Volatility returned to the stock markets in August after the broader indices all posted double digit returns through the first seven months of the year. While the overall market environment appears benign, there were troubling developments in the short-term lending repurchase (repo) market. This event received a lot of attention because it came as a surprise to the Federal Reserve (Fed) itself, and it stirred memories of the kind of emergency measures the Fed took preceding the Great Recession. The Fed has intervened appropriately, but the turmoil highlights a fragility in the functioning of these markets that needs to be addressed.
The US economy appears steady as it continues to grow at a 2+% annual rate due to a strong job market and resilient consumer. Non-farm payrolls have expanded by a monthly average of 161,000 during 2019. Workforce gains have also been accompanied by higher hourly earnings which have grown about 3% over the past 12 months. These positive developments have supported the US consumer, but economic weakness abroad produced earnings declines in the second quarter and third quarter estimates also point to further weakness.
Similar to earlier in the year, the initial cause of this volatility in the equity markets involved renewed trade tensions between the US and China. Higher tariffs threaten the global supply chain, raise costs throughout the global economy and portend slower economic growth and lower earnings. Our net view is that the US and China need each other enough to sustain a degree of economic cooperation. However, we also believe that there are no short-term solutions to these problems since the US and China each believe that they can outlast the other to gain a negotiating advantage.
The Federal Reserve lowered short-term interest rates by an additional 0.25% on September 19th to a range of 1.75-2.0%. This decrease marked the second cut during the quarter as the Fed sought to offset deflationary pressures caused by a slowing global economy outside of the United States. Recent US economic surveys have been weaker and wage inflation dipped in September, so the case for further Fed rate cuts on Oct 29-30th and in December has strengthened. A low interest rate environment appears poised to continue, and with it, investors’ limited options for compelling investment return options outside of stocks.
While the Federal Reserve’s interest rate stance as well as US economic growth have been positives for stocks year to date, tensions bubbled up within the overnight funding markets at quarter’s end. On September 16th, repurchase agreement (repo) rates spiked from 2.2% to almost 10%. Repos are con-tracts in which a borrower agrees to sell high quality bonds to a counter party for cash along with the promise to buy that same bond back for a higher price (usually the next day). This market is not well known. Why does it matter? Because large banks and many other financial intermediaries depend on it as a form of basic financial ‘plumbing’ to move almost $3 trillion in cash and debt securities daily to meet numerous obligations as well as to earn interest on cash loaned out that would otherwise remain idle.
Interest rates represent the cost of money. Interest rates are low now because money is cheap since there is more than enough supply of money and credit to keep the price low. However, something happened in the repo market to cause the price of money to increase by a factor of four. It appears to be a confluence of events in both the supply and demand for cash that caused these problems.
On the supply side, the Fed has been reducing its balance sheet by letting bonds that it owns mature without replacing them. The Fed is now learning it may not be able to unwind its huge balance sheet without causing problems in the credit markets. Before the financial crisis, the Fed maintained a balance sheet which held about $800 billion worth of Treasuries. After a couple rounds of quantitative easing, the balance sheet peaked at $4.5 trillion in early 2015 and has since shrunk to $3.7 trillion before the repo volatility. The smaller balance sheet reduces the amount of money in the system. The Fed clearly misjudged what was an appropriate level of cash to keep injecting through the purchase of Treasuries.
On the demand side, a couple of events coincided to cause the demand for cash to spike. The US Treasury has been busy issuing large amounts of bonds to fund a larger government deficit. Once issued, these Treasury Securities are snapped up by primary dealers for cash. Corporate tax payments were also due on September 16th so that large corporations demanded cash to pay their liabilities. Thus, an unusual amount of cash was sucked out of the market in a short period. Lastly, post the 2008/2009 crisis, banks are now required by law to hold far more daily liquidity on their books. US banks, despite being flush reserves, did not lend them out overnight as expected.
The Fed has indicated that it is looking at a concentration of reserves among a few large banks. According to policymakers and insiders, that concentration contributed to the rise in rates in two ways. Larger banks must meet much more stringent liquidity requirements now, particularly for same-day cash availability. Larger banks also have differing strategies for their own reserve holdings, which may not include lending them out overnight. This confluence of events caused a spike in demand for cash at the same time supply had shrunk thus causing ‘repo’ interest rates to spike drastically. The Fed responded to this liquidity crunch by injecting up to $75 billion of cash into the markets every day until short-term rates stabilized.
For the time being, it appears the Fed’s cash injection worked, and the system has returned to its normal steady state of providing short-term credit at low and stable rates. On the other hand, the surprising instability in the ‘plumbing’ of this short-term funding market suggests a lack of understanding on the part of the Fed and financial players in terms of how much liquidity is ‘enough’ to keep overnight credit running smoothly. Large financial institutions failed in 2008 because counter parties did not trust each other to pay their debts or they felt the need to hoard cash. Large US banks could have lent to borrowers who were willing to pay almost 10% for debt backed by high quality collateral such as US Treasuries, however, they chose not to lend that money. The only conclusion is that the banks themselves did not feel they had the capital to lend or that they believed counterparties might not have cash available to repay them in full the next day or next week.
Our comprehension of these credit facilities is evolving. However, we do not believe this episode is an omen of a seizure in short term credit markets like the panic that paralyzed credit in 2008/2009. There are adjustments that can be made to ensure short-term credit remains available at low rates that better align with the Fed’s discount rate. The Fed may also create a stand-by facility for just such occasions. Regardless, these markets need to be monitored because credit crunches often have far reaching consequences. Stated simply, the recent spike in ‘repo’ rates is a reminder that not only does the Fed not have all the answers, but that a hasty retreat to what was ‘normal’ monetary policy for the Fed pre 2008/2009 could be disruptive to maintaining the expansion.
Modern ESG Investing
Environmental, Social and Governance (ESG) investing evaluates potential investments according to three broad categories of factors to limit risk and potentially benefit society as a whole. This investing strategy is evolving and increasing in popularity. The definition of an ESG investor was originally thought to be one who avoids investments in so called “sin stocks” like tobacco, alcohol, and guns. Later, ESG investing became more identified with investing only in companies which were deemed to have a positive social or environmental impact—for example, solar companies as a path to reducing carbon emissions harmful to climate change. Both methods can be somewhat restrictive, and today fall in the Socially Responsible Investing (SRI) category.
The new ESG focus, commonly referred to as ESG integration, is to manage the risks of negative environmental, social or governance impacts of potential investments. “Environmental” risks are primarily related to climate change. For example, insurance and real estate companies can be directly impacted by increases in catastrophic weather events via higher payouts and expensive reconstruction. Utilities and energy companies are targets of those concerned with greenhouse gas (GHG) emissions.
“Social” risks include such things as exposure to child labor or privacy issues, generally affecting consumer goods and tech companies, respectively. The Gap, Inc had issues with child labor in the early 2000s and has worked to correct its shortcomings. Facebook has of course run into trouble recently with user privacy, such as the Cambridge Analytica scandal from last year.
“Governance” risks generally revolve around board and share class structures. Companies with these risks come from all sectors, but what mostly unifies them are compensation and incentive structures that stack the deck in favor of management and the Board at the expense of shareholders. WeWork is a recent example of a company that concentrated too much power in the hands of too few people. When a public light was shone on this dynamic for the first time recently, the reaction was less than kind. Please see the next section of our commentary on WeWork’s failed IPO for more details.
All of these risks expose companies to potential “fat tail” events, meaning those events which are rare but very large in magnitude. And if you are a long-term investor, these fat tail events are important considerations. This conclusion—that ESG integration is part of managing risks—has resulted in the concept being increasingly used when allocating assets—as it is now part of an owner’s fiduciary duty. When ESG meant restricting or eliminating investments in sectors such as energy, then an asset owner was violating his duty by potentially lowering returns. But if an ESG methodology is part of the risk analysis, not including its considerations in the review could potentially lower returns.
Many asset owners have determined that the best course of action is not to eliminate companies, but to manage ESG risk by directly investing in these companies, then becoming activist owners. A group of asset owners have signed the Climate Action 100+, representing $35 trillion in assets, to engage companies with a goal of reducing greenhouse gas emissions. Hiro Mizuno, the Chief Investment Officer of Japan’s $1.4 trillion Government Pension Investment Fund, has stated the fund will pay more to passive managers, i.e. those managing strictly to a benchmark, if the managers take an active investment role.
Analyzing possible risks and using active ownership is the logical approach to ESG investing and happens to match Eagle Ridge’s approach to investing in general. Eagle Ridge evaluates numerous sources of risk when making investments. We are active owners through voting proxies. We have policies for assessing the board—we review tenure, outside responsibilities and relevant skills. We don’t like staggered boards with multiple classes of members that have multi-year tenures. We prefer separate roles for the chairman and CEO. We also review policies, always looking to maximize shareholder representation.
Evaluating long-term risks is obviously difficult, and partially explains some of our ESG-like tilts in the portfolio. We think and invest as long-term owners. For example, we have not purchased a tobacco company as we don’t see much long-term growth in the market and view the potential for a fat tail event, e.g. severe government regulation, as high. We have been and remain under-weight energy, not just because of a negative view regarding supply, but because we see longer run demand threatened by consumer and governmental concerns over climate change and human health. Climate change will drive people to other sources of power and electric vehicles. We don’t own many utility companies but look for a diversity of power sources and less reliance on coal. We see more regulation regarding the use of coal and mandated alternative energy sources.
Going forward, ESG risk analysis will become more important in our evaluation of companies. Not just how the market will evolve for a company’s product, but also how a company will be affected by other shareholders. For example, if oil companies become subject to heavy activism demanding investment in green energy, that will alter their profitability and valuation. This scrutiny may make them less attractive investments. As always, we look to maximize long-term profits.
If you are interested in learning more about ESG investing and what we are doing to develop a pure ESG strategy, please reach out to us.
WeWork = No Go
WeWork, the co-working office space darling built for the flexible workforce of the future, failed to sell shares through a highly anticipated Initial Public Offering (IPO) even though it was scheduled to go public during the last couple weeks of September. This failure resulted in the recent resignation of its founder, Adam Neumann, and dismissal of 20 of his closest associates at the company. Since its inception in 2010, the firm was heavily financed by private equity as it rapidly grew its footprint of offices throughout the world including locations in 32 different countries.
At the beginning of this year, WeWork received its most recent $2 billion in capital from Japan’s SoftBank and the company was valued at $47 billion. Most of those funds have been spent and the company needs fresh capital from the public markets to offset operating losses and fund future growth. Wall Street sent recent signals to WeWork that its total market capitalization would be in the range of $10 to $15 billion. Therefore, SoftBank has lost about $1.3 billion of its investment this year which is equivalent to about 2/3 of its investment in less than nine months.
WeWork’s fall from grace illustrates the stunning disconnect between the values placed on rapidly growing companies in the private markets compared to the actual valuations realized within the public markets. The Securities and Exchange Commission (SEC) estimates that the market for non-registered securities is roughly a $3 trillion/year market which is larger than the public markets for stocks and bonds. It’s impossible to determine the size of the valuation differential between private and public markets based on anecdotes and small sample sizes, but the ultimate figure is probably significant.
The valuation advantage in the public markets makes sense since there is more information and much greater diversity of opinions. However, the inefficiencies of pricing within the private markets goes against the common belief that only the super wealthy and so called ‘smart money’ have access to the best private equity and venture deals.
WeWork’s valuation landed with a thud in the public IPO market because it was finally revealed that its business loses massive amounts of money, and the market was not confident those losses would abate any time soon. In calendar 2018, WeWork lost $1.6 billion on total revenue of only $1.8 billion. Losses continued to mount this year as the company reported losing $700 million on $1.5 billion in revenue during the first half of 2019 according to the prospectus it filed in August.
The public markets also specifically rejected the weak corporate governance standards apparent within WeWork’s IPO documents. Adam Neumann personally purchased buildings that were then leased to WeWork. Neumann also borrowed up to $700 million against the value of his WeWork shares in addition to cashing out portions of his ownership at higher rates than other stakeholders. The firm purchased a $60m Gulfstream jet for Neumann’s personal use which is now up for sale. The Wall Street Journal also profiled him in a September 18th piece portraying him as a charismatic leader who created a bizarre corporate culture. In 2016, the company fired 6% of its workforce during a party orchestrated by Mr. Neumann during which employees were served shots of tequila and serenaded by live rap music performed by Run DMC’s front man, Daryl McDaniels.
Technology has helped create more markets where one company dominates the competition to a greater degree than in the past. However, just because a company is able to grow its revenue past $1B quickly is no assurance that it is a start-up that will grow into an economic powerhouse such as Google, Amazon or Microsoft. To be validated by the public markets, business models need to show at least the promise of sustainable earnings and cash flow growth and managements need to operate transparently and openly with its investors and the larger world.