Panmure’s David McCreadie’s Challenges ahead!


Good morning and the list of earnings casualties continues to grow. What is ominous is that the list is geographically agnostic and it includes well run companies with respected management. Such is the growing momentum of misses, disappointments, warnings and downgrades the market won’t be able to hold the dam indefinitely. Reality is setting in and its not coming from equity strategists, it’s coming from companies. Phrases like ‘challenging market conditions,’ lower than anticipated demand ‘ and ‘margin erosion,’ are now common currency.’ Given the technical backdrop it would be difficult to conjure up a more favourable bearish market scenario. In fact, for bears, what we have is almost too good to be true. One is therefore left to contemplate if indeed, it is too good to be true and might a further upside test lies ahead. My fear is that the equity market is storing up trouble and when the ‘moment of collective market recognition,’ arrives the consequence will be more violent than otherwise might have been the case had the market discounted events, as is its perceived function but which it very rarely manages to do.

The whole Valeant thing in the US is not something that I’ll spend much time on but for those interested, John Hemptons blog makes good reading, (as always). You can find the Citron research piece here. 19 analysts meanwhile have buy recommendations, 6 with holds and just 1 with a sell recommendation. The 12 month average target price amongst them is $248. Guess we’ll find out who is right. Bill Ackman having bought another 2m shares yesterday is obviously going with the 19. I think his fund is heading south. What sort of advisor puts their client’s money into a fund that has such concentrated long and short bets that the failure or success of just one position gives the fund a binary outcome.


Staying in the US and the main financials look to have dodged a bullet, or a firing squad, in respect of oil and gas related loan losses. While the banks are seeing rising defaults and are setting aside increasing levels of provisions they are not taking the hits one might expect given the size of loans made. Banks made loans  to the sector backed by reserves. When the borrowers reached their limits the banks pushed them to issue bonds. They paid off the loans with the proceeds which enabled a new line of credit. When that was limit up, they repeated the exercise. This left the banks with revenue from bond issuance, interest income and fees but loaded up the companies with debt and bondholders who now carried most of the risk. Now that the sector is self combusting the banks are taking some collateral damage but the main bond investors, mostly private equity and hedge funds, are being eviscerated. The big trade of buying energy bonds for cents on the dollar in the expectation of a crude price recovery only works if there is a price recovery. The WSJ has listed those who have taken the biggest hits and names like Magnetar, King Street, Blackstone, Brigade, Phoenix are notable. The sector is instructive in reminding us that cheap does not always equal value.


Meanwhile, a warning comes from Thomas Curry, Comptroller of the Currency, in a speech yesterday. “We are clearly reaching the point in the cycle where credit risk is moving to the forefront.” The Office of the Comptroller of the Currency (OCC),  one of three federal bank regulators alongside the Fed and the FDIC is articulating their elevated concern about banks’ exposure to the increasing risks of ballooning auto loans, particularly subprime auto loans, and commercial real-estate loans. (We’ve discussed this frequently in the past!).


As you are probably aware, banks are “repackaging” these loans, including subprime loans, into highly-rated asset-backed securities, in face of “strong demand by investors” that are reaching for yield, in an environment where banks “are reaching for loan growth.” After having “already extended credit to their best customers,” they’re now lending to “less creditworthy borrowers, with all of the increased risk that entails.” But the auto-loan binge is good for everyone. It’s good “for automakers and the economy,” he said. “It’s also good for banks,” whose financing made “this activity possible.” By the end of Q2, auto loans accounted for 10% of all retail credit in OCC-regulated banks, up from 7% in Q2 2011. Total auto-loan balances outstanding shot up 10.5% in 12 months at the end of the second quarter and hit $1 trillion, according to Equifax. And 23.5% of new loans earlier this year were subprime, up from 22.7% a year ago. Mr Curry went on to say,’ But what is happening in this space today reminds me of what happened in mortgage-backed securities in the run up to the crisis. At that time, lenders fed investor demand for more loans by relaxing underwriting standards and extending maturities. Today, 30% of all new vehicle financing features maturities of more than six years, and it’s entirely possible to obtain a car loan even with very low credit scores. With these longer terms, borrowers remain in a negative equity position much longer, exposing lenders and investors to higher potential losses. Although delinquency and losses are currently low, it doesn’t require great foresight to see that this may not last. How these auto loans, and especially the non-prime segment, will perform over their life is a matter of real concern to regulators.’


In essence, he is not warning about the loans themselves but of the concentration of loans. Moreover, the regulator then goes on to warn about commercial property loans saying that ‘valuations are now rather full.’ In fact, US commercial property prices have soared 97% from May 2009 and are now 21% higher than they’d been during the days of September 2007, the peak of the commercial property bubble that collapsed with such splendid results during the Financial Crisis.  Fitch too are getting a tad nervous. They obviously rate Commercial Mortgage Backed Securities, “There is nothing inherently dangerous about a real estate cycle. It only becomes dangerous when market participants forget there is one.” And it warned: “CMBS cannot afford a repeat of the 2008-2009 experience.”


The NASA forecast, that there is a 99% risk of at least a 5.0 quake hitting LA within 30 months, is about the only thing that may offer mitigation for the overheated commercial property market. In summary, and the real thrust of this short note, is to make the point that structural excesses have again been baked into the system. No one can anticipate what the outcome will be in the real world but there is clearly enough there to worry regulators. If its worrying them, its worrying me. Meanwhile, corporates are reflecting a global slowdown and the technical backdrop of the market is nowhere near as robust as actual trading levels suggest.


I think this is as tough an investing environment for managers as they are ever likely to see. When it’s down 25%, everything is so much easier.


Have a great day! McC


David McCreadie


D +44 (0)20 7886 2711 | M +44 (0)7780 612 643 | S +44 (0)20 7886 2500

Panmure Gordon & Co  One New Change | London | EC4M 9AF | United Kingdom


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