Monday, May 9, 2011

Is it worth it to be the global reserve currency?

The dollar's status as the world's reserve currency is not necessarily the exorbitant privilege it's often described, especially not when facing growth-threatening fiscal deficits and sluggish industrial growth. When one looks at the dramatic need for growth in the US, the status as world reserve currency becomes much more expensive.

Recent news in China and the US underscores the difficulties of the current system, which even after an economic crisis is still structurally the same as before. In China, inflation is increasing (see for example China's recent fine of Unilever) while in the US, GDP growth has slowed to 1.8%. The difference between now and the last cycle is that US consumers have been sucked dry. The US consumer can no longer drive demand. The good news is that the middle class in China, India, Brazil, etc. is growing incredibly fast, driving increases in consumerism and urbanization. The bad news is that as long as the Dollar is the world reserve-currency it will be difficult to realize the full potential of this enormous opportunity. The valuation premium enjoyed by the Dollar due to its unique status is a constant downward drag on US exports as well as Chinese consumption.

But what is the cost of losing the reserve currency? To those with significant dollar-denominated fortunes, the costs are significant. The outflow of capital from US financial markets would significantly raise the cost of capital for US corporations, governments, municipalities, and consumers. It would effectively transfer wealth from the haves to the have-nots, as job growth would increase but the value of dollar-denominated portfolios would decrease. Though it is never a good idea to describe a policy decision as a wealth transfer, that is effectively what has happened in the US since China's entry into the WTO, and a reversal is necessary for the global economy to rebalance.

Ultimately, the "wealth transfer" angle to this policy makes it almost impossible to enact. This is not a new story. The role of Pound Sterling decreased throughout the 1900s as the British Empire declined. Much of British hegemony abroad was focused on the role of Sterling in trade and the great benefits enjoyed by the City as a result. The decline of the British Empire as well as the decline of Sterling were completely unplanned and unmanaged. The transition is simply impossible to manage. Britain, just like the the US now, fights to maintain this status for its currency, with force if necessary. Part of the problem is the disporportionate power of elites in these societies. These factions have the most to lose from a paradigm shift- it takes substantial political change to overcome the inertia of present policies.

Thursday, May 5, 2011

Risk pull-back

Oil is down 7% today. Gas is down 6%. Silver is down almost 9%. Rates are about 3 bps lower. Stocks are down 50 bps.

Something is happening in commodities. There are certainly reasons to be bearish. Prices are extremely high. Inventories are generally above their long-term average. Demand is pulling back. Most recent economic news has disappointed- from NFPs to ISM to GDP growth. So a pull-back is justified, but the change in commodities is far more extreme than the de-risking that is occurring in rates and equities. Why is that?

Bill Gross' new investment outlook reiterates his short treasuries thesis, this time relying on evidence from a recent paper by Carmen Reinhart and M. Belen Sbrancia. This paper describes how governments delever by setting treasury yields below real interest rates. It's a fascinating study and a valuable perspective. The last time the US faced an indebtedness comparable to today was during World War II, when total debt exceeded 100% of GDP. It's often assumed that we overcame the massive fiscal debt through 2 decades of substantial growth. But Gross, Reinhart, and Sbrancia remind us that yields on government debt were below real interest rates post WWII, thus effectively deleveraging the balance sheet over time. I've mentioned before the role of the Fed in supporting the government bond market during and after WWI and WWII. Milton Friedman describes the conflict between the Treasury and Fed after WWII, as the Treasury effectively forced the Fed to keep yields low for almost a decade after the end of the war (see Monetary History of the United States).

If Gross is correct and we are living in a world of negative real interest rates for savers, what is the outlook for inflation? Today's move in commodities says a lot. When the government is effectively deleveraging by keeping government debt yields below real interest rates, economic growth becomes the difference between hyperinflation and something more normal. That leaves commodities as the asset class the most leveraged to economic growth. As Gross points out, holders of Treasuries will get burned as yields stay below real rates. But with weaker growth than expected, commodities will no longer capture the yield being stolen by the Fed.

Saturday, April 23, 2011

What's Next for the Oil Risk Premium?

Crude prices soared after the situation in Libya escalated at the end of February. The sustained price increase since the conflict erupted is not justified by the amount of production displaced by the conflict. Libya exports 80% of its 1.6 mmbpd of production, so the supply shock is about ~1.3 mmbpd. OPEC has about ~5 mmbpd of spare capacity. When oil prices increased to $145 / bbl in the summer of 2008, Saudi Arabia boosted output to 9.6 mmbpd, well above the current output of 8.3 mmbpd. Notwithstanding capacity additions (which have been significant), Saud Arabia can cover the entire Libyan deficit by itself with spare capacity of 3 mmbpd. There is also significant refining spare capacity in Europe. Though heavy / light differentials will (and have) increased due to the quality difference between Libyan and Saudi oil, crude and product prices have gone higher than justifiable on a supply / demand basis.

Crude has moved further than justified by fundamentals due to the risk of further conflict. Nigerian elections are coming up this quarter and the severity of Syrian protests are growing. But the key driver is undoubtedly the tail risk of conflict escalating in Saudi Arabia itself.

Assuming a fair value crude price (Brent) of $90 / bbl implies a risk premium of around $30 (with Brent around $120-125). The uncertainty of what future conflict might look like makes it difficult to evaluation the value of the risk premium, but the relationship should look as follows:

It's difficult to take a strong stance on whether this risk premium is justified (my gut reaction given the implied probabilities is that the risk premium is overstated). I think a better question is how long does oil deserve this premium? It's hard to see a reason why the premium will disappear as long as we have headline grabbing news from the Middle East. The problem is that there are so many conflicts - Libya being merely the most conspicuous - that a risk premium may be warranted for an extended period. So while the value of the risk premium may be overstated, the premium may endure for longer than those focused on the progress in Libya might expect.

Thursday, April 21, 2011

What I'm Reading...4/21/11

Happy Thursday.

Reactions to Finnish parliamentary elections continue to trickle in as if the rise of nationalism in Europe is a great surprise. A blogger at the BBC described the strong showing of the True Finns (19%) as "a tremor hit[ting] the EU" (BBC article link). But growing nationalism in the EU is hardly a new development. (I wrote in June 2009 about the rising nationalist sentiment evident in European Parliamentary elections.) The drastic decline in popularity of the German FDP and concurrent rise of the German Green party (as manifested in the Green Party's historic win in Baden-Wurtemberg) are a case in point. As is the emergence of the Tea Party in the US or Marine le Pen and the Front National in France.

I would argue that we aren't seeing a vast movement to the right, but rather a further bi-furcation of political attitudes. In France, rising support for the Front National comes at the expense of the Sarkozy's UMP. Similarly, rising support for the Socialist party comes at the expense of the Green party and various French leftist parties. In the US, according to gallup Party ID is historically range bound in the US, with 30-40% of the US population identifying themselves as Republicans or Democrats. What fluctuates significantly more is the percentage of Dems/Indies/Repubs who think their parties are too liberal/conservative. Either way, the strong showing of the True Finns is unlikely to disrupt the Portuguese bailout as the pro EU National Coalition Party has already declared support for the Portuguese bailout as unconditional. Sure, the National Coalition Party will have to make concessions on other issues, but bailout will survive. That being said, debt investors seem to have realized just recently that they will likely take a haircut on their debt. The uncertainty of a debt restructuring is far scarier to me than rising nationalism, no wonder gold hit an all-time high today.

On an unrelated note, the WashPost has an article out today questioning China's "green leap forward." I was unaware that most of China's investments in green technology ultimately target Western markets. For example, Chinese investments produced half of the world's production of solar panels in 2010, but 99% of these panels were installed in foreign countries, presumably to those that subsidize these installments, such as Europe and the US.

"A green future will result not from subsidizing immature technology today but from developing competitive green technology that is effective and cheap. Wind and solar power are not yet competitive. Research would be a much better investment for Western countries than subsidizing imports of today’s green technology from China."

Well put. It reminds me of another report I read today (admittedly- only skimmed) that discusses the failure of the Climate Action Partnership to successfully push climate action despite out-fundraising conservative advocacy organizations 11 to 1 (and outspending on climate change related projects 44 to 1). I haven't had the time to go through it in full yet (its probably 100 pages long), but looks very interesting (ClimateShift "Clear Vision for the Next Decade of Public Debate").

It's hard to comment on news this week without mentioning Trump. It's easy to dismiss Trump's candidacy as a joke, but mainstream Republicans have reason to be worried. While his "birther" focus may not be a legitimate campaign platform for a national election, among Republicans his views align with the majority. A recent New York Times poll concluded only 32% of Republicans believe Obama was born in the US. Up till now, Trump is the only Republican candidate with a wide public recognition who relentlessly attacks not only Obama's policies, but even his legitimacy as President, a lingering issue for many conservatives. No other candidate has gotten as much traction among primary voters, with Gallup's new poll showing Trump tied with Huckabee for the 2012 Republican nomination.

Let's also not forget that seemingly ridiculous beliefs such as the birther issue are common among opposition parties. Ben Smith recently commented that the birther issue is to Republicans as the 9/11 "inside job" conspiracy theory was for Democrats. A full 22.6% of Democrats said it was "very likely" and another 28.2% called it "somewhat likely" that Bush either assisted in the 9/11 or took no action to stop the attacks.

I'll leave you with one last link. Hat tip to Mr. Felix Salmon for a link to a fascinating paper on global beer consumption trends (Felix Salmon's summary).

Saturday, April 16, 2011

China moves up the value chain

According to Dealogic, outbound Chinese M&A has totaled $24bn year-to-date. If this level of activity were to continue for the rest of the year, total 2011 outbound M&A by Chinese companies could reach $100bn, almost double 2010 numbers.

The overarching trend of the last 5 years has been an increased focus on natural resources companies. Outbound acquisitions by Chinese companies targeting the mining space have increased from 6% of total deal volume in 2006 to 34% in 2011 YTD. Oil & Gas has accounted for 30-40% of total outbound M&A volume for the last three years.

This trend is also reflected in the target countries with resource-rich Australia and Canada recently becoming the most targeted countries.

To what extent can we expect these trends to continue? As long as state-owned Chinese companies have a mandate to secure resources, we can expect cross-border mining and oil & gas activity to make up the vast majority of deals. But the massive surge in natural resources focused activity masks other equally important trends.

Recently, Chinese outbound M&A targeting higher value sectors has ticked up markedly. M&A targeting Healthcare companies is up from $0mm and $253mm in 2006 and 2007 to $603mm and $204mm in 2010 and 2011 YTD, respectively. On an annualized basis, the number of transactions targeting Healthcare outbound Chinese M&A is up 400% from 2007. Almost all of this activity has targeted the pharmaceutical or instruments sector within the Healthcare industry, which are significantly higher-value sectors than other verticals within Healthcare such as the care or products verticals.

M&A targeting computer & electronics companies has also increased significantly. Deal volume targeting these companies totaled $1,326mm last year (34 deals) compared to $406mm (12 deals) in 2006. If 2011 activity continues at its current pace, total 2011 deal volume could reach $2,000mm.

Though these increases can't compare with the increase in natural resources focused activity, in some ways these trends are more important. The amount of Chinese M&A targeting higher value-added sectors such as pharma and electronics is a valuable datapoint to tracking the nature of China's economic development. It is only logical that over time Chinese industry will increase its presence in higher value-added industries currently dominated by Western and Japanese/Korean companies. What might be surprising, however, is the pace at which this is already happening.

Note: my Dealogic dataset includes all announced M&A by Chinese companies where the target nationality is not Chinese.

Friday, October 15, 2010

Strongest quarter for LBOs since the credit crash

According to Preqin, Q3 2010 witnessed 498 pe-backed deals worth $66.7 bn, up 29% from Q2 and 300% from Q3 2009.

Fundraising is also up this quarter:

Monday, October 11, 2010

Bain's LBO of Gymboree looks like a slam dunk

When I read this morning that Bain Capital was buying Gymboree Corp. (GYMB) for $1.8 billion, I had never heard of the company. After reading through their 10-K and going over their stock performance, I was surprised Gymboree (a specialty retailer of children's clothing) had not been bought out earlier. This company is an almost perfect LBO target!

Existing debt consists of only about $70mm in leases. Cash flows are extremely stable. Revenues have not declined once over the last decade, growing 11% on average over the last five years. Also, over the last few years as growth has slowed, margins have improved and the company has reduced its operating leverage considerably in comparison to the earlier half of the decade. Gymboree is also less cyclical than other retail companies, possibly due to the fact that in hard times parents will rather cut their own expenses than those of their children. Finally, it's likely that improvements to GYMB's cash conversion cycle could dramatically increase value. If Bain manages to increase payable days and decrease inventories, Gymboree could possibly enjoy negative operating working capital and certainly increase free cash flow to pay down debt.

My analysis below breaks down how this LBO might work. There's obviously a lot about this LBO that we don't know yet, such as leverage, debt pricing, refinancing, and what happens to the existing cash on the balance sheet. Flipping the lease refinancing and special dividend switches in the model changes Bain's expected IRR by 10%. But even then (at 13% IRR), this is still a great LBO given my conservative assumptions (3% revenue growth, lower margins than in recent years, no multiple expansion).

If I were a merger arb, I might even consider betting another (probably financial) bidder will trump Bain's offer.