Look Away from the Pressure Point

Where will the QE3 spending make the most difference in asset prices?

As soon at the Fed announced its open-ended commitment to buy MBS at the rate of $40 billion a month, the market sold off the dollar, bought stocks and bought investment grade corporates and junk bonds, sold Treasury Long Bonds, bought non-dollar currencies, and bought just enough MBS to keep prices almost flat (up 2 basis points in yield for the day).

Think about that for a minute — the Fed says they’ll buy MBS, and the price of almost everything else moves more than the price of the MBS.

So the thing to think about is what else might happen as the Fed steps in like the Duke brothers to buy the market (and some day, to sell).

Our task is to figure out where the “disturbance” of QE3 will have the biggest potential effect.  Like the proverbial butterfly wings leading to a hurricane on another continent, the financial world has its own set of transmission mechanisms that can lead to unexpectedly large consequences.  In the bond world, that mechanism is yield spread.

Perhaps the most striking change that followed the Fed’s announcement was the new all-time low yield for junk bonds.  That was in face of rising yields on US Treasuries, with the fall in prices blamed on increased expectations of future inflation.  In other words, the spread narrowed more in a single day than we’ve seen for years.

So where will the QE3 program magnify itself most?  My bet is on corporate bond rates.  They have gone so low that they are now trading at lower yields than the bank loans to those same borrowers, even though the bank loans have higher credit priority should the borrower default.

We are seeing huge increases in corporate debt issuance now that QE3 is in action.  Drug chain Walgreens takes the prize for fastest out of the gate.  They raised a whopping $43 billion in new corporate debt the day after the announcement.  But the flood of other issuers is just getting started.

Perhaps most interesting, though necessarily with a delay, will be the effect on private equity and LBO (leveraged buyout) deal-making.

As we’ve seen before, the differential in tax rates embedded in our tax code can make all the difference in how people choose to invest, or disinvest.  Since the 1980’s, the huge difference in capital gains tax rates has provided a strong incentive to make money by taking profits from selling or refinancing rather than from building enterprises and reinvesting.

After all, the essential arbitrage built into our corporate tax code makes all interest payments an offset to profits, so that loading a company with enough debt to soak up all the profits has an automatic tax-shielding benefit for those who control the allocation of profits.  By simply borrowing enough (and taking the money out of the enterprise), a smart team of financial operators can make huge amounts of money, and even the money they make can be shielded from paying taxes literally forever, as long as they “make” the money offshore and don’t bring it back (directly) to America.  Even if they do bring the trading profits back onshore, it is only subject to capital gains tax rates, and only years later if they delay.

So here’s what I expect QE3 to do, but I can’t predict individual stocks that will benefit, unfortunately.  I can tell you what the companies that have outsized gains will look like, however.

They will be takeover targets, and some of them will be in industries that never looked attractive to private equity shops before now.  For example, grocery stores.  It’s a famously high-volume, low-margin industry.  But even grocery store chains make profit margins in the mid-to-high single digits.  Junk bonds can be issued now at roughly 6.5%, so even that thin profit margin can support the debt service of a junk bond.  If the target company owns real estate or employee benefit surpluses like retirement funds, so much the better.  If it has unions that can be “busted” by new ownership, that’s a trifecta.

Another sector that might have a surprise or two is developmental drug companies.  Since Big Pharma can now borrow nearly unlimited funds at very low rates thanks to QE3, I wouldn’t be surprised to see Big Pharma go shopping for new drugs just starting on their patent protection time window.  We might even see hedge funds or private equity funds step in ahead of Big Pharma, and attempt to gobble up a bunch of prospects before the big boys finish making their shopping list.

Finally, I’d be looking at resource companies (miners, energy extraction equipment makers, etc.) that are following Chinese demand downward, but have a better oil field drilling widget or a pile of ore waiting to be dug up.  The last group is a little dicier, since the global pressure on pricing through oversupply can lead to a lag in cash flow, along with the natural delay to payment from the moment you dig it up until you get paid.

If you are lucky enough to own a target company, chances are you’ll see a nice short-term gain on those stocks as this trend gathers momentum.  Knowing which target companies will actually be taken over is the 64 billion dollar question.

The one thing I’m quite sure of is that owning MBS while the Fed is buying them won’t be the best game in town.

Of course, the biggest payday will be for merger and acquisition bankers, private equity fund managers, and the lawyers who service them, but I’m not sure how you get onto that gravy train unless you’re already there.



7 Responses to Look Away from the Pressure Point

  1. Henry says:

    Hi Howard – good food for thought! What’s your view on the outlook for mREIT’s in the QE3 environment? They’ve been doing well in 2012, but getting increasingly squeezed.

    • hhill51 says:

      The mREITs should stay steady, more or less. They will have some more pressure on their carry income due to tighter spreads, but the repo market will be even hungrier to provide financing, so they can make it up with an uptick in leverage. They still average below 10x, or less than half what a dealer or bank uses. I’d expect to see a few of the more conservative ones cut dividend rather than increase leverage, and the more nimble traders (eg AGNC) take advantage of the trading opportunities to adjust their mix while taking some profits.

      We’re still so far below the reasonable maximum ratio of price to book that they could still have some price upside as junk bond ETFs and other income alternatives continue to price to lower yields.

      I don’t expect much movement until housing makes a big move up or down, in other words.

  2. Conscience of a Conservative says:

    I think ultimately this new QE initiative will have very few of the intended effects. First on those MBS purchases, the spread between current coupons and commitment rates has widened, which means banks that consumers will not be seeing significantly lower mortgage rates(assuming they are the best credits that qualify) but that banks will enjoy higher profit margins on mortgage origination and that banks get to keep more of those older higher coupon loans on the books.
    As far as that corporate cash, probably you do see more companies borrow, but I suspect they just wind up investing it in the debt of other companies that also issue, so on a macro basis I don’t see companies flush with cash and I don’t see them suddenly deciding to deploy that cash investing in new businesses until and if they see demand for products they can’t keep up with.
    One area I agree with you is on financial risk assets, I see QE3 reducing spreads and priming the market for more CLO issuance , junk bond issuance etc as pensions and various accounts throw caution to the wind and invest for yield. I think this part ends badly as it always does and it’s not just the sucker holding a busted CLO or junk bond, but the guy stuck with a 3% MBS pool or tranche he bought at a premium and is no longer trading as a short term bond but as 30 year paper with accounts rediscovering duration risk and being last man in.
    QE3 will not be inflationary. The banks are not able to increase lending. The market mistakenly focuses on bank reserves at the Fed, forgetting or not realizing that banks still have impaired balance sheets which is why the Fed gifts banks 1/4% on those funds and why Bernanke engaged in a plan to lower TBA yields knowing full well that banks had no intention of ramping up production of new mortgages. Bank stocks even today still trade at significant discounts to book and continue to deleverage.
    Bottom line is that everything the Fed & Treasury have done since the financial crisis be it on the QE front or the mortgage servicing crisis etc has really been done with one aim in mind which is as Geithner reportedly said, “to foam the runway for the banks” and buy them time.
    With the markets more artificial and distorted than ever the wise coarse of action is to retreat , not take credit risk, not take duration risk and to keep liquid( cash represents optionality and a very valuable asset). Investor’s should take a page from the fable Cindarella and not pick any of the ugly step-sisters and instead wait for the better deal to come along. You can’t fight the Fed but you can wait it out. Cheaper prices and higher yields eventually will come.

    • hhill51 says:

      Excellent ruminations, CofaC….
      Naturally I agree that the ZIRP and QE are in place so the banks can de-lever and recapitalize. Also you nailed it with the intention of the banks to simply grab some extra spread in new mortgage lending rather than passing the lower rates along to borrowers.
      I hate to say it, given the additional trouble still waiting to be found in the banks, but if QE3 does what you and I both think it will, then the deeply discounted bank stocks may be the best way to ride out the storm (at least among stocks).
      As always, the effects will not be where the mainstream expects them to be. Meanwhile, we have the biggest tightening of MBS spreads to Treasuries in any week since the crisis.

      • Conscience of a Conservative says:

        One problem with investing in bank stocks is the accounting is make-believe. Chris Whalen at Institutional Risk writes about this on a weekly basis. Enjoy your writing, please keep it up.

  3. Steve Meyer says:

    What do you think the effect would be of just eliminating the PE and hedge fund
    carried interest as LTCG current rule. Wouldn’t that eliminate the tax code
    arbitrage. I think maybe Romney could make the change just as Nixon
    was able to recognize China in the 1970s.

    • hhill51 says:

      Maybe $10 to $20 billion in additional revenue for the Treasury, now that the 2-and-20 crowd is collecting fees on over $1 trillion.
      It wouldn’t eliminate the arbitrage, because the real tax arbitrage is the deductibility of junk bond interest and arrangers’ fees. That allows profitable companies to be turned into break-even enterprises with most of the profit for the arrangers coming from not paying taxes by loading the companies with debt. Add in a pension raid and conversion to 401K, busting the union, outsourcing some jobs, taking owned assets into sale/leaseback format, and maybe some mortgages on the real estate, and you can strip the assets of a hundred year old successful company in just a few years.\
      This accelerated beginning in the 1980’s, and, IMO, is the main reason most of the wealth of America has been getting concentrated into fewer hands (along with the stupidity of rewarding that activity with lower or zero tax rate while still taxing productive activity and earned income at higher rates).

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: