The Federal Reserve meeting last week came and went, and now the markets are back to focusing on fundamentals, as they should. The problem for equity investors, however, is that the fundamentals aren’t great, and it is becoming increasingly more difficult for even the most bullish investors to find reasons for optimism, at least in the near term.
The economic environment in China (FXI) continues to worsen. We outlined our grave concerns regarding the implications of its collapsing stock market on the health of the country’s property market, and the resulting consequences on China’s largest banks. Commodity-linked entities in China continue to feel pain, and the preliminary reading on the Caixin China manufacturing purchasing managers’ (PMI) index fell to Financial Crisis lows of 47 in September, below last month’s measure, analysts’ forecasts, and signaling economic contraction. The reading hasn’t been this low since the panic bottom of March 2009, and we maintain the view that conditions in China may be even worse than feared.
Weakness in Asia has already spread. Export-dependent countries, including Brazil (EWZ) and Canada, are already in recession, and the former may be in a world of trouble. Political scandals and corruption, asset flight and resulting currency weakness are only exacerbating the hazards related to the country’s financial health. S&P recently downgraded Brazil’s sovereign debt to junk status, and there may be little the country can do to pull itself out of a recession, absent a recovery in commodity prices, which may not happen anytime soon without a sustainable bounce in China export demand, clearly out of reach at the moment.
Brazil state-run oil giant Petrobras (PBR) may be the first major casualty of the country’s deepening recession as a result of a triumvirate of corruption, weak earnings from collapsing crude oil prices, and exorbitant levels of US dollar-denominated debt in the face of an ever-weakening real. Net income at the company dropped 90% in the second quarter on an operating income decline of nearly 30%. Free cash flow of R$4.5 billion during the first half of 2015 is practically negligible compared to the firm’s total indebtedness of R$415.5 billion. Net debt on a US dollar basis stands at over $104 billion, and it’s difficult to envision a positive scenario for Petrobras investors without help from improving crude oil prices.
In an uncharacteristic two-notch move, S&P cut Petrobras from an investment-grade rating of BBB- to BB, junk status, earlier this month. The Brazilian oil giant is now the largest non-investment-grade corporate issuer, and prices for its bonds keep falling. Confidence has been shattered, and reports indicate that credit default spreads on the firm’s debt are “exploding.” As member nations of OPEC continue to produce to put US domestics out of business, Petrobras has been caught in the crossfire. The company may very well be forced to restructure its ballooning $90+ billion in dollar-denominated debt soon, and ironically, it may be the Fed that will eventually push Petrobras over the edge. Asset flight out of Brazil into US assets in the event of a rate hike in the US could weaken the real to a point where Petrobras’ debt becomes too expensive to service, even if crude oil rebounds.
All is not well with US producers of oil either. Line Energy (LINE) sounded the alarm bell when it announced that it would suspend its distribution on account of concerns that its borrowing capacity would be cut once banks reassess their crude oil price decks, a twice-yearly occurrence. Bloomberg reportedtoday that almost 80% of oil drillers will “see their borrowing base cut,” according to a survey by Haynes and Boone LLP, marking the beginning of the end of this debt-infused stock bubble, in our view. We’ve long stated that even the dividends of energy bellwethers, Chevron (CVX) and ConocoPhillips (COP) may not be safe. The sharks are circling.
The size of credit lines in the energy arena have been for some time completely detached from fundamental credit quality, in our view, so even an average credit-line cut of ~40%, according to the report, may only be the beginning, if credit markets continue to tighten. We would expect the probability of dividend cuts on the weakest upstream entities to increase, and many in the midstream space may eventually become victims of contracting credit, especially those that point to their revolver as a means to manage the dividend with minimal cash on the books. We continue to believe the master limited partnership model (AMLP) will be challenged during this cycle as credit dries up, and it is not surprising to see Energy Capital Partners looking to dump MLP assets, its interest in Summit Midstream (SMLP).
Stock market bulls continue to point to the view that because stocks only make up 15%-20% of Chinese household wealth that there is no need to worry about the growing risks of a global economic calamity. Those same bulls, however, may not know that only 16% of households were invested in US stocks right before the Crash of 1929. Though a Great Depression is simply not a possibility this day and age, in our view, we don’t think the global selling in equities is over, and it may not be for a while. Indexers could be in for more pain, as the Fed may hike not once but twice this year in failed attempts to counter-intuitively reestablish market confidence by communicating through the rate hikes that all is well. Bad news, however, is bad news again, and the Fed put is no longer in place.
Valuating Companies by Victor Goossens 