Alcoa might be the first to report quarterly earnings and to set the tone in the basic industries sector but it is Caterpillar, the maker of big yellow things, which is the real bellwether as it straddles both the commodities and the manufacturing space.
The company might not be due to report until next week but it made all the headlines yesterday with the announcement that chairman and CEO Doug Oberhelman is to step down next spring. When big changes happen at the top of bellwether companies, the world pricks up its ears.
Oberhelman has only been in the job for four years and his departure points towards the company struggling to meet its hard targets. During the commodity boom that followed the financial crisis, Caterpillar could do no wrong – it just had to switch the lights on in the morning to make a fortune – but the flow of hot money out of commodities and back into financial assets brought reality back onto the scene and reality is one thing investors don’t deal with too well. If they did, they wouldn’t have gone stark raving bonkers over Netflix, which might have beaten forecasts for new subscribers as they pushed the price higher by about 1.5% to close at a forward earnings multiple of 312 times.
Netflix might be an admirable company but it is pumping everything it makes back into original content – very good, original content I would add – but in doing so it is, to some extent, running to stand still. How it will ever throw off enough free cashflow to meet the dividend stream that is necessary to justify the pricing escapes me. I used to work with an analyst who would have, in this kind of situation, sat back in his chair during the morning meeting and coolly added “Foam the runway!”
The same cry might have gone up in the Gilts market, which had another miserable day. It could be added that the post-referendum rally was probably not justified and sharply overdone, and the sell-down back to where yields were on June 23 is possibly nothing other than a reality check.
Momentum
I have suggested repeatedly in the past few months that markets are struggling to connect the dots in terms of fundamentals, and that therefore trading momentum is the only game in town. Everybody into the pool; everybody out of the pool. The financing model might have broken in 2008 but the basics of running business did not. The problems began when ever-so-clever people concluded that they could invent a better way of running capitalism than letting demand and supply dictate the price of things.
Instead of letting the financial system blow itself up and rebalance itself, they decided that they knew a better way of doing it, and one which would prevent anybody from getting hurt, a sort of world which produced only winners. We are stuck in a parallel universe where asset prices bear no relationship to reality but where the cost of re-introducing reality looks higher than it would have been in 2008. Can monetary policy be normalised without prompting a hard landing?
I shall hark back to Mervyn King and his comments over the weekend. Many think of him as being one of the chief engineers of the credit bubble and few bemoaned his departure from the Old Lady and return to the ivory towers of academia. However, I am still trying to get my head around his very rational assertion that a weak pound, returning inflation and falling house prices were what everybody had been calling for. Now that they are beginning to happen there is nothing but moaning going on. ZIRP and NIRP were, I suppose, intended to permit the implementation of a victimless paradigm shift. Instead of doing so, I suspect that they have led to the weakest in society having exposed themselves even more – cheap credit will always encourage those who can afford it least to gear up further - which means that the political price of normalisation is not lower on the back of zero cost lending but even higher than it already was.
For a number of years I sat on the Secondary Markets Practices Committee of ICMA, the International Capital Markets Association. From there I watched the authorities assert more and more pressure on the way in which markets worked. ICMA had tried to have a dialogue with the regulating authorities but again and again was clearly given to understand that in the post-crisis world things were not up for discussion; this is what is going to happen and the banks would be well-advised to just accept it and get on with implementation.
Today I find an article in the FT which points out what most of us have known for a number of years, that the way regulation has been written means the repo market is struggling to fulfil its most basic role as the solid base of money markets. If you think of securities markets as a tree with many branches, the repo market is its root stock. With negative money market rates to contend with we have some ludicrously idealistic regulation which is in many cases framed by people who obviously believe in the Easter bunny and Father Christmas but who don’t know who the Grinch is.
It was gratifying to read ICMA’s Andy Hill write that “to interfere in the repo market is to tamper with the DNA of modern-day capital markets”. I’m afraid, Andy, that you’re trying to close the stable door after the horse has bolted. I was often frustrated by the timidity of ICMA in the past but I will add in its defence that its members, the banks, were still busily asking “How high?” when ordered to jump.
Which brings me finally to the subject of the Royal Bank of Scotland and HM Treasury’s decision to take another writedown in the value of its holding in the bank. I would like to remind everyone that the UK, along with the US, took the pain of a troubled banking sector on the nose in 2008 and 2009. Seven years on, and with most of the cadavers thought to have already been brought to the surface, Nicola Sturgeon’s national champion is still fighting for survival.
Now look at the likes of Italy; ask yourself how much there is left to be cleared up there and then wonder why they’re not all running away screaming. What was that I said earlier about investors and reality?