All posts by NY Times Bestselling author Lawrence McDonald

Larry McDonald; founder of THE BEAR TRAPS REPORT investment letter, is a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. As former Managing Director, Head US Macro Strategy at Societe Generale, he's a frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book "Colossal Failure of Common Sense" is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His "Bear Traps" letter is one of the most highly regarded on Wall St. He's participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the "Inside Job," BBC‘s "The Love of Money" and CBC‘s "House of Cards." He's delivered over 72 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

Populism’s Rage, Once Again has EU Banks in Pain

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Special thanks to ACG Analytics

Blog updated May 29, 2018 at 7:44am ET


Italy’s UniCredit Bank Equity
Italian banks led European financial stocks lower as the growing likelihood of new elections shook investor confidence. Banca Monte dei Paschi di Siena SpA, the habitually-volatile state-rescued bank, led declines with a drop of as much as 7.8 percent. The eight worst performers on the Bloomberg Europe Banks Index were all Italian lenders as of 12:07 p.m., with UniCredit SpA losing almost 4 percent and Intesa Sanpaolo SpAdown about 3 percent. At least a part of the pressure on equities came from the bond market. The yield on Italy’s benchmark 10-year sovereign bonds surged again on Monday to over 2.60 percent, it highest in nearly four years. – Bloomberg


Breaking: Italy Sells $5.7B of 183-Day Bills, Yield 1.213% 

Previous T-Bill Sales Below

May: +1.21%
April: -0.42%
March: -0.43%
Feb: -0.40%

– This is an incredible surge in the cost of short-term financing as of Tuesday Morning May 29, 2018.

Two Year Bond Plunge – Yield Surge in Italy
Italy 2 Year Bond Yields now through the US for the first time since November 2014.  

10 Year Bond Yields and Recent Change

US: 2.80% (-30bps)
Australia: 2.68% (-24bps)
Italy: 3.16% (+143bps)**
Canada: 2.30% (-23bps)
UK: 1.22% (-34bpss)
Spain: 1.64% (+47bps) **
France: 0.68% (-32bps)
Germany: 0.29% (-47bps)

Bloomberg data

Rough Weekend

As the cost of credit default protection is surging on Italian banks, the Five Star Movement’s (M5S) Luigi di Maio and Lega’s Matteo Salvini managed to reach an accord on their coalition’s program.  Likewise, the structure of a future cabinet and the candidate for the premiership are on the “Italy First” agenda. All that is left for the two is to seek out the mandate to rule from President Sergio Mattarella Over the weekend, discussions have taken a sharp turn for the worse as all sides failed to agree on a new finance minister.  Some in Lega party leadership insist on a Euroskeptic head of finance, others want a more centrist figure.  Together, the M5S and the League (Lega) have an impressive majority of 37% in the 630-seat Chamber of Deputies, though a slimmer edge in the Senate.  Their standing is up over 200% in recent years as the Populists have been able to steal political market share from center-left parties in Italy.  See our The Bear Traps Report with Larry McDonald; Tocqueville’s Italy – January 25, 2018_

Populists Surging in the Polls, Can You Wonder Why???
As you can see above, Italy’s raw deal on the Euro is an open wound – it can’t be swept under the rug for much longer.  It’s an #ItalyFirst moment indeed. 
A recent poll for the daily La Repubblica put support for the Trump-like Populist League (or Lega) at close to 22 percent, up from 17 percent in March, which would make it Italy’s second most popular party. Support for the League’s (Lega) largest rival,  5Star, stayed steady at 33 percent, while support for the incumbent center-left Democratic Party dropped from 19 percent to 18 percent.  Bottom line, populists now control 55% of the vote – Euroskeptic sentiment is on the rise.

“Italy First. Either this government gets started in the next few hours and we start working, or we might as well go and vote again and get an absolute majority.  Although it would be disrespectful to Italians if this government doesn’t get started because it’s unpleasant to someone in Berlin or Brussels.”

Lega Leader Salvini told a rally near Bergamo in northern Italy late on Saturday (Bloomberg reported).

” President, Sergio Mattarella said he could not countenance their  (Lega / Five Star) selection of an economics minister who he said threatened to take Italy out of the eurozone. He said even the threat of leaving the euro would have dramatic consequences on the markets, costing Italian families and investors money and its young people opportunities.” –

New York Times, reported Sunday evening, May 27, 2018

A Trump 2.0 in Italy

We believe the Salvini’s (Lega) surge in popularity is on par with Trump’s rise in 2016.  If the Lega star was a stock, you would want to be long of it.   Sunday evening, the leaders of the Five Star Movement were already discussing Mr. Mattarella’s impeachment, while Matteo Salvini, the leader of the League, who would not budge on his choice for a eurosceptic economics minister, and who has seen his popularity rise during the tortuous negotiations, is eager to go to early (new) elections. 

Near-Term Debt Coming Due, a High Mountain
Populists in Italy (Lega – 5Star) calling for the quick deportation of an estimated 500,000 immigrants (Sky News) from Italy, with $2.4T of debts and $2.0T of economic output, they question the financial sustainability of EU migration policy?  The cost of default protection on  Italy’s bonds is climbing the most since dark days of the European debt crisis.  Political uncertainty has unearthed risks inside the financial system of the southern European nation. The five-year Italian credit default swap rose about 42 basis points last week, the most since 2012, according to data compiled by Bloomberg. Populist leaders abandoned their attempt to form a government at the weekend after the president rejected their choice of a euro-skeptic finance minister, while Moody’s placed the country’s ratings on review Friday for a possible downgrade. 

“Italy has over $800B of debt maturities coming due between now at 2022, that’s nearly 40% of their total $2.4T debt load – some bills have to be paid here indeed.” – The Bear Traps Report, January 2018

Bonds for Sale – Italy Needs Friendly Capital Markets

Highly in need of friendly (wide open) capital markets, Italy needs easy access to financing.  If the beast inside the market continues to turn on Italy, this will place Mario Draghi’s ECB in a very difficult spot.  Italy still needs to sell bonds worth $130B in the markets this year, according to BofAML.  This figure will ONLY increase if populists get their way on an aggressive fiscal spending plan with tax cuts.  We MUST remember, there are rules within the ECB’s “capital key.”  The central bank cannot purchase large amounts of Italian debt relative to other EU countries.  These capital key limits will be stretched to high-stress levels in the coming months.  Draghi will need a sign off from Germany on additional capital key expansion for Italy. ” Angela, please get out the checkbook.”  The rise of “Germany First” populists in Deutschland presents political stress on the other side.  The AfD party has surged from 1% to 18% since 2013.  Populists in German (Afd) and Italy (Lega) both have their hands on a very large rubber band and they’re walking backward at an accelerated rate. 

Weekend Drama, Selection of New Finance Minister a Focus

According to Article 92 of Italian Constitution, it is the president who appoints ministers “following PM’s proposals,” (Lega wants Savona in a large way).

“Italy’s novice premier-designate Giuseppe Conte struggled to form a populist government throughout the weekend, stranded between a president who objects to a eurosceptic candidate for the economy ministry and a coalition ally threatening to force early elections.  Conte, 53, is working on a list of ministers to propose to Sergio Mattarella, 76, the head of state whose task it is to name the government team. The talks are likely later Sunday (May 27), according to an official of the anti-establishment Five Star Movement who asked not to be identified because the plans weren’t public. Economist Paolo Savona*, 81, a candidate for the economy ministry, said in a statement on an Italian website on Sunday that he was in favor of a European political union and urged full implementation of objectives in the 1992 Maastricht Treaty.  Efforts to form a populist government could be jeopardized by a tussle over Savona between the president and Matteo Salvini of the anti-immigrant League, which is Five Star’s junior partner, and lead to early elections possibly in the fall. The populists’ pledges of fiscal expansion and tax cuts would defy European Union budget rules, and the Italy-Germany 10-year yield spread reached the widest since 2014 on Friday.”  – Bloomberg

* Savona, a company executive and former industry minister, has come under fire both for repeatedly calling on the government to plan for a possible euro exit and for his criticism of what he sees as German dominance of Europe. Mattarella, a former constitutional court judge, insists on his right to appoint government ministers, without pressure from outsiders. In our view, we’re looking at a Savona moment.  If the new Italian government agrees with populists (Lega – 5Star) and chooses him as finance minister, it substantially raises the probability of a destructive EU conflict with Italy.  It would be gasoline on the “risk-off” fire.  If EU pressure prevents the populist agenda from moving forward, it will lead to a large surge in the polls for Lega – 5Star in the next round of elections (coming this year).  That’s bad news for markets as political pressure on the ECB is surging to it’s highest level in years.

Eurozone Debt Load

Italy: $2.2T
Spain: $1.0T
Germany: $860B
Ireland: $156B
Portugal: $150B
Greece: $60B

Bloomberg data

So, Draghi (ECB) expands the capital key / bond buying mechanism for Italy? And the others??

A Tale of Two Banks
Politics is driving asset prices here.  After months of House delay in sending a Dodd-Frank regulatory relief bill to the President’s desk, President Trump signed the legislation this week. As you can see above, KRE Regional Bank ETF has been pricing in the good news for months. The bill is identical to the version which passed the Senate in March and provides relief aimed at community banks, while raising the systemically-important financial institution (SIFI) threshold from $50 billion to $250 billion (although the Federal Reserve may still subject banks between $100-250 billion for enhanced supervision). Among other provisions, mortgages held by banks with under $10 billion in assets are automatically designated as “Qualified Mortgages,” and community banks which underwrite fewer than 500 mortgages a year will be largely exempt from Dodd-Frank mortgage rules. The amended law also provides regulatory relief for appraisal requirements in rural areas, as well as broader relief to community banks in having to furnish Home Mortgage Disclosure Act (HMDA) data and lengthens the examination cycle for well-capitalized banks from 1 year to 18 months. – ACG Analytics.

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A Placeholder President

Mr. Di Maio and Mr. Salvini presented the coalition’s Prime Minister (PM) pick to the President this week. The candidate, Giuseppe Conte, a law professor, is without governing experience. By selecting a political novice for the premiership, Di Maio and Salvini improved their chances of exerting influence on the likely future PM.

Deficit Spending and Tax Cuts

The coalition program plans to bolster the country’s spending by killing pension reform, introducing a flat tax, and by increasing expenditure on maritime migrant interception programs. While the major points of controversy were scrapped from the final proposal (the final version does not mention leaving the eurozone, or a plan to get bonds purchased as part of the ECB’s QE program), potentially fiscally worrisome measures remain.

Cost of Credit Default Protection, on the Rise
Clearly, the new governmental program will lead to a clash with Brussels.  The cost of credit default protection is surging in banks with heavy exposure to Italy.  We haven’t seen this kind of credit risk divergence between EuroZone and US banks in six years.  Our Index of 21 Lehman Systemic Risk Indicators is rising at the fastest pace since 2012.  See our full report on The Bear Traps Report with Larry McDonald; Tocqueville’s Italy – January 25, 2018_

Cost of Credit Default Protection (Updated April 29, 2018)

Deutsche Bank: 306 (+101)
Intesa Sanpaolo: 397 (+225)
UniCredit: 396 (+230)
CommerzBank: 224 (+80)
Santander: 244 (+140)
Soc Gen: 180 (+87)
BNP: 178 (+88)
UBS: 102 (+28)

*(change since April), sub CDS, in basis points, Bloomberg data

Keeping Financial Commitments

The agenda is likely to divert Italy from abiding by EU fiscal regulation (i.e. the Fiscal Compact). France has already issued a preemptive warning with French Economy Minister Bruno Le Maire stating: “The stability of the eurozone will be at stake if a populist new government in Italy fails to keep its financial commitments.”

Italy’s 50 Year Bond Price Plunge
Italy’s 50 Year Bond plunged 12 points last week. In October 2016, ‘Italy’s $5.6 Billion Sale of 50-Year Bonds Beats Peers’.  Italy sold five billion euros ($5.6 billion) of the securities, exceeding deals by Spain and France for similar-maturity bonds. The country became the latest in Europe to issue super-long bonds, following debt agencies in Belgium, France, Ireland and Spain taking advantage of historically low-interest rates made possible by the European Central Bank’s 1.7 trillion-euro stimulus program. The ECB, whose asset purchases were expected to run to at least March 2018 (now at least March 2019), has acquired more than 900 billion euros of debt just from the Italian, Spanish and French governments. Political risk continues to fuel market volatility and uncertainty in the sovereign bond market, especially with regard to, short-term security issuance aimed at covering the state suppliers and tax rebates–which, if implemented, could cost the Italian taxpayers more than 5% of the Italian GDP.

Stocks in Italy, 10% off their April Highs
Equities in Italy are approaching key technical levels.

Italy’s Baa2 Rating May Be Cut by Moody’s
Moody’s says the key drivers for the placement are the significant risk of a material weakening in Italy’s fiscal strength and the chance that the structural reform effort stalls. Italy’s long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at Aa2 and P-1, respectively.  “What’s the point of going to vote if it’s the ratings agencies that decide?” Luigi Di Maio, head of Five Star said Sunday in frustration.  He believed financial stress in markets played a roll in the veto of their proposed Finance Minister Paolo Savona.

No Strings Attached

The coalition agreement is not a legally binding treaty—the two populist heavyweights could resort to resuscitating the more radical among the scrapped measures in the future.  Even though the coalition partners left out of their final program some more drastic measures, there was an original proposal which contained a draft to explore ways of leaving the euro (as well as recommended ECB debt jubilee, or forgiveness).  Calling for the new government to stick to a responsible budgetary policy, the vice-president of the European Commission, Valdis Dombrovskis, noted that Italy’s borrowing was proportionally the highest of any euro-zone state except Greece.

Regime Change: Eurozone Equity Market Vol Crosses the U.S.
For the first time in a year, we’re seeing the cost of equity volatility protection in Europe surge through that of the U.S.  This is impressive since this year’s (White House trade and Fed interest rate) drama in equity markets has been U.S. centric. This speaks to a regime change in risk management to a more Europe leading focus moving forward. In the 2010-12 period, for months European credit risk moved well ahead of U.S. equity volatility.  A solid leading risk indicator indeed.

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A Back Away from High Drama, for Now?

The program has already inflicted High Drama on EU member states, especially within the eurozone. While M5S and Lega claim that the mini-BoTs proposal is not a veiled attempt at introducing a shadow parallel currency, many seem to doubt the honesty of their intentions.  We witnessed this dangerous political gamesmanship during the early stages of the Greece crisis in 2010.  When tensions are high, populist politicians in some cases leak sensitive parts of their agenda.  Almost as a trial balloon, they are testing both the markets and EU political leadership’s reaction process.  EXPECT A LOT MORE OF THIS TO COME.

The Di Maio-Salvini-Mattarella meeting will provide clarity on the new M5S-Lega administration, and reveal details on the coalition’s future program. It is not certain that the new government will actually move to implement all of the policies enumerated in the contract. With a small majority in parliament, it will be very difficult for the future government to pass radical legislation. Furthermore, President Mattarella retains the right to veto proposals.

Euro, Broke the Uptrend Line going back to 2014
Deutsche Bank bailout rumors, falling PMIs (economic data), Populism in Italy and government stability problems in Spain have all taken the Euro down to 1.16 from 1.25.  Spain’s opposition socialist party has filed a no-confidence motion against the prime minister, Mariano Rajoy, a day after his governing People’s party was found to have benefited from an illegal kickbacks-for-contracts scheme.

Full Term?

The new cabinet could be sworn in before the end of this week. The process would be finalized by a vote of confidence in both the Senate and the Chamber of Deputies. ACG Analytics does not believe that a M5S-Lega government can survive for a full term—the arrangement is likely to have a limited shelf-life, as the notable policy differences between the two parties and inevitable backstage influence of Berlusconi’s Forward Italy party on Lega is certain to exacerbate the tension between them.

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Prime Minister nominee Conte served on the Board of Directors of the Italian Space Agency as a legal consultant to the Rome Chamber of Commerce, and as a supervisory board member to a number of insurance companies going through bankruptcy.

Two Year Bond Yields, Screaming Higher in Italy – 2012-2018
Italy two year bonds, moving from -0.32% in early May to +0.48% this week.  We witnessed the largest yield spread differential between Italy and Spain in over 5 years.  Systemic risk is on the rise.

Further details of the coalition agreement cover:

“Parallel currency”: The new government plans to launch mini-BoTs, controversial securities similar to a parallel currency, as part of the administration’s plan to ramp up expenditure. These short-term securities would be used to pay overdue tax rebates and state suppliers.

Flat tax and universal income: The Lega made its flat tax policy for companies and individuals a part of the contract, with two tax brackets at 15% and 20%. The M5S inserted its basic income plan into the program, proposing a EUR 780 monthly compensation paid to those with no revenue.

EU policy: A number of measures introduced calling for the renegotiation of EU treaties and the EU’s economic regulation on several issues, including the single currency. Both parties pledged to tackle smuggling networks and illegal migration, calling for a new debate in Brussels on European migration. Furthermore, the program calls the immediate withdrawal of sanctions against the Russian Federation.

Pension reform: The program envisions the gradual scaling back of the “Fornero” pension reform.

Sovereigntist economy policy: The program aims to implement a legal minimum wage (not yet specified), ramp up savings protection, increase the responsibility of banking authorities, prevent the sale of Alitalia, and re-negotiate the Turin-Lyon high-speed railway project.

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Late Cycle Divergence: Commodities and Equities

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Since mid-December commodities are 10% higher with equities about 1% lower.  We believe markets have entered a late cycle secular shift into a new regime.

Returns in 2018

Cocoa: +49.6%
Lumber: +27.3%
Wheat: +16.4%
Oil: +14.3%
Nickel: +12.1%
Corn: +11.5%

Soybeans: +10.8%
Aluminum: +6.2%
Nasdaq 100: +4.0%
Gold: +2.1%
Russell 2000: +1.3%
S&P 500: -0.10%
Dow Transports: -0.6%
Dow Jones IA: -1.6%
Copper: -7.2%

Bloomberg terminal data

Hot Commodities laying Pressure on Bonds

Monday the Fed’s preferred inflation gauge (PCE) is expected to hit the central bank’s 2 percent target for the first time in a very long time.  Matching or exceeding that forecast would affirm traders’ conviction that inflation is headed higher, pushing up long-term yields.

Commodities Laying a Beating on Stocks in 2018
“One of the side effects from the 2009-17 period of “global monetary radicalism” is found in the extreme financialization of the developed world’s economy. In the U.S., CFOs (corporate financial officers) have been incentivized to become financial engineers. In recent years, capital investment has been two standard deviations below previous economic recoveries. “Secular stagnation,” low growth rates, paltry interest rates, and worsening demographics, all favored an outperformance of “capital” over “labor.” In these periods, financial assets – like real estate, stocks, and bonds – outperform hard/soft assets like commodities. For U.S. companies, capital investment and other “real” economy-related risk-taking, offered very poor rates of return as the economy operated below its already low level of potential. To keep shareholders pacified, financial engineering through raising low-cost debt to fund share buybacks, ruled the land in recent years. Today, for the first time in nearly a decade, we have a sharp surge in fiscal spending, while the U.S. is operating above trend, and demand for labor (wages, capex) is picking up. Bottom line: we see a cyclical shift into a new regime. As central banks shrink their balance sheets, hard/soft asset (commodities) will outperform relative to overly expensive “financial assets.” This is a freight train coming at us – the only question remains – who’s getting on? We expect this under-loved asset class (commodities) to show leadership in the new regime. In our view, the global QE (asset purchases, quantitative easing, 2009-17) period marked the near term top of “financialization” and its gradual withdrawal into a late cycle landscape will lead to a “rebalancing” between cheaper commodity-related assets and overly expensive financial assets. The tipping point of this secular shift is the central bank taper and tightening process.”

The Bear Traps Report, February 10, 2018


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Value Flashing a Loud Warning

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Late Cycle Recession Warning in Staples Capitulation

In the last week, we received an  XLY (consumer discretionary)  vs. XLP (consumer staples) warning in our “21 Lehman Systemic Risk Indicators” model (see below).  The recent move is not only unsustainable but also speaks to the increasing probability of recession in the next 12 months.

Over the last two years, value (consumer staples) -4% has underperformed growth (consumer discretionary) +29% by nearly 35%. – over the last year, -10% to +14%.  After last week’s colossal acceleration, the BEATING is now more than two standard deviations outside the thirty-year mean.

XLY vs. XLP Ratio and the S&P 500
Bottom line, the parabolic (see the white line above) outperformance of the consumer discretionary names (ratio of XLY to XLP) has been incredible and is “classic” late cycle activity.  The value depression end is in sight in our view.  Value will crush growth over the next 12-18 months.  A solid leading equity market indicator above, watch for a shift in consumer staples.  The sector typically starts to outperform (after a period of blow off top underperformance) 12-18 months ahead of substantial equity market drawdowns and recessions.

% of Stocks Above the 200 Day Moving Average

S&P Consumer Discretionary: 61%
Brazil: 61%
S&P 500: 54%
DJIA: 53%
Nasdaq: 47%
S&P Materials: 47%
Germany DAX: 37%
S&P Consumer Staples: 31% 

Bloomberg data

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The Four “Irrefutable Truths”

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In many cases, sell-side research (from the major banks) reminds us of the plump chef standing at the head of an “all you can eat buffet.”  Rarely would he whisper health tips into your ear or provide guidance toward restraint.  “Eat up Johnny, all is good.”

In all our years on Wall St., one major takeaway is the danger found in “broad theme consensus.”  Decade after decade we’ve seen this play out in so many different forms.  The more unanimous the sales pitch, when you hear it on every street corner, it’s the best leading indicator to RUN, not walk the other way.

The 2012-14 Sales Pitch: Four “Irrefutable Truths”
Look back to the summer of 2014.  Retail investors were lectured, over and over again on the “four irrefutable truths.”  MLP companies are 1) toll road businesses, with 2) fixed fees, 3) secure long-term contracts, and 4) the commodity price (oil and gas) doesn’t matter.  Of course, ultimately investors learned these truths were more than refutable.  Over the next 18 months, the average stock in the MLP sector would lose nearly 70% of its value (see below).

MLP (Master Limited Partnerships) in the Energy Patch

MLPs are pass-through entities, which distribute almost all pre-tax income to unitholders, who then are responsible for paying the taxes on it according to their individual situations. As such, they benefit from a very advantageous (almost 0%) tax treatment, while regular “C” corporations pay a 21% statutory tax rate (35% prior to tax reform). Since 2005 MLPs have been able, in the FERC’s words, “to recover an income tax allowance in their cost of service” — effectively boosting the amount of pre-tax income to be passed through. This “double recovery” of income tax costs that MLPs enjoyed is now disallowed.

Beaten Up Value, Left for Dead

“The investment industry has long misunderstood the business models and the analysis has been reflective of that misunderstanding.  Until 2015, MLPs paid an increasing percentage of CFFO back to investors, peaking as an industry at >90%.  However, since CAPEX and debt servicing also needed to be paid, debt leverage quietly increased until Debt/EBITDA approached 6x (from normalized 3.5-4x Debt/EBITDA for years) for the industry by the end of 2015.  Finally, when oil production peaked and started to fall in 2015, the credit agencies required pipeline companies to reduce leverage, and dividends were cut substantially.  The dividend cuts scared retail investors, and even today many believe that the business models are under threat.  The sector has fallen dramatically and has deeply underperformed the broader markets. Instead, many pipeline companies are actually doing well, at least operationally.  What has been difficult over the last 2 years is that the marginal dollar of cash flow is being sent to the debtholder and not the equity holder.  For an investment vehicle that is intended to deliver income to investors, incremental dollars not being returned to equity holders is a problem.  However, as in most leverage recovery situations, the recovery is a 2-3 year process and is now going on 3+ years.  So companies like Kinder Morgan (KMI) cut its dividend by 80% in Dec 2015, and has for the first time since then, guided to increase its dividend by 50% in 2018, and 25% for a few years further into the future.  And by the way, KMI’s EBITDA is higher in 2017 than it was in 2015, but the stock was at $40 in the first half of 2015 and is now below $19. We generally look at these companies comparing the RoIC vs the WACC.  The relationship between ROIC/WACC tells us what multiple of Invested Capital we should be willing to pay for the business.  So if a co has ROIC=WACC then it adds no additional value to the capital it has invested and the company should be valued at only its invested capital, no more no less.  If a co’s ROIC is 2x the WACC then the company should trade at 2x the invested capital, and so on.  What is interesting about the group today is that most companies are trading right around their invested capital, and sometimes at discounts.  Historically they’ve delivered 1.25-1.75x their WACC, and that is what makes the opportunity so interesting.”

Mark Laskin, from 2013-2017 he was the CIO of T Boone Pickens’ BP Capital Fund Advisors, where he managed Energy and MLP portfolios.

King of Retail Pain, MLPs
The ultimate goal of the Bear Traps report is to discover bear markets transitioning into the new bright bull.  Last year we were fortunate to get the solar, oil and steel sector migration north right.  This year in the MLPs, we got sucked into a bear trap in January.  In error, we chased this group (see the red circle above) into what we believed was a new bull market.  We could have stopped ourselves out (stop-loss sell) but our cost basis was manageable from a trading perspective.  Today, coming out or the grip of a multi-year grizzly bear market, we believe the MLPs are very close to a major bullish move higher.  Over the last few years (see above) we’ve witnessed an incredible amount of capitulation selling.  Only when the last retail investor (previous heavy ownership) has given up on the sector can it move higher.  The question is, who’s left to sell?

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Measuring Capitulation

Our seven-factor capitulation model quantifies the “fannies rushing to the exits”, and looks back historically in an attempt to measure the selling pain.  Is this a category three hurricane, or a more treacherous Cat 5?

In November’s first major MLP capitulation, we had an 18% gain from our AMLP entry into the new year (see above). Next, we tried to buy on the trend break (red circle above), thinking this was the great jailhouse break out of the bear’s multi-year grip.  Next, we were met with a painful second round of selling last month, and we should have, in all likelihood, lightened our position there. In October, she was trading 9M shares a day, but by the November capitulation, it was 20M a day! They were jumping over the seats, swinging on the chandeliers, trying to get out through the bathroom window, the wild mob wanted OUT of the MLPs. Moving forward to the March capitulation, we had reached 25M shares a day, a true panic yet again!  Who’s left to sell the MLPs?

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Rising Interest Rate Risk

“It is true that in rising rate environments the relative performance of MLPs to the S&P 500 is lower, but relative to other known rates-like sectors (such as utilities and REITs), MLPs tend to outperform. This makes sense as oil prices are the key driver, and oil often goes up in hiking cycles. As oil prices continue to rise we expect MLP performance to turn higher as oil becomes the marginal driver. Over the past decade, MLP correlation to crude prices has remained quite high. Against the rate backdrop it is important to notice that in credit spread terms, MLP yield valuation are getting very attractive again, especially given these oil price levels and their trends. The average spread of Alerian MLP (AMLP) to the Ten year treasury yield since 2000 has been around 350bps, and is currently over 600. The yield valuation is there while AMLP yields over 8%.  Bottom line, MLPs are a BUY (AMLP equity) in our view with an attractive risk – reward.”

Bear Traps Report, March 28, 2018

Impact of FERC (Federal Energy Regulatory Commission)
The Federal Energy Regulatory Committee (FERC) ruled last month that it will revise its 2005 Policy Statement for Recovery of Income Tax Costs and no longer allow master limited partnership (MLP) interstate natural gas and oil pipelines to recover an income tax allowance in the cost of service rates. The news triggered a dramatic capitulation sell-off (see above) in the MLPs out of fears of a considerable hit to their operating profit.

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FERC Noise

With the recent developments since the FERC rate policy change, the stocks most impacted were those with higher exposure to the cost of servicing pipelines. Given the weakness in EEP and TCP, which are also financing vehicles for C-Corps, we could see difficulties in executing drop downs, a way energy companies monetize the midstream part of their operations. Most of the other MLP names are not as exposed to this recent FERC-related negative impact on the share price, as their drop downs look ok to us. The most impacted pipelines under this ruling are those that have legacy costs of service rates, and those that are earning at their maximum rate. However, the FERC ruling applies only to interstate pipeline assets and not to those that originate and terminate within the same state. Furthermore, the rule is not expected to go into effect until 2020.

In cases where the MLP holds the pipeline asset but a C corporation ultimately owns the MLP, the FERC rule applies. In a reverse case, where the C corporation owns the pipeline within an MLP, the asset would not be subject to the ruling. As a result, we could see strategic reviews and acquisitions within the MLP sector to circumvent the income tax order. Examples of these would be refining companies buying back assets currently held in MLPs (see our M&A section above). The ruling does not apply to, for example, Kinder Morgan (KMI), which acquired its MLP some years back. But in the case of Williams Co. (WMB), it might be collaborating with Williams Partners to create a new corporate structure to hold long-haul assets like its Transco gas pipeline. This is a big opportunity that is certainly worth watching.

The Takeaway

The period of time (between today and the enactment of this tax code restriction), where corporations have the opportunity to buy (and therefore secure) a tax-advantage that they previously saw more value in divesting. They were wrong, and they now have the chance to fix it. Ultimately, only a few MLPs will see a meaningful impact on their earnings from the FERC ruling.  On the other hand, we could see strategic reviews leading to some buybacks of MLPs that were spun off in the past. Refiners have spun out their pipeline assets into MLPs in prior years, but may now want to buy them back to circumvent the new ruling.



The Broken Seesaw

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Imagine walking through the park and across the way there’s a seesaw with an obese child on one end and a thin youngster on the other, that’s no fun.  It simply doesn’t work.

When you think about the $1.5T of capital that’s flown into passive bond ETFs and risk parity strategies in recent years, this crowd has a colossal disinflation bet on.  In other words, so much money has flown into bonds at extremely low-interest rates, if yields surge* there’s no protection on the other side.

*Forget about a surge, just don’t rally.  Interest rates down, bond prices up.  If interest rates are unchanged, bond prices will be as well.

In a regime change, a period where stocks and bonds move lower together, the flight of assets out of passive bond / risk parity strategies will be ferocious.  Click here to get a peek at our winners in this new regime.

VIX Spikes above Twenty vs. US 10 Year Bond Yield

Mar 2018: 2.76%
Feb 2018: 2.81%
Nov 2016: 2.29%
Jun 2016: 1.37%
Feb 2016: 1.68%
Sep 2015: 1.97%
Jan 2015: 1.67%
Oct 2014: 1.90%
Jan 2014: 2.57%
Oct 2013: 2.50%

Bloomberg data

Stocks Down, Bonds Down?

Think of the dentist in Cleveland, Ohio with $1M in stocks and $1M in bonds in a portfolio.  For the first time in 30 years, he / she is looking at their brokerage statement and seeing NO wealth destruction OFFSET from bonds.   We have an eye on credit quality globally (AAA rated corporates / sovereign credits are off 30-40% in terms of the amount of high-quality paper last 10 years).  Next, shift your eyes on the debt to GDP in the G20, up from 70% to near 100% (maybe 110%). Then look at the EM dollar-denominated debt issued 2007-2017, in the trillions, there’s a new player at the table trying to sell / refinance a large debt load. All this speaks to a regime change, we’re in the 1-2 inning we believe, more to come.

Q1 2018, Jack and Jill Ran Down the Hill

Even with the bond rally in March, they still finished Q1 in the red with stocks.

Largest US Equity Market Wealth Destruction

2008: -$10.5T
2015: -$4.5T
2011: -$3.7T
2018: -$3.2T**
2010: -$2.4T

*Last 10 years, Bloomberg US Market Capitalization data.
**only instance in the last 18 years where bonds also lost value. In the 2018 equity drawdown, bond SOLD OFF from 2.05% to 2.85%, ADDING nearly $1.4T of ADDITIONAL wealth destruction.




Lucy and the Football, Wall St. Faked Out Yet Again by the Fed

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Lucy and the Football

Heading into Fed meetings, each time public “Fedspeak” (governors on the speaking tour) raise the hawkish bar (expectations for a more aggressive policy path – rate hikes). In every instance, Wall Street gets drawn in, gold heads into capitulation. Next, the “dovish hike” (below sky-high expectations) triggers the gold rally. Rinse and Repeat.

Gold Miner’s $GDX Returns after Fed Rate Hikes

Mar 2018: +5% (so far)
Dec 2017: +17%
Jun 2017: +17%
Mar 2017: +18%
Dec 2016: +36%
Dec 2015: +136%

Bloomberg data

Hook, Line, and Sinker

Each and every time the Fed has hiked rates, their effort to signal the hike has been well over-cooked.  In an effort to provide transparency they’ve consistently oversold rate hikes.  Wall St. (sell-side economists) take the sales pitch hook, line, and sinker.  It’s “Lucy and the Football” over, and over and over again.  Heading into the Fed meetings, very consistently, the hawkish song (threats of pulling away accommodation)  from the Fed has punished gold, only to see a beautiful relief rally each time.

Managing and Measuring the Street’s Expectations is the Key

The Federal Reserve has been gold’s best friend. Heading into (rate hike) Fed meetings, each time the public “Fedspeak” (governors on the speaking tour) raises the hawkish bar (expectations for a more aggressive policy path – rate hikes). In every instance, the Wall Street gets drawn in, gold heads into capitulation. Next, the “dovish hike” (Fed delivering well below sky-high expectations) triggers the gold rally. Each round of expectations out of balance has led to higher gold (and gold miner’s) price action in the weeks after rate hikes.

Since last week’s Fed Meeting, the probability of a June rate hike has plunged, from 90% to near 73% – while gold has surged from $1307 to $1350. When you’re trading gold, you’re actually trading eurodollars, the Fed rate hike expectations curve.

Gold Silver Cross, Speaks to a Global Economic Recession

The divergence between the two means prices for gold are 82 times those of silver, which is 27% more than the 10-year average and the highest level in two years, data analyzed by WSJ Market Data Group show.  A higher gold-to-silver ratio is viewed by some investors as a negative economic indicator because money managers tend to favor gold when they think markets might turn rocky and discard silver when they are worried about slower global growth crimping consumption. Industrial uses account for about 55% of demand for silver, according to the Silver Institute, leading some traders to link it more with base metals like copper and others.

China Warning

The precious metals ratio last stayed above 80 in early 2016, when worries about a Chinese economic slowdown roiled markets, and in 2008 during the financial crisis. The ratio’s recent rise comes as speculators have turned bearish on silver and inventories in warehouses have risen, a sign there could be too much supply.

COT Data, Bullish

Our friend Jordan Roy Byrne notes net speculative positioning in Silver (against Open Interest) hit 1.7% this week, the lowest on record. To us, this is more than BULLISH.  Friday’s commitment of traders (COT) report showed speculators shifted aggressively net short, something NOT seen every day, and commercials are almost in balance, which is also unusual and bullish in our view.

MSCI World Equities vs. the Gold Silver Cross
This is a bit of a mindblower.  Over the last twenty plus years highs in the gold-silver cross (extremely weak silver pricing relative to gold) were met with bear markets in global equities.  Which makes a lot of sense, for decades silver has been a global economic bellwether.   In the 2017-18 global equities, paradigm stocks have climbed even as silver has dramatically cheapened.   To us this speaks to deleveraging in China, industrial metals are pricing in some pain, a lookout warning for the global economy (and equities).  Pick up our full report here.


Must Read from the WSJ on Silver, well done.

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Oil Impact: President Trump and the Iran Deal, Countdown to Conflict

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“President Trump, by demanding on Friday that European allies agree to rewrite the Iran nuclear deal within 120 days or he will kill it, set himself a diplomatic challenge that would be formidable even for an administration with a deep bench of experienced negotiators.”

The New York Times, January 12, 2018

By now, most market participants know the abrupt “You’re Fired” Rex Tillerson (former U.S. Secretary of State) moment was driven by a conflict with the President over the Iran deal.

Countdown to May 12th

Brent is nearly 4% higher over the last week as Tillerson’s exit has put a bid under crude.  The perception across commodity trading desks is that the U.S. is far more likely to pull out of the agreement as early as May 12, the next deadline for the White House to extend the waiver on the sanctions.

The North Korea Connection to the Iran Deal

Some of our contacts in Washington doubt the Trump – Kim Jong-un meeting (North Korean leader Kim Jong-un) will actually happen.  They believe it’s a stunt by North Korea.  As the theory goes, NK’s Kim Jong-un wants to push talks out to mid-May when the next JCPOA (Joint Comprehensive Plan of Action – US Department of State) deadline is going down.  What a coincidence, that’s around the same time President Trump has threatened he will withdraw from the Iran Deal.  If the White House does pull the U.S. out, North Korea will fully pursue a nuclear program openly and justify it by claiming the U.S. can’t be trusted in international agreements.  The Trump Administration has said they want to meet before May which backs that up this line of thinking.

Large Upside for Crude if the U.S. Kills Iran Deal

Oil bulls have their minds on 2012.   As the U.S. launched touch sanctions with a bullseye focused on Iran’s oil industry.  Exports plunged by over one million barrels a day.  As we look toward the May 12 deadline on the Obama era Iran deal, a repeat of the drama six years ago would DOUBLE the expected supply deficit in the second half of this year.

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