Tag Archives: uncertainty

The New Normal (Again)

I expect that next week’s reinsurance jamboree in Monte Carlo will be full of talk of innovative and technology streaming-lining business models (as per this post on AI and insurance). This recent article from the FT is just one example of claims that technology like blockchain can reduce costs by 30%. The article highlights questions about whether insurers are prepared to give up ownership of data, arguably their competitive advantage, if the technology is really to be scaled up in the sector.

As a reminder of the reinsurance sector’s cost issues, as per this post on Lloyds’, the graph below illustrates the trend across Lloyds’, the Aon Benfield Aggregate portfolio, and Munich’s P&C reinsurance business.

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Until the sector gets serious about cutting costs, such as overpaid executives on luxury islands or expensive cities and antiquated business practises such as holding get togethers in places like Monte Carlo, I suspect expenses will remain an issue. In their July review, Willis stated that a “number of traditional carriers are well advanced in their plans to reduce their costs, including difficult decisions around headcount” and that “in addition to cost savings, the more proactively managed carriers are applying far greater rigor in examining the profitability of every line of business they are accepting”. Willis highlighted the potential difficulties for the vastly inefficient MGA business that many have been so actively pursuing. As an example of the type of guff executives will trot out next week, Swiss Re CEO, Christian Mumenthaler, said “we remain convinced that technology will fundamentally change the re/insurance value chain”, likely speaking from some flash office block in one of the most expensive cities in the world!

On market conditions, there was positive developments on reinsurance pricing at the January renewals after the 2017 losses with underlying insurance rates improving, as illustrated by the Marsh composite commercial rate index (example from US below).

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However, commentators have been getting ever more pessimistic as the year progresses, particularly after the mid-year renewals. Deutsche Bank recently called the reinsurance pricing outlook “very bleak”. A.M. Best stated that “the new normal for reinsurers appears to be one with returns that are less impressive and underwriting and fee income becoming a larger contributor to profits” and predicts, assuming a normal large loss level, an 8% ROE for 2018 for the sector. Willis, in their H1 report, puts the sectors ROE at 7.7% for H1 2018. S&P, in the latest report that is part of their Global Highlights series, also expects a ROE return for 2018 around 6% to 8% and estimates that “reinsurers are likely to barely cover their cost of capital in 2018 and 2019”.

S&P does question why “the market values the industry at a premium to book value today (on average at 1.24x at year-end 2017), and at near historical highs, given the challenges” and believes that potential capital returns, M&A and interest rate rises are all behind elevated valuations.  The recent Apollo PE deal for Aspen at 1.12 times book seems a large way off other recent multiples, as per this post, but Aspen has had performance issues. Still its interesting that no other insurer was tempted to have a go at Aspen with the obvious synergies that such a deal could have achieved. There is only a relatively small number of high quality players left for the M&A game and they will not be cheap!

As you are likely aware, I have been vocal on the impact the ILS sector has had in recent years (most recently here and here). With so-called alternative capital (at what size does it stop being alternative!) now at the $95 billion-mark according to Aon, A.M. Best makes the obvious point that “any hope for near-term improvement in the market is directly correlated to the current level of excess capacity in the overall market today, which is being compounded by the continued inflow of alternative capacity”. Insurers and reinsurers are not only increasing their usage of ILS in portfolio optimisation but are also heavily participating in the sector. The recent purchase by Markel of the industry leading and oldest ILS fund Nephila is an interesting development as Markel already had an ILS platform and is generally not prone to overpaying.

I did find this comment from Bob Swarup of Camdor in a recent Clear Path report on ILS particularly telling – “As an asset class matures it inevitably creates its own cycle and beta. At this point you expect fees to decline both as a function of the benefits of scale but also as it becomes more understood, less of it becomes alpha and more of it becomes beta” and “I do feel that the fees are most definitely too high right now and to a large extent this is because people are trying to treat this as an alternative asset class whereas it is large enough now to be part of the general mix”. Given the still relatively small size of the ILS sector, it’s difficult for ILS managers to demonstrate true alpha at scale (unless they are taking crazy leveraged bets!) and therefore pressure on current fees will become a feature.

A.M. Best articulated my views on ILS succinctly as follows: “The uncorrelated nature of the industry to traditional investments does appear to have value—so long as the overall risk-adjusted return remains appropriate”. The graph below from artemis.bm shows the latest differential between returns and expected cost across the portfolio they monitor.

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In terms of the returns from ILS funds, the graph below shows the underlying trend (with 2018 results assuming no abnormal catastrophic activity) of insurance only returns from indices calculated by Lane Financial (here) and Eurekahedge (here). Are recent 5 year average returns of between 500 and 250 basis points excess risk free enough to compensation for the risk of a relatively concentrated portfolio? Some think so. I don’t.

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Whether reinsurers and specialty insurers will be able to maintain superior (albeit just above CoC) recent returns over ILS, as illustrated in this post, through arbitrating lower return ILS capital or whether their bloated costs structures will catch them out will be a fascinating game to watch over the coming years. I found a section of a recent S&P report, part of their Global Highlights series, on cat exposures in the sector, amusing. It stated that in 2017 “the reinsurance industry recorded an aggregate loss that was assessed as likely to be incurred less than once in 20 years” whilst “this was the third time this had happened in less than 20 years“.

So, all in all, the story is depressingly familiar for the sector. The new normal, as so many commentators have recently called it, amounts to overcapacity, weak pricing power, bloated cost structures, and optimistic valuations. Let’s see if anybody has anything new or interesting to say in Monte Carlo next week.

As always, let’s hope there is minimal human damage from any hurricanes such as the developing Hurricane Florence or other catastrophic events in 2018.

Broken Record II

As the S&P500 hit an intraday all-time high yesterday, it’s been nearly 9 months since I posted on the valuation of the S&P500 (here). Since then, I have touched on factors like the reversal of global QE flows by Central Banks (here) and the lax credit terms that may be exposed by tightening monetary conditions (here). Although the traditional pull back after labor day in the US hasn’t been a big feature in recent years, the market feels frothy and a pullback seems plausible. The TINA (There Is No Alternative) trade is looking distinctly tired as the bull market approaches the 3,500-day mark. So now is an opportune time to review some of the arguments on valuations.

Fortune magazine recently had an interesting summary piece on the mounting headwinds in the US which indicate that “the current economic expansion is much nearer its end than its beginning”. Higher interest rates and the uncertainty from the ongoing Trump trade squabble are obvious headwinds that have caused nervous investors to moderate slightly valuation multiples from late last year. The Fortune article points to factors like low unemployment rates and restrictions on immigration pushing up wage costs, rising oil prices, the fleeting nature of Trump’s tax cuts against the long-term impact on federal debt, high corporate debt levels (with debt to EBITDA levels at 15 years high) and the over-optimistic earnings growth estimated by analysts.

That last point may seem harsh given the 24% and 10% growth in reported quarterly EPS and revenue respectively in Q2 2018 over Q2 2017, according to Factset as at 10/08/2018. The graph below shows the quarterly reported growth projections by analysts, as per S&P Dow Jones Indices, with a fall off in quarterly growth in 2019 from the mid-20’s down to a 10-15% range, as items like the tax cuts wash out. Clearly 10-15% earnings growth in 2019 is still assuming strong earnings and has some commentators questioning whether analysts are being too optimistic given the potential headwinds outlined above.

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According to Factset as at 10/08/2018, the 12-month forward PE of 16.6 is around the 5-year average level and 15% above the 10-year average, as below. As at the S&P500 high on 21/08/2018, the 12-month forward PE is 16.8.

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In terms of the Shiller PE or the cyclically adjusted PE (PE10), the graph below shows that the current PE10 ratio of 32.65 as at the S&P500 high on 21/08/2018, which is 63% higher than 50-year average of 20. For the purists, the current PE10 is 89% above the 100-year average.

click to enlargeCAPE Shiller PE PE10 as at 21082018 S&P500 high

According to this very interesting research paper called King of the Mountain, the PE10 metric varies across different macro-economic conditions, specifically the level of real interest rates and inflation. The authors further claim that PE10 becomes a statistically significant and economically meaningful predictor of shorter-term returns under the assumption that PE10 levels mean-revert toward the levels suggested by prevailing macroeconomic conditions rather than toward long-term averages. The graph below shows the results from the research for different real yield and inflation levels, the so-called valuation mountain.

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At a real yield around 1% and inflation around 2%, the research suggests a median PE around 20 is reasonable. Although I know that median is not the same as mean, the 20 figure is consistent with the 50-year PE10 average. The debates on CAPE/PE10 as a valuation metric have been extensively aired in this blog (here and here are examples) and range around the use of historically applicable earnings data, adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation).

One hotly debated issue around CAPE/PE10 is the impact of the changing profit margin levels. One conservative adjustment to PE10 for changes in profit margins is the John Hussman adjusted CAPE/PE10, as below, which attempts to normalise profit margins in the metric. This metric indicates that the current market is at an all time high, above the 1920s and internet bubbles (it sure doesn’t feel like that!!). In Hussman’s most recent market commentary, he states that “we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index”.

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Given the technological changes in business models and structures across economic systems, I believe that assuming current profit margins “normalise” to the average is too conservative, particularly given the potential for AI and digital transformation to cut costs across a range of business models over the medium term. Based upon my crude adjustment to the PE10 for 2010 and prior, as outlined in the previous Broken Record post (i.e. adjusted to 8.5%), using US corporate profits as a % of US GDP as a proxy for profit margins, the current PE10 of 32.65 is 21% above my profit margin adjusted 50-year average of 27, as shown below.

click to enlargeCAPE Shiller PE PE10 adjusted as at 21082018 S&P500 high

So, in summary, the different ranges of overvaluation for the S&P500 at its current high are from 15% to 60%. If the 2019 estimates of 10-15% quarterly EPS growth start to look optimistic, whether through deepening trade tensions or tighter monetary policy, I could see a 10% to 15% pullback. If economic headwinds, as above, start to get serious and the prospect of a recession gets real (although these things normally come quickly as a surprise), then something more serious could be possible.

On the flipside, I struggle to see where significant upside can come from in terms of getting earnings growth in 2019 past the 10-15% range. A breakthrough in trade tensions may be possible although unlikely before the mid-term elections. All in all, the best it looks like to me in the short term is the S&P500 going sideways from here, absent a post-labor day spurt of profit taking.

But hey, my record on calling the end to this bull market has been consistently broken….

Bumpy Road

After referring to last year’s report in the previous post, the latest IMF Global Financial Stability Report called “A Bumpy Road Ahead” was released yesterday. Nothing earth-shattering from the report when compared to previous and current commentary. The following statements are typical:

“Many markets still have stretched valuations and may experience bouts of volatility in the period ahead, in the context of continued monetary policy normalization in some advanced countries. Investors and policymakers should be cognizant of the risks associated with rising interest rates after years of very easy financial conditions and take active steps to reduce these risks.”

and

“Valuations of risky assets are still stretched, with some late-stage credit cycle dynamics emerging, reminiscent of the pre-crisis period. This makes markets exposed to a sharp tightening in financial conditions, which could lead to a sudden unwinding of risk premiums and a repricing of risky assets. Moreover, liquidity mismatches and the use of financial leverage to boost returns could amplify the impact of asset price moves on the financial system.”

With the US 10 year breaking 2.9% today and concerns about a flattening yield curve, the IMF puts global debt at $164 trillion or 225% of GDP (obviously a different basis from the IIF’s estimate of global debt at $237 trillion or 318% of GDP) and warns about the US projected debt increase due to its “pro-cyclical policy actions”.

In a chapter the IMF calls “The Riskiness of Credit Allocations” it presents an interesting graph, as below, using its financial conditions index which uses multiple inputs constructed using a methodology that’s wonderfully econometrically complex, as is the IMF way.

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The IMF warn that “a variety of indicators point to vulnerabilities from financial leverage, a deterioration in underwriting standards, and ever more pronounced reaching for yield behaviour by investors in corporate and sovereign debt markets around the world”.

Nero fiddles

This week it’s Syria and Russia, last week it was China. Serious in their own right as these issues are, Donald Trump’s erratic approach to off the cuff policy development is exhausting markets. In the last 60 trading days, the S&P500 has had 9 days over 1% and 12 days below -1%. For above 0.5% and more than -0.5%, the number of days is 21 and 15 respectively! According to an off the record White House insider, “a decision or statement is made by the president, and then the principals come in and tell him we can’t do it” and “when that fails, we reverse engineer a policy process to match whatever the president said”.  We live in some messed up world!

As per this post, the mounting QE withdrawals by Central Banks is having its impact on increased volatility. Credit Suisse’s CEO, Tidjane Thiam, this week said, “the tensions are showing and it’s very hard to imagine where you can get out of a scenario of prolonged extraordinary measures without some kind of, I always use the word ‘trauma’”.

Fortune had an insightful article on the US debt issue last month where they concluded that something has to give. According to an Institute of International Finance report, global debt reached a record $237 trillion in 2017, more than 317% of global GDP with the developed world higher around 380%. According to the Monthly Treasury Statement just released, the US fiscal deficit is on track for the fiscal years (Q4 to Q3 of calendar year) 2018 and 2019 to be $833 billion and $984 billion compared to $666 billion in 2017.

This week also marks the publication of the Congressional Budget Office’s fiscal projections for the US after considering the impact of the Trump tax cuts. The graphs below from the report illustrate the impact they estimate, with the fiscal deficits higher by $1.5 trillion over 10 years. It’s important to note that these estimates assume a relatively benign economic environment over the next 10 years. No recession, for example, over the next 10 years, as assumed by the CBO, would mean a period of nearly 20 years without one! That’s not likely!

The first graph below shows some of the macro-economic assumptions in the CBO report, the second showing the aging profile in the US which determines participation rates in the economy and limits its potential, with the following graphs showing the fiscal estimates.

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The respected author Satyajit Das highlighted in this article how swelling levels of debt will amplify the effect of any rate rises, with higher rates having the following impacts:

  • Increase credit risk. LIBOR has already risen, as per this post, and large sways of corporate debt is driven by LIBOR. This post shows some of debt levels in S&P500 firms, as per the IMF Global Financial Stability report from last April and the graph below tells its own tale.
  • Generate large mark-to-market losses on existing debt holdings. A 1% increase is estimated to impact US government debt by $2 trillion globally.
  • Drive investors away from risky assets such as equity, decimating the now quaint so-called TINA trade (“there is no alternative”).
  • Divert cash to servicing debt, further dampening economic activity and business investment.
  • Restrict the ability of governments to deploy fiscal stimulus.

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Back in the land of Nero, or Trump in our story, his new talking head in chief, Larry Kudlow, recently said the White House would propose a “rescission bill” to strip out $120 billion from nondefense discretionary spending. Getting that one past either the Senate or the House ahead of the November midterm elections is fanciful and just not probable after the elections. So that’s what the Nero of our time is planning in response to our hypothetical Rome burning exasperated by his reckless fiscal policies (and hopefully there wouldn’t be any unjustified actual burning as a result of his ill thought out foreign policies over the coming days and weeks).

CenturyLink 2018 Preview

I don’t do this often but as I am travelling this week I thought I’d give some predictions on the Q4 announcement from CenturyLink (CTL) due after market close this Valentine’s Day. As my last post on the topic in August stated, I am taking a wait and see approach on CTL to assess whether enough progress has been made on the integration and balance sheet to safeguard the dividend. Although CTL is down 15% since my last post, the history of LVLT has taught me that extracting costs from a business with (at best) flat-lining revenue will be a volatile road over the coming quarters and years. Add in high debt loads in an increasing interest rate environment and any investment into CTL, with a medium term holding horizon, must be timed to perfection in this market.

The actual results for Q4 matter little, except to see revenue trends for the combined entity, particularly as according to their last 10Q they “expect to recognize approximately $225 million in merger-related transaction costs, including investment banker and legal fees”. They will likely kitchen sink the quarter’s results. The key will be guidance for 2018 which the new management team (e.g. the old LVLT CEO and CFO) have cautioned will only be the 2018 annual range for bottom-line metrics like EBITDA and free cashflow. Although many analysts know the LVLT management’s form, it may take a while for the wider Wall Street to get away from top line trends, particularly in the rural consumer area, and to measuring CTL primarily as a next generation enterprise communication provider.

At a recent investor conference, the CFO Sunit Patel gave some further colour on their targets. Capex would be set at 16% of revenues, the target for margin expansion is 5%-7% over the next 3 to 5 years reflected cost synergies coming into effect faster than previously indicated, and they will refocus the consumer business on higher speeds “more surgically [in terms of return on capital] in areas that have higher population densities, better socioeconomic demographics, better coexistence with businesses and where wireless infrastructure might be needed”. Based upon these targets and assuming average LIBOR of 3% and 4% for 2018 and 2019 respectively plus a flat-line annual revenue for the next 3 years (although a better revenue mix emerges), I estimate a valuation between $20 to $25 per share is justified, albeit with a lot of execution risk on achieving Sunit’s targets.

On guidance for 2018, I am hoping for EBITDA guidance around $9.25 billion and capex of $4 billion. I would be disappointed in EBITDA guidance with a lower mid-point (as would the market in my view). I also estimate cash interest expense of $2.25-$2.5 billion on net debt of $36-$36.5 billion. Dividend costs for the year should be about $2.35 billion.

Wednesday’s result will be interesting, particularly the market’s assessment of the plausibility of management’s targets for this high dividend yielding stock. There is plenty of time for this story to unfold over the coming quarters. For CTL and their people, I hope it’s not a Valentine’s Day massacre.

Follow-up after results:

I am still going through the actual results released on the 14th of February but my initial reaction is that the 2018 EBITDA guidance is a lot lower than I expected. Based upon proforma 2017 EBITDA margin of 36.1%, I factored in a more rapid margin improvement for 2018 to get to the EBITDA figure of $9.25 billion than the approximate 80 basis point improvement implied in the 2018 guidance to get to the mid-point of $8.85 billion. In response to an analyst’s question on the 5%-7% margin improvement expected over the next 3 to 5 years, Sunit responded as follows:

On the EBITDA margin, to your question, I think, in general, we continue to expect to see the EBITDA margin expand nicely over the next 3 to 5 years. I think we said even at the time of the announcement that with synergies and everything pro forma, we should be north of 40% plus EBITDA margins over the next few years and we continue to feel quite confident and comfortable with that. So I think you will see the margin expansion in terms of the basis points that you described.

I will go through the figures (and maybe the 10K) to revise my estimates and post my conclusion in the near future.