The Lex Newsletter: are we nearly there yet?

Dear reader,

It feels increasingly as if the answer to the question posed in our headline is “Yes”. Between them, the Federal Reserve, Bank of England and European Central Bank have raised rates 35 times since inflation started ripping. For the record, reference rates are 4.5 to 5.5 per cent across the group.

Strategists will debate the impact of every morsel of economic data. But the market is already discounting further significant rises. Yields on benchmark government bonds have been dropping for the past month.

Like shy woodland creatures emerging from their burrows after a storm, chief executives are taking stock of the changed landscape.

Simon Carter, boss of British Land, suggested this week that the cycle had reached an inflection point. He gave practical expression to that view by turning down a substitute tenant offered by Mark Zuckerberg’s Meta for a property it rented but never occupied near Regent’s Park in London.

Take that, Zuck!

Carter reckons he can get more money letting the property on the open market. Low occupancy remains a problem, but demand for prime sites is brisk.

Lex recently called the peak in European bank interest earnings. We followed up for Japanese lenders this week. The five largest of them, including the financial arms of Mitsubishi, Sumitomo Mitsui and Mizuho posted record half-year earnings of ¥2tn ($13bn).

If the Bank of Japan dispenses with negative rates, banks could make further gains. But Fed policies will have a bigger overall impact, given that much of the earnings surge originated in the US.

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Walmart, America’s universal emporium of cheap stuff, has prospered through the pandemic and the era of rate rises. The stock is up almost 65 per cent since late 2018. It dipped this week as management warned that consumer wobbles and deflationary pressures could hit sales.

Lex acknowledged that trading down by consumers had benefited the Bentonville behemoth. But we are maintaining our long-term bullishness on Walmart. We think cheaper food will leave shoppers with more to spend on those alluring if somewhat random discretionary items superstores seem to specialise in.

Easing rates offer some respite for overleveraged businesses. But for German residential landlords such as TAG Immobilien, it may be a case of losing on the swings what they have gained on the roundabouts. Property prices have been dropping in response to rising rates and a slowing economy.

These will put pressure on TAG’s loan-to-value ratio. This has remained steady in the third quarter at 47 per cent. Debt covenants are at risk and shares have accordingly taken a beating.

One way to deal with a can that threatens to trip you up is to kick it down the road. For this reason, payment-in-kind bonds, which save the issuer interest payments but add to their debt balance, are popular with struggling US corporates.

Carvana, which sells used cars online, recently reported improved cash flows, thanks partly to a PIK refinancing.

PIKs can permit investment, the returns on which may help cover the eventual, increased payment of principal. But lenders should think carefully about the mix of short and longer-term incentives for bosses. They may hop to new jobs before repayment is due.

Can-kicking is also a core competence of mature UK businesses with large, legacy pension schemes. Extending deadlines to cover deficits served them well. Higher discount rates have subsequently shrunk the liabilities of many schemes, though not those of BT Group. Having hedged out rates, it more than halved its deficit to £3.7bn the hard way — by making steep contributions.

In our view, the scheme now looks exposed to writedowns of such “growth” assets as private equity and property. These represent a third of the asset base.

A final point to make on peak rates: they are creating bargains for acquirers with cash resources. Purchasers have an opportunity to step in and buy distressed but fundamentally sound businesses as rates drift lower and economic conditions improve.

That, we suspect, may be what Warren Buffett has on his mind. His investment group Berkshire Hathaway has sold about $40bn of stock in companies such as General Motors, HP and Chevron in the past year. It now has a cash stash of $157bn.

Bear necessities

Pandas are herbivorous mammals famed for their low libidos and resemblance to pyjama cases. It is their fate to serve the Chinese Communist party, like most other organisms dwelling in that populous nation. The CCP is embarking on a renewed round of “panda diplomacy” with plans to dispatch some of its black-and-white bears to US zoos as diplomatic gifts.

Joe Biden veered off script this week, however, describing Xi Jinping as a “dictator” following a summit. At least he did not compare the Chinese president to another bear: Winnie the Pooh. This seems to be the ultimate thought crime.

Lex is a third variety of ursine: a market bear. We doubt talks will lead to any meaningful rapprochement. There has been no discussion of rolling back US curbs on advanced chip sales, US investment in Chinese technology and the disputed areas of the South China Sea.

Shanghai’s Composite Stock index looks historically cheap at 1.2 times book value. But we believe the real estate crisis is worsening. Savvy investors will wait for signs of asset price deflation slowing before buying the dip.

Chinese customers are important to many high-end western consumer product businesses. They did not spend as heavily post-lockdown as hoped and have been spending even less as economic growth slows.

Posh mac maker Burberry reported weakening half-year profits this week. But it “delivered a more coherent brand aesthetic”, which is presumably more important. The UK-based business tried but failed to break into the top league of fashion in the noughties and early 2010s, so we remain keener on France’s luxury giants.

Estée Lauder, Canada Goose and Apple have all been hit by falling Chinese sales. We think shares in the US cosmetics business are still too expensive at 39 times forward earnings.

Things I have learnt this week

Football is not inevitably a money pit where status-hungry billionaires splurge their money on the latest playing sensations. Manchester City appears to be making sustainable profits, not least from trading in footballers.

Barclays is in a strategic bind. It aspires to be a steady performer, but its hit-and-miss investment bank precludes this. A Big Read by Stephen Morris and Harriet Agnew unpacked the issues skilfully.

The so-called basis trade in Treasuries is the new big short. The best part of $660bn in notional underlying futures value is tied up in the trade, as I discovered while researching a column on the subject.

Burberry describes its products as “heritage rainwear”. I have an old anorak at the back of my wardrobe that would answer to the same description.

I hope you stay dry amid the autumn showers,

Jonathan Guthrie
Head of Lex