May 27, 2019–Rates On Hold As FOMC Stands Pat For The Time Being. What Are the Fed’s Next Steps?
Hedge Fund legend David Tepper Retires. What Happens To His Firm Appaloosa?
Google Suspends Huawei from its Android Platform as U.S.-China Relations Worsen. Where Does Huawei Go From Here?
FCC Chairman Recommends Approval of T-Mobile’s Acquisition of Sprint. Is This Deal Going To Close?
What Happens When We Combine The Value And Momentum Factors?
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian: Welcome investors to Episode 15 of the Absolute Return Podcast. Today is Saturday May 25th. It’s a bit of a crummy day out there, cold, rainy. So, a perfect day to be in the office chatting about markets. I’m your host Julian Klymochko.
Mike: And I’m Mike Kesslering.
Julian: We got a lot of interesting topics to chat about today. Off the top – rates on hold as the FOMC stands pat on rates for the time being. We’re going to talk about the feds next steps. Hedge fund legend David Tepper retires, what happens to his firm Appaloosa? Google suspends Huawei from its Android platform as U.S.-China relations worsen, where does Huawei go from here? FCC Chairman recommends the approval of T-Mobile’s acquisition of Sprint. Is this deal going to close? And finally, we’re going to discuss a recent blog post that we wrote about combining the value and momentum factors and how that can improve investment success.
Talking the Fed with their minutes of the FOMC meeting and coming out this week. It detailed the FOMC’s desire pretty much to leave interest rates where they are. Some of the central bank’s officials they did raise concerns about what happens if inflation remains below their 2% target and this has really been pervasive since pretty much the 2008-2009 global financial crisis, where inflation has consistently come in below the Fed’s 2% expectation and not really just in the US, but you can really make that comment globally, especially in developed markets really low inflation throughout the eurozone and North America and other developed markets.
Since introducing its 2% target in 2012, the central bank has failed to lift inflation to that level on a sustained basis. Getting into some numbers here, the personal consumption expenditures price index, this is the Fed’s favorite inflation gauge. It rose 1.5% in March year-over-year, so quite a bit off the 2% target. Another index, the core index and this strips up volatile food and energy costs. They pay attention to this one as well. It rose only 1.6%, I’d also like to comment that this FOMC meeting did take place, I believe it was early May. So, this was before the recent flare-up in U.S.-China trade tensions in which the supposed deal fell apart and President Donald Trump implemented additional tariffs and talks really dropped off, what are your thoughts on the FOMC minutes this month?
Mike: Yeah it was looking at it through the lens of those were mentioned higher tariffs in the U.S.-China trade war and how it could impact the consumer prices, which would in turn impact the monetary policy is economists are currently split on the impact that this could have. I’ve seen estimates ranging from just a 5-basis point impact all the way to 50 basis points. So, if it is 50 basis points, that would bring the inflation right to the targeted range. So that is something interesting to watch moving forward as well I did just want to mention that, when looking at the meeting minutes they were a little bit less hawkish than investors had initially thought with Powell’s first press release. But the S&P; it failed to really move equity markets, the S&P was actually down just over 1 percent for the week. So, I guess my question would be do you think that the Fed policy is having less of an impact on equity markets?
Julian: I don’t think so. Because if we go back to Q4 specifically in December and then in Q1 in January, you had a big market drawdown 20% on the S&P500 basically based on Powell’s commitment to the continued balance sheet runoff and continued steady pace of rate hikes from the Fed. Then once the market declined, certainly investors were not happy with the steady increase in rate hikes. Once that happened and Trump really got angry and all this pressure was piled onto Powell at the Fed, he really did a complete 180 degrees turn in early January in which he vowed to hold off on rate hikes in addition to the balance sheet runoff. So pretty much a complete reversal of what he had said only in Q4 and that had the effect of reversing that stock market decline and pretty much taking it near new all-time highs. So, you know to answer your point, I think they are very sensitive to what they call financial conditions. But investors view of financial conditions really is where is the S&P 500 trading at and where credit spreads. Yeah ultimately, they are kind of driven by the market and at this point you know the market is doing well, valuations are lofty, credit spreads and financial conditions look great. So, I think that they’re pretty fine standing pat here.
Just a summary of some of their views – FOMC viewed growth as quote solid. But acknowledged slower consumer spending and business investment. The committee also saw the dip inflation as quote transitory. Which we discussed last time and there was no indication that the central bank is prepared to cut rates anytime soon. Even though the market wants it to do so and I believe market expectations of a rate cut are greater than 70%. Perhaps 70 to 80% last time I checked for a 2019 rate cut. So, keep that in mind.
In general, the Fed officials are in agreement on the FOMC’s patient approach to policy. Pretty much staying put on rates for the time being.
Big news in the hedge fund space with legend David Tepper retiring. Some background here, he was a former Goldman Sachs trader turned distressed debt hedge fund manager. He officially hung up the gloves at his hedge fund after a really tremendous career. His firm is called Appaloosa and it indicated that it plans on returning investor money and converting to a family office. By a family office they’re just running David Tepper’s money.
Some background on the firm, it was started in 1993 and reportedly returned 25% annually net of fees since inception. Which is one of the greatest track records of all time and I should note that his strategy wasn’t necessarily buying the best companies or the highest quality companies. In fact, he did the exact opposite.
He was a distressed debt investor to start out where he was buying bonds of companies in bankruptcy or near bankruptcy, then he moved on to more equity and macro investing. What he’s up to now or one of the reasons he’s retiring is he recently purchased the Carolina Panthers NFL franchise for a record 2.2 billion, wanting to focus more time on that pursuit. He’s a Pittsburgh native. He made a name for himself during the financial crisis through investments in depressed bank shares and other bold calls over the last 26 years and Tepper when he would appear on CNBC, he could really move markets with some of his bullish comments.
Appaloosa, his firm managed about fourteen billion in assets with Tepper’s own money making up about 70%. So not a lot of client assets relative to the overall size of the firm. What are your thoughts on Tepper retiring here?
Mike: I mean you mentioned this 70% of the assets being his and part of that is because he’s been one of the few hedge fund managers that over the last number of years, early since inception is when they would have great years he would return back some of the principal to investors. So, the name of the game typically and with many hedge funds is to gather assets and beyond clip the coupon on the management fee in hope to have performance. But he was really focused on his performance and so didn’t want to grow that capital base too large. The other interesting thing with him is you’d mentioned that he was a former Goldman Sachs bond trader left after not really getting at the partnership that he really wanted. The other aspect was his returns back in the financial crisis was in 2008, he did lose 25%. So more than a broader basket of hedge funds. But you’d mentioned in 2009 where he actually made 7 billion dollars and 2.5 billion dollars himself and his thesis with the banks there really comes down to when the US Treasury Department introduced the financial stability plan, which involved mandatory capital injections into the banks.
He estimated there was about a 20% chance that the US would nationalize the banks. Which seems absurd now looking back with her revisionist history, you know it’s easy to say oh there was zero chance of that happening. But he gave it about a 20% chance and then from them he gets looked at the distressed pieces of the capital structure and really saw a favorable risk return asymmetry and made the investment based on that. So, read about that, I thought that thesis was quite interesting looking back to the financial crisis.
Julian: I long followed David Tepper’s career and one of the most meaningful things that I remember him saying in where he really attributed the success of his firm over the past 25 years is, he said that they’ve been so successful, because he’s willing to lose money. As you indicated down pretty big in 2008, I know he had it really tough 1998. He got caught up in the Russian default there. Took a big hit, so he has had big draw downs. But in order to make those 25 percent annualized returns, you have to take risk. You can’t do that in a low volatility fashion. You’re going to have to accept big draw downs with the goal of attaining tremendous long-term returns, which he certainly has.
Mike: Yeah in speaking to that is that he didn’t necessarily just jump in and call the bottom of these banks. He was buying the all the way down and so even in 2009, at one point he was down about 10% and then the fluctuation by the end of the year was I believe it was up 120% net of fees. Which is just insane volatility? But it’s a high conviction trade that he had with a favorable risk/reward scenario and makes sense.
Julian: Certainly, and I believe at the time they’re actually levered long in 2009 largely in these bank securities, bank equities. I know he went big into Bank of America stock in early 2009. So certainly, a prescient call by David Tepper and he’s had many many of those over really a tremendously successful career, one of the best ever in fact.
U.S.-China relations starting to worsen with Google suspending Huawei from its Android platform. What happened was Google cut off Huawei from its Android mobile phone operating system after the Chinese company Huawei was banned by President Trump. Huawei claim it’s stuck in the middle of the U.S-China trade war, while the U.S along with other nations, such as Canada, England, Australia and New Zealand, in addition to others they are growing increasingly concerned that Huawei really is a tool of the Chinese Communist Party and could potentially be used for espionage, spying and other activities such as that.
Some background on Huawei, last year it sold 200 million phones, a pretty big market share in China. It promised its customers that the current phones would continue to work and have access to Google Play Store and to buy apps. Huawei also said it will be able to roll out its own mobile phone operating system very quickly.
However, you know well the market except that will it be successful, there’s a reason why Android operating system is on you know pretty much 80% of mobile phones worldwide. Huawei also relies on silicon chips made by US companies such as Qualcomm, Intel. Now it has stockpiled five years of spare parts reportedly for its phones and one-year worth of components. But it calls into question if they are relying on five-year-old parts, can they make quality phones with such dated components?
A comment from a Citi research analyst, he said “the potential software ban could paralyze Huawei smartphone an equipment business, which is problematic for the U.S.-China trade war”. Because China has used Huawei certainly as a national champion. So, worries that the US and China are digging in for a longer costlier trade war weighed on financial markets on Monday as Beijing accused Washington of harboring quote, extravagant, “extravagant expectations for a deal to end their dispute.” Interesting comment in the China Daily, which really shows diverging views of this whole situation. It stated, “it seems as if the US takes it for granted that it has the absolute say over everything in its dealings with the rest of the world. Which has to take whatever the US dishes out no matter how arbitrary and despotic of that is. But China will not take it, and neither will Huawei.” So, China certainly digging in their heels there, protecting their national champion. What are your thoughts on this situation here?
Mike: Yeah specific to Huawei is they may be currently trialing, I believe they are currently trying their, some of their OS in certain parts of China. But you know this is going to, this is you know what’s call version one. There’s going to be multiple updates of this and Android has just such a large advantage at that that you know this is going to take a lot of money, a lot of years. Which they do have the capital to put it towards. But this is going to take some time. The other interesting aspect is you know looking into China and what other responses they can have to the U.S in terms of this trade war and an interesting lens to look at it through is the supply chain, which has already been impacted through the chip makers. But also, the you know the potential for export quotas for rare earth elements, which could be quite interesting since they are essential for the electronic components industry and China controls 90% of the production. So, if they put some sort of export quotas on this, this could have a drastic supply on global supply chains in the electronics industry. Which could be a second-order effect to watch here.
Julian: The interesting thing about rare earths is in fact they aren’t all that rare. The reason why China has such high market share is they’re incredibly destructive for the environment. So, most countries aren’t willing to take that risk. I mean while China they never really had any concern for the environment and they just you know resulted in high market share of that market. But I know the US has had mines of rare earths, which have shut down over time. But I believe they could find replacement supply. It’s just a matter of how long that takes to come online and your comment on why creating a new operating system that is on par with Android, I mean that’s like creating a new search engine that’s on par with Google. It’s just not going to happen, it’s certainly going to be of much lower quality. There’s no way they can match the quality of the Android operating system. So certainly not a good situation for Huawei to be in and you know quite perilous with respect to any potential future sales, lower quality product. I think it is a safe bet coming from them. In the future however, the US has indicated that Huawei could be part of a potential trade deal with China. So, they just kind of threw that out there as a carrot to get the Chinese to the negotiating table and put it into the trade war.
Mike: Absolutely and I agree with those comments and the other aspect that you’d have to look at for rare earth materials in you know potentially mining it in North America is just the political will. That’s something that the Chinese really don’t have the government there doesn’t have to worry about. They don’t have to worry about the populace is political will in that, doing that in North America would just be problematic politically.
Julian: Talking deals, big news out of T-Mobile and Sprint this week. You had the FCC, the Federal Communications Commission Chairman Ajit Pai recommending that the FCC approved T-Mobile’s 26 billion merger with Sprint. Now this would bring the wireless competitors in the U.S from four to three, which is a pretty big deal. Some consolidation there. The approval from the FCC bodes well for the last remaining approval of the deal. Which requires a nod from the DOJ, Department of Justice. However, sources indicate that the DOJ may be leaning against the deal. Which is a pretty interesting dynamic there.
The FCC and the DOJ almost always agree publicly on merger reviews. But we’ll see what happens in this case. The DOJ which often follows its staff recommendations, they’re expected to make a decision in about a month according to sources.
Getting into some market shares here. So, AT&T; and Verizon each have roughly 34 percent of the U.S Wireless market. T-Mobile has 18 and Sprint has 12. So a merged entity they’d still be behind AT&T; and Verizon at roughly 30 percent. To get this approval they had a number of divestitures and promises to build a world-leading 5G network totally as the next generation of wireless service. T-Mobile also announced that it will divest Sprint’s Boost Mobile pay-as-you-go business as part of a series of commitments, that it’s making to the FCC.
As for the 5G wireless network coverage they did promise, they say it’s going to go to 97 percent of the US population and 85 percent of rural America three years after the deal closes. In addition to that they won’t raise plan prices until then. So, the regulatory bodies really seeing two major things out of this deal, number one they like to see increased investment and development to 5G and number two they like to see increased national coverage especially in rural areas of cell phone coverage.
A quote from the FCC Chairman Ajit Pai, he stated “I believe that this transaction is in the public interest and intend to recommend to my colleagues that the FCC approve it.” Now the DOJ s approval this is really the last hurdle that this deal faces.
It may come down to the question that was at the center of this process from the onset and it’s it has been a very long process, while reducing the U.S Wireless market from four to three national carriers per competition.
The most compelling argument for letting T-Mobile merge with Sprint, so the number three and number four players, even if it ranks lowest on that regulators list of factors is that Sprint’s business is in a really rough shape and it’s only getting worse. They recently released their I believe Q1 results and they burned through nearly 2 billion of free cash flow in the 12 months through March. So certainly, Sprint is facing a tough market here, they can’t really seem to get their legs under them. They can’t turn profitable and some market participants believe if T-Mobile is not allowed to acquire Sprint, that Sprint could in fact go bankrupt and close up shop. What do your thoughts on this deal here?
Mike: Yeah yeah now I think that your last point about Sprint and their debt load and cash burn is a very valid point in that yeah, the regulators are in the short-term worried about three-four mergers. But you could just have one of those Sprint’s just going away through bankruptcy if just left on their own. But well the other aspect that I did want to point out was that it’s actually extremely rare for the two agencies to be split in their opinion and this hasn’t happened in the last 40 years, which is quite a unique scenario. The other aspect that, the other topic that has come up a lot in this debate is the difference between behavioral and structural remedies in terms of appeasing the regulators. Julian can you give a bit of a description of the difference between behavioral and structural remedies.
Julian: Yeah, I mean behavioral is things that they promise to do in the future such as this 5G build-out and not raising prices. Effectively promises that they’re making to the regulators that regulators, it effectively addresses their concern regarding anti-competitive nature potentially of this consolidation. Because as we know as markets become more concentrated, companies become less you know less competitive, it becomes more of an oligopoly in which these companies can take advantage of consumers and really have way too much power in the market.
So, a regulators main job is to prevent that lack of competition and really look out for the consumer with respect to prices of products and services.
Now I wanted to mention the background of this deal. Now we used to run a merger arbitrage fund, not currently running one. But I remember in December 2013 is when we initially took a position in T-Mobile. Currently no position in either of the securities, but almost six years ago you know five and a half years ago we took a position in T-Mobile. Because Sprint was rumored to be buying T-Mobile. Now at the time Sprint was quite a bit larger than T-Mobile and since for nearly nine or ten years, T-Mobile got a new CEO John Legere, you know nearly a decade ago and he has really just dominated the market. They came up as a scrappy a fourth-place player T-Mobile did and implemented some really really tremendous marketing and consumer friendly strategies to take tremendous market share, not only from Sprint but AT&T; and Verizon as well. So, you’ve got to give a lot of credit to John Legere. He’s really a superstar CEO, certainly by far the best in the communications sector and over time since 2013 T-Mobile has really just shot the lights out from an operational perspective. Steadily gaining new subscribers nearly every quarter while all the others pretty much continued to lose their clients to T-Mobile. Such that now T-Mobile’s quite a bit larger than Sprint and we already commented on the long tough slog that Sprint has been in and their market cap can have used to decline, their debt load increases and really been unprofitable for a very long time. They’re not growing and T-Mobile really wants to utilize consolidation, economies of scale and synergies to have a better chance of becoming the market leader ultimately and so a really interesting dynamic here and that this deal has been at least rumored to be happening for nearly six years and almost half a dozen years behind it.
So sometimes these deals take a very long time to play out. But it looks on this, looks like on this one we may see a final conclusion perhaps in even a month. But nonetheless, both stocks doing very well rallying off this FCC decision as the market looks forward to potentially a DOJ approval and being able to close the deal.
Mike: And from an entertainment perspective you mentioned T-Mobile CEO, I highly recommend listening to their conference calls as he is quite entertaining and very colorful in terms of his language on the calls, his descriptions of competitors. It’s just really interesting in somewhat of an old space that you know it wasn’t traditionally exciting and one other comment is just looking at Verizon and AT&T; with every good bit of news on this merger. Looking at consolidation and looking at pricing power is with every bit of good news they are rallying. Which would imply that the market believes that pricing will become more rational with this merger.
Julian: Put out a blog post this week titled, “what happens when we combine value and momentum.” I just want to quickly go over it. I encourage you to read it and basically want to state that the conclusion is value and momentum factors are very attractive in their own right. But when we combine them into a multi factor model, they’re very complementary. Because generally they are negatively correlated. So, when we combine them basically what results is higher risk-adjusted return, that means a better return for each unit of risk or volatility. So that summarizes the post for this week, when we combine value in momentum and certainly encourage you to go and read it.
And that’s it for Episode 15 of the Absolute Return Podcast. You can hear more at www.absolutereturnpodcast.com, Apple iTunes or wherever you listen to your podcasts. That’s it for us and we’ll chat with you next week, Cheers.
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