Foresight Capital Partners

Last week we discussed how ¬the availability of credit has lead to inflationary asset price rises. Here we will continue our discussion and ask how associated credit risk is being distributed amongst market participants.

One sure sign of any asset price bubble is when credit rather than fundamentals (e.g. earnings) is the main support for the prevailing price. The dot com boom (1998-2000), which lead to the dot com bust (2000-2003) was one such instance when the money supply via investors was cut-off and the fundamentals (e.g. earnings) did not support the prevailing prices. It was only when the credit was cut-off, that the risks became clear, or as Warren Buffet would say, “it is only when the tide goes out that you learn who is not wearing trunks”.

The headline “FTSE up with private equity driving top risers” sums up market action this year. All the buy-out targets, with Reuters, Hanson and ICI being the latest on a log line of examples, have all seen sharply higher share prices, with cheap credit being the primary driver behind these buy-out offers. In last week’s Sunday Times business section an article entitled “Will the credit bubble burst?” reported the huge amount of debt being taken on in all these takeovers as $4 of debt for every $1 of equity.

In recent years, leveraged lending in Europe has shifted away from banks towards hedge funds and other non-bank credit investment groups. At the turn of the century according to Standard and Poor’s 95% of all leveraged lending, and lending to firms of non-investment grade status was under-taken by banks. In 2005, banks represented 75% of the market, and in March 2007, this was down to 49.8%. This structural shift moves more than half to leverage credit from a tool in managing corporate relationships to a purely investment asset.

Bloomberg reported the UBS hedge fund lost the company about £150 million in the US sub-prime sector, and then just shut up shop. With RealtyTrac reporting, US Mortgage foreclosures rising 62 percent in April and the number of Americans falling behind on home loans climbing this year, such reversals are only likely to continue. Rise in defaults will lead to rise in defaults in Mortgage Backed Securities, which are generally bundled with credit derivatives and sold as AAA rated securities. These bundles are themselves typically used as collateral in further leveraged activity, which could lead to a domino effect if the AAA rated securities go into default.

This is not happen yet, but it is a possibility, which is being under-priced within credit markets, as illustrated by the existence of “negative basis trades”, which is another story for another time.

Next week, I continue the theme of liquidity and consider the example of China.

Last week we detailed how inflation targeting without monetary grow constraints, leads to excess credit, which in turn results in inflationary asset price rises (see Playing Defensive on Inflation). Here we continue our discussion and ask where inflationary asset prices rises are taking place.

When the supply on any asset outstrips demand its price will fall, and vice versa. As mentioned last week monetary growth (as measured by M4 in the UK), has lead to the growth of money supply in its various forms outstripping the growth in products and services. This imbalanced has resulted in the real rate at which debt if available falling.

Cheap debt particularly at the longer maturities is alarming. A 30 year UK Gilt pays an annual yield of 4.58%, which is less than the present RPI of 4.9%, and if history is any guide will provide a real return (return over inflation) less than the return which has been available on cash over the past 30 years. Alan Greenspan last year famously referred to this situation as a ‘conundrum’. Here we will not attempt to dissect as to why such a situation has occurred but instead just identify some of its consequences.

The most obvious consequence is that cheap debt results in low hurdle rates for leveraged purchases. If an asset provides a higher earnings yield than the servicing costs of the debt required to purchase the asset, then a debt backed purchase can seemingly offer a risk-less profit. Everyone from buy-to-let investors to private equity firms have employed this strategy over recent years leading to infrastructure and real estate asset prices being marked up with associated earnings yields falling.

PFI Infrastructure in their interim report dated 7th March 2007, detailed this effect as,

“The downward pressure on yields in the secondary market continues, driven by the substantial weight of money in this sector and the low yields on comparable investments such as property.”

Where PFI this week itself received a proposed buy-out offer at a price of more than 35 times earnings (i.e. < 1/35 = 2.86% earnings yield). On the other side, bank and cash flow rich firm have been selling into this theme. In particular, HSBC this month sold and leased back its London headquarters at an annual yield of 4% over 20 years. Goldman Sachs, Merrily Lynch and Barclay’s all recently completed similar deals. ABN Amro upgraded Tesco on 4th May, on the understanding that it would “unlock value from its freehold assets” in a similar fashion.

In short, liquidity has lead to certain transactions taking place at levels significantly higher than would have been the case a few years ago. This I turn has reallocated risks, which will be the topic of next week’s column.

Source Data
Supplementary material for “Recent destinations of liquidity”

Though there may seem little in common between German property (earlier post on German property) and Isle of Man companies an investment holding company, called:

Speymill Deutsche Immobilien Company plc
http://www.investegate.co.uk/Index.aspx?company=SDIC

owns and manages more than 13,000 properties in German. The shares presently trade at 117p, and where originally placed at 100p on AIM. The company was established to construct a German retail property portfolio which would generate a 7%+ net yield with the possibility of capital up-lift. The argument behind the expected capital up-lift was that property in Germany could be purchased at below replacement cost, where the managers saw the German property converging to at least their replacement cost over time.

Anyway, this firm provides a good example and the typical holding structure which is set up here on the Isle of Man, with a local manager who will be locally regulated with a remote “investment adviser” who in this case is naturally located in Germany. The registered offices are within a stone throw from my office and their broker is strangle enough called Fairfax PLC (my family name).

Yield Curve

The formal measure of the `price of money’ over different time spans is the yield curve, which plots the rate available on UK Government debt (UK Gilts) against differing maturities. A general over view of how the yield curve can be interpreted is available at:

http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve#normal

Download Excel file with UK/US Yield Curve Source data and chart for 7th May 2007.

Yield Curve Conundrum

The “conundrum” as detailed within the speaches of Alan Greenspan reference dates back to at least 2005, see:

http://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm

PFI Infrastructure

The interim report of 7th March 2007 is available at:

http://www.investegate.co.uk/Article.aspx?id=200703070700594617S

and other regulatory postings is available at:

http://www.investegate.co.uk/Index.aspx?company=PFI

Property Deals

Goldman Sachs, Merrily Lynch sold and least back their London headquarters and Barclay has recently sold and leased back hundreds of its branches.

For details concerning HSBCs sale of its London Headquarters, see:

http://news.independent.co.uk/business/news/article2499358.ece

Investing is much more about playing a great defense than playing a great offence. An investor is always much better served by focusing on
potential loses rather than dreaming of possible returns. One area I am particular wary of at present are the prospects for inflation in the UK.

Over the past ten year’s the independent Bank of England (BOE) has performed very well at its principle role of keeping inflation in check. However, as recent figures show the risk of an inflationary cycle in the UK economy which could even lead to “stagflation” and a return to a boom-bust scenario of the 1970-80s has increased. “Stagflation” refers to a period of price inflation combined with slow-to-no output growth, rising employment, which eventually leads to recession. The odds of such an outcome occurring definitely shortened last week when the UK consumer price inflation (CPI) came in at 3.1% and the broader RPI measure came in at 4.9%. Against a backdrop of a strengthening pound, moderated energy prices, and constrained wage-price increases.

The CPI number lead the market to re-price UK interest rate expectations with base rates now priced to hit a peak of 5.75% later this year. This in turn has allowed banks to increase rates available with IOM deposit takers offering rates on instant access deposits of over 5.5%, and 1-year term deposits paying over 6%. A peak of 5.75% is the central expectation and I for one would lean towards expecting even higher rates than this, and I am not alone in this belief. For example, Roger Bootle of Capital Economics expects to see a peak of 6-6.5%, where as Professor Tim Congdon of the London Business School thinks interest rates will need to hit 7.5% to control inflation.

The divergence in views originates from differing views on monetary policy and the effectiveness of inflation targeting. The inflation targeting of the BOE unlike the European Central Bank (ECB) gives a low priority to moderating credit and monetary growth. Since the CPI inflation target does not encompass these monetary forces. This how allowed complete freedom over monetary growth (M4) and the BOE has run an excessive monetary growth averaging 13.06% from March 2006 - Feb 2007.

The excessive monetary growth has feed out through financial markets and manifested itself as credit for both private equity buy-outs and the UK consumer. This credit also referred to as liquidity has pushed up the price of everything from quoted securities such as Sainsbury’s, to UK real estate.

This asset price growth will ultimately feed back into inflation though wages and other mechanisms. Hence, the narrow definition of the CPI, which excludes housing and energy costs, results in inflation targeting being a reactive rather than pro-active monetary policy. That is, by the time the inflationary pressures show up in the CPI, the inflation genie is already out of the bag, which is what I believe we are seeing now.

Source Date Used

For source data see Supplement for “Playing defensive on Inflation

Interest Rates Expectations

Interest rates trade primarily through interest rate swaps and interest rate futures contacts. By backing out the prices of these contracts’ one is able to obtain what is generally referred to as the yield curve. The yield curve is a plot of the maturity (period) against the rate that can be expected over that period. The best publicly available yield curve plot I am aware of is available at:

http://www.yieldcurve.com/marketyieldcurve.asp

UK Debt Statistics:

http://www.creditaction.org.uk/debtstats.htm

Isle of Man Deposit Takers

As an example of “IOM deposit takers offer rates on instant access deposits of over 5.5%, and 1-year term deposits of over 6%”, we provide the Anglo Irish Bank see:

http://www.angloirishbank.co.im/personal-savings/interest-rate-summary.asp

Data of Public and Private Sector Debt

The private sector debt levels:

http://www.creditaction.org.uk/debtstats.htm

And UK GDP:

http://www.statistics.gov.uk/cci/nugget.asp?id=192

The public sector debt level of 37.4% (March 2007) detailed on the ONS site at:

http://www.statistics.gov.uk/cci/nugget.asp?id=206

UK M4 Monetary Growth

http://www.bankofengland.co.uk/statistics/ms/current/index.htm

In a free oil market the price dynamics of both oil stocks and the oil products themselves, will be determined by the supply and demand dynamics of the various products (namely crude oil, natural gas, petroleum and other refined products) and the components which form the means of their production (primarily oil reserves, rigs, refineries and personnel).

Since the markets for oil rigs, refinery capacity and personnel are free, present shortages should be brought back into equilibrium through normal market dynamics. However the input materials and in particular crude oil may not obey such economic principles since the markets in which they operate are increasingly being tied up by national oil companies (NOC) such as Saudi Aramco. Such NOCs often lack transparency and are only answerable to their political rather than economic masters, and certainly do not follow the Anglo-Saxon model of free markets.

Estimates based on data from the Energy Information Association (EIA) (2006) suggests that 90% of the world’s crude reserves (at least conventional oil) are under the control of national oil companies, with more than 60% under the control of OPEC cartel members. In contrast the global oil majors Exxon Mobil, Chevron, BP and Royal Dutch Shell in 2005 held about 3% of the world’s oil reserves. Moreover, in the EIA (2006) reference case world oil demand will increase by 46% from 2003 to 2030, and 90% of this new supply will come from national oil companies (primarily in the Middle East). This differs significantly from the past 30 years in which 40% of the production originated from the oil majors.

US oil production peaked in 1971 and has been in continual decline ever since. At present the US imports twice as much oil as it produces. Similarly, the UK’s North Sea peaked in 1999 and has already lost about 1/3 of its rate of production leading to the UK needing to import natural gas. With more of more nations slipping into such a position, power is shifting further into the hands of the national oil companies.

Though the West is crying foul of the major producers (for example, Europe’s friction with Russia over gas supplies), the producers are only aligning their production in accordance with their political masters. For example, Fatih Birol the chief economist at the IEA, estimates that there is a 20% global investment short fall of the $20,000bn investment needed to ensure adequate energy supplies for the next 25 years. Though such under investment does not make any sense from an economic perspective it makes perfect sense politically if oil is treated as a national treasure rather than an economic input.

Note: For source data references please see post: “Oil Supply and Free Market Dynamics” Supplement