisingly wide open. Airbnb is the latest unicorn company to go public, making its debut on the Nasdaq during December. The company’s valuation impressively soared above $100 billion during first days of trading but has since receded to a meager $80 billion. Amazingly, this happens while stories circulate of Airbnb rental property owners going bust during the pandemic. These may be false, but it does give pause.

Pop quiz: Airbnb being the popular web destination for vacation rental searches with millions of bookings… what was operating income for Airbnb for the nine months ended September 2020? Trick question. A loss. A record $689 million loss. To be fair, bookings and revenue were down substantially year-over-year in 2020. But take 2019, a year of record revenue of $4.8 billion and still Airbnb reported operating loss of $501 million (loss…negative!).

COVID-19

A new variant of Covid-19 has been detected in the UK and South Africa that has raised alarms. This new variant is estimated to be 70% more transmissible, though no more deadly. The new COVID-19 vaccines are expected to remain efficacious, but it is early to know with certainty. The worry is just the interim – cases, hospitalizations, and outcomes – as the vaccines are rolled out globally. The new variant is being found elsewhere now. In the US it has been found in at least California and Colorado.

Stimulus

Stimulus in the US is another political football with proceeds going any which way to interest groups. With the convenience of hindsight, perhaps, it seems little stimulus goes towards solving the problems at hand. It is evident that combined government stimulus and central bank actions were a capital market boom in 2020 considering how things started and ended in the markets. With central bank and government balance sheets multiples bigger than they ever were, subsequent need for stimulus must be ever larger if it is to be impactful. After months of wrangling over what and how much, the US government has reached agreement on a new, second round of stimulus. This time much smaller and without additional central bank firepower. Whether you agree with stimulus or not, this latest package appears to be too little too late in terms of moving the needle. This smaller stimulus combined with the latest news about COVID-19 and we may see a major pullback in economic activity and capital markets in the coming months as the 2020 liquidity injection fund flows dry up and various regions shelter from surging virus cases.

It is December already… What election?

Equity markets are at all-time highs. We are some sort of broken record, but this market performance is not congruent with fundamentals around us. There is still a giant economic hole and a high level of unemployment. While interest rates have been on the rise they remain near historic lows. Central Bank intervention is still unlike anything prior to 2020. Washington has not agreed on stimulus but nevertheless sees the need. With this as a backdrop, equity investors are willing to buy companies at historically high valuations. Again, equity markets are at all-time highs. Why?

Tesla

Will there ever be a month we are not left amazed.

• Rivian reveals pricing of EV truck and SUV: link
• SpaceX hauls another crew to space station: link
• Tesla’s value surges, to be included in the S&P 500: link
• Peak…?: link
• Buoyant market, brazen move, Tesla in S&P all at once: link
• Nikola – 60 to zero in… no more pickup truck: link
• Tesla market capitalization greater than $500 billion: link
• Musk second richest in the world: link  

Iran

Nearly a year ago, the United States killed Iranian General Suleimani. Tensions rose and Iran accidentally shot down a civilian aircraft, killing many innocents. Shortly thereafter, COVID swept the country and the globe. So too did it consume everyone’s attention and the Iran situation was forgotten.

Fast forward to the end of November – coinciding with the closing months of a US presidency – and there was a flurry of activity that could further stoke the flames of this long tense relationship in the Middle East. The top scientist of Iran’s nuclear program was assassinated by a remotely operated machine gun and a high ranking Iranian Guard commander was killed in an airstrike. Iran has accused Israel of the former and we know Israel was conducting the airstrikes. After these events Iran voted in parliament to overtly contravene the nuclear agreement in place since 2015. Iran demands that sanctions be lifted, or they will suspend UN nuclear inspections and enrich more uranium.

This could result in dramatic escalation. Why does this matter? Because a war is never productive and because turmoil in the oil rich middle east could be particularly disastrous for global markets if we see energy prices spike.

SP Global & IHS

Data grab in the financial markets is alive and well. In a market where passive (vs active investment management) is king, data is king of kings. Consolidation of data providers makes for fewer choices and higher fees. Passive is built around indexes and the surest way to make money in a passive investing future, where passive funds lower costs to nothing (and destroy active investing), is to own the indexes and related data and charge higher fees for licensing and data access. In the last year we saw the London Stock Exchange acquire Refinitiv, another major data provider. In November, S&P Global – the owner of various index products, a major credit rating agency, and various other important financial products – offered to acquire IHS Markit for $44 billion. IHS is a leader in energy and derivative markets. Like we said above, fewer choices make for high prices. We consumers and investors should not like this. This  market is ripe for trust busting.

Treasury Strip

As a parting gift from the Treasury Secretary, various emergency funds provided to the Federal Reserve as part of its response to the financial turmoil that resulted from the coronavirus were called back to the Treasury. This came under protest by the Fed chairman, who thinks these funds should remain in place until such later date that the economy is in the clear. Sure, the funds were not actively being used and new emergency funds could be sought if the urgent condition resurfaced, but the funds likely provided assurances to market  participants that the waters were safe. Time will tell whether pulling the funds back is detrimental to sustained market recovery.

Portugal Negative 10yr

In a first, Portugal’s 10-year bond has traded with negative yield. Portugal! And the yields of equivalent US Treasuries are positive and rising…

In case you were wondering, the total market value of negative yielding debt globally stands at around 17.17 trillion (that is a ‘T’). That is very near the all-time high of $17.47 trillion set on November 20, 2020. Yay!

 
SPACs

Special Purpose Acquisition Corporations are the rage. They are more commonly known as blank check companies. These companies are registered with the Securities Exchange Commission and publicly traded. But with no underlying business they are nothing but a pile of cash – looking for something…anything. Quick, before we must return all this cash, or it burns a hole in our pocket.

How does the following sound? Write us a big check for an investment we’ve yet to think up over the next few years, pay us fees on said capital, we’ll take a percent of the acquired company with no money in, and forget about whether this should all be worth more or less than the check you wrote me today. Sound like something you would be interested in. Give us a call.

Bitcoin/Cryptocurrency

Institutions are trickling in. Last month we reintroduced the topic of cryptocurrencies after PayPal announced entry. This month Guggenheim’s Macro Opportunities Fund made a filing with the SEC allowing the fund to hold up to 10% of the fund’s NAV, or $530 million, in Grayscale Bitcoin Trust, an unrelated investor vehicle that “holds” bitcoin. Elsewhere, Visa announced a new card with Bitcoin rewards through partner BlockFi. These institutions and others may well “corner the market”, fueling the mother of all speculative frenzies. Maybe 2017 was a fluke top and precursor to the real Tulip Mania. That is all speculative, of course. Like last month, we continue to watch with bewilderment. Meantime, Bitcoin is back to all-time highs.

Biogen

Where one can find a lesson in biotech, holy grail treatment, and efficient markets. For decades, biotech companies have sought treatment for the disease Alzheimer’s. Biogen, after previous clinical trials failed to meet study endpoints, reported new findings from its latest trial suggesting success treating Alzheimer’s. That is huge. If valid, it would mean Biogen has a leading drug treatment for a disease with few options. The stock price skyrocketed higher from around $250 to $365 in a single trading day only to fall to $225 over the next two days. A panel of scientists flagged the results as questionable. Head fake. What a ride. We wonder which part efficient markets played.

COVID-19 Vaccine

November was quite a month for COVID. Not only did new cases and deaths surge but everyone got a shot of hope as not one, but three vaccines (Pfizer, Moderna, and AstraZeneca) reported strong clinical trial results. The trick will be getting to the other side of winter when these vaccines are expected to become widely available. Even then, two of the vaccines require sub-zero temperatures which creates a complex logistical challenge for the volume and reach that will be needed.

It is easy for our collective attention to be drawn to what these vaccines could directly mean – everything back to normal. But we wonder if there is something bigger, something much more valuable than what is currently on everyone’s mind. A point that goes little noticed in these recent announcements is the breakthrough nature of these virus vaccines. They are first of their kind to use mRNA, or messenger RNA. The methods and properties may well be used to combat other viruses commonly spread or dangerous. Imagine a vaccine for the common cold – the future economy could look more productive. Reuters produced an article touching on some of this. Imagine the silver lining to this hell many have endured.