The BAN Report: Inverted Yield Curve / Strong Retail Data / FDIC Risk Report / WeWork IPO-8/15/19
Inverted Yield Curve
World markets plummeted this week as the yield curve inverted.
The yield on the benchmark 10-year Treasury note broke below the 2-year rate early Wednesday, an odd bond market phenomenon that has been a reliable, albeit early, indicator for economic recessions.
The yield on U.S. 30-year bond also turned heads on Wall Street during Wednesday’s session as it fell to an all-time low, dropping past its prior record notched in summer 2016. The two historic moves coming in tandem show that investors are increasingly worried, and indeed preparing for, a slowdown in both the U.S. and global economies.
Earlier Wednesday, the yield on the benchmark 10-year Treasury note was at 1.623%, below the 2-year yield at 1.634%. In practice, that means that investors are better compensated for loaning the U.S. over two years than they are for loaning for 10 years. The yields steepened later in the session, pushing the 10-year rate back above that of the 2-year note at 1.58%.
Data from Credit Suisse going back to 1978 shows:
- The last five 2-10 inversions have eventually led to recessions.
- A recession occurs, on average, 22 months following a 2-10 inversion.
- The S&P 500 is up, on average, 12% one year after a 2-10 inversion.
- It’s not until about 18 months after an inversion when the stock market usually turns and posts negative returns.
Going farther back in history, the yield curve’s track record gets a little more spotty. Post WWII, inversions have predicted seven of the last nine recessions, according to Sung Won Sohn, professor of economics at Loyola Marymount University and president of SS Economics.
While much of the economic news is positive (low unemployment, strong GDP growth, etc.), an inverted yield curve is an alarming sign. The risks of a recession will lessen if there is a favorable resolution of the US / China trade dispute, but a recession seems likely if trade tensions continue to worsen.
Strong Retail Data
Retail data was encouraging this week as Walmart reported strong sales and raised forecasts for the year.
Walmart Inc. said sales rose in the second quarter and it raised its profit forecasts for the year, extending the retail giant’s multiyear streak of growth as it takes market share from struggling competitors and expands online.
Sales at U.S. stores and websites operating at least 12 months grew 2.8%, due to strong grocery sales, online and off, and slightly more shoppers visiting stores and websites. U.S. e-commerce sales rose 37%.
“We’re gaining market share. We’re on track to exceed our original earnings expectations for the year,” said Walmart CEO Doug McMillon Thursday in a release.
Walmart now expects U.S. comparable sales to rise at the upper end of a 2.5% to 3% range for the full year, an improvement from an earlier prediction of sales falling somewhere in that range.
Meanwhile, retail sales in July jumped.
Retail sales, a measure of purchases at stores, restaurants and online, climbed a seasonally adjusted 0.7% in July from a month earlier, well above economists’ expectations, the Commerce Department said Thursday. Excluding autos, retail sales were up a robust 1.0% in July.
The broader trend this year shows steady growth in retail sales. Consumer spending increased 1.8% in the May through July period compared with the previous three months.
Americans increased their outlays in July at electronics stores, clothing stores and restaurants. Online sales were particularly strong, a possible result of Amazon.com Inc. ’s Prime Day, a day of deals on the e-commerce site.
“U.S. consumers continue to do very well,” said Ben Ayers, senior economist at Nationwide. “As consumers continue to see income gains and positive job gains…that’s obviously good news for growth and should keep us on a positive track for a while.”
Consumer spending is more than 2/3 of the economy and the consumer is strong. Lower interest rates could also boost the housing market as well.
FDIC Risk Report
Earlier this month, the FDIC released its new annual risk review. The FDIC identified six key risk areas to banks, including Agriculture, Commercial Real Estate, Energy, Housing, Leveraged Lending and Corporate Debt, and Nonbank Financial Institution Lending.
The agricultural economy is now in its sixth year of low commodity prices and farm incomes, and agricultural exports have reflected pressure from trade uncertainties and slowing global growth. A slowdown in the agricultural economy is an important risk to the FDIC because farm banks are a large source of financing for the agriculture industry and represent about one-fourth of banks in the United States.
Commercial real estate (CRE) market fundamentals remain favorable as the economic cycle matures. However, outstanding CRE loan balances are rising, and competition among lenders to maintain market share in the face of slowing loan growth is increasing.
U.S. oil production reached record highs in 2018, but the energy industry is susceptible to volatility that has produced past boom and bust cycles. Banks most exposed to this geographically concentrated industry are vulnerable to future downturns
The housing market began to slow in 2018 as concerns about affordability intensified. Banks with concentrations in this portfolio could be vulnerable to the slowdown, but credit quality has been resilient so far.
Nonfinancial corporate debt as a share of gross domestic product (GDP) has reached a record high level. The increase has been driven by growth in corporate bonds and leveraged loans, which have become increasingly risky as the share of low-rated bonds has grown and lender protections in leveraged loans have deteriorated.
By lending to nondepository financial institutions, banks are increasingly accruing direct and indirect exposures to these institutions and to the risks inherent in the activities and markets in which they engage.
The last one is particularly interesting, as much of the riskiest lending has been pushed to non-bank lenders, who are financed typically with warehouse facilities from banks. For example, when the regulators cracked down on leverage lending several years ago, the credit shifted from banks to non-banks. We are already seeing material weaknesses in non-bank lending portfolios that could have larger repercussions.
Financial analysts are foaming at the mouth in criticism of WeWork’s filing for an IPO this week. Bloomberg was especially critical.
The financial disclosures make it clear that WeWork — which, it should be said, is a commerce office leasing company and not truly a tech company — shares the hallmarks of Uber Technologies Inc. and other high-profile young technology startups.
At this point in WeWork’s life, it’s tough to assess whether the company is economically viable in the long term. Its growth is overwhelming, but it’s not clear that it got there in a sustainable way. This company is a leap of faith, as are many of the young tech-ish companies hitting the stock market. Many of them have done poorly as public market stocks.
In short, everything about WeWork is utterly odd. It is a real estate company valued like a tech company. It is a young company with questionable economics that has committed to paying tens of billions of dollars in future years for office building leases. This is a company whose intricate relationships with its chief executive requires 10 pages of disclosures. And this may be the first time I’ve seen an IPO filing with a section titled “Expected Resilience in a Downturn.”
WeWork may be the most magical creature in the last decade of richly valued “unicorn” startups that are attempting to bust up established industries. Its ambition is ambitious even by unicorn standards. So are its growth, losses, potential conflicts of interest and financial gymnastics. Succeed or fail, at least WeWork is not boring.
We’ve seen this formula before. Differentiate a company that is very much like another company (in this case Regus) and convince Wall Street that you are a technology company and deserve a much higher valuation. Regus filed for bankruptcy over a decade ago, so one wonders how the WeWork model will survive a recession. In the first six months of the year, WeWork lost nearly $700 million on $1.54 billion in revenue – a negative 45% net margin.
The BAN Report: China Devalues / HSBC Tosses CEO / Drugstore Disruption / Open Plan Offices Stink / Can’t Live Alone in NYC on 100K-8/8/19