The First Signs of 'Fallout' From Rising Rates
More bad news for GE… Why the latest rally is unlikely to last… The first signs of 'fallout' from rising rates… An 8-year high in mortgage rates… Auto lenders are pulling back… Why yields could be headed even higher…
It's been a rough summer for a couple of our favorite 'whipping boys'...
Yesterday, we discussed the latest in the ongoing saga of electric carmaker Tesla and its increasingly erratic CEO Elon Musk. But Tesla isn't the only familiar name making headlines of late...
Back in June, we noted that General Electric (GE) was booted from the Dow Jones Industrial Average after more than 110 years. As we mentioned at the time, this wasn't particularly surprising... GE was the worst-performing stock in the Dow for the previous five years. But it was a stark reminder of just how far the once-iconic company had fallen. Unfortunately, the news hasn't gotten any better since...
Early last week, GE announced the ouster of CEO John Flannery, who had served just 14 months in the role. The company also warned that cash flow and earnings for the year would come in well below previous guidance, and announced that it plans to write off another $23 billion stemming from its struggling power business – its largest division.
The following day,
Like before, this news wasn't entirely unexpected...
Flannery had promised to "turn around" the troubled industrial conglomerate. So we weren't shocked to learn that the board was unimpressed with his progress to date. It appointed Larry Culp – the highly-respected former CEO of successful global conglomerate Danaher – as Flannery's replacement, marking the first time in GE's history that it has gone with an outside hire.
Of course, longtime Digest readers know we're skeptical that GE will ever return to its former glory, regardless of who's at the helm. As Porter explained in an update in the January 19 Digest earlier this year...
GE still holds billions in financial assets of dubious quality, financed by more than $130 billion in debt. Meanwhile, the company's cash return on assets is only 1%. In other words, as interest rates rise, the company is going to have a hard time financing its portfolio of financial assets.
But that's not the big problem. The big problem is what lies at the center of this company, hidden in those financial assets, is an enormous fraud.
The latest example is a $6.2 billion charge in its insurance unit... that will require another $15 billion in reserves over the next seven years. The charge and the demand for new reserves came from a Kansas Insurance Department investigation.
And these problems will become significantly worse as interest rates rise...
That's because GE is already struggling to pay merely the interest on its massive debt loads. As Porter noted a few months later in the April 27 Digest...
[GE is] saddled with more than $60 billion in net long-term debt. (Please note: That's net debt – after subtracting all of GE's cash.) Even with record-low interest rates, GE still faces interest obligations of almost $3 billion per year.
And here's the problem: These interest rates are likely to rise a lot faster than GE's ability to grow earnings. Currently, GE earns only $3.6 billion a year, when measured by "EBIT" – that's earnings before interest and taxes. If its interest expenses grow and its earnings don't keep up, GE will have a difficult time paying its debts in its current structure.
And don't forget, GE requires at least $7 billion a year in capital investments (capex) to maintain its facilities and position its businesses for future growth. In other words, while GE can do some things to avoid bankruptcy (like cutting its annual capex spending), it isn't earning enough capital to finance both its debts and future growth.
GE bulls cheered the news of Flannery's departure...
Shares jumped as much as 16% following the announcement – marking their biggest intraday rally in nearly a decade – and have continued higher since. They're now up nearly 21% so far this month.
Still, even after the recent rally, GE shares are down more than 40% over the past 12 months. And again, we don't expect the celebration to last long. GE has quietly written off roughly $40 billion in questionable assets over the past two years, but much more is likely to come.
Speaking of rising interest rates...
Regular readers know the yield on benchmark 10-year Treasury notes has surged from near 2.80% in late August to more than 3.20% today. The yield on 30-year Treasury bonds has risen from just below 3.00% to near 3.40% over that time.
These are significant moves over a relatively short period of time. And we may already be seeing the first signs that higher rates are beginning to weigh on the broad economy.
For example, the average rate on 30-year mortgages has now passed 5% for the first time in eight years, according to Mortgage News Daily. While we have yet to see a significant decline in home prices, we were already on pace for the first year-over-year decline in home sales since the financial crisis. Higher mortgage rates are likely to dampen sales even further.
Meanwhile, data suggest auto lenders are suddenly pulling back from cheap financing for the first time in years. As the Wall Street Journal reported on Sunday...
In September, the percentage of new cars financed with an interest rate of 1% or less fell to 5.3% for the month, down from 8.2% in September 2017 and 11.7% in September 2016, the year U.S. auto sales peaked, according to market research firm J.D. Power. No-interest loans have become even scarcer, accounting for 3.4% of all new-car financing in September, down from 9.1% two years ago, J.D. Power said.
Overall financing rates on new-car loans have also crept up... The average financing rate for a new-car purchase was 5.75% in the second quarter, up from 4.82% two years ago when auto sales were at their strongest, according to Experian Automotive.
"You're definitely seeing the entire industry pulling back," said Jack Hollis, general manager of Toyota North America, of the scaling back of interest-free auto loans. "Obviously, interest rates rising is a reality in the marketplace, and we're going to react."
Unfortunately, we believe this trend could continue...
And the biggest reason comes down to simple supply and demand: The Federal Reserve is unwinding its massive
With tax cuts by President Donald Trump's administration putting the U.S. budget deficit on track to hit $1 trillion next year, Steven Mnuchin's Treasury plans to borrow $770 billion in the second half of 2018, a more than 60% increase from the same period last year.
Meanwhile, the central bank will increase the pace at which it shrinks its holdings of Treasury and federal agency bonds by a quarter in October, to $50 billion a month.
The net impact is dramatic. BlackRock estimates that the net supply of Treasury securities will more than double this year, to over $900 billion, and rise to nearly $1.2 trillion in 2019. The market hasn't had to digest that much government debt since 2010.
Once again, we'll remind you that this is no reason to panic...
While rising rates could eventually trigger a reckoning in the corporate bond markets and a bear market in stocks, we're still not seeing any of the clear warning signs that typically precede serious trouble.
In other words, we're inching closer toward the end of this long bull market, but we're still not there yet.
New 52-week highs (as of 10/8/18): none.
In today's mailbag: Feedback from a new Stansberry Alliance member... and several readers weigh in on Tesla. What's on your mind? Let us know at feedback@stansberryresearch.com.
"I recently became an Alliance member. I have been reading all subscription updates and have learned so much just in a few months. I tell my family that the membership fee is like a college education... except, I am 'going to college' for a lifetime. The insights you provide on so many opportunities are very valuable. You also introduced me to Options, commodities, distressed corporate bonds trading, and many more! I initially signed up with Ten Stock Trader and this got me started on reading books on technical analysis.
"I have also acted on several recommendations. Unfortunately, it seems like I showed up to the party late because I had to stop out of a few trades in the past few weeks. This has been the most difficult thing to change for me... honoring the stops! It takes a lot of discipline to do so. I am trying to get rid of the old habit that my short-term trades become
"I attended the conference in Las Vegas remotely. I enjoyed most of the sessions from the comfort of my home. But, I missed the opportunity to meet the editors and attend
"Didn't Gordon Gecko spend 8 years in prison for Securities Fraud? Isn't that what Elon deserves? Oh please, oh please..." – Paid-up subscriber Craig R.
"I think the SEC is going easy on Musk because of influence put on them by the Defense
"I think you get distracted with TSLA. What matters is Space X. That's where his power lies. And his power is immense because Musk is launching the Pentagon's satellites. As long as he has the Pentagon in his pocket, he will [survive]. What's $ 230 million for the Pentagon? Nothing. Watch Space X." – Paid-up subscriber Fabian H.
Regards,
Justin Brill
Baltimore, Maryland
October 9, 2018