Friday, June 23, 2017

The Bezos and Buffett Effect?

Matthew Boesler of Bloomberg reports, Amazon Has at Least One Fed Official Rethinking Inflation:
News that rocked the retail world last week is coming at just the wrong time for U.S. central bankers already puzzling over why inflation is conspicuously absent.

When online retail giant Amazon.com Inc. announced last Friday that it would purchase Whole Foods Market Inc., a plunge in retail and grocery stocks reinforced the disinflationary tone set by three straight months of disappointing data on consumer prices. It’s an example of the technological forces that are increasing competition and further limiting companies’ ability to pass on higher wage costs to customers.

“That normally indicates that somebody thinks that they are not going to be earning as much as they were,” Federal Reserve Bank of Chicago President Charles Evans said of the market reaction to the deal while speaking with reporters Monday evening after a speech in New York.

“For me, it just seems like technology keeps moving, it’s disruptive, and it’s showing up in places where -- probably nobody thought too much three years ago about Amazon merging with Whole Foods,” he said.

Evans, a voter on the Federal Open Market Committee this year who supported its decision to raise interest rates last week, says he is less confident than most of his colleagues that inflation will soon rise to their 2 percent target.

A big reason for his ambivalence: Deflationary competitive pressures could have become more important for the overall trend in prices than the so-called Phillips Curve relationship, which links inflation to the state of the labor market. That model, coined almost 60 years ago, is the basis for the Fed’s outlook for continued gradual rate increases.


In order for it to work, though, businesses need to be able to raise prices to offset increases in labor costs as unemployment falls and available workers become more scarce. But a stumble in corporate profit margins suggests companies are struggling to raise prices.

“That’s one of the things that makes me nervous, that I think there’s something possibly going on, some secular trend, that isn’t just a U.S. story,” Evans said.

“We know that technology is disruptive. It’s changing a number of business models that used to be very successful, and you have to wonder if certain economic actors can continue to maintain their price margins, or if they are under threat from additional competition,” he said. “And that could be an undercurrent for holding back inflation.”


Every indication from FOMC leadership is that continued tightening in the labor market will lead to higher inflation, despite the recent wobbles in the inflation data, which Fed Chair Janet Yellen called “noisy” in a press conference following last week’s meeting.

“We think if the labor market continues to tighten, wages will gradually pick up, and with that, we’ll see inflation get back to 2 percent,” William Dudley, who as New York Fed president is also vice chairman of the FOMC, said Monday in Plattsburgh, New York.

Such remarks reinforce expectations that policy makers will hike again before the end of the year, as signaled by their latest forecasts for interest rates.

Evans isn’t ready to abandon that logic yet, either, but he does sound more skeptical.

“I can’t say that the Phillips Curve isn’t going to lead to higher inflation, but I worry that it’s very flat and it’s not going to,” he told reporters Monday. “It’s still very early in this process.”

The Chicago Fed chief is not alone in thinking about the impact of disruptive technologies on prices. Dallas Fed President Robert Kaplan -- another FOMC voter this year -- describes such forces, and the uncertainty they generate, as currently the most intense he’s ever seen.

Ultimately, if the unemployment rate continues to fall and inflation doesn’t respond, the Phillips Curve may fall further out of favor as a guide to inflation dynamics, and by extension, interest-rate policy, as Evans hinted at Tuesday in a follow-up interview on CNBC.

“If that’s the case -- and I think that’s just speculative at this point -- then it means we need even more accommodation to get inflation up,” he said.
You can read Federal Reserve Bank of Chicago President Charles Evans's speech here. Take the time to read through this speech, it's excellent.

Last Friday, I discussed whether the Fed is making a huge mistake tightening as the US economy slows. I went over a comment written Minneapolis Fed President Neel Kashkari explaining why he dissented again.

In that comment, I stated the following:
I've been warning of the risks of debt deflation for a very long time, long before I began writing this blog in 2008 right before the financial crisis hit full force.

In a recent comment of mine where I discussed why Citadel's Ken Griffin is warning of inflation, I went over yet again six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  • The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  • Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  • The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  • Excessive private and public debt: Rising government debt levels and consumer debt levels are constraining public finances and consumer spending.
  • Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality, is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  • Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics,  and other technological shifts that lower prices and destroy more jobs than they create.
Now, we can argue about the importance of each structural factor but there is no arguing that an aging population, a less-than-spectacular labor market, the global pension crisis, excessive public and private debt, rising inequality and technological shifts are all deflationary.

All this to say that I agree with Neel Kashkari, I think it's silly for the Fed to raise rates in a deflationary environment, especially now that the US economy is slowing. Not surprisingly, institutional investors are "increasingly uncomfortable" with the Fed tightening during a slowdown.
I don't just think it's silly for the Fed to raise in a deflationary environment, I'm equally perplexed when I read comments on why the Bank of Canada is all of sudden in a hurry to raise rates. On LinkedIn, I posted this comment regarding this article:
"I think it is highly unlikely the Bank of Canada will hike in July if oil prices keep dropping from now till the meeting. If the BoC hikes, it will only exacerbate deflationary pressures. The only rational argument I've heard for hiking is to cool speculative activity in the housing market, but the market is already taking care of that. Having worked with Steve Poloz at BCA Research a long time ago, he might like to suprise people once in a while, but he's no cowboy and is well aware of the deflationary risks I'm talking about."
Speaking of BCA Research, I agree with Anastasios Avgeriou, BCA's Chief Equity Strategist, no matter what Pimco's Ivascyn says, this time isn't different, the inverted yield curve is signalling a US recession ahead:


I warned my blog readers in April that the next economic shoe is dropping and more recently to prepare for a US slowdown

The US slowdown is already underway and next will follow Europe, Japan, China and the rest of the world. This is why I remain long US long bonds (TLT), the US dollar (UUP) and select US equity sectors like biotech (XBI) and technology (XLK) and I'm underweight/ short energy (XLE), materials (XME), industrials (XLI), financials (XLF) and emerging markets (EEM).

In fact, had you loaded up on biotech (XBI) prior to the US presidential election back in November when I wrote about America's Brexit or biotech moment and loaded up on US long bonds (TLT) at the start of the year when I explained why it's not the beginning of the end for bonds, you would have made great returns and thrown me a bone via a donation or subscription to this blog (I remain long biotech but took some profits and added to my US long bonds).

Anyway, I'm talking up my book and getting off track. Back to the Bezos or Amazon effect. I was talking to a buddy of mine earlier this week about Amazon's impact on inflation. He mentioned to me "it's like the Wal Mart effect that happened in the 90s but on a much bigger scale and much more pervasive."


I agree, Amazon has forever changed the retail landscape which is why many retail stocks (XRT) have gotten killed over the last year (click on image) :



Now, before you go buying the dip on retail stocks, let me show you a scarier chart that goes back over ten years (click on image):

  
I'm not saying we are going to revisit the 2008 financial crisis levels but I would be very cautious on retail stocks. In fact, if you want retail exposure, you're probably better off sticking with Amazon (AMZN), the online retail goliath that has been growing by leaps and bounds over the last ten years, succeeding in online shopping and its cloud business (click on image):



Still, I think it's best to temper your enthusiasm on any retail stock, including red-hot Amazon as we head into a US and global recession.

Also, following Amazon's Whole Foods deal, I saw some grocery stocks like Kroger (KR) get killed as if it's a done deal (it's not) and as if grocery stores will never be able to compete against Amazon (click on image):




Kroger's stock is way oversold (resting on its 400-week moving average) and although I'm not particularly bullish on it, I think this is a gross overreaction and if a recession hits, you want to have defensive stocks like grocers in your portfolio.

Anyway, there is little doubt Amazon has an impact on inflation just like Uber, Nexflix (NFLX) and Tesla (TSLA) do. In fact, my buddy shared this me earlier this week:
"The biggest influence on inflation is oil. Tesla is changing the automobile market and as demand for electric cars picks up, it will impact oil prices over the long run. Why do you think the Saudis are selling Aramco? They see the writing on the wall and need to diversify their economy. Netflix is also impacting inflation. As people stop going ot the movies, they stop going out and spending on restaurants and order more as they stay home."
I told him that explains why shares of Domino's Pizza (DPZ) have been on a tear over the last five years while other restaurant stocks haven't been sinking (click on image):


Now, this comment is called the Bezos and Buffett but so far, I've only focused on Amazon.

Matt Scuffham of Reuters reports, Shares in Canada's Home Capital surge as Buffett rides to rescue:
Warren Buffett's Berkshire Hathaway Inc (BRK) is providing a C$2 billion loan to Home Capital Group Inc (HCG.TO) and taking a 38 percent stake in the mortgage lender, a move which is pressuring short sellers who targeted the stock as Canada's housing market has turned riskier.

Shares in Home Capital closed up 27 percent on Thursday.


Shares in other Canadian alternative lenders also rose on Thursday. Equitable Group Inc (EQB.TO) closed up 12.5 percent. Street Capital Group (SCB.TO) closed up 8.3 percent. Shares in mortgage insurer Genworth MI Canada Inc (MIC.TO) were up 11.5 percent.


The deal may bring to a close a two-month effort by Home Capital's board, and advisers RBC Capital Markets and BMO Capital Markets, to replace a costly credit facility with the Healthcare of Ontario Pension Plan (HOOPP) and shore up the lender's balance sheet.


The credit facility was arranged earlier to provide funding for Canada's largest non-bank lender which had suffered from the withdrawal of 95 percent of its high interest deposits in the past two months.


Alan Hibben, a former Royal Bank of Canada executive who was recruited to the Home Capital board last month, said over 70 parties had expressed interest in investing in the lender. In an interview, Hibben said Home Capital was drawn to Berkshire Hathaway because of Buffet's credibility with both investors and depositors.


"The board decided it would be nice for a sponsor to give us a view where somebody could say 'wow, if that smart person thinks the Home Capital business model and portfolios are good, I'm going to think that'," he said.


Hibben said Buffett had become involved "later in the process" with Home Capital approaching Berkshire Hathaway rather than the other way round.


Home Capital has played an important role in Canada's mortgage market, lending to new immigrants and self-employed workers who may not be able to get loans from the country's biggest banks.


But home prices in Toronto and Vancouver have fallen after the government introduced measures to cool overheating prices with household debt in Canada has reaching record levels.


Investors are wondering whether the deal will be as successful as Buffett's decidedly bigger deal to buy Goldman Sachs preferred shares during the global financial crisis in 2008.


“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” said Berkshire's chairman Warren Buffett, in a statement on the deal released by Home Capital on Thursday.


SHORT SELLER NOT CONVINCED


Short sellers are continuing to take positions in Home Capital though, aiming to profit by selling borrowed shares on the hope of buying them back later at a lower price.


Combined short interest in the company's Canadian and U.S.-listed shares stands at about $183 million, up $62 million this month, according to data from financial analytics firm S3 Partners.


Marc Cohodes, a short seller who has been betting against Home Capital for two years, said on Thursday he continued to do so.


"If it wasn't Warren Buffett's name, the stock would be way, way way, down today," he said in an interview.


Home Capital was forced to raise new capital after depositors rushed to withdraw funds from its high-interest savings accounts. They pulled 95 percent of funds from Home Capital's high-interest savings accounts since March 27, when the company terminated the employment of former Chief Executive Officer Martin Reid.


The withdrawals accelerated after April 19, when Canada's biggest securities regulator, the Ontario Securities Commission, accused Home Capital of making misleading statements to investors about its mortgage underwriting business.


Home Capital reached a settlement with the commission last week and accepted responsibility for misleading investors about mortgage underwriting problems.


"The 'endorsement' from Warren Buffet may prove to rehabilitate depositor confidence, thus turning deposit flow positive," said National Bank of Canada analyst Jaeme Gloyn.


The Berkshire credit agreement comes with an interest rate of 9.0 percent, with a standby fee on funds not drawn down of 1.0 percent, compared with 2.5 percent previously.
Katia Dmitrieva and David Scanlan of Bloomberg also report, The real reason Warren Buffett is rescuing Home Capital:
Warren Buffett has become the lender of last resort for Home Capital Group Inc. The billionaire investor agreed to buy shares at a deep discount and provide a fresh credit line for the Canadian mortgage company, tapping a formula he used to prop up lenders from Goldman Sachs Group Inc. to Bank of America Corp.

Buffett’s Berkshire Hathaway Inc. will buy a 38 per cent stake for about $400 million and provide a $2 billion credit line with an interest rate of 9 per cent to backstop the embattled Toronto-based lender, Home Capital said late Wednesday in a statement. The interest on the one-year loan would net Berkshire at least $180 million if it’s fully tapped.


“While the terms of the new credit line with Berkshire Hathaway remain harsh, we believe the purpose of this loan is to motivate Home Capital’s management to bolster their own funding sources,” said Hugo Chan, chief investment officer at Kingsferry Capital in Shanghai, which owns shares in Home Capital. “This again shows Mr. Buffett’s masterful capital allocation skills,” said Chan, citing his investment motto: “be greedy when others are fearful.”


Home Capital shares surge as Warren Buffett rides to the rescue


The financial backing from the billionaire investor is poised to send the stock higher Wednesday, though it comes at a cost, in keeping with his past bailouts of financial firms. Buffett has buoyed some of the biggest U.S. corporations in times of trouble, including a combined $8 billion injection to prop up Goldman Sachs and General Electric Co. when credit markets froze during the 2008 financial crisis.


Berkshire’s purchase of $5 billion of Goldman Sachs preferred stock paid Buffett’s company an annual dividend of 10 per cent, and the billionaire also got warrants he later used to get more than $2 billion of the bank’s shares in a cashless transaction.


Deal Discount


In the Home Capital deal, Buffett’s firm agreed to pay an average price of $10 a share, a 33 per cent discount to yesterday’s closing price of $14.94. Berkshire would become the largest shareholder in Home Capital, which has a market value of $959 million.


“If you have the Warren Buffett seal of approval, people will take you more seriously than if you don’t,” said Meyer Shields, an analyst with Keefe, Bruyette and Woods. “So you sort of look beyond the settlement and say, ‘OK, what matters most now is that Warren Buffett trusts this company. And that in turn, allows Warren Buffett to get much better returns on capital than maybe some other lender would have been able to.”


The $2 billion credit line is only marginally cheaper than the emergency credit provided by the Healthcare of Ontario Pension Plan, which company directors have termed as “costly.”


Under the new credit agreement, the interest rate on outstanding balances will fall to 9.5 per cent, from 10 per cent under the existing HOOPP line. The rate will drop to 9 per cent after the initial investment is completed. The standby fee on undrawn funds will dip to 1.75 per cent from the current 2.5 per cent, then fall further to 1 per cent. The credit line is for one year. Home Capital has drawn about $1.65 billion from the HOOPP loan.


The investment “is a strong vote of confidence,” in the long-term value of the business, Brenda Eprile, Home Capital’s chairwoman, said in the statement.


New Terms


The move is the latest sign of a turnaround in the 30-year-old lender after a regulator in April accused it of misleading shareholders on mortgage fraud, which sent its shares tumbling, sparked deposit withdrawals and threatened to disrupt Canada’s real estate sector. Earlier this week, Home Capital agreed to sell a portfolio of commercial mortgages to affiliates of KingSett Capital Inc. for $1.16 billion in cash.


“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” Buffett said in the statement.


The share purchase will be done in two parts: an initial investment of $153 million for about a 20 per cent equity stake, then an additional investment of $247 million taking the stake to about 38 per cent. The second phase requires extra approvals.


Berkshire will not be granted any rights to nominate directors and has agreed to only vote shares representing 25 per cent of the company’s stock, Home Capital said.


Home Capital shares have almost tripled since bottoming in May when its troubles began to accelerate, though remain about 73 per cent down from their peak in 2014. The company last week took full responsibility over allegations the lender misled shareholders about mortgage fraud and agreed with three former executives to pay more than $30 million to reach settlements with regulators and investors.


Buffett’s Berkshire Hathaway is wading into a tense Canadian housing market, with Toronto house prices cooling after being hit with a 15 per cent tax on foreign buyers and tighter mortgage regulations, and confidence shaken by the Home Capital drama. Meanwhile, prices are surging in Vancouver again after being sideswiped by similar policy moves.
There's no doubt the "Buffett effect" boosted shares of Home Capital Group this week but I would seriously take any profits if you risked capital and bought shares at the bottom (click on image):


I didn't buy shares of Home Capital when they tanked because I don't have Buffett's deep pockets and because I don't like the sector from a macro perspective. I can also guarantee you Buffett won't make anywhere near the killing he made when he bought Goldman Sachs's preferred shares during the crisis.

But I had a feeling something was going to happen after I wrote my comment on Canada's pensions to the rescue where I noted that pension heavyweights Claude Lamoureux, Ontario Teacher's former CEO, and Paul Haggis, the former CEO of OMERS are joining Home Capital's Board.

Home Capital approached Warren Buffett but don't kid yourselves, Claude Lamoureux, Paul Haggis and even former Board member, HOOPP CEO Jim Keohane certainly had something to do with facilitating this deal.

[Note: I send my blog comments to Warren Buffett's Executive Assistant, Debbie Bosanek, but I doubt he reads them. The Globe and Mail reports that Buffet's interest in rescuing Home Capital Group was piqued by an email from 82-year-old Don Johnson, a Canadian banker who sends his thoughts to the investment guru now and then.]

I asked Jim Keohane how this deal will impact HOOPP's investment earlier today and he replied: "Buffet will provide a line of credit at a slightly better rate and Home will pay ours off.  Our loan was always intended to be a short-term liquidity fix and we expected that we would get paid back in a relatively short time frame."

Jim is at an offsite for the Board of Queen's University so I appreciate him taking the time to answer me.

Anyway, I wish all of you a great weekend and all Quebecers a Happy St-Jean Baptiste Day! Please remember to support my blog by donating or subscribing via PayPal at the top right-hand side under my picture.

Below, Federal Reserve of Chicago President Charles Evans speaks to CNBC's Steve Liesman about the Fed's inflation target, the outlook for rate hikes and the state of the US economy.

And Alan Hibben, Board member at Home Capital, explains how the company secured a $1.5 billion lifeline from the Oracle of Omaha. Again, there was a process, and whle the provincial government didn't have anything to do with this deal, I'm sure Claude Lamoureux, Paul Haggis and Jim Keohane did facilitate this deal. They all have solid reputations that helped ease Buffett's concerns.

And Berkshire Hathaway's Warren Buffett discusses Jeff Bezos' extraordinary success with Amazon, calling him 'the most remakable business person of our age'. No doubt, Bezos is changing the world in ways we can't imagine, but my fear is the world isn't ready for such disruptive change and we need to address this and rising inequality in order to sustain a vibrant and healthy democracy.

Remember what Buffett once said:"The marginal utility of an extra billion to me is not as much as it can be to millions of others in desperate need."

Interestingly, Jeff Bezos hasn't signed the Giving Pledge that Buffett, Gates and other billionaires have signed but he is now looking to donate billions to philanthropy and is looking for help (see clip below).

There are many great philphilanthropic causes but I would urge Bezos and the world's billionaires to figure out ways to help the poor and disabled to earn a living and stop being marginalized by society.




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