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PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse?

Takeaway: The excessive amount of capital in play in commodity industries is only beginning to decelerate and inflect.

Below we offer three different conclusions to supplement the credit-cycle section in our Q1 themes deck:

  • Planned capital spending cuts are only the first leg of the capital flush needed in commodity related sectors.
  • There is a gross excess of capital chasing current production levels, and this excess greatly overshadows the near-term effect of planned capital spending cuts – The market needs an extended period of underinvestment to reduce the excess capital deployed.
  • The non-GAAP reporting splurge should get worse with impairments and write-downs as the back side of the cycle plays out.

 

----------

 

We outlined the risk that is beginning surface in credit markets in the themes presentation. Coming off the summer 2014 lows in spreads and volatility, credit spreads are now widening on an unprecedented amount of corporate credit outstanding.

 

Moreover, commodity producers in mature industries have chased inflation expectations with free money to gain a much larger share of this expanding ‘debt pie’. One rhetorical question that we’ll ask with regards to monetary policy’s attempt to create inflation post-crisis:

 

Has monetary policy, in its attempt to create inflation, actually perpetuated deflation? Or, taking the policy discussion off the table, have inflation

expectations from producers created deflation?  

 

The answer is elusive, but we can probably make at least one conclusion: Free-money policy harvested a credit binge from commodity producers anchoring on higher prices:

 

Investment banker A says “don’t bother predicting commodity prices. Assume today’s prices (at the highs) and model the economics of digging a hole, pulling something out of it, and selling it. Then we can pitch this free money capital raise to Company X” - Leverage yourself up, and undertake projects at peak margins while everyone else is doing it.

 

Using a sample of 34 different producers in 4 different subsectors, commodity producer debt as a % of corporate credit outstanding has multiplied ~2.5x in 10 years. This group’s aggregate debt level is up ~5x in 10 years. The chart below shows the jump in commodity producer debt as a share of aggregate corporate debt levels.  

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Commodity Producer Debt   total corporate credit

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Real Rates Vs. Gold Miner Debt

 

To help illustrate the height of the leverage problem as rates move wider, the chart below shows interest expense charges for that same group of 34 producers. Every interest rate cycle since coming out of the early 1980s has led to lower lows in rates, and near the lower bound in rates commodity producers splurged.

Even though a bulk of the financing happened near this lower bound, interest expense has gone straight up over the last 10 years.  

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Interest Expense vs. Commodity Credit

 

Looking at three completely different markets (Energy, Gold Mining, and Potash), these price chasing charts paint the same picture. Projects look attractive to all of the same people at the same time at peak margins:

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Real Gold Price vs. Gold Miner Capex

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Potash Capex

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Capex less D A in energy

 

With one of the conclusions in the deck yesterday being that the deflation sewing investment splurge has taken credit markets to peak leverage, the cyclical bubble charts below show that the move off the low in rates and volatility of mid-2014 is in transit.

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - pg 43 macro deck HY spreads

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Pg 44 IG Spreads

 

And now that spreads are widening, the leverage problem worsens. Once credit spreads begin to widen for an extended period of time, they don’t revert within the same cycle without the commencement of a recession. 

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Credit Spreads and Recessions

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - PG 41 macro deck credit outstanding

 

A key call-out to monitor with regards to balance sheet trouble with spreads now moving is that a large amount of credit in the commodity space is on the edge of high yield even though much of it still trades like investment grade credit. Looking at a number of large producers in our sample of 34 companies above:

  • 9 of the larger producers have $211Bn in credit outstanding that could be tiptoeing the high yield line by late 2016 (arguably longer for BHP and Rio Tinto, but our macro view is not in their favor). That $211B is nearly 3% of corporate credit outstanding
  • Several IG credits trade like high yield is inevitable
  • 5 of the 9 listed below are on negative watch by Moody’s

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - IG to HY Table Image

 

To conclude with the most important point of the note, the capital in play chasing each unit of production is excessive and is just beginning to inflect. As mentioned at the top, the market needs an extended period of underinvestment to flush at the excess capital deployed per unit of production across the space, with energy and gold mining exemplified below:

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Gold MIner Net PPE per Oz.

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Production vs. Net PPE 2003

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Production vs. Net PPE 1998

 

While we look at the delta in aggregate capex as an indicator of capacity coming online, on the unwind, looking at capital in play or capital on balance sheet for every unit produced may be the best metric to gauge the flush.

 

There is still way too much capital chasing every unit produced, especially when considering the empirical evidence to support that, in general, producers have gotten better and more efficient at producing commodities over the long haul. The supply-side backstop that builds the foundation for a favorable long-term outlook for these businesses takes time to surface.

 

 

 


The Macro Show Replay | January 7, 2015

 


CHART OF THE DAY: This Indicator (Always) Signals 20%+ Stock Market Crash

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye U.S. Macro analyst Christian Drake. Click here to learn more. 

 

"... In the Chart of the Day below we show corporate profit growth vs forward year returns in the S&P500. 

 

The takeaway is straightforward:  While 2+ consecutive quarters of declining corporate profits haven’t always signaled recession, such occurrences have always signaled stock market crashes in the subsequent year."

 

CHART OF THE DAY: This Indicator (Always) Signals 20%+ Stock Market Crash - EL profits


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.33%
  • SHORT SIGNALS 78.49%

Lion's Den

“Lions Don’t Lose Sleep Over the Opinions of Sheep”

-Anonymous

 

Some version of that mantra must maintain residence in the non-consensus psyche of a contrarian – even if it’s not said aloud. 

 

We’ve been making and defending the late-cycle, growth-slowing call and selling rallies since July.

 

While commodities, currencies, EM and domestic small caps have been crashing and confirming that view for months, with the Dow and SPX now flirting with double digit drawdowns from their respective highs, our panglossian pushback stream has finally ebbed to a trickle.    

 

Chinese traders getting multiple days off as the market trades limit down within minutes of the open is remarkable but not remarkably surprising.

 

The path by which being on the wrong side of the global growth curve manifests in interconnected market risk is always uncertain … the net result on prices, less so. 

 

We’ll announce the details of our 1st major acquisition in the coming weeks but even if we never scale headcount beyond our core team from here, I won’t lose sleep.

 

I’d rather go to (macro alpha) war with 10 lions than a 100 sheep. 

 

Lion's Den - bull riding cartoon 08.26.2015

 

Back to the Global Macro Grind …

 

The capacity for information absorption is inversely related to density.

 

Drowning this missive with deep analytics may sound impressive and read well in the moment but a week from now most of it will be forgotten. 

 

Instead,  I’d like to focus on one salient point from our 1Q16 Macro Themes call from Tuesday (ping for the replay/details if you missed it). 

 

We are past peak in corporate profitability. 

 

That’s not our contention, that’s simply the data. 

 

The peak in both SPX operating margins and aggregate corporate profits is now rearview – and with growth estimates declining, income and consumption growth slowing, capex plans falling and inventories continuing to grow at a premium to sales, the retreat in margins looks set to persist over the nearer-term.   

 

Earnings growth and corporate profits have been negative QoQ for two consecutive quarters as of 3Q15 and should be negative YoY in back-to-back quarters once 4Q15 is reported.   

 

Earnings recessions have preceded actual recessions in each of the last three cycles and margin contractions greater than -60-70bps have almost always coincided with economic contractions. 

 

The ‘almost’ modifier sits as the battleground point currently. 

 

The last time we saw a significant earnings and margin contraction without a subsequent economic recession was in 1985-86 when oil prices dropped ~60% and profitability in the energy sector cratered, dragging broader EPS growth and profitability down as well.

 

Superficially, that sounds very much like the current setup  – although global macro dynamics and the capacity for policy to cushion a decline are decidedly different. 

 

So, could we again avoid a recession amidst an energy/industrial-centric profit recession?

 

Perhaps, but that may or may not be the right question.

 

In the Chart of the Day below we show corporate profit growth vs forward year returns in the S&P500. 

 

The takeaway is straightforward:  While 2+ consecutive quarters of declining corporate profits haven’t always signaled recession, such occurrences have always signaled stock market crashes in the subsequent year. 

 

Limit down with no liquidity is the lion’s den for complacently long PnL.  Last refuge currency devaluations and the limiting of shareholder sales to 1% of shares outstanding within a 3-month period (the CSRC response to today’s action in China) is a sheepish, reactionary policy response to market gravity. 

 

Complacently long of Gravity is usually the better allocation.  

 

To borrow the poker phrase:  If you look around the lion’s den and can’t tell who the sheep is  ….

 

… It’s okay, both sheepishness and asset allocation are (reversible) choices - keep moving. 

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 2.09-2.25%

SPX 1

VIX 17.93-24.48
USD 97.91-100.12

Oil (WTI) 32.06-36.88  

 

To long bonds and long sleeps,

 

Christian B. Drake

U.S. Macro Analyst 

 

Lion's Den - EL profits


PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse?

Takeaway: The excessive amount of capital in play in commodity industries is only beginning to decelerate and inflect.

Below we offer three different conclusions to supplement the credit-cycle section in our Q1 themes deck:

  • Planned capital spending cuts are only the first leg of the capital flush needed in commodity related sectors.
  • There is a gross excess of capital chasing current production levels, and this excess greatly overshadows the near-term effect of planned capital spending cuts – The market needs an extended period of underinvestment to reduce the excess capital deployed.
  • The non-GAAP reporting splurge should get worse with impairments and write-downs as the back side of the cycle plays out.

----------

 

We outlined the risk that is beginning surface in credit markets in the themes presentation. Coming off the summer 2014 lows in spreads and volatility, credit spreads are now widening on an unprecedented amount of corporate credit outstanding.

 

Moreover, commodity producers in mature industries have chased inflation expectations with free money to gain a much larger share of this expanding ‘debt pie’. One rhetorical question that we’ll ask with regards to monetary policy’s attempt to create inflation post-crisis:

 

Has monetary policy, in its attempt to create inflation, actually perpetuated deflation? Or, taking the policy discussion off the table, have inflation

expectations from producers created deflation?  

 

The answer is elusive, but we can probably make at least one conclusion: Free-money policy harvested a credit binge from commodity producers anchoring on higher prices:

 

Investment banker A says “don’t bother predicting commodity prices. Assume today’s prices (at the highs) and model the economics of digging a hole, pulling something out of it, and selling it. Then we can pitch this free money capital raise to Company X” - Leverage yourself up, and undertake projects at peak margins while everyone else is doing it.

 

Using a sample of 34 different producers in 4 different subsectors, commodity producer debt as a % of corporate credit outstanding has multiplied ~2.5x in 10 years. This group’s aggregate debt level is up ~5x in 10 years. The chart below shows the jump in commodity producer debt as a share of aggregate corporate debt levels.   

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Commodity Producer Debt   total corporate credit

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Real Rates Vs. Gold Miner Debt

 

To help illustrate the height of the leverage problem as rates move wider, the chart below shows interest expense charges for that same group of 34 producers. Every interest rate cycle since coming out of the early 1980s has led to lower lows in rates, and near the lower bound in rates commodity producers splurged.

Even though a bulk of the financing happened near this lower bound, interest expense has gone straight up over the last 10 years.  

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Interest Expense vs. Commodity Credit

 

Looking at three completely different markets (Energy, Gold Mining, and Potash), these price chasing charts paint the same picture. Projects look attractive to all of the same people at the same time at peak margins:

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Capex less D A in energy

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Real Gold Price vs. Gold Miner Capex

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Potash Capex

 

With one of the conclusions in the deck yesterday being that the deflation sewing investment splurge has taken credit markets to peak leverage, the cyclical bubble charts below show that the move off the low in rates and volatility of mid-2014 is in transit.

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - pg 43 macro deck HY spreads

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Pg 44 IG Spreads

 

 

And now that spreads are widening, the leverage problem worsens. Once credit spreads begin to widen for an extended period of time, they don’t revert within the same cycle without the commencement of a recession. 

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Credit Spreads and Recessions

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - PG 41 macro deck credit outstanding

 

A key call-out to monitor with regards to balance sheet trouble with spreads now moving is that a large amount of credit in the commodity space is on the edge of high yield even though much of it still trades like investment grade credit. Looking at a number of large producers in our sample of 34 companies above:

  • 9 of the larger producers have $211Bn in credit outstanding that could be tiptoeing the high yield line by late 2016 (arguably longer for BHP and Rio Tinto, but our macro view is not in their favor). That $211B is nearly 3% of corporate credit outstanding
  • Several IG credits trade like high yield is inevitable
  • 5 of the 9 listed below are on negative watch by Moody’s 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - IG to HY Table Image

 

To conclude with the most important point of the note, the capital in play chasing each unit of production is excessive and is just beginning to inflect. As mentioned at the top, the market needs an extended period of underinvestment to flush at the excess capital deployed per unit of production across the space, with energy and gold mining exemplified below:

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Gold MIner Net PPE per Oz.

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Production vs. Net PPE 2003

 

PRODUCER LEVERAGE | Non-GAAP Splurge to Get Worse? - Production vs. Net PPE 1998

 

While we look at the delta in aggregate capex as an indicator of capacity coming online, on the unwind, looking at capital in play or capital on balance sheet for every unit produced may be the best metric to gauge the flush.

 

There is still way too much capital chasing every unit produced, especially when considering the empirical evidence to support that, in general, producers have gotten better and more efficient at producing commodities over the long haul. The supply-side backstop that builds the foundation for a favorable long-term outlook for these businesses takes time to surface.

 

Ben Ryan

Analyst 


Cartoon of the Day: Pooh Bear Market

Cartoon of the Day: Pooh Bear Market - stocks. bear in the woods 01.06.2016

 

This one speaks for itself.


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