Is the bond market getting crazy?

At the peak of the Euro debt crisis in 2012; Spanish 10 year bond yield was 6% higher than the 10 year US Treasury Bills. Since the ECB wrote a blank cheque and declare 'we will backstop Spain at any costs' --- Spanish bond yields has been falling and now Spain can borrow at a rate lower than the US in the bond market. For bond investors like myself: I am wondering why is it sensible to assume Spain is more credible than the US now? What really change since 2012 - are Spanish bonds really safer than US bonds?  

                                   

Investors keep buying 5 year US Treasury bills and return after inflation has been negative since the start of 2014. Locking in negative return for 5 years does not look smart for investors if inflation rate stay the same for the next 5 years. If inflation rate rise another 50 basis points; bond price will like falls; investors will lose more money on 5 year Treasury bills.



Junk to AAA Spread --- this graph shows the extra return of junk rated US corporate bonds compare to the highest grade US bonds (the US government). The Junk spread are heading towards 20 year low lately; this indicate investors are getting confident low credit rating US companies can repay their loans in the future.

The movement of US 10 year Treasury yields might be more volatile than you think --- bonds have a reputation as a safe investments; however movement of prices of long term bonds can be volatile. Yields has been falling since mid 1980s and history suggests we might see decades of increase in bond yields when the trend change.

The fixed income markets are getting crazy these days --- the Spanish bond yields just get below US bond yields in June and the yield of the US 5 year Treasuries bills has been below inflation for 5 straight months (negative return after inflation). It seems traders are expecting very low inflation in Europe and the US for the next 5-7 years.

Investors seeking yields are buying junk bonds or low grade Sovereign bonds. US junk bond spread are heading towards 20 years low and yields of Spanish bonds are lower than US Treasury Bills. It seems the bond market is getting a bit crazy betting default rate will stay low or any crisis will be backstop by the central banks. Sensible investors might ask --- Prices are at 20 year high, even if junk bond price going up further -- is it worth the risk?

Bond investors buying high grade government bonds also seems to think inflation is dead and will stay low forever --- for now the return of US government 5 year Treasury bill is negative and the return on 7 year and 10 year Treasury bills are near zero; sensible investors might not buy Treasury bills for income; they are buying Treasury bills hoping for a capital gain if yields goes lower. I don't really think this will be the trend for the next decade --- US Fed has been working to end their QE program and start raising rates next year and inflation might not stay low forever --- betting on the Fed not to reduce the size of monetary stimulus might not be wise. I wonder we might be at the peak of the 'QE party' and the size of monetary stimulus from central banks around the world might have peaked. 

Return on cash might be low but income seeking investors might be smarter staying in cash. Canadian investors can earn a return of 1.5% to 1.9% on 1 year GICs (fixed deposits); this is higher than the 1.68% return of 5 year US treasury bill. When government bonds and high yield bonds are getting expensive; staying in cash or GIC might not be a bad idea. This is a painful time for income investors; however if you risk your money chasing yields (buying long term bonds and junk bonds); you might regret your decision down the road.


Putting your money in the bond market make sense only if:
- you think default rate will stay low; this is the case if you are buying junk bonds ( low grade corporate debt and sovereign bonds) --- chances are we will have another recession down the road and junk bond spread will increase.
- and inflation is not likely to rise in the next 5-10 years; this is the case if you buy government bonds----- this is possible, however you are betting on lower inflation when inflation expectation is near the lowest point in almost 30 years.
- deflation is likely and central banks around the world will increase the size of monetary stimulus and long term bond yields will fall, this is the case if you buy long term government bonds with maturity dates over 10 years---- This is possible but the last time we saw 10 year treasury yields at these level; it was the 1940s and 1950s --- it is hard to convince investors the low interest rate environment we have right now is 'not the normal times' but this is indeed the case if you look at the data.

http://www.businessinsider.com/spanish-10-year-yields-fall-below-us-10-year-yields-2014-6

http://soberlook.com/2014/06/markets-now-expect-shock-and-awe-from.html
http://soberlook.com/2014/06/gold-weakness-is-inconsistent-with.html
http://pragcap.com/how-much-tighter-can-junk-spreads-get
http://www.businessinsider.com/10-year-us-treasury-note-yield-since-1790-2012-6

Saputo 2014 earnings

Canadian dairy producer Saputo just reported their results for fiscal year 2014 which ended in March 31st 2014. For fiscal 2014, profits per share was $2.73, up 12.1%. Saputo ranking on the 2013 Robobank global dairy companies jumped from 12th to 9th overall. Saputo is a major processor of Cheese in North America and it became more diversified when it entered different markets and into new product lines.

EBITDA for Saputo grew 27% to $821 million in fiscal 2014, International divisions and US divisions were driving growth for Saputo while Canadian divisions saw earnings declined. US divisions EBITDA increased 36% to $469 million; International division EBITDA increased 232% to $93 million while Canadian division EBITDA decreased 4% to $457 million.

Strong financial results in 2014 was boosted up by the acquisition of Morning Star Foods in the US and Warrnambool Cheese and butter in Australia. While sales and profits were driven by strong cheese prices and acquisitions; Saputo said profit margins was under pressure --- While the consolidated EBITDA margin decreased to 11.1% in 2014 from 11.8% in 2013 resulting from lower EBITDA margin in Canada and lower EBITDA margin in the USA sector.

Saputo indicated in its quarterly conference call today they are looking at acquisition opportunities from $100 million to as much as $4 billion.

"The (U.S.) industry still is very fragmented," he said. "So I think there are some great opportunities for us that could be small, medium or large."

Saputo may also look for acquisitions in Canada worth around C$100 million and is eager to add to its new foothold in Australia, where seven or eight players control up to 95 percent of the dairy industry, he said.

Latin American countries like Brazil are attractive as well due to their growing middle class, Saputo said.

Dairy product prices has been increasing over the last decade due to increasing demand from emerging countries like China and India. As per the Robobank outlook for Dairy industry, China, India and South East Asia expected to account most of the volume growth of diary products; these markets however might not have an appetite for Cheese product and Cheese sales might underperform the overall dairy market. To take full advantage of market growth in Asia and India; Saputo might need another transformational deal. The acquisition of Warrnambool Cheese and butter in 2013 will give them a foothold in the growing Asian markets; it will be interesting if Saputo can acquire companies with exiting products in the China or India.

Growth will be highly skewed to emerging markets, with countries like China, India and South East Asia expected to account for more than 80% of market volume growth, while western markets continue to mature. "Tapping into emerging market growth will present a particular challenge for many of the world's dairy processors, most of which are domiciled in, and still focused on, the EU and U.S. markets," said Tim Hunt, Global Dairy Strategist for Rabobank.

Opportunities will also be uneven across product categories. Economic, demographic and dietary trends are likely to see cheese sales underperform the broader dairy market. With sales of higher end whey product set to track a much faster growth path, the strategic value of whey pools is rising rapidly. "The divergence of cheese growth and whey demand represents a major structural shift in the market, and justifies a re-evaluation of ingredient production and sourcing strategies," said Mr. Hunt.

Saputo's trail of acquisitions: (from Montreal Gazette)
1954 — Giuseppe Saputo and family, new immigrants with cheesemaking in their blood, start their business in Montreal in humble quarters. It begins to grow immediately as people outside the Italian community take to Italian-style pizza topped with mozzarella.

1997 — Saputo, with son Lino Sr. firmly in control, tries to buy Canada’s Ault Food Inc., but is outbid by Italy’s Parmalat. It would have cost more than $350 million to win Ault, and Lino Sr. said that was more than Ault was worth. Lino takes Saputo public at $17 a share and denies a brush with the Mob.

1998 — Saputo buys Stella Foods Inc., the fifth-largest U.S. dairy processor with 12 plants, for $563 million. Lino Sr. says Saputo’s goal is to become a global cheesemaker.

1999 — Saputo completes the takeover of two U.S. plants of Avonmore Waterford Group and Bari Cheese Ltd. in Vancouver and pays $483 million for Jos Louis and Mae West snackmaker Culinar, saving it from a U.S. takeover, moving the company beyond cheese for the first time.

2000 — Saputo Inc. makes another big deal with the $407-million acquisition of Dairyworld Foods, with several plants in Western Canada, from the Agrifoods co-operative. That creates Canada’s largest dairy processor and North America’s fourth largest. Saputo’s annual revenue hits $3.4 billion.

2003 — Saputo expands into Latin America with the $51-million acquisition of Argentina’s third-biggest dairy processor Molinos de la Plata SA, which exports to several other Latin markets and to Europe. Lino Sr. speculates a U.S. acquisition may get top priority next.

2004 — Lino Saputo Sr. hands over the job as chief executive to his second son, Lino Jr., formerly president and COO of the company’s U.S. division. Saputo rumoured to be eyeing Latin American assets of Europe’s Parmalat.

2006 — Saputo enters German market by buying a distributor of mozzarella, ricotta and mascarpone. It also bought Biscuits Rondeau in Quebec, saying it would back troubled Culinar and bring it back to profitability after a big restructuring.

2007 — Saputo buys Land O’Lakes’s U.S. West Coast industrial cheese business for $216 million U.S. to secure a long-term fluid milk supply and also the U.K.’s Dansco Dairy Products, a maker of mozzarella, for $12 million to fit with its European expansion.

2008 — Saputo buys the Nielsen Dairy division of Weston Foods (Canada) for $465 million to back up its fluid milk activities in Ontario and also Alto Dairy Cooperative (Alta), a U.S. mozzarella producer for $160 million U.S.

2010 — Listeria contamination prompts the voluntary recall of cheese from one of Saputo’s biggest Montreal plants. It contained the problem by closing down one line of production. About 150,000 kilograms of cheese are affected.

2011 — Saputo buys Fairmony Cheese Holdings, parent of the U.S. DCI Cheese Co., one of the largest U.S. cheese marketers, for $270.5 million U.S. Lino Jr. says the real focus remains on building a global presence in cheese and dairy products.

2012 — Saputo bolsters its position as North America’s second-largest dairy company with a $1.45-billion deal to buy Morningstar Foods.
2013 - Acquiring Australian dairy company Warrnambool Cheese & Butter for $450 million 

Read more: http://www.montrealgazette.com/Saputo+timeline+long+road+steady+expansion/7645708/story.html#ixzz2E38PrLob
Robo bank outlook for dairy industry 2012:
http://www.commodities-now.com/reports/agriculture-and-softs/9863-rabobank-outlook-for-global-dairy-industry.html
Saputo Annual report 2014:
http://www.saputo.com/uploadedFiles/Saputo/investors-and-medias/financial-documents/SAP_RA2014_EN.pdf

Prem Westa of Fairfax Financial joins the bear camp of China observers:

Prem Westa of Fairfax Financial joins the bear camp of China observers:

Observers of China has big question marks about its remarkable credit growth in the last 5 years and they are wondering the 'errie resemblances between the 2008 credit crisis in the US and the 2014 debt markets of China' --- more observers has joined the bear camps recently, including Prem Westa of Fairfax Financial in Canada who wrote: There is a monstrous real estate and construction bubble in China which could burst anytime, It almost did in 2011 but China increased its credit growth significantly since then. This is a summary of the viewpoints of China bulls and bears. While the bulls are bullish about the long term prospects of China, the bears argue, the GDP growth target of China is 'unrealistic' and the policy mistakes of the past 5 years will result in a credit crisis in the near future. The skeptics of China argues: the collapse of the credit bubble in China might not be imminent but it might be drawing nearer to that point -- you can compare China in 2014 to what the Western world was in 2005-2006.  

A full blown debt crisis for China might not be imminent. However, China is increasing its debt at a rapid rate (replicate the US commercial banking system in 5 years) and if it follow the current trend; its total debt to GDP ratio will be similar to Spain in 5 years. The stimulate effect on China's GDP for additional unit of credit is declining rapidly and this suggest the road of 'pumping up GDP with infrastructure investments' might end in the near future. I am not in the 'bear' observers camp, there is still time for China to re-adjust and avoid a debt crisis if it is willing to accept a lower rate of growth and focus on the 'quality' instead of 'quantity' of economic growth.

Viewpoints of the China bears:
- Travellers in China saw blocks of empty apartments everywhere that are sold but kept empty by 'investors'. The logic of real estate investments by Chinese is not generating 'income', the Chinese are focus on 'capital gain' and feared depreciation in their properties once their properties are occupied. Rental yields of apartment buildings in China is low -- once the expectation of rising prices reverse, we might see a glut of selling by 'investors'. The St Louis Fed published a report in 2013 claimed significant store of value demand for housing in China is speculative in nature; the bubble could burst when both the household income growth and saving rate start to decline and capital controls in China starts to relax. Predicting when and how investors lose faith in housing and how soon and fast these events will happen is difficult if not impossible 

- The bears argue there are signs of overbuilding of housing in part of China. Ordos has replaced Fengdu as the 'Ghost city of China' and this is well documented by foreign media. The bears argue China has been building the wrong type of housing for its people -- they point to the fact that there are not enough social housing or affordable homes for its vast population of migrant workers and middle class and too many luxury apartments has been built for investors as 'deposit boxes with windows'. Some analysts in Hong Kong estimated 15% of the housing stock in China remains 'unoccupied', pointing to the fact that speculation in housing might be rampant.

- a significant jump in bank balance sheet and credits over the last 5 years, China's credit jumped from $9 trillion USD in 2008 to $23 trillion USD in 2013. Bank credit has been rising faster than the GDP in 2013, bank credit growth rate @ 12% to 14% vs GDP growth of 7% to 7.5%. Each extra dollar of credit has added 0.17 in GDP in 2013, this ratio was 0.29 in 2012 and 0.83 in 2007. The bears argue, China will run its broken model of 'investment led growth' to the ground and not making changes until the end game begins -- China is following the footsteps of the Americans in 2008.

-China's credit market is showing signs of strain. There are occasional spikes in inter-bank lending rate (Shibor) when rumours of corporate defaults are floating around. The bears argue we might see a rising trend of defaults in the high yield debt and credit products of the shadow banking sector later in 2014. Even George Soros has called the 'eerie resemblances' between the 2008 banking crisis and China's debt market in 2014.

- Government GDP targets are too high -- they set their targets at 7.5% and the trick to keep this pace of growth is throwing money in 'fixed asset investments' . The bears argue GDP growth might drop to 4% to 6% when China shrink its target growth in fixed asset investments and slow down its credit growth to a sustainable rate. In a hard landing scenario, China might experience two quarters of negative GDP growth and then follow by a sustainable path of growth of 4% to 5%. Some economists who are sceptical about the growth model of China argue, China should focus on income growth of its people and not on rate of GDP growth, they argued China can achieve its goal with sustainable growth rate of 5% while increasing the income of Chinese at 7.5% per year via redistribution of wealth from the State to its own people (via higher wages, higher interest rate on deposits and gifting state owned assets).


Viewpoints of the China bulls:
- rebalancing is well underway in China. The service sector contributed 46% of GDP in 2013, surpassed the manufacturing sector (44%) for the first time in history. The fastest growing sector in 2013 was 'wholesale and retail'. Consumption contributed 50% of Chinese GDP growth in 2013 --- capital formation contributed 54% and net export (-4%). The bulls argue China is well on its way in re-balancing to 'consumption led growth' with the service sector leading the way.

- loan growth by Chinese banks are significant but the banks in China are healthy --- they have healthy capital ratios, their non performing loans ratios are low (Chinese banks reported non performing loans ratio of 1%) and the shadow banking system is 'well regulated'. The pace of loan growth is 'under control'. For 2013 the total social financing aggregate grow 9%, slowed sharply from 23% in 2012, this pointed to the fact that China has been reining in credit growth and growth in shadow banking.

- China experienced a giant increase in debt over the last 5 years but the total debt ratio is low compare to other industrialised countries. China's total debt ratio was 215% in 2012, well below UK or US at roughly 350% of GDP and Spain @ 400% GDP. China made vast investments in areas like highways, subways, high speed rails, hospitals, apartments --- China is a developing economy and its per capita share of these facilities are well below the standard of developed countries like the US. You can argue the rate of debt growth is unsustainable but this is already under control and the investments made by China will bear fruits in the future.

- The bulls argue, the model of old China is dead --- while the new China is still growing at a rapid pace and will eventually take over as the growth engine of the future. 'the service sector, renewable energy, information technology, high end manufacturing, health care'  The bulls argue, China will drag on with growth rate of 6% to 7% for the near future, they argue the investment led growth model is working and the bears were wrong when they called the 'end of China' in 2011.

- The bulls argue there are no real estate bubble in China, prices are high because income of Chinese are rising at a rapid pace and the growing ranks of middle class are lining up to jump in and buy. In fact, the trend of rising price is still going on in China and those who made investments in real estate will be winners. The bulls point to the fact that the Pudong district of Shanghai was once the 'ghost city of China' and today it is the heart of Shanghai.


BBC Documentary - How China fools the world:
http://www.youtube.com/watch?v=HUSjMnmS5lI#aid=P-R9SvyqaQ8

GDP Growth of China
http://www.reuters.com/article/2014/01/20/us-china-economy-gdp-idUSBREA0I0HH20140120

The Changing debate over China's economy (Michael Pettis)
http://blog.mpettis.com/2013/08/the-changing-debate-over-chinas-economy/

The Great Chinese housing boom -- Federal Reserve Bank of St Louis
http://research.stlouisfed.org/publications/es/13/ES_13_2013-05-03.pdf

The $15 trillion shadow over Chinese banks
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/10611931/The-15-trillion-shadow-over-Chinese-banks.html

China loan creation tumbles
http://www.zerohedge.com/news/2014-03-10/china-loan-creation-tumbles-lowest-credit-growth-20-months

Prem Watsa's 2013 shareholder Letter
http://www.valueinvestingworld.com/2014/03/prem-watsas-2013-shareholder-letter.html

How 2014 could be like 1929
http://humblestudentofthemarkets.blogspot.ca/2014/02/how-2014-could-be-like-1929.html

SoGen Hard landing scenario China
http://www.businessinsider.com/chinese-hard-landing-severe-shock-to-em-2014-2