A Bit of Background

So, how does a company that just two years ago had raised $961m at a lofty valuation of $6bn AUD from SoftBank and was talking up an IPO at a humble valuation of $7bn AUD (according to industry insiders) just a month ago, collapse almost overnight? What that might suggest about valuations and the IPO market in its current form may be an article in its own right but for now let’s look at what happened.

Firstly, let’s begin with what Greensill actually does. Simply put, the business, despite its later diversified revenue streams including conventional banking services and bonds (on debt it has purchased) to outside investors, operates in the world of supply-chain finance as its bread and butter. Think about it as BNPL for a supply chain. Essentially it is factoring in reverse, whereby a buyer uses a bank or financial institution to finance a suppliers invoice. Because the invoice gets immediately sold, the supplier gets immediate cash whilst the buyer has more time to pay off the cash. In this entire transaction there are three parties involved, the buyer, the supplier and the mediating financial institution (cue Greensill).
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Simple, right? However, for the financial institution, there are even more hurdles. A company like Greensill needs two further things, access to immediate capital (a line of credit) to pay the suppliers on behalf of the buyers and, from a risk perspective, an ability to adequately insure the possibility of non-payment by the buyers. On face value this seems simple enough. However, problems can arise when any one of these pieces fails to work.

 So, what happened?

The problem began around eight months ago, when Greensill found itself in a situation whereby the insurers, IAG (IAG.ASX) in this case, were unwilling to insure or renew around $4.6bn AUD in policies. With that first major problem, the dominos began to fall. Without insurance, there was no way that banks or financial institutions, in this instance Credit Suisse and GAM Holdings, were going to extend liquidity in order for them to make the requisite payments to their suppliers. The business model effectively falling to pieces as soon as this occurred.

There was some last minute flurry when Greensill sought an injunction in order to stop IAG from ceasing coverage. Unfortunately for Greensill, it was not until the last minute (they had found out about IAG looking to cease coverage in September 2020) that they sought to do so and the Justice cited this issue as the reason for denying the firm. Shortly following this Credit Suisse froze close to $10bn AUD in funds.

What went wrong?

This begs the question, why did IAG actually suspend coverage? What went so wrong? The answer lies not in the Greensill business model itself but around how it handled its risk and we’re quite sure that this is what IAG realised rather slowly. The big red flag for investors, including Softbank, should have come from the fact that when the firm sought a change in auditors due to increased complexity, two of the Big Four accounting firms (and the smaller BDO) all declined the business.

But let’s look at the risk and Greensill’s management of it or lack thereof, a somewhat understandable scenario given the founder and CEO’s propensity for risk-taking and making bold moves. So bold in fact that, despite the firm’s claim of over $163bn in financing and north of 10m customers, by far the biggest and most lucrative client was a single entity, GFG Alliance (the group owned by Sanjeev Gupta). This group owes close to $7.3bn AUD. Not only had the firm engaged in traditional supply-chain finance but they had made loans which were then repackaged, securitised and sold back to GAM Greensill Supply Chain Finance Fund (which has now been closed for subscriptions and redemptions).

Mr Gupta, of course, has conveniently indicated that repayments would be frozen and had previously indicated that GFG itself would file for bankruptcy should Greensill stop providing it with working capital loans. A relationship that had turned particularly toxic and was predicated much upon the personal relationship between the heads of both groups.
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As if the concentration and reliance on one client wasn’t enough, it seems that, on the other end of the spectrum, IAG through its subsidiary BCC was the only substantial insurer. So, the firm in its entirety relied on one client and one insurer to make or break its business. A situation that helped it when it grew rapidly. The GFG and Greensill alliance, though now seemingly toxic, was mutually reinforcing (on the way down too it seems). On the positive for GFG, the loans from Greensill were unsecured.

For the shareholders of IAG? Despite the beating it took at the time of writing, the company has apparently managed to sell off its exposure. The subsidiary, BCC (the entity writing contracts to cover Greensill bonds), actually sold a chunk to Tokio Marine Management, itself owned by three companies all linked to the Mitsubishi UFJ Financial Group (MUFJ) keiretsu. IAG sold its  50% of BCC to Tokio on 9 April 2019 and the deal effectively wiped out any exposure to trade credit insurance. The timing was coincidental, of course. This author would like to know how Mitsubishi feels about this particular coincidence.

Where to Next?

Call me a cynic, but I for one have a feeling that it wasn’t an accident that the working capital issue was left to the last minute. Much of the recent mess may have been avoided with a timely IPO at a requisite valuation and enough of a liquidity injection. No one would have been the wiser. But for now, Apollo Global Management, the private equity firm with enough brains to see a good deal, are probably going to come out on top. They are likely to buy out the business for a tidy $127m, minus the headache of the Gupta loans of course. Remember, this is a business that still made close to $35m AUD in 2019 (that’s net profit) and, if you take out the biggest headache (GFG) and reinsure it with some capital on top, that may just be a decent deal (if done well, one might say, the deal of a lifetime).

As for the Honourable Lex Greensill CBE (oh yes, he’s that too)? The golden boy from Bundaberg might’ve fallen from grace along with his eponymous firm but, somehow, I doubt this will be the last we will see of him. For the moment, the now former rich lister might file for insolvency and be protected under safe harbour laws for whatever is left of his business (after Apollo is finished with its cannibalisation).

For us mere mortals though, it shows us some useful lessons when assessing a business. Always look to the downside, after all, it only took IAG pulling its support and a $7bn business went to 0 almost overnight.

​We are at a very interesting juncture in capital markets. Equity markets have moved a long way up from the short term Covid induced nadir about a year ago. Profit taking always happens at some point and halfway through this February was that moment. Global Equity markets still rose c.2.5% in US$ terms. By way of comparison the Global Government Bond Index declined c.1% as long rates rose and the yield curve steepened.

It is still our view that for investors certain equities remain a better option than cash which yields nothing and government bonds which are fast becoming a return free risk as opposed to a risk free return. However, we want to make clear again that we are at a defining moment in capital markets and policy making.

Market participants have been told clearly and repeatedly by central banks, that there is no reason to raise interest rates. So much is clear but what is NOT clear is what the intentions are towards the longer end of the yield curve – an area which typically central bankers have left to market participants to set the price and yield. The defining moment is here because so much QE and now potentially another large fiscal programme (=8% of US GDP) has created a significant back up in the price of the 10 year US note. The SHAPE of the yield curve is steepening since investors rightly fear continued abuse of the fiat money system and continued inflation well over 2% (in some areas it is already here); and it is this and not the level of short rates that the equity market is now correctly focusing upon. What will the Fed do (they will say they are not concerned) about this?

So we will briefly make the following observations

• Steeper yield curves presage stronger nominal GDP and a shift in equity styles whereby Value will do better than Growth
• The time value of money with a steeper yield curve, means that it now matters WHEN profits and dividends are paid to investors. The longer you wait, the less value
• Central banks will have to shortly decide whether to let this rise continue or to intervene. At some point, quite soon actually, the SHAPE of the US yield curve will be the same as it was in May 2013 when we had a big ‘taper tantrum’.
• IF they decide to intervene to prevent this taper tantrum, then we will ponder how and how much AND whether they will return us to the 1950s when we had centrally directed capital allocation to buy government debt issuance. Do not rule this out. Much as the 1950s financial repression was necessitated by financing two wars, we have had a similar ‘war on Covid and have debt levels typically associated with wars.
• At some point continued expansion of the Fed balance sheet will itself call into question the value of fiat money.
• If they decide to return us somewhat to capitalism, and let the long end find a natural level given inflation expectations, then the long term benefits will be pleasing BUT SOME companies and bonds will not make it through. The cost of refinancing will be too high. Do not invest in loss making or companies whose multiples are stratospheric. (Scott McNealy’s words from 2001 should come to mind)
• This dilemma has been handed to Jay Powell by his predecessors. This has been about 25 years in the making and asymmetrical monetary policy (always cut more than you sometimes raise) and now fiscal incontinence make for a heady combination and typically mean inflation.
• Much like managing a forest – small frequent fires (recessions) are a lot better than letting the detritus build up and then having a MONSTROUS blaze (depression). Sadly we have had the latter over the last 25 years; and it has essentially been ‘monetary policy for rich people’.
• There is hope! A recent but somewhat unnoticed comment came from the New York Fed President, John Williams, when he said that a higher minimum wage would work best to support the economy AND that there is some evidence that low interest rates can move asset prices disproportionately held by wealthy households.  It’s a start.

Significant price changes in the month occurred in Industrials, Basic Materials and Energy companies. Valero, one of the world’s most sophisticated refining complexes, rose almost 40% in February as the market reappraised the need for non-renewable energy sources and downstream products. In Texas there was a complete blackout caused by unusually cold weather, raising the obvious point that renewables should be a piece of the generating capacity, but not all of it, and that natural gas is both clean and easily stored and transported. Texas, needless to say, has a number of peculiarities about its power system but a need for better and more investment in USA infrastructure is clear.

On March 3rd (US time) the American Society of Civil Engineers, releases its quadrennial report on the state of USA Infrastructure. Last time, in 2017, the grade was D+. Surprisingly, it went up and there will be a lot more interested readers this time.

​Other significant company developments were Sony’s results (beat and raise) Quest Diagnostics (beat and raise) and Discovery A shares where the share price rose 25% as they announced strong subscriber growth for their streaming service. Over the last 1 2 and 3 years at the time of writing, Discovery A shares have outperformed those of Netflix.

We sold Nexon in Japan and reinvested in Kurita Water. We sold Legal & General in the UK and reinvested in Euronext the French based European exchanges owner operator. We took large profits in Hong Kong Exchanges where the share price had run up on the basis of the exchange receiving an infinite number of mainland China listings, no longer welcome via ADR in the USA. It is a large opportunity for HK in a region where other exchanges are lamentably short of large and quality companies, but everything and more is in the price. We reinvested into China Construction Bank H shares which are on a wide discount to the A shares and the Chinese financial system appears to be pulling back from wilder excesses. Some companies are allowed to default to the detriment of executives and bond holders. If only the USA was quite so enlightened.

In the medium term, infrastructure companies in the US especially will be subject to news flow surrounding the Green Energy Policy and thus volatile, but their revenue bases are stable and dividend yields attractive. The return of National Industrial Policy (also a nudge upward for inflation) will make logistics, storage and transport companies attractive – globally. Industrial companies likewise. Asia including Japan remains financially, economically and now geopolitically strong, and so is a favoured area.

How far we have come within the space of 12 months. Negative rates, negative energy prices to the polar opposite across everything from a resurgent oil price and a decade high in the price of Dr. Copper, a favourite inflation gauge for market participants. Add in a $1.9tn USD stimulus package and we have a seemingly perfect storm lined up.
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But hang on a minute, how have inflation fears catalysed a sell-off in gold? Isn’t it meant to be a hedge? And why are energy prices so resurgent despite a considerable segment of the planet still in lockdown? Moreover, the yields at the long-end of the curve that’s on everybody’s minds are at a stellar 1.37% on US 10-years, I don’t know about the readership, that doesn’t sound like a particularly attractive prospect to me. This is especially the case when official targets for inflation are around 2% (depending on country), you’re effectively telling me I should lend you money and you will pay back less than what I gave you 10-years from now? So let us try and unpack that for a moment.

Do treasury yields actually mean what they used to? 

Let me give you a couple of simple statistics.

365%. That is the estimate of the global debt-to-GDP ratio to finish 2020.

106%. That was the public debt-to-GDP ratio in the US to end 2019. It is now closer to 130% (and likely to continue to grow disproportionately given the packages and budgetary measures currently under review on the Hill).

Think through this for a moment, what does even a 10 basis point increase in yield on the long-end imply in terms of debt servicing? More importantly, is any central bank likely to stomach that increase?
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We have already seen Christine Lagarde of the ECB make a statement mentioning that they will be closely monitoring yields on the long-end. Stateside, Powell might very well be in a similar situation. This is not the same as the days of Volcker where debt-to-GDP ratios were a more manageable 70-80%. The tax base is not enough across most of the western world to support increases to debt-servicing requirements. The ruling out of yield curve control Stateside will, in my view, go the same direction as Lowe’s ruling out of QE in Australia back at the beginning of last year.

Simply put, yields will continue to rise as the market continues to factor in the potential for greater issuance of public debt and a resurgent economy. Where they might get it wrong, and what investors are seemingly ignoring, is a central banker caught between a rock and a hard place. There will be suppression of yields and government debt will be issued on the long-end. A scenario that increases the likelihood of inflation and yield suppression if within a reasonable range.
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The government will issue, the central bank will buy, thus creating more money supply. Yes, I’ve just said it, debt monetisation. In fact, since the beginning of covid-19 the Federal Reserve has bought close $3.5tn in bonds in 2020 alone, the Bank of England allowed an overdraft of the government account and Australia has seen its central bank buy government securities, though on the shorter end of the curve, to put a lid on the yields.

Why inflation now? 

It was during the depths of the GFC that central banks embarked upon then unconventional policy in the form of quantitative easing (after a certain amount of time, unconventional becomes conventional). Many doomsayers suggested that this might give rise to runaway inflation. It didn’t. Because they forgot one thing, increasing bank reserves doesn’t necessarily translate into the real economy, it just shows up in asset valuations rather than consumer discretionary spending.

However, where things change and the real economy gets impacted directly is direct stimulus measures. Take, for example, the stimulus cheques now under consideration. That is new money supply into the economy. Similarly, infrastructure projects that add to GDP but also contribute actual jobs. This comes along at the same time as increasingly frosty relationships between the major geopolitical powers of the day. I am of the view that technology wasn’t entirely the reason for the deflation of the past, rather the greatest deflationary event of the past two decades was China, which not only enabled cheaper production but stagnant wage growth across most of the western world. Something that, somewhat ironically, was good for the investor, may not have been the case for the average wage earner but, lets face it, we’ve done well out of it.

This situation of globalised supply chains led to things like Just-in-Time inventory systems, centralisation of healthcare systems, lowest cost production. All seemingly good things but what it also does is underinvestment in those very things as the costs continue to be driven down.

What happens when bottlenecks are introduced out of the blue, tough? A bottleneck like an economic lockdown due to a pandemic perhaps? Re-localisation of supply chains because of a shift in geopolitical priorities/government policy? Last week I wrote about the shortage in semiconductors within the automotive segment. We are seeing similar things in commodities, such as copper, which saw massive underinvestment for close to a decade due to uneconomic prices. But what happens if you add in potential for infrastructure projects, like renewables, while at the same time lacking an existing supply pipeline to deal with the increase? Is it any wonder that the Chinese have been the most aggressive buyers within that particular market?

So what am I trying to say?

I remain exceptionally bearish on global treasuries and USD overall. What we have seen through much of the year so far are short-term pivots. Precious metals are not selling off because the yields make such an attractive proposition, it is rather investors taking cash off the table after a run-up in the market to move towards re-allocation. If you sell-off your treasuries, the process is first to cash before you make a further allocation (thus putting a short-term upward pressure on the currency). In circular trajectory, once that happens and the yield goes up even slightly, it is the high-growth stocks (precisely those that have done well during Covid) but stand on premium valuations that get sold off (all of a sudden you can use a discount rate). Similarly, a short-term spike in the USD leads to a short-term sell-off in Gold due to the inverse correlation.

I remain of the conviction that we will see inflation coming back into the picture but not yet and yields certainly will not be going up in proportion. This is not necessarily a bad thing for the investor. It should only be concerning if said picture gets out of hand. We will continue to see accommodative monetary policy that drives markets but with the caveat that some of the higher-growth names you are used to might not see the same returns. More importantly, as fiscal expansion continues across most of the developed world, we will see every indicator of broad money supply increase and ridiculous valuations across anything that has scarcity value (even Bitcoin, though this author doesn’t quite understand that particular market).

What has been interesting to watch is the money flow towards pockets such as the Dow, industrials and emerging/Asian markets.

​How to allocate? 

In every economic expansion cycle over the past two centuries, inflation doesn’t hurt in the initial stages. As governments continue to occupy a greater proportion of GDP, we will see two things happen, household debt will proportionally decrease (i.e. crowding out) and corporate debt remains somewhat manageable (take a large firm such as Berkshire, for example, which issued debt at 105bps in 2020) as you effectively eat away the real value of the debt. We might quite literally have the Roaring Twenties roar back to life.

Remember that your portfolio should have three different pockets; the contrarian, income/defensive and a growth pocket. These react in different ways depending on the situation. Your defensives won’t do well in a bull market but that’s how they’re supposed to behave, precious metals fall in this category too (it doesn’t yield anything and it has no intrinsic value but it is an evergreen hedge against uncertainty, not inflation but uncertainty). Your growth will be healthcare and technology with the caveat of long secular growth stories, not the hype of the day, but SECULAR. Think about artificial intelligence, mobility or emerging markets. The third pocket, the contrarian, is the one that is an allocation assuming you have everything wrong (i.e. not contrarian to the market but contrary to your base case). Again for Australian investors, strap your belts, we are the beginning of a bull cycle in commodities.

Disclaimer: The Roaring Twenties (a name coined by Fitzgerald) weren’t “roaring” for everyone, with the most common job in the US being farming/agriculture. Harding was exceptionally kind to the investor, much like one recent ex-President, and the economy had deflation as opposed to inflation. In the words of Twain, “History doesn’t repeat itself, but it often rhymes.”

Conclusion? The music is still playing for now, it might even get louder. Dance while you can.

This is definitely worth thinking about at some point but it shouldn’t affect your investing decisions just yet.

And now a non-exhaustive list of other things life is too short to worry about:

1. Having one more TimTam
2. The lack of fundamentals behind Tesla’s share price
3. Gossip
4. Missing the train/bus
5. What happened last night on MAFs