A 'Powder Keg' Ready to Blow
Your last chance to learn Jeff's gold-trading strategy... Apple reports its first sales decline in 15 years... But growth could be just around the corner... SocGen echoes Porter... Corporate debt is a 'major risk'... Ratings 'inflation' is back... A 'powder keg' ready to blow... Global risks are rising like never before... P.J. O'Rourke: My own personal fantasy political league...
Before we begin today's Digest, a quick reminder...
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Apple reports its first sales decline in 15 years...
Consumer-electronics giant Apple (AAPL) reported quarterly results yesterday after the market close. And the headline numbers weren't great...
The company reported a decline in revenue and profit for the third straight quarter. It also reported its first annual decline in both measures since 2001. Revenue fell 9% to $46.9 billion last quarter, while earnings fell 19% to $9 billion, or $1.67 per share.
But it wasn't all bad news...
Despite its first full-year decline in earnings in 15 years, Apple remains the most profitable company in the U.S. It still earned an incredible $45.7 billion over the past 12 months. And last quarter's lower earnings still came in above analyst expectations of $1.66 per share.
The company also noted strong year-over-year growth of 24% in its services business, which includes Apple Music, iTunes, and its App Store. And perhaps most important, last quarter ended just one week into the launch of Apple's new iPhone 7, which has been selling better than many analysts expected. As CEO Tim Cook noted in the company's earnings call last night, "The customer response has really been off the charts... We couldn't be more happy with how it's been received."
In fact, the company says it now expects to return to growth as early as this quarter. From Dow Jones Newswires...
Apple issued a bullish forecast for the current quarter, which includes both the holiday-shopping season and sales of its new phone. The company said it expects revenue of $76 billion to $78 billion in the quarter, which would be an increase from $75.9 billion in the same period a year earlier. Before Apple's announcement, analysts had been expecting revenue in the current quarter of $74.9 billion, according to FactSet.
Apple also projected gross margin, a closely watched measure of profitability, of 38% to 38.5%, even to slightly up from 38% in the just-completed quarter.
Neil Cybart, an independent analyst who follows Apple, said the revenue projection for the current quarter implies that Apple expects iPhone unit sales to increase more than 5% from a year earlier, when the iPhone 6S was its newest model.
The news suggests Apple's dominance may not be over yet... And folks who panicked and sold shares earlier this year may regret that decision. As our colleague Dr. David "Doc" Eifrig shared in the May 17 Digest...
There's no reasonable explanation for why Apple isn't worth more than its current valuation.
People are obsessed with growth these days and are hypersensitive to the news. The headlines trumpeted Apple's earnings miss as if it were the death of the company. Short-sighted investors sold. But Apple remains one of the most profitable and healthiest companies in the history of the world. No headline or tweet should cause you to forget that.
While shares declined about 3% today, they are still up more than 20% since Doc's prescient call.
U.S. corporate debt is a "major risk"...
So says Andrew Lapthorne, global head of quantitative strategy for French bank Société Générale.
Late last week – in a note that sounded remarkably similar to Porter's warnings here in the Digest – Lapthorne warned that the outlook for U.S. businesses continues to deteriorate.
He noted that companies have been "overspending" like never before in history. As Porter has explained, they've been loading up on record amounts of debt to buy back their own stock and boost earnings per share.
Meanwhile, he also warned that their ability to finance all that debt is increasingly uncertain. He believes U.S. corporate profitability is now in a "cyclical downtrend," and the earnings "recession" is likely to continue.
In short, like Porter, Lapthorne believes this situation is unsustainable... and it is certain to end badly. As he wrote, "Asset valuations are extreme; returns are poor, the probability of losses is high and the ability to recover any losses quickly is low."
Credit-rating "inflation" is back...
Speaking of the corporate debt binge, it appears the credit-ratings agencies have been quietly helping the bubble grow larger... just as they did during the housing bubble last decade.
Bloomberg reports the two biggest firms – Moody's and S&P Global Ratings – have been cutting the largest companies "slack" so they can take on debt more cheaply for mergers and acquisitions. From the article...
Over the past year and a half, both have bumped up their ratings by two, three or even six levels on a majority of the biggest deals, the analysis found.
For example, suppose the debt of a particular highly leveraged company might usually be rated BBB-, which is the lowest (riskiest) level of investment-grade debt. According to this report – which, by the way, the ratings agencies do not deny – they have recently been rating them higher. Instead of BBB-, this debt might be rated BBB+ or even as high as AA-.
Why does this matter? Because it would allow the company to borrow more money at a lower cost.
Unfortunately, as we saw during the financial crisis – when these same agencies "inflated" the ratings of large swaths of mortgage debt – this can also give investors the impression they're buying something that is far safer than it actually is.
According to investment bank Barclays, $258 billion of the record $1.6 trillion in new investment-grade issuance in 2015 was used to finance acquisitions. And corporations are on pace to borrow even more this year.
In other words, this could be a serious problem. As Jerry Cudzil, head of U.S. credit trading for money manager TCW Group noted to Bloomberg...
You have some very large companies that are getting the benefit of the doubt from ratings agencies and from the market. The longer this goes on, the higher the likelihood that all of that leads to not only financial losses but to a significant slowdown in the economy and ultimately a recession.
A "powder keg" ready to blow...
Elsewhere in the bond market, a potentially greater problem continues to grow...
One of the most concerning effects of unprecedented central bank easing has been the rush into higher-yielding debt. And a huge portion of this money has gone into long-term government bonds...
In fact, Bloomberg data show $733 billion has flowed into government bonds due in 10 years or more so far this year. This is the most on record... and it's only October.
As regular Digest readers know, these folks are likely taking on much greater risks than they realize. This is due to something called "duration," a measure of a bond's interest-rate risk. As we wrote in the May 12 Digest...
Bonds with longer maturities generally have higher durations. This means they're more sensitive to changes in interest rates.
For example, according to Wall Street Journal data, one-year U.S. Treasurys have effective duration of 0.959 years. In simple terms, this means that one-year Treasurys will fall about 0.96% in price for every percentage point increase in yield.
By comparison, 10-year Treasury notes currently have a duration of 9.184 years (representing a 9.2% decline for every percentage increase in yield) and 30-year Treasurys have a duration of 20.692 years (representing a 20.1% decline for every percentage point increase in yield).
In other words, the further out in time investors reach for yield, the more likely it becomes that even a small increase in rates could create massive losses that would wipe out the entire expected annual yield.
The record-breaking rush of money into long-term bonds has also pushed duration to record levels across the globe. As Bloomberg reports...
Duration is at or near unprecedented levels across sovereign debt markets. The effective duration on Bank of America's global government bond index climbed to an all-time high of 8.23 in 2016, from 5 when it began in 1997. The metric set a record 5.9 for U.S. obligations, 7.2 across the euro area and 8.8 in Japan.
That means the stakes are high: a one-percentage point increase in interest rates equates to $2.1 trillion in losses for global investors, based on a Bloomberg Barclays sovereign-debt index. That magnitude of yield swing isn't necessarily a rare event. Benchmark 10-year Treasury yields have climbed by that amount over the course of a calendar year 10 times in the past four decades, twice as frequent as a 10 percent slide in the S&P 500 index.
If you still own long-dated bonds, what are you waiting for? According to Kathleen Gaffney, a money manager who runs this year's top-performing U.S. bond fund, long-term bonds are a "powder keg" ready to blow... And investors would be wise to raise cash and reduce duration immediately...
"Rates are rising from a very, very low base, which means there's lots of downside and very little upside... If you don't know how to time it, and I certainly don't, you just want to get out of the way."
Global risks are rising together like never before...
Today, we're seeing unprecedented warning signs in credit markets all around the world...
The global scale of these problems means the coming crisis – what Porter has called "the greatest legal transfer of wealth in history" – will be truly historic.
Folks who don't see what's coming could be wiped out... while those who prepare now could set themselves up to earn a fortune as the inevitable bust plays out.
This is why we're launching our brand-new Stansberry's Big Trade service next month.
You can learn more now – including how you can get immediate access to all of our preliminary research BEFORE Stansberry's Big Trade officially launches next month – by clicking here.
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New 52-week highs (as of 10/25/16): Nuveen Floating Rate Income Opportunity Fund (JRO), iShares MSCI Global Metals & Mining Producers Fund (PICK), and ProShares Ultra MSCI Brazil Capped Fund (UBR).
In today's mailbag, a subscriber is also skeptical of AT&T's new deal. Send your notes to feedback@stansberryresearch.com. And be sure to read on past the mailbag for the latest from contributing editor P.J. O'Rourke.
"People have short memories. AT&T tried the same thing in 1998-1999 with the acquisitions of TCI, MediaOne, and Prime Cable, with horrible results... This one sentence from Wikipedia summarizes AT&T's prior success with cable operators: 'AT&T spent over $105 billion to form the cable unit, agreed to sell to Comcast initially for $72 billion, but settled at $47.5 billion due to the declining market.' Talk about destruction of shareholder wealth! I know which side I will place my bets on whether this one will work out or not." – Paid-up subscriber Frank P.
Regards,
Justin Brill
Baltimore, Maryland
October 26, 2016
My Own Personal Fantasy Political League
As I've mentioned about 100 times before, I'm very unhappy with this election. And I can't do anything to fix it. So I'm going to give up and retreat into fantasy.
No matter how bad reality is, you can always use your imagination. Wish upon a star for hope and change. (Or did somebody try that already?)
Anyway, come with me to the Land of Make Believe.
Let's pretend that a good, respectable, intelligent, decent, honest, and reasonable Democrat is running for president against a good, respectable, intelligent, decent, honest, and responsible Republican.
Quit laughing! We're trying to have a daydream here.
As long as we're dreaming, let's make the Democrat a working-class guy from the Rust Belt, a skilled machinist for instance, who runs a small business, has to make payroll, and feels the full effect of OSHA, EPA, EEOC, Obamacare, and every other government regulatory burden.
And – since we're talking unicorns, flying ponies, and candy-flavored rainbows – let's make the Republican a minority woman from a disadvantaged background.
I have nothing against GOP presidential candidates being random old white men. I'm one of them myself. But it's about time Republicans heard from somebody – other than a brain surgeon or a governor of Alaska – who knows what it feels like to be an outsider.
The way America's identity politics, partisan animosities, and factionalized society are going, everybody is going to be feeling like an outsider soon. The GOP should get ahead of the curve.
But I'm talking about reality again, and I promised not to do that. Let's get back to our castle in the sky.
Suppose these two ideal candidates debate each other. Do you think their debate would sound anything like the ones we've heard this year? That wouldn't be a dream. That would be a nightmare.
In our imaginary perfect world, we wouldn't even need a moderator. (As far as I can tell, the only reason we had moderators in the real-world 2016 debates was to bring the average IQ on stage up to three figures.)
Our ideal candidates flip a coin to see who goes first. They speak briefly with opening remarks, listen to what the other candidate says without interrupting, and then respond.
Our Republican wins the toss. She begins...
Good Republican: The most important issues facing our nation are the federal debt and deficit. When you find yourself down in a hole, quit digging. If we don't get government overspending under control, we will end up with the soaring consumer price index and plunging economy last seen during the "stagflation" era of the 1970s and – heaven forbid – disco might make a comeback.
Good Democrat: I agree with my esteemed opponent about the dangers of the debt and deficit – and disco. But America has been down in this debt-and-deficit hole before, after World War II and the Civil War. In both cases, rapid economic growth was our ladder out.
I believe the most important issue facing our nation is economic growth. I believe government has a role to play in stimulating growth through wise spending on much-needed infrastructure. And I mean wise spending – not sticking Solyndra solar panels where the sun never shines or building a light rail to get stoned millennials back to their shared housing in downtown Portland.
GR: Yes, fixing the debt and deficit without economic growth would be like trout fishing in Death Valley. I'd stimulate the economy by cutting taxes and reduce the deficit by cutting spending. We know cutting taxes stimulates the economy. It's so obvious, even a Death Valley dead trout would understand – having more money makes you richer.
As for spending, the U.S. gross domestic product is about $18 trillion. Combined U.S. federal, state, and local government spending is about $6.5 trillion. That's more than a third of GDP. Oughta be enough! If you were sending a check for a third of your income every month to your stoned millennial kid in Portland, he could use Uber.
GD: Fortunately, my millennial kid works in the family machine shop back in Cleveland and limits himself to a couple of beers on the weekend. However, I take your point.
Unfortunately, about two-thirds of the federal budget goes to entitlement programs. And politicians from both parties have been about as willing and able as your dead trout to tackle entitlement cuts. I'd be a big liar if I said I had a quick fix for entitlement spending, even if I had majority support in the House and Senate.
Also, let us not forget that while entitlements can be – and are – abused, they also provide a lot of help to people who would be helpless without them. For example, Social Security, for all its problems, virtually eliminated severe poverty among the elderly in America. Let's be honest here, do you really want your mother-in-law living in your spare bedroom until she's 103?
GR: You met my mother-in-law when our families went to church together. No, I don't.
GD: I also take your point about taxes, they are too high for some people. But then again, for some other people, maybe they're not high enough. While we're being honest, let me point out that I'm a Democrat. I will raise taxes on very rich people. Even Adam Smith, of whom you Republicans are so fond, had something to say in favor of a graduated income tax.
Smith pointed out that one of the principle duties of government is to protect property. People with a lot of property should pay a higher rate of taxation because they get a higher rate of protection. Paying taxes is like paying for a guard dog. But if you don't have anything to guard, all you're paying for is a stray pit bull.
GR: We'll have to agree to disagree about rates of taxation. But you must admit our tax system is a mess. The U.S. tax code is now 4 million words long. If you printed that out and dropped it on a taxpayer, it would squash him flat.
GD: Yeah, he'd be roadkill. You could peel him off the highway and sail him like a frisbee.
GR: We have to do something about that.
GD: We sure do. I have some specific ideas about how to do it.
GR: So do I. Let's discuss them...
And the debate would continue in such a manner – substantive, but good-natured – for exactly one hour. Because, no matter how good presidential candidates are, an hour of listening to them is all we can stand, even in our dreams.
At the end of the debate, the Good Republican would say to the Good Democrat, "You obviously care about people. If I'm elected, I'm going to appoint you Secretary of Health and Human Services – and of Education, too, because, to save money, I'm going to eliminate that Cabinet post and put it back into the Department of Health, Education, and Welfare."
The Good Democrat would say to the Good Republican, "You're obviously sharp about fiscal and monetary policy. If I'm elected, I'm going to appoint you Secretary of the Treasury."
And then they'd hug.
Now I'll wake up and wipe the drool off my face.
Regards,
P.J. O'Rourke