Podcasts

Absolute Return Podcast #28: The Yield Curve Just Inverted— Should You Sell Everything?

By August 27, 2019 No Comments


August 27, 2019—Pembina to Acquire Kinder Morgan Canada in $2.3 Billion Deal. What’s the Strategic Rationale?

China Fires Back With Additional $75 Billion of Tariffs on U.S. Goods. Why Are They Escalating the Trade War?

U.S. PMI Falls Below 50 , Signalling Manufacturing Decline for the First Time Since 2009. What’s Driving This Slowdown?

VMWare Announces Acquisitions of Pivotal and Carbon Black. Why Did They Do These Deals?

What Should Long-Term Investors Do About The Yield Curve Inversion?

Subscribe: iTunes | Podbean | YouTube | Spotify | Stitcher | Overcast

Transcript

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 Klymochko:  Welcome investors to Episode 28 of The Absolute Return Podcast, I am your host, Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is Monday, August 26, 2019. Got a number of interesting events from the past week that we are going to chat about on the podcast today.

    • From the top, some M&A news in Canada with Pembina acquiring Kinder Morgan Canada in two point three billion dollar pipeline and infrastructure deal. We are going to discuss the strategic rationale behind that M&A transaction.
    • A brief trade war update with China firing back with an additional 75 billion of tariffs on U.S. goods. Why are they escalating the trade war?
    • A bit of macro stuff. We are going to comment on U.S. PMI falling below 50 for the first time since 2009. I think that’s a really, really important data point for investors to consider. So we are going to talk about what is driving this economic slowdown in the U.S.
    • Some additional M&A news with VMWare announcing two deals in one day with the acquisitions of both Pivotal and Carbon Black. Why did they do these deals?
    • Lastly, we are going to touch on some portfolio management with respect to what long-term investors should do now that the yield curve has inverted.

Big deal up in Canada with Pembina Pipeline Corp announcing a two point three billion dollar acquisition of Kinder Morgan Canada. Now Kinder Morgan Canada was a relatively recent spin off or carve out of its larger parent Kinder Morgan, which trades in the U.S., based in Houston, I believe. They carved out their Canadian assets and took them public, I believe, within the past two years. So a fairly brief life for Kinder Morgan Canada, and ultimately this was kind of a mercy kill. It was at a 37 percent premium, but I should comment that was off near an all-time low.

If I believe it traded at that low the same week that they announced this deal. This 37 percent premium looked high, but it is just worth traded about six months ago. Now, this deal represents an increased bet by Pembina on the future of the Canadian oil sands. Pembina also becomes a key provider of the condensate that oil sands companies need to blend with their thick crude to enable it to flow through pipelines. What condensate is, it is very, very light petroleum liquid that is blended with oil sands bitumen to make it flow freely through these pipelines.

Another thing with respect to this transaction is concurrently Pembina is acquiring the Cochin Pipeline from parent company Kinder Morgan, the U.S. entity, for about 2 billion. This number Kinder Morgan Canada deal is contingent upon the closing of that cushion, 2 billion dollar pipeline transaction. Other key assets in the deal on the Kinder Morgan Canada side include oil storage terminals up near Edmonton. One key aspect of this transaction, it really highlights an ongoing trend that we have really seen over the past five, six years, which is international capital flight out of the oil sands. You’ve seen a number of relatively large divestitures, exits from the Canadian oil sands, whether it be Conoco Phillips, Royal Dutch Shell, Devon and now Kinder Morgan, effectively wiping their hands dry, cutting loose any Canadian oil sands, assets and allocating capital elsewhere. A lot of E&P companies going and reinvesting the proceeds into the Permian. Remember that was the strategic rationale that Devon was following.

Touch on valuation twelve point four times EBITDA, which is relatively good valuation for this asset. Interesting commentary from the Pembina CEO talking about this deal and a former Kinder Morgan Canada asset, Keystone XL pipeline, which they actually recently divested to the Canadian government after facing years and years of regulatory and environmentalists pushback.

The CEO Pembina stated, “We don’t want to submerge our entire management team and subject our entire organization and reputation to all the noise that entails.” Basically what he’s saying is, look, Keystone XL, we can operate this better than anyone else, but that thing is just radioactive at this point and we wouldn’t touch it with a ten foot pole. That is an interesting deal happening in Canada. Certainly a fairly large one at two point three billion dollars. What are your thoughts on this transaction?

Michael Kesslering: Yeah. First for the strategic rationale. It will give the Pembina some oil storage capacity Edmonton with the Kinder Morgan Canada portion. Then as you mentioned, the Cochin pipeline takes condensate to the Chicago market. There is some strategic rationale there as well as those assets, as you had mentioned. Kind of in that, twelve point three, twelve point four times EBITDA multiple on the transaction. So another four hundred million dollars EBITDA that Pembina will be gaining in this transaction.  The really interesting aspect, as you had mentioned, is just the competitive environment in the pipeline space right now is they’ve done their strategic alternatives process a few months ago went no bid or if they did get any bids. They must have just been, you know, in the lower range where they were not favourable for the company at that point in time.

Julian Klymochko:  Right. So Kinder Morgan Canada announced a public process where they aim to sell the company and effectively no one came to the to the table to buy them and the stock dropped pretty precipitously.

Michael Kesslering: Absolutely, and then in terms of deal specific notes is that the closing of both the transactions are conditional on one another. That is interesting. It will have to pass through Competition Canada. But at least in terms of what the markets are saying in this deal, there really isn’t much concern of the deal closing as it’s trading at a very negligible spread, you know, less than less than a couple of percent annualized.

Julian Klymochko: Right, so it is kind of in the 2 percent range. I would consider this a fairly low risk deal. The assets in addition to that, these are low risk assets. Long life storage assets and pipelines that are fairly consistent cash flow generators.

All right. Moving on to some trade war updates here. China fired back with 75 billion of additional tariffs on U.S. goods. It announced that it would impose five to 10 percent tariffs on 75 billion of U.S. products. These would include agricultural products, apparel, chemicals, textiles, things of that nature. Now, these tariffs are being applied to the remaining U.S. imports in which the punitive taxes, these tariffs have not yet been applied. The reason that they are doing it, the reason that they are escalating this trade war further is basically in response to the U.S. applying the latest round of tariffs on 300 billion of Chinese products. Basically this trade war has gone tit for tat thus far. The U.S. announces something not only does China not roll over, but they come back with basically the opposite, which is additional tariffs on U.S. goods. It is kind of a tit for tat escalation here, and what we’re seeing in this case is further escalation on the Chinese side in response to the latest tariffs announced by the U.S. As for timing the Chinese Tariffs sign 75 billion in U.S. goods will be imposed in two batches, the first on September 1st and then on December 15th. Now, these are the same dates. That the U.S. tariffs on Chinese goods will go into effect.

One way that the Chinese are responding here to the increased economic pressure caused by the U.S. tariffs on their exports is they are letting its currency drop to the lowest level in a decade. What this does is a weaker yuan or weaker Chinese currency, makes Chinese exports cheaper. Basically, it is somewhat of a relief valve or an air cushion to dampen the effects of this trade war on their economy. But it’s not without negative consequences. If Chinese citizens see the currency rapidly depreciating, that could lead to a flight of capital out of the country as they obviously do not want to see themselves get poor.

One major key consideration in this trade war is that China imports less than the U.S. does from it. China’s ability to impose tariffs is quite limited. As you could see, China’s response to 300 billion of tariffs on the U.S. side is only 75 billion. It just goes to show you the massive trade imbalance on both sides. The U.S. can actually enact much more pressure on the trade side, just given they import much more from China than they do export. But on the Chinese side, obviously, this is a negative for their economy. Consensus is that this latest escalation will cause Chinese economic growth to decline by about 50 basis points. So half a percent taking economic growth down this year, below their target of 6 percent. We are definitely seeing some negative effects on the Chinese economic growth figures. What are your thoughts on this latest trade war battle?

Michael Kesslering:  First, with regards to their GDP, their estimate being the lower now, I would still have my money on them making their estimate. They usually find a way to fudge the numbers and make their estimates with their guidance GDP. Like you mentioned now another 75 billion dollars’ worth. This is the last of the remaining goods, now that they can levy tariffs on and so China will have to be more creative with any further retaliation. But as well, just bizarre in the sense of there is also Trump tweeting on Friday, I believe it was where he had hereby ordered U.S. companies to move back their Chinese operations back to the U.S., which was just kind of a weird tweet as the enforceability of this. Like there was some people in the markets wondering if this was actually an executive order, which obviously it was not, you know, can really just be taken with a grain of salt, but just adds to the overall confusion in the marketplace right now.

Julian Klymochko: Yes, certainly you never want to trade or invest based off any sort of Trump tweets, because more often than not, they seem unrealistic and perhaps nonsensical. But, you know, you definitely need to take it into account. This trade war has been happening for, what, 18 months now and it has only got worse and worse and worse. You see him tweet that we are having great talks and things are really progressing. But realistically, we are definitely not seeing any of that. I made a joke that Trump is playing 3-D chess here. His strategy is to perhaps get interest rates to go negative just on these punitive economic measures that he is inflicting not just the Chinese economy. But that affects the global economy and the U.S. You are seeing a lot of U.S. companies struggling with these tariffs and ultimately that gets passed on to the U.S. consumer, and we know that the U.S. consumer drives 70 percent of U.S. GDP. And so if you don’t have the support of that consumer and prices are rising, then, you know, that’s certainly not great for U.S. GDP figures, which he holds so dearly.

Michael Kesslering: Absolutely, and looking forward to this week, we do have the G-7. So I’m sure there will be some quotes from there from the Trump camp.

Julian Klymochko: Getting to some macroeconomic data here, U.S. PMI fell below 50, signalling a manufacturing decline in the U.S. for the first time since 2009. What happened here is that U.S. manufacturing activity is contracted for the first time in nearly 10 years. With IHS Markit’s U.S. Manufacturing Purchasing Managers Index, the PMI, dropping to forty nine point nine in August. I wanted to explain what PMI or the purchasing managers’ index is without getting too technical. Basically, the reason why I wanted to flag this for investors and why this data point is so important is that the PMI is one of the most reliable leading indicators in assessing the economy. And what we mean by leading indicators is it gives you insight into forecasting where the economy is heading on a short term basis. What the PMI is, it is a monthly survey of purchasing and supply executives in the U.S. asking them to identify month over month changes in 10 business activities such as new orders, production, employment, deliveries, inventories. Now, this figure of the forty-nine point nine was U.S. specific, but they do have PMI lines globally. And what we’ve seen as a trend over the past six to 12 months is dramatically declining PMI as with many below 50 globally.

Just recently, the U.S. was one of the few countries with PMI remaining above 50, but that is no longer. What a PMI reading about 50 signals is an expansion, while a PMI reading below 50 signals a contraction. It is relatively easy to read. Now, economists, there is a consensus estimate that PMI would come in for August at fifty point five and it came in with quite a big missed at forty nine point nine. So certainly a negative surprise on that side. Globally, PMI are below 50, or at least declining largely in nearly every major economy and this is really just showing evidence of a major global economic slowdown. And it’s fuelling recession fears, this has been a topic that we’ve discussed I had nausea over the past number of months, whether it be inverted yield curve or negative interest rates or now PMI is below 50. These are all signalling the same thing, which is a global economic slowdown.

Michael Kesslering: I would like to point out that there is somewhat of a feedback loop with the manufacturing PMI as it is something that is sensitive to trade wars are really just general uncertainty by nature. And one other indicator being the services PMI, which is similar to the manufacturing PMI, just focusing on the services sector, is that it is actually still above 50 at fifty point nine with its last reading, although that did come in below expectations, it still is in that expansion territory. The other thing to keep in mind is that the services area of the economy is larger in the U.S. than the manufacturing sector. So there is a little bit of a contradiction there, but something to keep in mind that it is very much of a feedback loop because there is some anxiety globally that purchasing managers that will be reflected it in their orders.

Julian Klymochko: For sure and you make a good point of it being a self-fulfilling prophecy in that, you know, businesses see declining economic numbers and, you know, it scares them perhaps that they want to slow down their hiring, perhaps they want to slow down their expansion plans. And it just turns into this feedback loop, the other thing you got to consider is the effect of this trade war. Right, how much of that is flowing through these negative economic data points that continue to pile on? And that being said, if they somehow resolve this trade war. Will, that just erase all these negative data points and we will go into a growth mind-set again and start seeing much better economic figures coming out globally. That has to be seen, and it is certainly something to keep an eye on. I believe monitoring the PMI figures going forward, really makes sense for investors.

Relatively odd event in the M&A space with VMware announcing not one but two deals on the same day with the acquisitions of both Pivotal and Carbon Black. In a rare double deal, VMware announced the acquisition of software development platform Pivotal Software for two point seven billion and also cloud security company Carbon Black for two point one billion. So almost five billion dollars of deals from VMware announced in one day. Got a quote here from the VMwear CEO on the strategic rationale behind these deals, he stated, “These acquisitions address two critical technology VMware priorities of all businesses today it is building modern enterprise grade applications and protecting enterprise workloads and clients. With these actions, we meaningfully accelerate our subscriptions and SaaS offerings and expand our ability to enable our customer’s digital transformation.” So there is some corporate strategic speak for you.

Some background on these companies. Now, Carbon Black was founded in 2002 and went public in early 2018. At the time of its IPO, its valuation was about one point two five billion. Stock was relatively volatile. It traded as low as less than 13 dollars earlier this year, but since recovered to about 21 bucks per share. Now, VMware in this deal is paying 26 bucks per share in cash, so relatively decent premium for carbon black shareholders there. They expect the deal to close by the end of January 2020 on the pivotal side. This was actually originally incubated at VMware an EMC Corporation, which EMC Corporation was taken over by Dell, taken private, and then Dell recently came public and they actually control VMware. They have a controlling stake in VMware so it is basically pivotal returning to its parent company, which incubated it all those years ago. Now, these deals were relatively weird. They were, I say, way outside a VMware’s core competency and investors really punished the stock. You saw VMware down 10 percent on the news, pretty heavy volume. So investors not too pleased on this announcement of this double deal. What are your thoughts on it?

Michael Kesslering: Yeah, with regards to some of the negative sentiment, you’d mentioned that it’s down about 9 percent, which is quite unusual given that these are cash deals. So there is no share consideration which would put some short pressure from merger arbitrage. The other interesting aspect is investors have been quite negative on it just with regards to corporate governance, where some sell side analysts have mentioned a view that VMware may have been forced to acquire pivotal by Dell, as you had mentioned, bringing it back under control of Dell. The other interesting aspect is that some of the investors believe there might be some margin dilution with the business model. As you know, Pivotal does have lower margins. So there is some concern there. The other interesting thing that I would like to point out is that Carbon Black is actually trading through the cash consideration that you had mentioned of 26 dollars. The last I checked, it was trading in there, 26.13 range. So it is trading above that cash consideration amount, which would indicate that investors think an overbuild may be coming in. And if there is an overbid, there would be a 70 million dollar break fee paid by Carbon Black if these accepted a superior proposal so that be in the 4 percent range of total deal size.

Julian Klymochko:  Right. Makes sense that perhaps they are not too impressed with the valuation and the premium and they are looking for VMware to pay more. But we shall see on that one.

Another piece of odd company specific news is at Overstock.com, a fairly interesting stock and very dynamic and interesting CEO Patrick Byrne, who is seems to be always in the in the media, not generally for good reasons. Well, we had really interesting news with his retirement. Do you have any thoughts on what happened there?

Michael Kesslering: Yeah, I would highly recommend taking a look at his resignation letter, which was published, I believe last Thursday where he indicated his reason for stepping down as CEO was his involvement as a federal informant in the investigation of a Russian spy whom he was dating, and this make performing his duties impossible. He made various references to his Rabbi in Omaha, which was alluding to Buffett, Warren Buffett that is.

His father was actually an executive at Geico. Back in the early days of Geico and was actually one of the reasons it is believed that Warren Buffett invested in the company. That is where their family’s wealth has come from. They have made a lot of money in the insurance industry over the years, as he was known as a very high quality executive, but you had mentioned, his involvement with Overstock.com, they were kind of one of the pioneers in the e-commerce space back in the late 90s, early 2000s. As you had mentioned, very weird in the sense of once their stock did become under pressure in around 2004, it began. He was really going on a crusade against naked short selling, which he blamed for the company’s struggles. More recently has become a major advocate for crypto currencies, investing a lot of company resources into block chain projects, as well as a new exchange that would be on the on the block chain that would combat naked short selling, which from most market participants point of view really isn’t an issue. So it is kind of addressing an issue myself personally do not believe is an issue. But just in terms of Overstock performance over the last number of years, they’re down 46 percent over the last year and down 4 percent over the last five years. The stock really has not done much over the last number of years.

Julian Klymochko: Right, but it did pop a little bit on news of his retirement, just given that investors I think they’re pretty fed up with his antics and they feel like this is noise, undue noise that is finally leaving the situation and they can allow Overstock to operate with all these distractions.

Put out a blog post last week called Should Long Term Investors Worry about a Yield Curve Inversion? Now the media has been heavily focused on gloom and doom that has historically accompanied the yield curve inversion. Now, they say that in the media if it bleeds, it leads. And that’s what they use to get clicks. They like to focus on bad news. What happened on Wednesday, August 14th about a week and a half ago, we had the first yield curve inversion in which the 10 year yield fell below the 2 year Treasury yield. Now, investors kind of freaked out about this. The Dow dropped 800 points on the day, which was the largest drop of 2019. CNBC, of course, came out with their markets in turmoil special, which usually happens after large market drops and notably is a relatively consistent contrarian indicator. Nonetheless, there are additional points of consternation in the market that shows how concerned investors are with respect to markets. There is almost 17 trillion of negative yielding debt globally, which includes 1 trillion of negative yielding corporate debt. So a lot of investors buying negative yielding bonds, which obviously shows you, look, something is happening in the markets.

I wanted to briefly touch on what is the yield curve inversion. What it is, it is a phenomenon in the government bond market. And what is the long-term bond yield, typically that of the 10 year Treasury bond falls below the yield of a short-term bond. So typically, on the short term, we are talking about a three-month or the two-year. It is an abnormal event. Typically, yields are not inverted. Specifically in the U.S., I know, perhaps the Japanese yield curve has been weird for a long time, but an inverted yield curve is a weird event.

Past yield curve inversions in which long term bond yields fall below that of short-term Treasury bond yields have often been a harbinger of an economic recession and a bear market or a big decline in the stock market. Now the jury’s out on whether an inversion signals an upcoming recession or in fact is one of the causes of an upcoming recession. But in the U.S. the previous five occasions in which the yield curve did invert a recession followed. While the timing is not super consistent, historically, the economy has entered a recession within 24 months that the yield curve did invert. So the timing there is not relatively consistent. I mean, it is kind of all over the place. But over the past five-six yield curve inversions in the U.S., the economy has gone into a recession within the next two years. Now, why does an inverted yield curve matter? Well, the reason that many investors slow down equities, but a week and a half ago, upon learning that the yield curve is inverted, is that they believe, judging by precedent yield curve inversions, that a recession is likely to happen within the next 24 months. They are basically going off what happened historically. They also believe that a recession would bring your standard bear market, meaning a stock market decline of minus 20 percent or greater. But there is a problem with using the inverted yield curve as an indicator on what to do with your investments.

Number one,  my thoughts are if you’re certain that the market was going to fall sometime over the next two years by an indeterminate amount, say, you know, 20, 30 percent, would you actually sell even though, you know, in the meantime, it could rally pretty significantly? I know over the past handful of yield curve inversions the S&P 500 has actually rallied north of 13 percent prior to the next recession, so that is something to keep in mind. The other thing that keep in mind is if you actually do have perfect timing, you top tick it; you sell right at peak valuations, peak of the market, would you buy back in? And if so, how would you know when the bottom is? So you effectively need to make to perfect decision, perfect time when to sell. Perfect time when to buy. Assuming that, you know, the historical average does sustain itself and the market does in fact decline. What I am saying is that I don’t think it’s necessarily a good idea for long term investors to plow out of their equity investments here. Basically what long term investors should do is we looked at some data and by long term, I’m talking about 10 year returns.

We looked at the yield curve inversions over the past 40 years, and since 1978, there has been about a dozen, you know, 10 to 12 of them. Over that time period, we’re talking about 10 year annualized returns. They have largely been positive. You know, at the high end, we have had after the December 1988 inversion, over the next 10 years, the S&P 500 compounded north of 18 percent annualized, which is just a massive return like no one would ever complain about that. If you sold there, you looked like an idiot. Now, the lowest and only negative 10-year future return from an inversion was that during the tech bubble February 2000, the 10-year subsequent returns were negative, zero point six percent annualized, which sucks, but that is not a massive loss. Nonetheless. On average, since 1978, the, you know, 10 or so yield curve inversions, the subsequent 10 year annualized return of the S&P 500 was ten point six percent. So that’s positive figure and ten point six percent annual return, in my opinion, is a very good investment return. That is something for long-term investors to consider. Yes, you do take some pain in a recession and in a bear market, but I think instead of trying to be cute with it, sell at the top, since you are picking a new bottom, getting in and out, and dancing in and out of the market, that you are probably better off just holding. And this is the price, this is a premium you pay for taking that volatility in the market as a long term investor.

And that’s it Ladies and Gents, for episode 28 of the Absolute Return Podcast. If you liked it, you can check out more at absolutereturnpodcast.com. As always, we will chat with you next week. If you like it, please give us a review. Leave some comments. Ask some questions. Reach out on Twitter, LinkedIn, Facebook, wherever it is. Send us an email; we will chat with you soon. Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.