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Don’t miss our next trade idea. Get on the Bear Traps Report Today, click hereIn our 21 Lehman Systemic Risk Indicator basket, consumer credit is an important component. In any late cycle economic slowdown, charge-offs at banks, or credit write-downs must be monitored closely.
With this in mind, Capital One COF is an important bellwether to keep an eye on – they have a heavy hand in the consumer credit space. From Q1 2006 to Q1 2008, COF equity was 55% lower, she was screaming, “Houston we have a problem.”
Today, there’s a far different picture (below). Shares of Capital One surged nearly 5% Friday after the bank reported first-quarter results ahead of Wall Street expectations. The company reported first-quarter adjusted net income of $2.90, topping analysts’ expectations of $2.68 in the period. Adjusted revenue of $7.08 billion was also above Wall Street’s $7.01 billion expectations. Revenue increased 1% year over year while non-interest expenses decreased 11% to $3.7 billion in the period.
They scored Q1 2019 net income of $1.42B or $2.86 EPS (earnings per share), compared with $1.33B or $2.62 EPS in Q1 of 2018. We have an eye on provisions for credit losses, which rose 3% sequentially, or 1% year-over-year, in Q1 to $1.6B, but charge-offs remained relatively flat.
The company’s management sees “degradation” in customer credit quality. Overall, COF’s 1Q U.S. card charge off rate was 5.05%. While industry charge off rates rose to 3.85%, the highest since 2Q12. There are clearly some red flags pointing toward problems approaching the credit-card industry. A look at loans thirty days past due, a warning of future write-offs, surged at all seven of the largest U.S. card issuers.
There’s been a “degradation” in credit quality for some customers, per Richard Fairbank, Capital One’s CEO. The company is the third-largest card issuer in the USA. Fairbank said some customers with negative credit events during the financial crisis are now seeing those problems disappear from their credit-bureau reports.
“In general, we have been contracting credit policy at the margin and tightening,” Discover CEO Roger Hochschild said on a conference call this week. American Banker noted, some credit card companies are closing inactive accounts and slowing down the number and size of credit-line increases for both new and existing customers. Consumer credit is contracting, slowly shrinking, a tightening of financial conditions relative to recent years in our view.
Capital One, leaving Regional Banks Behind
Capital One COF was a standout this week, we noticed significant divergence to the upside relative to regional bank equities. A short squeeze was in play in our view, short interest in COF shares rose to nearly 6m shares in Q1, up from 3m shares short in September 2018. Strong earnings results were the driver of the squeeze, the company also put forth initiatives to boost margins as it lays out a path to become more efficient. It’s important to note, few stocks actually lost too much ground in Financials as the sector was firm this week but trust bank State Street STT was the worst performer. Organic growth at Trust Banks is facing a number of headwinds.
Winner and Losers
The driving theme for the week across asset classes may have been the increasing emergence of relative value trades even as the S&P 500 Index climbed to a new all-time high. To be sure, being ‘long & strong’ has paid off for US stock investors again in April — the S&P 500 is up over 3.5% for the month. But April has also brought even greater returns from relative trades such as long Tech/short Healthcare or long the dollar vs. the euro over the past week.
Stocks Back on their Highs without Junk Bonds
Stocks are partying like it’s 1999, while junk bonds are showing signs of cracking. We’re looking down the barrel of a high pace of credit rating downgrades. Per S&P Ratings this year, the ratio of downgrades to upgrades is the worst since 2016’s energy price collapse, back then oil was $26 vs. $64 today. We’re seeing a sharp breakdown, a meaningful underperformance of poorer quality credits. Credit deterioration is picking up even with CCC high yield index up +10.1% YTD, Q4 loss was near -10%. If you look at the frequency of bonds in a -20% or more hole (substantial sell-off in price), in 2019 we’re at double the pace of 2017 in terms of blow-ups in the CCC corporate bond space.
Bonds: US CCCs in Q1
Loss of 10% or More: 8.2% of the Universe
Loss of 20% or More: 5.1% of the Universe
Citi data
It’s kind of a mind-blower. Since 2014, the European Central Bank has been in accommodation mode to the tune of a $2.7T bond-buying spree (see above) found in their colossal balance sheet expansion. At the same time in the U.S., the Federal Reserve has hiked rates nine times, eight since the 2016 election and REDUCED its balance sheet by $500B. Is the U.S. economy that much stronger than Europe’s? Clearly, there’s $62T of GDP OUTSIDE the U.S. and $18T inside – so Fed rate hikes tend to do a number on the global economy which feeds back to Europe in a negative way, which then comes back to the U.S. and stopped the Fed in its tracks (in Q1 the Fed put forth one of the most significant policy reversals in the history of central banking). A five-year-old can tell you this is a broken model. You can’t have one central bank hiking rates nine times in 3 years, and another buying up nearly $3T of global assets – markets just told us this is a highly unsustainable dynamic in modern central banking. We believe the Fed, ECB, PBOC (China), BOE (UK) now get the joke. Looking forward – we see a “convergence” in global central bank policy, NOT unsustainable divergence. This will have MAJOR implications for the dollar, precious metals and emerging market equities. Pick up
Today, economic demand struggles are bottoming globally, and the Yuan (China currency) is beginning to strengthen. One of our favorite global economic indicators is found in 3-month China yuan volatility. As a currency is strengthening volatility plunges, while a weaker currency is often met with a surge in forex volatility. Looking back over the last 5 years you can see – above- the powerful impact on global equities. There’s an inverse relationship between equity prices globally and China forex vol. BUT, but , but; above all, the last time China currency volatility was this low, global equities were a lot higher – see the grey circle above.
China’s easier economic policies transmission to consumption has not convinced so far. March jump in car sales may be the 1st sign of this happening. Car sales rose more than 10% over the month (strongest since April 2009), reversing the y/y trend growth from 22-year lows. Special thanks to our friend Patrick Zweifel and Pictet Asset Management for this observation.
Our Bear Traps Report team developed this thesis in early January – see our chart above. We’re pleased to say, NOW Goldman is backing up our work. It’s very disturbing that the main street media continues to spin a narrative which is completely false. When looking at the numbers, Goldman’s US portfolio strategists David Kostin and Cole Hunter find many of these arguments (Buybacks > Capex) don’t hold up in reality! In particular, they emphasize that even as companies return a large amount of cash to shareholders, there is sizable reinvestment; in fact, growth investment at S&P 500 companies has accounted for a larger share of cash spending than shareholder return every year since at least 1990, with the largest share repurchasers far outpacing market averages in the growth of R&D and capex spending. They also find those executives who stand to gain the most from buybacks— those whose compensation depends directly on EPS—did not allocate a greater proportion of total cash spending to buybacks in 2018 than executives whose pay was not linked to EPS.
Aswath Damadoran, professor at New York University Stern School of Business, agrees that buybacks aren’t coming at the expense of investment. Rather, he argues that large, mature companies returning cash to shareholders allow that cash to be put to more productive uses; so it’s not that companies are investing less, it’s those different companies—with better growth opportunities—are investing instead.
Tesla stock price is on the bottom end of a sustained trend channel, as investor’s optimism slowly dwindles. However, “proposed” legislation could be the boost the equity needs to bounce off nearby support – as long as it moves quickly trhough Congress.
This year’s earnings expectations for Tesla have crashed down from their fantasy levels. At the beginning of the year EPS expectations were over $6.00 for the year, now they have fallen over 40% to near $3.25. Expectations slid due to increased competition in Europe and the company not hitting bullish delivery estimates – the loss of tax credit did not help their bottom line. 
In October of 2018, Tesla reported another rare profit. After 8 quarters of mounting losses, shorts were once again caught on the wrong foot (as you can see above – red circle). Why the sudden turnaround? Unlike almost any other mass car producer, Tesla delivers from their order book. With Model 3 production (finally) at adequate levels, Tesla first started delivering the top range Model 3s, which often go for ~$55K vs a $35K base price. To exemplify, Tesla makes an estimated $3,500 operating profit on the $45K version while it loses some $3,900 on the base Model 3. This is how Tesla showed a rare profit in Q3. Keep in mind, Tesla didn’t just turn profitable, it also showed positive cash flow – or more pain for shorts. This was mainly due to reversals in working capital and tax credits. All this came as huge surprise to the market and the stock ripped higher, as short sellers once again rushed to cover. We MUST look at the Tesla credit (5.3s due 2025). In late October / early November as the stock soared, Tesla’s junk bonds were NOT buying the price action in the equity and lost 4 points (early November to late December)! Sure enough, a few weeks later the stock caught up with the bonds on the downside. 
