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[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns

Takeaway: With the taxable bond category in a rare redemption cycle, investors are flocking to Treasuries in a flight to safety.

Editor's Note: This is a complimentary research note which was originally published February 18, 2016 by our Financials team. If you would like more info on how you can access our institutional research please email sales@hedgeye.com.

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While the ICI taxable bond category is broad including investment grade corporates, high yield, government, and global bond issues, the across cycle pattern is clear. When rare redemptions in the category occur, a resulting decline in 10 year Treasury yields ensue as investors are likely rotating within the group, out of corporate and global bonds and into U.S. government securities. Only during the Taper Tatrum of 2013, did ICI taxable bonds redemptions (the white line below on a 5 week moving average), not result in lower 10 year Treasury yields (represented by the green line below). This week, taxable bond funds gave up another -$729 million, the 14th consecutive week of outflow.

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - Treasury Yields to Taxable flows

Investment Company Institute Mutual Fund Data and ETF Money Flow:

In the 5-day period ending February 10th, volatility picked up, equity markets tumbled, and investors backtracked on their contributions to domestic equities. U.S. stock funds lost -$3.6 billion in withdrawals, negating the prior week's inflows and bringing demand for total equity mutual funds and ETFs to a negative -$1.2 billion on the week. In fixed income, investors continued to favor municipal bonds and ETFs over taxable bonds. Munis brought in +$1.4 billion in contributions with fixed income ETFs gaining +$932 million, while taxable bonds lost another -$729 million. Finally, investors shored up +$3 billion of cash in money funds.

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI1 large 2 24

 

In the 5-day period ending February 10th, total equity mutual funds put up net outflows of -$1.4 billion, trailing the year-to-date weekly average outflow of -$993 million but outpacing the 2015 average outflow of -$1.5 billion. The outflow was composed of international stock fund contributions of +$2.3 billion and domestic stock fund withdrawals of -$3.6 billion. International equity funds have had positive flows in 41 of the last 52 weeks while domestic equity funds have had only 6 weeks of positive flows over the same time period.

 

Fixed income mutual funds put up net inflows of +$690 million, outpacing the year-to-date weekly average outflow of -$1.2 billion and the 2015 average outflow of -$475 million. The inflow was composed of tax-free or municipal bond funds contributions of +$1.4 billion and taxable bond funds withdrawals of -$729 million.

 

Equity ETFs had net subscriptions of +$158 million, outpacing the year-to-date weekly average outflow of -$4.6 billion but trailing the 2015 average inflow of +$2.8 billion. Fixed income ETFs had net inflows of +$932 million, trailing the year-to-date weekly average inflow of +$2.3 billion and the 2015 average inflow of +$1.0 billion.

 

Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.



Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the weekly average for 2015 and the weekly year-to-date average for 2016:

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI2

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI3

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI4

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI5

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI6



Cumulative Annual Flow in Millions by Mutual Fund Product: Chart data is the cumulative fund flow from the ICI mutual fund survey for each year starting with 2008.

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI12

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI13

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI15

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI16



Most Recent 12 Week Flow within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI), the weekly average for 2015, and the weekly year-to-date average for 2016. In the third table are the results of the weekly flows into and out of the major market and sector SPDRs:

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI7 2

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI8



Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, investors seeking safety poured +$588 million or +7% into the long duration Treasury TLT ETF. Year to date, the TLT has experienced a +37% inflow or +$2.6 billion. Of the flows in the table below, that is the largest percentage inflow by far.

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI9



Cumulative Annual Flow in Millions within Equity and Fixed Income Exchange Traded Funds: Chart data is the cumulative fund flow from Bloomberg's ETF database for each year starting with 2013.

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI17

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI18



Net Results:

The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a negative -$2.8 billion spread for the week (-$1.2 billion of total equity outflow net of the +$1.6 billion inflow to fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52-week moving average is +$641 million (more positive money flow to equities) with a 52-week high of +$20.5 billion (more positive money flow to equities) and a 52-week low of -$19.0 billion (negative numbers imply more positive money flow to bonds for the week.)

  

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI10 2

 


Exposures:
The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:

 

[UNLOCKED] Fund Flow Survey | Taxable Drawdowns = Treasury Takedowns - ICI11 

 


CHART OF THE DAY: A Chart For The Bears To Hang Their Hats On

Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye Senior Macro analyst Darius Dale. Click here to learn more.

 

"... All told, the confluence of the aforementioned factors continues to underpin our bearish outlook for domestic equities and credit. Accordingly, we anticipate that the performance divergence between investors who are selling rallies because of deteriorating fundamentals and those who are buying dips because “everyone is bearish” will widen from here.

 

And even if we’re dead wrong on all the fundamental factors detailed above, there’s always the Chart of the Day for bears to hang their hats on…"

 

CHART OF THE DAY: A Chart For The Bears To Hang Their Hats On - Chart of the Day 2 24


Relatively Insignificant

“One thing the American defense establishment has traditionally understood very well is that countries don’t win wars just by being braver than the other side, or freer, or slightly preferred by God. The winners are usually the guys who get 5% fewer of their planes shot down, or use 5% less fuel, or get 5% more nutrition to their infantry at 95% of the cost.”

-Jordan Ellenberg

 

What a novel concept. War stories are usually adorned with lovable heroes and detestable villains – both of whom are typically larger than life – as well as tall tales of clear technological, personnel and/or geographic advantages shared by the victorious side. Rarely mentioned are “relatively insignificant” details such as luck or operational efficiency.

 

That’s not unlike our industry. Stories about great trades and investors alike are usually teeming with and often commenced by tall tales of how “smart” a particularly investor is or how much money they have. Rarely mentioned and seldom highlighted are “relatively insignificant” details such luck, process or simply being alive and having access to capital at the onset of major bull markets.

 

Relatively Insignificant - bull cartoon 02.08.2016

 

The quote highlighted above comes from a book I just picked up titled, “How Not To Be Wrong: The Power of Mathematical Thinking” by the aforementioned Jordan Ellenberg, the Vilas Distinguished Achievement Professor of Mathematics at the University of Wisconsin-Madison. Despite the fact that the author attended Harvard (pardon the petty rivalry), I am looking forward to the read because the book’s sole mission is to simplify complex mathematic concepts in ways that even former football and hockey players like ourselves can internalize and apply the knowledge to one’s craft.

 

Back to the Global Macro Grind

 

As macro research analysts, simplifying the complex is something we are tasked with daily. The economy – fully loaded with the public and private actors therein and the financial markets that underpin it – is a large, unruly beast that operates in a chaotic, nonlinear fashion.

 

Accurately forecasting inputs as basic and widely understood as GDP or CPI requires at least some understanding of advanced stochastic approximation methods. Moreover, the dependency of financial market returns at any given interval to growth and inflation is a dynamic function in and of itself that anchors on the slope of the policy vector = P. Advanced statistical analysis reveals that [GDP] growth, [consumer price] inflation and [monetary] policy are principal components of asset class returns, which is why accurately forecasting deviations in these variables is such an important task for investors.

 

That’s a particularly non-simplified way of saying investors would do well to understand pending material changes in growth, inflation and policy. I like simplicity. It makes my head hurt less.

 

5 bullets on GROWTH:

 

 

5 bullets on INFLATION:

 

 

5 bullets on POLICY:

 

  • The intersection of the aforementioned vectors (i.e. Growth and Inflation) should lead one to anticipate marginally dovish policy out of the Federal Reserve and, absent a gangbusters FEB Jobs Report at the end of next week, most market participants expect them to revise down the fairly steep slope of their infamous “Dot Plot” when the FOMC releases its revised Summary of Economic Projections on the 16th of next month.
  • The problem with revising down the Dot Plot is just that – it’s not QE. The road from communicating “3-4 hikes in 2016” to implementing “QE4” is rocky at best. The FOMC risks losing a substantial amount of credibility by communicating that transition in a hasty (i.e. stock market dependent) manner.
  • The presidential election cycle may be a complicating factor for any such transition as well. A lot of investors thought Jeb might keep Janet in check, but with his decision to [appropriately] bow out of the race, the focus shifts to Bernie’s anti-Wall Street rhetoric. Trump and Rubio have been openly critical of the Fed at various intervals as well.
  • Ignoring those factors for argument’s sake, it remains to be seen how impactful incremental QE will be in asset price appreciation terms. To butcher an old saying, every time the corporate profit and credit cycles met Fed easing, only the cycles left with their reputations intact.
  • Specially, the most important takeaway from studying the 1990-91 downturn, the 2000-02 downturn and the 2007-09 downturn in unison is that the stock market will appropriately price in obviously-bearish fundamentals no matter how much the Fed eases.

 

All told, the confluence of the aforementioned factors continues to underpin our bearish outlook for domestic equities and credit. Accordingly, we anticipate that the performance divergence between investors who are selling rallies because of deteriorating fundamentals and those who are buying dips because “everyone is bearish” will widen from here.

 

And even if we’re dead wrong on all the fundamental factors detailed above, there’s always the Chart of the Day for bears to hang their hats on…

 

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr Yield 1.61-1.83% (bearish)

SPX 1 (bearish)

VIX 19.64-28.96 (bullish)
EUR/USD 1.09-1.13 (neutral)
YEN 111.20-114.80 (bullish)

Gold 1176-1258 (bullish)

Crude Oil (WTI) 25.97-33.69 (bearish)

 

Keep your head on a swivel,

 

DD

 

Darius Dale

Director

 

Relatively Insignificant - Chart of the Day 2 24


Early Look

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The Macro Show Replay | February 24, 2016

 


MTW | MFS-W Trading, Implied Crane Value Quite Small

Unfortunately, One Can’t Borrow A When Issued

 

Summing The Parts, With Actual Parts:  MFS-W, the when issued trading for Manitowoc Foodservice, began trading this week and closed today at 12.92 on 950,000 shares traded – the first day of decent volume.  Since MFS will have about $1.4 billion in net debt and about 137 million shares, the MFS enterprise value pencils out to just shy of $3.2 billion.  The combined current MTW EV comes out to $3.475 billion, of which about $210 million is the net debt of the remaining Cranes business.  That leaves the lightly levered remaining Crane business, with nearly $2 billion in sales and potential Chinese suitors, with just over $100 million in equity value.  At 2014 Crane segment profitability that equity value equates to a P/E of roughly 2 by our estimates. 

 

MTW | MFS-W Trading, Implied Crane Value Quite Small - MTW MFS 2 23

 

 


CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values

Takeaway:  While Cat Financial’s year-end credit metrics were better than our expectations, we still expect an impact from lower equipment values and increasingly stressed customers. The Cat Channel appears to be holding units off the market with unrealistic pricing.  Borrower flexibilities with respect to negative equity and skip payment options may be forestalling the eventual impact of weaker end-markets.  Of course, we may also be misreading Cat Financial’s exposures and are continuing a dialogue with management.  While we will not dismiss the disconfirming evidence of favorable portfolio metrics lightly, we still expect an eventual negative impact from pending mine closures, oil & gas bankruptcies, and equipment auctions.

 

 

Overview

 

As we went through CAT’s 10-K, we were struck by steady to improving credit trends at Cat Financial.  Relevant used equipment values have generally been falling, and credit quality in many key customer categories has been deteriorating (e.g. mining, coal, oil & gas, emerging markets).  We view CAT’s reporting as having become more aggressive as the company now risks falling below the key $3.50 EPS compensation threshold.  Switching pension accounting methods and changing receivable loss allowance calculations can add to reported profits.  The credit trends at Cat Financial could be part of the same ‘efforts’.  They also may be a byproduct of a captive finance subsidiary’s role in stabilizing used equipment pricing, which can often prove costly.  Perhaps Cat Financial can navigate the current environment adequately.  We review some details below. 

 

 

Used Equipment Pricing Is Pretty Clearly Down

While it is challenging to determine exact pricing trends in used equipment (i.e. collateral for equipment financings) the changes we track have mostly been negative.  We see more equipment for sale and generally lower prices.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 1 2 23

 

 

Perhaps unsurprisingly, oil and gas equipment is piling up.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 2 2 23

 

 

Construction Equipment, Too:  Used equipment pricing pressure isn’t limited to mining and oil & gas equipment.  While we think this chart overstates used excavator price weakness, it seems pretty clear that excavator auction prices have declined in recent years.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 3 2 23

 

 

Cat Financial Credit Metrics Moving The Other Way

Usually, we would expect used equipment values to correlate with customer creditworthiness, and for both to correlate with Cat Financial’s portfolio metrics.  Interestingly, that is not what we saw in the 2015 10-K.

 

 

Dubious Allowance For Credit Losses:  The allowance for credit losses is down, but this is largely because CAT changed the calculation in 3Q 15 (reviewed here http://app.hedgeye.com/feed_items/47347).  From the 10-K The decrease in allowance rate is primarily a result of changes in our estimate of the loss emergence period and loss given default.”  As we see it, allowance is not sequentially comparable; such historically low reserve levels in the present environment seem dubious at best.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 4 2 23

 

 

Write-Offs Somewhat Elevated:  We would also note that 2H 15 saw a modest increase in write-offs, which help can improve other portfolio measures by removing troubled loans.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 5 2 23

 

 

91+ Days Past Due Looks Better:  The past due payments improved sequentially, which is a noteworthy positive.  While higher write-offs help, it is a surprising trend relative to our expectation.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 6 2 23

 

 

Regional Data Mixed:  Latin America & Europe were worse year-on-year, but North America and Asia/Pacific improved.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 7 2 23

 

 

Total Past Due Also Improved:  While partly from larger write-offs, total past due also improved sequentially and YoY.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 8 2 23

 

 

Non-Accrual Status:  The year over year increase decelerated, albeit on a smaller portfolio.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 9 2 23

 

 

Skip Payments & Consigning Negative Equity Equipment

 


Perhaps Just Delayed:  We would note that Cat Financial generally offers the option to skip payments: “Skip payment plans (up to 3 per year) are available on monthly payment schedules”*, and the ability to offset negative equity in specific equipment with positive equity in a customer fleet.  That said, these factors were also true a year ago.

*https://www.catfinancial.com/en_US/solutions/finance/loan.html

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 10 2 23

 

 

Keeping Used Prices High & The Role Of Captive Finance Subsidiary

 

 

Accumulating Equipment For Sale (Charts Below):  As we have previously noted, used equipment appears to be piling up at CAT Dealers.  Equipment counts and sale durations do suggest to us that CAT is trying to hold prices up in the aftermarket.  Critically, only about 10% of CAT machines are sold by non-CAT auctioneers. Maintaining aftermarket prices is a standard theoretical role for a captive finance subsidiary, partly so used equipment doesn’t compete with new sales. In the face of prolonged end-market downswings, these efforts can prove costly.

 


Auction Results vs. Cat Asking Prices:  Comparing used mining trucks is a bit difficult given specific features, rebuilds, and maintenance histories, but we do not see auction prices that in any way correspond to the asking prices on the CAT Used website.  For example, CAT Used lists the price of a 1999 785C with 61,823 hours (although some zero hour components) at $1,350,000.  That mining truck has been offered at that price in Winchester, VA since at least 2014, when demand for mining equipment was stronger.  Given the coal/mineral mining capital spending environment, it would seem that the likelihood of remarketing the truck at all is low, let alone at a 2014 price.  Looking at Ritchie Bros. auction results, a 2005 785C with 36,759 hours sold for $105,000 in April 2015.  Even since then mining equipment demand has weakened.  Similar comparisons show up for many of the rock/off-highway trucks on the CAT Used site – this one is no way unique.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 11 2 23

 

 

Raises A Number Of Questions: How is collateral valued if equipment doesn’t receive a bid?  Is this the reason Cat Financial dropped the word “liquidation” from the recent 10-K?  Where would used equipment values settle if Cat wanted to sell more quickly?  How does it make sense to, presumably, shorten the loss emergence period when equipment is accumulating and lingering?

 

 

Liquidation vs. Fair Value:  We questioned CAT management on a seemingly important language change in the 2015 10-K.  The allowance for credit losses on receivables that merit individual evaluation switched from consideration of “liquidation of collateral” to the PV of effective interest or the “fair value”.  In the context of unsold equipment, the change seemed material to us.  When queried, Cat Financial responded with: “The disclosure regarding methodology of allowance for credit losses attributable to specifically evaluated finance receivables does not represent a change in methodology but rather additional disclosure of the methods that we use for evaluation.  The methods disclosed in 2015 are standard practice under US GAAP for evaluating impairment of finance receivables.” Presumably, then, Cat Financial has already been using fair value… The word “liquidation” was removed from the filing.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 12 2 23

 

 

Accumulating Used Equipment In Cat Channel

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 13 2 23

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 14 2 23

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 15 2 23

 

 

Closures, Bankruptcies Still Coming: As we understand it (see here for call with Michael Currie http://app.hedgeye.com/feed_items/47572), mines will start to move from idling to closures this year.  Permanent closures, which mostly have been avoided so far, should involve significant equipment liquidations.  Oil & gas hedges will also expire, creating further pressure in an increasingly saturated used equipment market.

 

CAT | Mismatch Between Cat Financial Trends vs. Used Equipment Values - CAT 16 2 23

 

 

Upshot:  While Cat Financial’s year-end credit metrics were better than our expectations, we still expect an impact from lower equipment values and increasingly stressed customers. The Cat Channel appears to be holding units off the market with unrealistic pricing.  Borrower flexibilities with respect to negative equity and skip payment options may be forestalling the eventual impact of weaker end-markets.  Of course, we may also be misreading Cat Financial’s exposures and are continuing a dialogue with management.  While we will not dismiss the disconfirming evidence of favorable portfolio metrics lightly, we still expect an eventual negative impact from pending mine closures, oil & gas bankruptcies, and equipment auctions.


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