Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.
A ‘mid/late cycle slowdown’ or ‘something more sinister’?
The key question for investors at this current juncture is as follows:
Is this recent bout of volatility a ‘mid/late cycle slowdown’ or ‘something more sinister’?
If it’s something more sinister, then with our medium term tactical market timing models now back on ‘across the board’ SELL, and with the S&P500 having reached key resistance levels, then there’s an argument for beginning to build SHORT positions.
FIG 1: Longview ‘fast moving’ scoring system vs. S&P 500 Index
Our central view is, however, that the recent correction in global equity markets represents the former, i.e. the pricing in of a mid/late cycle slowdown. Indeed, our assessment is that US recession risk is low (as laid out HERE). As such, high inventory levels, recent Fed tightening and the back-up in bond yields all set the stage for a bout of ‘eat, sleep, rinse, repeat’ (i.e. a growth soft patch, see HERE for detail). Added to which, the recent, sharp shift in Fed policy direction, coupled with the strong cash flow position of the corporate sector, suggest that a ‘mini cycle’ slowdown is unlikely to morph into something more sinister.
The risks: Are bubbles bursting?
There are, however, risks. In particular there is a risk that one or more bubbles in global financial markets are bursting. A decade of easy money, negative rates, financial repression and money creation has inflated a number of bubbles in global markets. And as Charles Kindleberger demonstrates in his analysis of financial crashes (see ‘Panics, Manias and Crashes’), tight/tightening money is the main trigger that bursts bubbles.
In that respect, we have identified 8 bubble risks including: i) the Damocles debt sword (see HERE); ii) the canaries in the coalmine (i.e. various expensive housing markets across the globe – e.g. see Australia recession risk note HERE); iii) the Italian govt bond spread risk; iv) the US ‘inflated asset prices’ bubble; v) the private equity bubble; vi) the ‘Chinese structural imbalances’ bubble; vii) rates and zombies; & viii) Asian structured products.
In this note, we will focus on two of those bubbles. First, and briefly, the China macro risks. Of note in that respect, and on reviewing our Chinese housing data this week, it’s become clear that the usual pattern of behaviour of the data is breaking down. In particular the data has a distinctly mixed message. Chinese house prices and housing starts have been trending higher. Chinese housing completions, though, have been contracting for 19 months (on a 6m smoothed basis, see FIG 2), while housing transactions have recently started rolling over. Indeed the most recent reports on the volume of Chinese houses being sold is somewhat alarming:
“China new home sales decline by 56 per cent during Lunar New Year holiday”
“A survey of 14 cities by Huatai Securities found that only four cities had posted growth in sales year on year during the February 4-9 period. On the other hand, Yangzhou in Jiangsu province, Fuzhou in Fujian province and Zhaoqing in Guangdong province reported declines of 80 per cent or more.”
Source: South China Morning Post, LINK
FIG 2: Chinese housing starts vs. completions (Y-o-Y %, 6m smoothed)
Determining the drivers of that mixed message is difficult. One possible candidate might be a shift in psychology towards housing (as an asset) and the puncturing of inflated prices (NB as we laid out HERE, prices in some Chinese cities are amongst the most expensive across the globe). As such, this needs to be watched closely. Over the next few days, we will be publishing our updated views on iron ore prices with an embedded view on Chinese housing as a part of that analysis.
Secondly, and much underappreciated, is the bubble in valuations in private equity. According to CB Insights, there are now 309 unicorns in the world (defined as recent start-ups with valuations of at least US$1 billion). China and the US dominate that landscape. The vast majority of these start-ups are disrupting one industry or another.
Because of financial repression, though, and the negative yields on offer in some of the government bond markets, and the volatility in public equity markets (not to mention the expensive housing markets in many parts of the globe), there’s a widespread belief that private equity is an attractive and relatively low volatility asset class. As such it has attracted considerably high levels of funding (with projected returns now, unusually, below those of public equity markets).
That high level of funding has led to high valuations. Both WeWork and Uber are two classic examples of that phenomena. WeWork was valued, in its latest funding round at US$20 billion (i.e. 20x current revenues and 10x projected 5 year forward revenue). WeWork is essentially a broker of real estate office space (albeit with some ancillary services as well). On its latest publicly available income statement, revenue of approximately $1 billion, translates after expenses to a loss of just shy of US$1billion. WeWork then adjusts for various (‘inconvenient’) expenses, to generate what the company calls ‘community adjusted EBITDA’. Not surprisingly that shows a positive outcome, i.e. a profit.
FIG 3: WeWork consolidated statement of operations (2016 & 2017)
Source: FT Alphaville April 2018, LINK
Similar companies including Regus (now known as IWG), are valued at considerably lower multiples of revenue.
According to the FT:
“IWG is the world’s largest serviced office provider, with more than 10 times the number of offices (of WeWork) and a profitable business model. Yet it has an equity value below $4bn. This values IWG at 1.2 times forward sales. If valued at the same multiple, WeWork would be worth around $2.7bn.”
Uber, another of the top 10 most expensive Unicorns, is a second example of a start-up valued using a multiple of revenues. Uber is expected to IPO in 2019 (along with a number of other private equity start-ups, including Pinterest – which was announced today). According to Forbes, Uber is worth approximately US$120 billion (bullish case), based on a 5.4 multiple of revenue. As of yet, though, Uber isn’t profitable while it recently exited its business in south east Asia (due to competitive pressures).
As argued many times before, the best valuation tool incorporates some measure of liquidity within it. As Kindleberger argues, bubbles are inflated because of cheap money, they are usually accompanied by high debt levels, and high valuations, whilst they are always surrounded by a good narrative. Private equity unicorns seemingly fit all of those bubble conditions.
If correct, and this is a bubble and reliant on continued cheap money to sustain it, then the interesting question becomes how does the eventual deflation of that bubble feed into public markets/US economy? And indeed, is it meaningful? Determining that playbook is complex. Clearly a significant amount of marginal US (& Chinese) economic activity has come from the rapid growth of these start-ups. Often with bubbles, though, the channels are not obvious until after the event. One clue may come from comments made by Chamath Palihapitiya, CEO Social Capital.
“Start-ups spend almost 40 cents of every VC dollar on Google, Facebook and Amazon… advertising in tech has become an arms race”
Source: Social Capital shareholder letter, October 2018
Other clues will probably come from the price action of any corporate bonds, where available, of these private equity businesses. WeWork’s bonds, for example, after a prolonged fall from August last year through to the start of 2019, have rallied sharply in recent weeks. If that continues that’s a strong sign that money remains readily available for PE businesses. With our risk appetite models now back on SELL, though, the next few week’s price action of these bonds will be critical and one that bears watching closely.
FIG 4: WeWork corporate bond price
Have a great weekend.
Kind regards,
Longview
Longview Research Recently Published
This week:
Longview Letter No. 121, 22nd Feb 2019:
“The Rhythm of ‘mini-cycles’ a.k.a. Bond Yields, Inventories & Orders” – see HERE
Weekly Market Positioning Update, 18th Feb 2019:
"Fearful positioning - not extreme"
Last week:
Quarterly Global Asset Allocation Alert No. 5, 15th Feb 2019:
"Switch out of US Equities & into Cash" – see HERE
Longview ‘Tactical’ Alert No. 50, 15th Feb 2019:
“Move Neutral Equities in Tactical Portfolios (from OW)” – see HERE
Macro Trade Recommendation No. 98, 14th Feb 2019:
"Move SHORT AUD & LONG Aussie interest rate futures" – see HERE
Macro Trade Recommendations No. 97, 14th Feb 2019:
"Move SHORT EZ banks, SHORT the EUR vs. the USD, & play a widening BTP spread over Bunds" – see HERE
Global Macro Report, 12th Feb 2019:
"Australia in 2019/2020: Recession Likely" – see HERE