The London Brief - February 19th, 2023

The London Brief

February 19th, 2023

A busy work schedule, an active holiday period and a parental hazing exercise in the UK called the “11+ Exam”, conspired to keep me away from you. But more importantly, I haven’t had strong convictions on market direction until recently.

But one trend prevalent in most business cycles is fraud. This tends to pop up when financing gets more expensive and tighter. The Hindenburg Group released a litany of charges against the Adani Group in exhausting research that included downloading the entire Mauritius corporate registry. The FTX fraud is already being geared up for a movie.

Germany’s largest fraud is Wirecard, the €21 billion market cap payments processor that ended up going into administration in 2020 and being worth zero. The scandal has potentially turned Ernst & Young into the new Arthur Anderson. It’s also created a documentary and a book called Money Men, written by the Financial Times reporter who did battle with the company and its spies over seven years.

The lessons from the scandal include such gems as “potential red flags warrant further scrutiny” (Forbes). Stanton Chase, who advises board members says, “the supervisory board must be independent”. The Centre for Economic Policy Research advises “to understand… what their business models are”.

My Lessons from Wirecard

When a Nigerian astronaut sends you an email that he wants to come home and needs you to open a bank account for him, or a someone wants to send you $5 million from an award payment against Internet scammers, our instinct is to hopefully delete the email. If it’s too good to be true, it probably isn’t.

Looking at Wirecard’s inexplicably high margin third party acquiring business, and comments from competitors, even without knowing if there was any fraud, you could suspect something was fishy. Yet everyone chose to ignore it including one of the world’s foremost accounting firms. Why? People want to believe. Wirecard was going to be Europe’s champion payments processor; a European response to the dominance of U.S. fintech. A German CEO who could wear black turtlenecks. When sceptical journalists at the Financial Times diligently reported on the fraud, they were considered Anglo-Saxon villains wanting to prevent a German company from succeeding. Ernst & Young’s partners, who were minting millions of dollars wanted to believe for the money.

So, my three easy lessons are:

Lesson 1: The company’s auditor should change every five years; this way the auditor does not have to worry about a revenue stream ending, or the prestige for auditing a corporate client, because they know the payment stream will end at the termination date (note Germany is now looking to impose a ten year change the auditor rule and they are still not sure; now we know why it takes so long for them to approve Leopard tanks to the Ukraine).

Lesson 2: If you don’t understand how a company makes money, then it’s best to avoid it. I remember looking at Wirecard as a potential takeover target for Ingenico. I asked sell-side analysts what this third-party processing business was about; and no one had a compelling explanation. One analyst told me Indian companies may not find processing easy and pay more; I told him global banks were all trying to do payment processing business in India and Wise was starting to have a big business at a fraction of the fees – why pay such huge fees to Wirecard? Not much of an answer. We passed. Ingenico denied the rumours.

Lesson 3: When people believe, it’s hard to make money shorting the stock. When the Financial Times first broke the Wirecard story in 2014, the market cap was around €5 billion but the share price ultimately hit €21 billion. While the shorts were right, they had to lose 4x their money before it paid off, and it required an independent probe by PWC. That said when the results of the company audit were supposed to be announced, there was a delay, and the shares were trading; if it was a clean bill of health then the company would have been press releasing and doing morning interviews on CNBC. That was a bit of a tell, and a good time to short. So, if you think you have a fraud, short tactically around the news and cover if it doesn’t work.

Triple Three Rule

Wirecard’s main method of fraud was through its Indian subsidiary. One must ask, why is the word ‘fraud’ and “India’ so often in the same sentence? One FT comment spoke of India’s Triple Three Rule which says, “businesses looking to invest in India will cost three times more, take three times longer and make three times less profit than you envisaged.”

We’ll see where the Adani Group scandal ends up, but there is a national angle to the story as the Adani Group and Prime Minister Modi are intricately tied. When Modi called for a “self-reliant India programme”, Adani stepped in and started to develop a coal mine project in Australia and a Godda coal-fired power plant in Jharkhand State which will import Australian coal. Adani Green came in to build 25 GW of renewable power by 2025 when Modi set a renewable target. When Modi called for an indigenous defence ecosystem, the Adani Group stepped in to do it. Worried about semiconductors, Adani promised a “value chain that is fully indigenous and aligned with the geopolitical needs of our nation.” In terms of investment, domestic companies are short on cash. Foreign companies and the rest of the domestic private sector are too concerned on political risks (probably just following the Triple Three Rule). India’s state-owned banks and insurance companies have substantial loans and equity to Adani Group companies and will probably lose a great deal of equity if the allegations are true. Note that before the Hindenburg report, Jupiter Asset Management, BNP Paribas, Soc Gen and Goldman Sachs all backed the Adani Group rights issue which means they still have not learned from Lessons 1 and 2.

Market Direction Hard to Predict

At the beginning of last year, I had strong conviction that the S&P would be lower by 10% by the end of the year; it ended up down 19% (but I didn’t anticipate that Russia would invade the Ukraine which caused more inflation pain than I expected).

This year is more challenging to predict. On the positive, inflation is coming down, China’s re-opening has the potential to improve global GDP growth and all accounts show consumer spending is still strong. Larry Summers now says, “It looks more possible that we’ll have a soft landing than it did a few months ago.”

On the negative, we don’t know the trajectory of inflation, China’s growth could inhibit western central banks 2% inflation goal (creating higher interest rates for longer), global growth is the lowest it’s been since the Global Financial Crisis (GFC); and the Ukraine War remains a risk.

As a result of the divergent signals, I can make both compelling positive and negative cases for markets. For instance, Europe seems to be on fire. Euro-area equities are up 38% since the end of last September in U.S. dollar terms. Its investment grade credit has outperformed by 6%. The euro has appreciated by 10%. People have been happy about a mild winter, something that perhaps made European equities underperform last year. China has reopened and Europe is more exposed to trade flows with China, particularly Germany. Europe trades at a 30% discount to U.S. multiples. Europe doesn’t have as many growth stocks, where high discount rates in the terminal value have led to sharp share price declines. European indices have a high weight in financials and net interest margins are increasing.

But I can also make a compelling bear case. First, while U.S. inflation trends are in a firm downtrend, it is not the case in Europe. Carrefour recently told analysts that they are still in discussions with suppliers for 2023 pricing, but they are expecting inflation of a similar magnitude as 2022 with much of the impact front-loaded for the first half. Inditex raised wages in Spain 10%. Unemployment remains at its lows, with firms planning to hire more, rather than make job cuts. Germany’s public sector unions are seeing a 10.5% increase in the latest round of bargaining, and unions all over Europe are demanding high wage increases (in contrast, in less unionized America, wages pressures have peaked and seem to be migrating down). German companies are now looking at thousands of layoffs in Silicon Valley as an opportunity to recruit top talent. German postal workers are striking demanding 15% wage hikes. In Spain consumer prices rose 5.8% year on year higher than estimates and higher than December’s 5.5%. Core inflation climbed to 7.5% from 7.0% previously. If inflation trends persist in Europe, the ECB may encounter the same issues as Japan where the bond market has tested the BOJ’s resolve. The 10-year JGB briefly rose above 0.53% and the yen has had a sharp appreciation. Second, European central bankers seem to understand the inflation trends. Christine Lagarde in December said that markets were underestimating potential interest rate hikes. Rates could rise “at a 50-basis point pace for a period of time.” Governing Council member Klaas Knot said, “We made a step down in December from 75 to 50 basis points – that will be the pace for a multiple number of meetings. So that means at least two in February and March. I do think that we will continue to be in tightening mode until the summer… We focus on core inflation where, unfortunately, there is no good news. Because it’s still on the rise. Underlying inflationary pressures show no signs of abating yet.” Bloomberg reported that the sharp decline in office valuations across Europe is creating breaches of loan covenants leaving investors trying to bridge financing gaps. Apollo said, “Europe is going to go through the great unwind of ten years of easy money.” Third, Europe’s current benign inflationary trends have been the reversal of the sharp rise in energy prices from the Ukraine War. An unusually warm winter created unusually full gas storage. Power prices have declined to levels last seen before the summer. Yet the International Energy Agency still believes Europe is short what it needs for next winter and lacks capacity to handle emergencies. It is easy for a cold snap to create a rapid rise in energy costs given the Ukraine War. Ian Bremmer at the World Economic Forum heard that there was a general view that spare oil capacity was 2.0 to 2.5 million barrels. Given higher than expected Chinese growth, that’s a very tight energy market. Finally and maybe most significantly, financial conditions in the U.S. are likely to tighten in 2023, which will flow into general markets.

Follow the Liquidity

Financial conditions, which measure strains across asset classes, are at a looser level than March 2022, according to Bloomberg. The VIX crushed in to 17 (it’s been trading in the low-20s with spikes to 30 during 2022). The Fed notes its concerns that easing conditions could hurt their efforts if it’s driven by “a misperception by the public of the committee’s reaction function.” (translated: “please don’t price in a Fed pivot”).

Instead, over the course of 2023, financial conditions are likely to tighten. A key metric to money creation in the U.S. has been credit cards. When you remove it, money growth is falling. The low leverage of households and savings from COVID checks have helped cushion the pain of a slowing economy, but these seem to be close to exhaustion. Corporates are defensively drawing down on revolvers. Jamie Dimon said on JP Morgan’s recent earning call, that they are likely to pay more interest on deposits to guard against depositors looking to buy U.S. government securities at higher risk-free rates.

The upcoming budget discussions will also be important for monetary tightness. Treasury Secretary Janet Yellen has urged lawmakers to boost the debt ceiling. Today the Treasury has been spending its cash balance and not increasing its debt to comply with the debt ceiling. It’s unlikely that cash is exhausted before June. Economists think the government has until August. The current debt is $31.4 trillion. In December 2021, Congress had raised this by $2.5 trillion. The government is $78 billion from the limit.

If the Treasury is allowed to borrow more from markets, that will drain liquidity given the Fed is no longer buying. But if debt creation slows, there is enough cash in money market funds and on the side-lines that believe the current level of interest rates is compelling and may be willing to buy bonds as QT winds down keeping financial conditions relative looser. My prediction here is that the debt ceiling will be raised, which should lead to tighter conditions later in the year.

Another source of tightening is from Japan as the BOJ will have to relent on its yield curve management at some time next year. This could lead to Japanese investors selling foreign bonds and repatriating cash to absorb JGBs at higher interest rates.

If financial conditions grow tighter, then the rate of return the market demands from equities should be higher. Additionally, given the reshoring (away from China) and rewiring pressures (climate change), it’s hard to see a sub 2% inflation rate. The level of the valuation will be directly correlated to how tight monetary conditions get, which is something hard to predict one year out from now, but probably means lower from here.

Also, all this new data notwithstanding. Prices are still very high. It’s a bit unclear why the data doesn’t correlate with people’s real-world experiences. Maybe the data will not be as benign as we think forcing rates even higher.

So, my new prediction: the S&P is back around 3,600 sometime this year (10% lower).

End Note

Two Air Force F-22 fighters scrambled from Nellis Air Force Base in Nevada to Montana, where a Chinese spy balloon was observed. The air force opted to not shoot it down fearing the safety of people below and shot it down a week later. The government was taking steps to shield sensitive sites but added that the reconnaissance systems on the balloon were of limited value added relative to low earth object satellites. This begs the question; if China is so advanced and are going to lead in the space race, why are they still using hot air balloons?

Cobham, Surrey

February 19th, 2023