Dr Janet Yellen surprised the financial markets with her hawkish take on interest rate policy and inflation even as the FOMC raised the Fed Funds rate for the fourth time since December 2015. Despite successive weak CPI and auto/retail sales data, Dr Yellen asserted that the fall in inflation was transitory (data packages, medicine), that the US labour market was tight and that economic growth will be resilient despite doubts about Trump’s fiscal stimulus. The Federal Reserve also maintained its dotplot forecast of another interest rate hike in 2017, possibly as early as the September FOMC conclave. Incredibly, Dr Yellen even bought forward the timing of her plan to shrink the Fed’s $4.5 trillion balance sheet.
This ‘hawkish tilt’ was the reason the US Dollar Index soared from 96.25 to 97.50 after the FOMC statement while gold and growth stocks (NASDAQ) slumped. The divergence between the Fed’s forecast of three rate hikes in 2018 and implied forward rates in Chicago’s Eurodollar futures contracts has also widened, a metric of Wall Street’s skepticism on the new central bank ‘hawkish’ take on monetary policy. Hence the flattening of the US Treasury yield curve after the FOMC statement and Dr Yellen’s press conference in Washington. This is a recession risk SOS that investors will be wise not to ignore even as inflation break even rates in Uncle Sam debt plummet.
A $50 billion shrinkage in the Federal Reserve balance sheet is tantamount to a de facto 50 basis point hike in the Fed Funds rate. This means the planned balance sheet ‘taper’ (awful memories of June 2013!) could well trigger an inverted yield curve, a policy mistake and a US recession whose shock waves would devastate global financial markets. It is no coincidence that the flagship emerging markets index fund (symbol EEM) was slammed after the June FOMC. It is only a matter of time before recession risk hits psychology in US equities, now trading at 18 times forward earnings after 7% revenue growth and 14% earnings growth in 1Q 2017. Complacency in the debt market also means the risk of another bond market meltdown as the Fed continues to tighten this autumn.
Assume the Fed shrinks its balance sheet by $50 billion and raises the Fed Funds rate at least four times by next summer. This could well mean three month US Treasury bill trades at 2.75% or 50 basis points over the ten year US Treasury bond yield. This means an inverted yield curve would once again haunt the bond market. I can never forget that an inverted yield curve in 2000 and 2007 preceded draconian bear markets and economic recession.
Castigated by the financial markets for being too ‘dovish’ in the past, Dr Janet Yellen is now convinced that the resilience of the US economic expansion allows her to ‘normalise’ monetary policy before her term as Fed Chair expires in February 2018, even if the bond markets do not believe her.
The foreign exchange market is far more convinced about Dr Yellen’s intention to tighten monetary policy, the reason the US Dollar Index surged a full point above its November 2016 lows despite news that special counsel Robert Mueller has opened an investigation of the President for obstruction of justice (a Trumpian witch hunt!). The euro has plunged to 1.1140 as I write, not surprising given the latest Italian banking horror story and the fact that speculative longs in the euro were at six year highs. The euro was the mother of all crowded trades on the eve of the June FOMC. The unwind of the long euro rally since mid-April has now begun. This is a trend reversal.
It was no surprise that Governor Kuroda at the Bank of Japan kept his policy rate unchanged at minus 0.10% and reiterated his zero yield pledge on 10 year Japanese government bonds. Even though the Japanese labour market is now at its tightest since 1990, the peak of the epic Tokyo bubble, the idea of a premature ‘taper’ is anathema to the Bank of Japan and PM Shinzo Abe. The central bank decisions in Washington and Tokyo mean it is rational to expect dollar/yen to trade at 112-113 within the next two weeks.
Even though a ‘soft Brexit’ scenario led to sterling’s rise to 1.2760, the Bank of England is more worried about political uncertainty and Brexit than inflation risk. The slump in UK retail sales was inevitable as consumers were squeezed by higher petrol and food prices and a fall in real wages. This means the path of least resistance for cable is still 1.25 as the political fallout of the Grenfell Tower fire tragedy engulfs the Tories.
Stock Pick: Fox News is a media money machine for its parent!
Global media shares fulfil the gist of the ancient Chinese curse ‘may you live in interesting times’. The print business has been devastated by the online advertising revolution engineered by Google and Facebook. Subscription based video on demand content aggregators (and now content generators) like Netflix have revolutionised network television. ‘Cord cutting’ has hit the profitability of even the world’s most powerful cable empires, from Disney’s ESPN to Viacom’s Nickelodeon. The ATT-Time Warner merger and Fox’s bid for Britain’s Sky creates new models of scale economics and vertical integration. Regulators in the US have cracked down on advertising industry media rebates. On Wall Street, the rumour grapevine is surreal, from a Disney Netflix deal to the House of Redstone’s palace coups and family/boardroom battles at Viacom and CBS. This is a hugely complex, technology-backboned, global, constantly evolving business that utterly fascinates me and sometimes even generates compelling money making ideas. Like now with Fox.
21st Century Fox (symbol FOXA), run by James Murdoch (Citizen Rupert’s younger son) has been a mediocre investment in the past twelve months, down 2%. The news flow from Fox News, America’s most viewed news channel, has been absolutely awful. Both Roger Ailes, the founder of the network, and Bill O’Reilly, whose show generated ad revenues of $160 million per year (peanuts given Fox’s revenues in 2016 were $28 billion), were axed by the Murdochs after harassment claims by multiple women. Yet the meteoric political rise of President Trump, Fox News’s most favourite fan and a frequent guest on its shows, taps into the political zeitgeist of the new populist, extreme-right Republican Party partisans in America. Fox trades at a modest 14 times 2017 earnings and 12.8 times forward 2018 estimates at $28 a share.
The latest bad news to hit the shares is the hung parliament in Westminster, since several Labour MPs have voiced opposition to its $14 billion bid to takeover UK’s Sky, which would add 26 million households and an invaluable distribution platform in Europe to its global platform. Fox also owns Star India ($1 billion sales) made it an underperforming asset after Modi’s rupee demonetisation hit Indian ad spending and its failure to win broadcast rights to trophy cricket tournaments. However, Fox, shunned by Wall Street, is a classic case of Nathan Mayer Rothschild’s advice to buy shares ‘when there is blood on the street’ and Spike Lee’s dictum ‘don’t believe the hype!’.
My investment case for Fox rests on three assumptions. One, despite the setback to the Conservative party’s parliamentary majority in Westminster, Britain’s Ofcom will approve the deal in late 2017, albeit after protracted negotiations. This was the reason Sky (my virtual 24-hour companion in the endgame to the UK election) plunged 4% in London the day after the election even as the Footsie index rose.
Two, Wall Street underestimates the sheer earnings power, growth prospects and global appeal of Fox’s unique media properties – Fox News, National Geographic, STAR India, Fox Sports, FX, even Hulu. Take Fox News, which could well generate $1.8 billion in profits in 2017 or 26% of its parent’s profits and boasts an incredible 90.6 million subscribers, $6.7 billion in affiliate revenues and 65% cash flow margins. As America goes blood-red in partisan politics, Fox News is the mother of all media money machines.
Fox News is the most profitable cable network in the US, with a nightly viewership that exceeds even Disney’s ESPN. Fox News boasts 3 million average daily views, double MSNBC. I thought Megyn Kelly and Greta Van Susteren’s departure would have a negative impact on ratings. It has not. Tucker Carlson has stepped into Megyn’s prime time role and Fox News has built a deep bench of talent and programming assets. Scary thought, but Fox News could be the most watched news channel in the history of the western world. Dr Goebbels, the Third Reich’s Propaganda Minister, would have loved it. A lie, repeated often enough, becomes the truth!
Three, I think Mr Market undervalues Hulu’s potential to transform the economics of Pay TV, Fox’s EPS growth, affiliate gains, Superbowl ad steroid shot and prospect of share buybacks. Value stocks take time to perform, as proven by my successive picks Citigroup, Morgan Stanley, KKR and Blackstone. Fox will be no different. So I sell long dated, high delta put options on the path to (hopefully) 35!
Market View: is it time to buy the Standard Oil twins?
Energy has been the worst performing sector of the S&P500 index in 2017 as oil prices plunged from $56 to $46 even after OPEC extended its November output cut and natural gas prices lost 22%, down to $3 per million British thermal units. Not even public evidence of a Saudi-Russian rapprochement and 90% GCC compliance on the output cut deal was enough to stabilise oil prices.
The shale oil revolution has resulted in a new paradigm in the economics of oil drilling, production and supply. For instance, US producers raised output by an incredible 900,000 since Saudi Arabia brokered its original Vienna deal last November. Technology creates obsolescence at breakneck speed (black and white TV? Typewriters? Telex machine?) and the electrification of the world’s auto fleet/Uber economy will lead, long term, to an epic plunge in oil prices, possibly down to real 1999 levels near $20 Brent. This is all the more possible since Moore’s Law operates with a vengeance in the technology of hydraulic fracturing, making Texas’s vast Permian Basin the new swing producer of black gold since it will generate new output on a scale unseen since the epic Saudi Arabian, Iraqi and Kuwaiti oil strikes in the late 1940’s. ‘Howdy’ is the new tagline of the world oil market in the Age of Shale.
Keynes pointed out that we are all dead in the long run – but must trade and invest in our human lifespans. I see some data points that convince me that there could be a tactical bullish trade in Wall Street’s oil and gas supermajors and oil service companies. Why? One, NYMEX oil futures on the West Texas Intermediate crude contract have moved from contango to backwardation. This is a telltale sign of a balance between oil supply and oil demand. Two, the season increase in refinery utilisation rates and field maintenance will lead to drawdowns from admittedly bloated crude oil inventories. Three, oil exploration and production shares have grossly underperformed their high yield debt or credit default swap value range. This implies, though does not confirm, a tactical bottom in valuations. Four, the Qatar embargo and the Daesh terrorist attacks in Tehran inject a geopolitical risk premium on oil prices. Five, global PMIs show clear evidence of the first synchronised global economic recovery since 2010. Global demand could thus rise to 100 million barrels a day by end 2018.
However, these data points are only bullish on oil prices in the short/medium term. Long dates futures contracts on the New York Merc suggest the West Texas crude will trade below $50 in 2020. Like Shakira’s hips, oil futures do not lie, though they can well mislead. Still, it is rational to be bearish on petro-currencies and shares/property in Planet Crude from Abu Dhabi to Aberdeen. Yet this does not preclude tactical trades in oil and gas supermajors. So I channel the ghosts of John D. Rockefeller to help me choose the best ideas among his corporate progeny.
Exxon Mobil, the fabled Esso (‘put a tiger in your tank’ of my boyhood!), is a value buy for me but only if it falls to 75–76. Exxon has slashed its cost structure and drilling/capex budget. It has added to long life reserves at rock bottom prices. It has boosted its free cash flow yield, reduced its debt/EBITDA ratio to 0.9 and vastly boosted its net interest coverage ratio. It can well deliver 4% output growth in the next three years. Its 3.8% dividend yield at 76 puts it in deep value zone. I would not be surprised to see Exxon bottom at 75–76 for a 85 target if West Texas regains the $50 handle this autumn. The risk/reward in Jersey Standard (Exxon) at 76 is compelling.
Chevron used to be once known as Standard Oil of California, has the highest output growth profile in Big Oil, thanks to its megaprojects in Angola, the Australian LNG plants and the Caspian Sea. Its 4.2% dividend yield if the shares trade at 104 is even juicer than Exxon, even as its valuation relative to earnings and its own oil and gas reserves is at a discount. Now that the Gorgon and Wheatstone LNG plants are almost complete, Chevron’s capex will tank and free cash flow will surge. Its Permian Basin acreage alone virtually guarantees 2018 output growth estimates. This is beyond yummy, especially if speculative bear raids send the shares down to the late 90s.
Image (c) iStock
