The 5 economic trends that worry me (2/2)

[Continued from Tuesday]

3. The hype around FinTech

Last year the rise of Financial Technology (‘FinTech’) software and apps led some experts to predict the ‘disruption of traditional banking. The new providers of financial services would maximise the agility and cost efficiency provided by technology and as a result would kick the incumbents plagued by legacy systems and excessive layers of staff.

LendingClub_logoLendingClub, founded in 2006, was perceived as one of the standard-bearers of that shift. As a P2P lending company it offered to put individuals or small businesses directly in touch with lenders through an online platform – a mix of Uber and Match.com. LendingClub was claiming that it would enable small businesses to get easier access to funding while providing lenders with an investment offering a (relatively) decent return.  LendingClub was just taking a percentage of the loan as a one-off fee and therefore was not taking any risk.

In 2016 the picture is somewhat different, as Patrick Jenkins points out. Hedge funds and banks have replaced individuals and small businesses and have started securitising the loans – rings a bell? Poor credit risk assessment processes led to the first defaults, the departure of the CEO and a 25% share price drop. Compliance started to take its toll as the company grew. To command a technology startup valuation multiple, revenue growth requires LendingClub to accept an ever increasing volume of loans (new loans account for 90% of revenues), including riskier ones. And the company proved sensitive to credit cycles. As a solution, LendingClub started taking retail deposits to channel them towards its lending platform – basically what a traditional bank does, with a tiny bit of software on top. No quite disruptive any more.

Historical evolution of LendingClub's share price. A slow descent into hell... Sources: Yahoo Finance, author analysis
Historical evolution of LendingClub’s share price (in USD) since IPO. A slow descent into hell… Sources: Yahoo Finance, author analysis

In the meantime, regulators across the world are running behind and have not proposed a robust framework to monitor this new array of services yet – raising the risk to “systemic stability”.

 

4. Banks desperately looking for yield

Banks are by far the biggest losers of the negative interest rates policy implemented by Central Banks across the world. Their deposits do not generate any revenues any more. Worse, they are a source of cost. Given that very few banks have dared passing the cost through to the customer yet (i.e. charging current accounts), banks are now looking for more profitable investment to make up for the difference – notwithstanding the fact that banks have been massively streamlining their teams over the last 12 months. This implies taking more risks.

O&G companies for instance were granted higher quantums of debt at the time oil was getting close (or above) $150 a barrel – especially those involved in shale gas production. Those quantums backfired when the barrel dropped by more than 80% – shale gas then became almost unprofitable to produce. Despite the recent correction, the O&G industry has been suffering a series of bankruptcies as a result – 42 last year alone. In the US, car loans, student loans and credit cards balances and delinquency rates are also reaching abnormally high levels according to Le Figaro. By willing to invest at all cost, banks are becoming less and less concerned about the quality of their customers.

 

5. Housing market engineering is back in the game

I thought the 2008 mortgage subprime crisis would repel investors from the housing market for a while. I was wrong.

collapsinghouse
Credits: www.polizeros.com

According to TechCrunch, Opendoor, a company founded in 2014, “currently buys homes sight unseen when a home seller visits its site, asks for a quote, and accepts Opendoor’s bid, which the company comes up with based on public market information about historical home sales and its own proprietary data about market conditions”. Fortunately, the company selects its investments, not purchasing “any home built before 1960 [or] homes outside a $100k-$600k price range” – according to TechCrunch this still means that 90% of homes are eligible, so the criteria are not that drastic after all…

The startup’s balance sheet is currently worth “hundreds of millions of dollars”. Talking about profitability, its CEO “Opendoor isn’t focused on [profitability] just now”. Let us hope for them that the housing market does not decide to spiral down again.

 

Some hope: Investors seem to have learnt (part of) the lesson

After a euphoric 2015, investors seem to wake up (some of them hungover) and are becoming more realistic about the true potential of ‘disruptive’ investments.

First, raising equity has also proven increasingly difficult for startups since the beginning of the year, especially for those seeking very large cheques (greater than $100m). In Q1 2016 $25.5bn got invested in startups globally, an amount down 8% yoy. When they manage to do so, the financing package comes with increasing strings attached, even for well-established brand names. The bond Spotify issued in March contains an ‘bomb-ticking’ interest rate which strongly incentivises shareholders to look for an IPO in the short to medium-term – in substance, creditors are asking the company to become palatable for the stock market as a whole and not just a series of cherry-picked investors.

logoSecond, the ‘real’ value of existing investments is being re-assessed. BlackRock, for instance, decided to cut its valuation of DropBox by 20% last October. Rocket Internet, the controversial startup studio, lost 18.5% of its equity value in two days in April after it revised the valuation of some of its investments downwards. On a side note, Carl Icahn, the famous activist investor, recently revealed that his fund Icahn Enterprises had a net short position of 149%.

Donald_Trump_August_19,_2015_(cropped)Politics is also joining the party. In the US, the Presidential Election held later this year represents a clear source of uncertainty. Candidate Trump has already declared that “we [were] in a bubble right now” and has been criticising the role of the Fed in the construction of that bubble. The kind of mitigating action that Mr. Trump would implement to negate the bubble still remains unclear at this stage.

Credits: www.fineartamerica.com
Credits: www.fineartamerica.com

What’s next? Because of the excessive amount of liquidity in our economy, value destruction has reached a scale never witnessed before. This is clearly not sustainable. When the liquidity tap will stop flowing, there will be boats left stranded on the shore. But to which extent? Will we ever come back to a pre-crisis environment? I do not believe so either. As I mentioned in an earlier post, I think the answer is in-between: we need to give birth to a ‘new normal’. I fear, however, that the delivery will not be painless.

The 5 economic trends that worry me (1/2)

Normal-Rockwell-Boy-on-High-DiveMany experts agree to say that the current economic environment is something we have never witnessed before. Despite negative interest rates – $10tn in total, now including some high-quality corporate securities – global growth is expected to remain limited – only 2.4% forecast in 2016 according to the latest World Bank report – as well as inflation – for 2016 the OECD forecasts 0.06% in France, 0.43% for Great Britain and 1.07% for the USA despite encouraging unemployment figures. This environment makes the hunt for growth significantly more challenging than in the past and has thus favoured the emergence of behaviours that, taken together, may well threaten the stability of the economy in the medium-term. Although the reader may find many more, I have taken 5 examples which have particularly struck me over the last few months.

 

  1. Stock markets reaching all-time highs despite weak macro indicators

The weak growth prospects expressed in my introduction have not deterred investors from massively buying stocks. Last week the S&P500 reached a level only 0.5% below its all-time high, lifted by a slight recovery in oil prices and the increased likelihood of a Fed Reserve rate ‘status-quo’ in June. This has come on top of the second longest bull run in the S&P’s history – the longest lasted from 1987 to 2000. And yet it is difficult to identify the ‘hard facts’ that investors base their bullish assessment on.

theres-a-new-most-bearish-strategist-on-wall-street“If you look at U.S. stocks on a global perspective, to be touching or near that high is pretty phenomenal. “Yet when we look forward, we’re struggling to find that next source of growth. Maybe the drag has passed, but where is the growth going to come from?” (Gina Martin Adams, Wells Fargo Securities LLC)

As Benjamin Graham, the famous value investor, claims in his book The Intelligent Investor, we may have switched from an investment strategy, where people believe in the true intrinsic capabilities of the firm they invest in, to a speculative strategy, where people believe that they will be able to sell their shares to someone who puts a higher valuation on them, irrespective of the company’s performance. The former is characteristic of a potential bubble.

 

2. Unicorns and unicorpses: party like it is 2000

the-18-billion-london-tech-unicorn-thats-struggling-to-pay-its-staff-is-worried-about-going-bustFor those unaware, ‘unicorns’ are companies which have managed to raise equity with an implied valuation exceeding $1bn. Not so long ago, the ‘unicorn’ club was made of a handful of companies with (i) proven business models, (ii) established profitability and (iii) huge opportunities for global growth. Today, the ‘club’ has grown to 150 members or so, all of which cannot claim to tick the three boxes mentioned above.

First, entrepreneurs have realised that being labelled a ‘unicorn’ could turn out to be a real marketing tool and business booster. Some of them decided to enter through the service door by actually raising a relatively limited amount of equity (let us say in the single-digit millions) for an even smaller share of the capital (let us say 0.1%). As a consequence, the firm manages to qualify for the ‘unicorn’ label, even if clearly no investor would be willing to pay close to $1bn for the entirety of the company.

Furthermore, to make up for the lack of revenues, entrepreneurs have come back to the non financial-related KPIs made famous in the late 1990s to support what ended up being the ‘dot-com bubble’: number of users, number of clicks, number of hours of videos uploaded on website etc. Growth is not about top line or EBITDA anymore as taught in corporate finance classes but measured by the notion of ‘increased engagement’ and ‘scale’ instead. Spotify, for example, managed to raise equity last year based on a $8.4bn valuation despite not having made a profit yet. This is easier than in the 2000s given that, as rightly pointed out by Terence Fung, the new ‘Web 2.0’ is mainly about B2C applications rather than B2B software which contributed to the ‘dot-com’ firms’ reputation.

20150210005716!Slack_IconFinally, some startups benefit from potentially inflated growth prospects. Slack has managed to raise $200m of equity based on a $3.6bn valuation in April. The company is nonetheless far from shaking the industry at the moment. It offers a simple chat app and is currently used by 2.7m daily active workplace users, only 800k of which are paying at present. Each paying customer is therefore implicitly valued at $4,500.

2015 witnessed soaring unicorn valuations but 2016 and 2017 may bring those valuations down to earth, a forecast trend that has given birth to the term ‘Unicorpse.

[To be continued on Thursday…]

Is the Western oil & gas ecosystem collapsing?

Cartoon from Russia-Insider.com

As the crude oil prices start their second month under the $40 a barrel barrier, the large-scale effects of low oil prices are starting to become apparent. Chesapeake Energy, the second-largest gas producer in the US, and Saipem, the Italian oil services company, took well-covered large hits in the stock markets yesterday and today – Chesapeake’s stock is now down 51% over the last month and Saipem’s is down 48%. Chesapeake had to dismiss rumours that it hired Kirkland & Ellis to restructure its debt while Bernstein advised investors to stay away from Saipem’s planned capital raise, according to Les Echos.

We may thus be entering a new phase in the ‘deep pocket’ war that the oil market has become over the last few months. The cash reserves that oil companies had put aside for ‘tough times’ are running empty, and the cracks we are witnessing today are probably only the first ones in line.

The risk of contagion is indeed not negligible. As rightly pointed out in this article from Reuters, Chesapeake is legally bound to oil infrastructure providers, for instance pipelines, through significant (several billion dollars a year) long-term contracts. No surprise then to note that Williams Companies’ share price was also down 35% for the today (9th February) and almost 50% down over the past 30 days.

So why not a pure write-off? First, these companies can rely on a cushion of tangible and partly re-deployable assets. Since the start of the year, companies in the industry – including Saudi Aramco – have been said to consider either raising capital (including through an IPO in the case of Aramco) or selling assets – both methods have equivalent impacts on net debt. The latter is a short-term solution that Chesapeake could well be tempted to consider. Second, the evolution of the share price is also a proxy for the expected evolution of the oil price in the future: shall the share of unprofitable US production sources remain high in the long term, the investors will lose faith in the potential recovery of the market and may decide to further turn their back on O&G stocks.

Update (10/02): This very interesting piece of analysis from Wood Mackenzie confirms the $30 a barrel environment leads a very large share of oil fields to be run at a loss.

Update (29/02): Chesapeake reported last week a $14.9bn loss. At the same time, Les Echos reported that petrol funds were to sell $400bn in assets.