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Weekly – Investment Adviser– 07 October

Unicorns’ pain

Flamboyant firms are shining less

Unicorns are private-held companies valued above $1bn when they go public. After years of benign flows of new tech IPOs, the spigot definitely opened in 2019. In the first semester 2019, more than 170 US firms (formerly start-ups) comply with the definition, versus c.10 a decade ago. A very large majority of tech companies (over 80% according to Recode) that went public in 2018 were unprofitable. Such very high proportion was only seen in 2000, the year of the dot-com bubble.

En - Year of the unicorn

Among the most flamboyant ones, Uber and Lyft made the headlines lately. In the last days We Company, the parent firm of WeWork, has just postponed its IPO after investor scrutiny over widening losses and corporate governance, as well as business model that relies on long-term liabilities and short-term revenue. It was previously reported that WeWork is halting all new lease agreements with property owners. Airbnb is also expected to go public in 2020.

 

The debt burden, a growing source of concern

Supranational organization like OECD, IMF etc. are in the process of delivering their 2020 forecasts. They are globally revised down. In a nutshell, world growth should barely reach 3% in 2020, which is considered as a stall speed by most economists. For sure, these organization tend to be ¨late in the game¨, i.e. they rarely anticipate trends (and quasi never spot timely trend changes). Still, at this very late stage of the economic cycle, one should pay attention to correlated developments in the credit cycle. According to BIS, financial / credit cycles tend to boom ahead of recessions. One of the common features of unicorns is their elevated gearing / leverage.
The frenzy over flamboyant tech IPOs may be over

EN - high valued IPOs

Recent pressure on Netflix, Tesla and the likes is of the same nature
Just like the very rapid fall of sovereign long-term yields (3,25% to 1,50%) in recent quarters

  • Signs that we are getting closer to the end of the credit cycle are multiplying
  • This is traditionally a period where caution is better rewarded than risk taking

 

Fixed income. Wind of change in Europe

Another unexpected shake-up at the ECB. Sabine Lautenschläger will resign by the end of October. She has been on Executive Board since January 2014; her term would normally end in January 2022. She has been mainly responsible for setting up the Single Supervisory Mechanism. The reasons for her resignation are unclear. It is perhaps a protest against the ECB’s recent decision to engage in another round of easing. She has been the most vocal to publicly criticize the bond purchasing program. Her resignation of means that there will be two new Executive Board members this autumn, as Benoit Coeuré term will finish at the end of the year. By year-end, 5 of the 6 Executive Board members will have seen a new occupant within the space of around a year and a half. While to some extent dissenting views is another step toward becoming a mature central bank, the fact that opposition to the last policy decision has become very vocal shows how fragile the ECB is.

After weak European PMIs, recession fears have intensified. But monetary developments are pointing in a different direction. The broad money supply (M3) increased from 5.1% in July to 5.7% in August, mainly driven by an acceleration in the narrow money supply M1. The M1 increase from 7.8% to 8.4% is particularly noteworthy. Real money supply is one of the best leading indicators for the eurozone economy. Even if the lag time is considerable, this supports a better economic sentiment.

At the same time, private sector borrowing also improved. This is more of a coincident indicator. While the credit impulse is not necessarily enough to boost growth, it shows that financial conditions have supported a small acceleration in lending growth. Economic environment will stay uncertain, but the ECB will likely take this data as a confirmation that the expansionary policy is having some positive impact at a time of slowing growth.

EN - M1 and GDP

  • The ECB will remain dovish, but we expect no more easing measures

 

Fixed income. Are US loans back to the forefront?

Covenant-lite loans are loans with fewer covenants i.e. with fewer restrictions for borrowers. A lender might set a covenant based on leverage to avoid trouble. If the issuer violates a covenant, the lender can call or reprice the loan. Nowadays, cov-lite loans are about 80% of leveraged loan US market. The situation is a bit more complex.

There are arguments to be made that they won’t be problematic. Cov-lite loans had lower default rates and higher recovery rates in the last recession. Specifically, in November 2009 the overall default rate on leveraged loans was 10.8% and the cov-lite default rate was 5.2%. Cov-lite loans have also had high recovery rates. From 1987-2017, the average recovery rate was 71%.

However, in the current cycle, cov-lite loans will be the focus since they dominate the market. Therefore, the question is if their default rates will peak higher in the next recession. That partially depends on the depth of the next recession. According to S&P Global, cov-lite loans might perform worse in the next recession because, their recovery rate will be lower by 10 points compared to previous crisis. That is interesting because the average spread over US Treasuries have nonstop tightened. That implies cov-lite loans on average were considered less risky.

  • While inflows are resurfacing, US loans look rich and not offering sufficient premium

 

Equities. Now, a US-China financial war

After the commercial and technological war, here is coming the financial war. For several months, we had raised the risk of Chinese companies listed in the United States in the context of a large US-China war, and the problem of the legal structure used by them, that is to say the constitution of registered offshore entities, mainly in Cayman and Bermuda. The shareholders of these offshore legal structures profit from the financial flows, but are in no case the real shareholders of the Chinese parent companies, like Alibaba, Baidu and the others, because China prohibits the foreigners from being in the capital of Chinese companies.

Three important topics are discussed at the White House:
1. Restriction of US financial investments in China, total or partial.
2. The limitation or prohibition of listings Chinese companies in the United States.
3. The limitation or prohibition of investments into listed Chinese companies by US pension funds.

The White House justifies these (potential) next steps by the lack of transparency and governance of Chinese companies, creating a significant risk for US investors.

In contrast, Nasdaq’s response was: “One critical quality of our capital markets is that we provide non-discriminatory and fair access to all eligible companies. The statutory obligation of all US equity exchanges to do so creates a vibrant market that provides diverse investment opportunities for US investors.”

Such limitations or prohibitions would have a significant impact on the stock market: US ETFs/funds holding shares in listed Chinese companies in the United States, or even in Hong Kong, should dispose of these prohibited shares, representing billions of dollars. The market capitalization of Nasdaq Golden China Dragon (Chinese companies listed in the United States) is $1,400bn, including Alibaba $430bn, China Mobile $167bn, PetroChina $150bn et China Life $100bn.

The American threat is serious, which should encourage Chinese companies to favor domestic and Hong Kong. Listings Chinese retaliation is possible with the sale of US Treasury and/or US equities, with more volatility on the financial markets.

  • Caution on Chinese stocks listed in the United States
  • Prefer Chinese stocks listed in China (A-shares)

 

Equities. Netflix, the competition is coming

Since mid-2018, the Netflix share price has been struggling (-40%) and is down 2% in 2019. Analysts observe:
1. A sharp rise in investment to increase content, generating an increase in debt and worrying negative free cash flow. Netflix has spent $ 8 billion on content in 2018 and is expected to spend $ 15 billion in 2019.
2. The arrival of powerful new competitors in streaming TV like Disney+, Comcast, Discovery, AT&T (HBO), Viacom, CBS, Apple. Netflix will lose licenses like The Office, Friends, Marvel, and Star Wars.

Netflix will release its results on October 16th. More and more analysts anticipate a deceleration in subscriber growth and a deterioration in free cash flow.

EN - Netflix stock price

 

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