Dying Malls Increasingly Rely On Taxpayer Handouts For Survival

America"s dying malls have been a frequent topic of discussion of late as these relics of the 80"s have been forced to convert once valuable high-end retail square footage into grocery stores, libraries and doctor offices just to keep the lights on.  Here"s just a small sampling of the recent carnage:

• A Third Of All Shopping Malls Are Projected To Close As "Space Available" Signs Go Up All Over America


• America"s Desperate Mall Owners Turn To Grocers, Doctors & High Schools To Fill Empty Space


• Failing Malls Turn Empty Parking Lots Into Carnivals To Generate Cash

But, as Bloomberg points out today, one other funding source is increasingly emerging as a key financial sponsor in the efforts of commercial REITs to re-purpose their failing assets: taxpayers.

In Brookfield, Wisconsin, for example, the city is using tax-increment financing (TIF), a common tool for municipalities to subsidize development by putting property taxes from new projects into a fund that pays for building cost, to help rebuild the Brookfield Square Mall. Meanwhile, as if that weren"t enough, the city has also agreed to pay for remediation costs related an old Sears auto repair shop and to build a new convention center and hotel where the Sears once stood.

In this depressing landscape, there is at least one player still willing to take the risk: local governments hungry for tax revenues. Developers incorporating additions such as housing and parks in their plans are turning to public partners to help rehabilitate the aging retail meccas that dot the U.S. Public subsidies have been part of retail development for decades, but with landlords pouring billions of dollars into renovation to battle a wave of store closures, public-private partnerships are more urgent, and more fraught, than ever.

 

At the Brookfield Square mall in Wisconsin, the landlord, CBL & Associates Properties Inc., needed a new occupant for a fading Sears. CBL had been tinkering with the mix for the past few years. Earlier, in 2008, it completed a 20,000-square-foot expansion, adding grocery stores and restaurants and renovating the interior.

 

In the end, it found its tenant: the city of Brookfield.

 

The local government plans to step in to build a conference center and hotel. By creating a hub for small and medium-size conventions on 9 of the 29 acres currently occupied by Sears, the city hopes to boost CBL’s efforts to reinvent the property, the largest taxpayer in Waukesha County. The idea is a greater focus on entertainment, recreation and business, according to Daniel Ertl, director of community development for the city of about 38,000.

 

“The Sears store is really a shadow of what it used to be,” Ertl said. “We encourage CBL to continue to reinvent themselves. God knows where retail is going to be in 20 years.”

As Bayer Properties CFO, Jami Wadkins, who just secured all sorts of taxpayer-funded handouts to rebuild a failed mall in Alabama, points out, public funding is becoming an "important element of the capital stack of every developer."

These expansive developments often secure additional public financing through various forms of tax arrangements and incentives, as well as infrastructure spending for things like parking garages. Such funding has become an important element of the capital stack for every developer, according to Jami Wadkins, chief financial officer of Bayer Properties, a real estate company that develops and manages retail real estate.

 

In Birmingham, Alabama, Bayer worked with the city government to transform the site of the Pizitz, a historic department store that closed in 1987. The Pizitz, which Bayer bought as a vacant building in 2000, was in a rundown neighborhood that lagged behind the revival occurring in other areas of downtown.

 

Numerous plans ended up on the scrap heap before federal and state aid was secured to build a mixed-use community, which opened in 2016. The development houses 143 residential units -- now 90 percent occupied -- a co-working space, a food hall and retailers, including Alabama’s first Warby Parker.

 

The project cost was $70 million, including public and private funds. Bayer was able to obtain a low-interest loan from the U.S. Department of Energy, as well as tax credits from the state. The city paid to refurbish the landscaping in the area, including the sidewalks and street lamps, according to Wadkins.

 

“If you can put a plan together for a city that doesn’t put the city at great risk, then they will invest with you,” Wadkins said. 

To conclude, perhaps no one summarized this lunacy better than Ronald Reagan who succinctly described the Government"s approach to economic affairs as follows:

"Government"s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it."

Malls are clearly now in the "subsidize it" phase of the Government"s economic plan.

The "Iron Coffin Lid": Why The Euphoric Surge In Japanese Stocks Is Coming To An End

Last week, Japan"s Nikkei 225 index enjoyed its longest winning streak in history which eventually ending after 16 consecutive days of gains, only to resume rising after a brief one day hiatus. And, as foreign investors once again flood the Japanese stock market, chasing the momentum which has pushed local stocks to levels not seen since 1996, the question on everyone"s lips is how much longer can this continue?

Offering a decidedly downbeat outlook on Japan"s market exuberance, Shannon McConaghy - portfolio manager at what we have in the past dubbed the world"s most bearish hedge fund, Horseman Capital Management - believes that the euphoria is about to end. The reason: the ominously sounding "Iron Coffin Lid."

In a note released late last week, McConaghy writes that there has been a lot of excitement over Japanese equities of late, with hyperbole from the sell-side, and others interested in promoting Japanese equities, becoming extreme. However, he cautions that "there is not a lot of discussion around the risks to Japanese equities from current elevated levels" and adds that "one observation I would make is that Japan has risen to these levels on a number of occasions over the last 25 years, only to fail spectacularly each time against what is referred to, by some in the Japan markets, as the “Iron Coffin Lid”. History suggests it is far better to be short Japanese equities from these levels than to be long."

So what is this Iron Coffin, why does it have a lid, and what happens next?

Below is a visualization of this "Iron Coffin Lid" effect: it shows the key resistance level in the Topix beyond which the index has failed to progress every time in the past quarter century.

There"s more than just a chart however: here is Horseman"s take on why this latest rally in Japanese stocks is also set for disappointment.

For those unwilling to outright short, I would point out that historically Japan has had meaningful underperformance following past bursts of outperformance. In these periods it is particularly appealing to short against longs in higher growth areas. Japan also provides amplified short returns during global down turns. As such it can be a low cost but high return hedge to risk-off impacting long positions elsewhere. One way to identify when Japan is about to provide its greatest periods of underperformance is when its market capitalisation exceeds its Gross Domestic Product (GDP). Again, on this measure history suggests it is far better to get short Japanese equities at current levels than to get long.

 

 

One way to think about Japan’s persistent underperformance is that past market rallies have been quickly frustrated by structurally weaker GDP growth, as opposed to other markets with more sustainable growth. Japan’s GDP only grew +1.7% over the last 10 years, a CAGR of +0.169%. It grew even less in the 10 years prior. It is no mere coincidence that the market has failed to break out during decades of weak economic activity. Once again the market is pricing in significant economic expansion to come in Japan but its demographics, the key reason for past structural weakness, are only getting worse. I expect the euphoric hope held by many in the market, that “this time is different” in Japan, will once again be crushed by the “Iron Coffin Lid” that is Japan’s structurally weak economy. Long positions in Japan will likely be buried alive again while short opportunities thrive. Yes, Japan’s GDP growth rate has been higher since 2012, during what I would consider a recovery phase. But the drivers of growth in the three largest components of GDP growth are unsustainable, exhausted and now showing clear signs of reversing. Our market views to be released over coming days will look into these three major components of recent GDP growth in more detail.

Originating from Horseman Capital, hardly known for its optimistic outlook, here is the fund"s take on why Japan is set for more pain once the current euphoria fades, and how to capitalize on this imminent decline:

As a short preview, Japan faces immense risks to its economic system from;

 

1. Declining private consumption as the number of households in Japan starts to decline. Nowcast data also shows a marked decline in household consumption in recent months.


2. A precipitous decline within the financial sector, an often forgotten component of GDP. With the Japan Financial Services Agency now reporting that most regional banks have become loss making in core businesses.


3. A roll-over in the real estate sector as residential oversupply hits, vacancy rates rise, rents fall, prices decline in some areas and contract ratios indicate more price cuts are coming.


4. Net export growth, which has been driven by a weak Yen and weak oil prices, faces a risk of the Yen strengthening 22% back to the long run real effective exchange rate, as well as continued oil price rises.

 

Short opportunities in regional banks, real estate developers, Real Estate Investment Trusts (REITs) and mid-size retailers are particularly appealing. The first three of these sectors, about which we have written over the last two years, have been noticeably weak but still offer significant downside. The retail sector, about which we have only recently began to write, has yet to turn down but was a notably weak performer in the last years of the last global  credit cycle. Importantly we believe that shorting these sectors does not require an end to the global credit cycle, but they would likely generate amplified short returns in that environment and hence afford excellent hedges to other longs elsewhere.

Finally, it"s worth recalling that as of one month ago, the BOJ already owned three quarters of all Japanese ETFs: a number which is now certainly higher, and is a non-trivial reason why Japan"s stocks have enjoyed the recent surge. Of course, with ETF supply declining rapidly and the BOJ soon to be locked out of further purchases, the question is what will stoke further "flow" into risk assets (and frontrunning of central bank purchases), and will the BOJ expand its mandate further to buy single name stocks next in the name of "price stability?"

 

A Former Lehman Brothers Trader: It's Time To Buy Brick And Mortar

Authored by Jared Dillian via MauldinEconomics.com,

Everyone thinks it is only a matter of time before Amazon puts every department store, every mall, every brick-and-mortar retailer out of business. Amazon gets an infinity market cap and everyone else gets zero.

Sound familiar?

That’s the accepted wisdom.

Is Amazon a great business? Yes.

Is a department store a bad business? Probably.

Does Amazon get 100% market share, with department stores getting zero? Probably not.

Amazon has over 80 million Prime subscribers in the US. It’s not quite saturated, but it’s getting close.

Source: Business Insider

I admit to being a Prime member, a late adopter.

It is pretty cool. Stuff shows up on my doorstep in two days, for free. The huge poker chip set I just ordered probably weighs about 40 pounds—free shipping! And I get all the Prime movies and TV shows.

But here is my thesis: Amazon will grow and grow, but there will always be a role for physical retailers. A reduced role, for sure, but there will always be a role.

From a capital markets standpoint, now might be the time to put on the trade.

The Bottom of Brick and Mortar

This is when I started thinking that we"ve reached a bottom in physical retailers.

Last week, ProShares—a $27 billion ETF manager—registered to list some double short leveraged ETFs on brick-and-mortar retailers! 

Ding!

In my experience, specialty ETFs like this are usually listed at the worst possible times. Plus, you know my thoughts on leveraged ETFs. When 2x short leveraged ETFs are being listed on physical retailers… it is probably time to buy physical retailers.

The graphic from AEI below is a couple of months old. Since then, Amazon’s market cap has soared to $481 billion. Meanwhile, Macy’s market cap has fallen to a little under $6.5 billion.

Source: Yahoo Finance

Amazon is worth around 75 times more than Macy’s? That doesn’t seem right.

I hope by this point I have you thinking.

I am no Macy’s fan. It is a pretty terrible business, it sells middlebrow stuff in middlebrow locations. Although its online business is actually not bad.

I used to buy ties at Macy’s, back in 2001. People laughed at those ties. I no longer buy ties at Macy’s.

But look—at a $6.5 billion market cap, Macy’s is reaching distressed levels…

That means we have to put our distressed investor hat on, pick this business apart, and see if there is value—in all parts of the capital structure. Maybe we don’t like the stock, but maybe we like the bonds, for example.  

And, Staples was bought by private equity recently for about 0.4 times revenue. Apply that standard to Macy’s and you get to a $10 billion valuation. They’re still kicking.

Plus, there’s an argument that this whole Internet retailing thing is just a giant bubble, according to the chart below.

Source: @bySamRo

How Do You Play It?

This is a smart trade, but it is also a dangerous trade unless you are smart.

There are two ways to do this:

1)  Be a distressed investor: Look at the worst-case scenario, look at all parts of the capital structure, and find value.

2) Be a quant:  Buy a basket of physical retailers, sell a basket of Internet retailers, and wait for them to converge.

The worst way to play it is just to naively buy Macy’s (or another retailer) and hope for the best.

Furthermore, I think it’s time to go dumpster-diving in mall REITs.

One final remark. As you look around for ideas, invest in things that would get you laughed off the set of CNBC. I assure you, if I went on Fast Money and pitched Macy’s as a long idea, I would get laughed off the set.

Those are the best trades.

Financials Give Up Stress-Test Gains As FANGs Falter

Well that escalated quickly...

As Bloomberg notes, today’s selling is nearly as broad as yesterday’s buying.

Investors can’t ditch technology and consumer-oriented stocks fast enough. Yield-sensitive sectors --utilities, REITs -- are getting hit with sell tickets too as bonds sell off (10-year Treasury yield is up as much as 15.8 bps in just three days, breaking the key 2.25% level). Wall Street is mostly risk off, worried that central bankers worldwide are threatening to pull away the punch bowl just as inflation picks up in Germany ahead of key PCE data for the U.S. tomorrow.

Tech’s weakness is extending a global retreat for the sector. TECHNOLOGY It’s hard to pin the broad drop in the sector on any specific news. Rather than any change in corporate fortunes, the reason may just be rotation, out of social/computer companies and into banks. The losses are broad.

Financials opened exuberantly but it appears "sell the news" is the plan...

As the Big Banks all roll over...

We"re gonna need moar buybacks.

Why Tomorrow's TIPS Auction May Seal The Fate Of The Reflation Trade

With the dollar bouncing back and bond yields and breakevens rising, RBC"s head of cross-asset strategy, Charlie McElligott, "sniffs" that the market is trying to convince itself to turn "cautiously constructive" again on Trump tax movement.

However, as he details below, there are a few red flags to pay attention to...

SUMMARY:

• ‘Sniffing’ that the market is trying to convince itself to turn “cautiously constructive” again on Trump tax movement, as per two ‘stories’ out overnight / this morning centered around “simplification” / “narrowing the scope” of the policy effort.


• Despite ‘capitulatory-looking’ price-action in rates yesterday, we’re likely in the ‘7th inning’ of the ‘short rates’ stop-out.  As such, this actually is helping drive the reformation of both ‘reflation’ / ‘deflation’ camps looking for tactical trading opportunities.


• A timeline then can develop for an opportunity to put ‘reflation’ back on: 1) charts indicate the short-term potential for higher rates / USD and lower gold which takes us back to 2.30 ‘gap fill’ level; 2) we see the recent ‘rates longs’ re-engage there at low-end of range, which in turn drives a final ‘capitulatory wave’ to the 2.05 level, perhaps boosted by final nerves into the French election or further ‘mean-reversion’ lower in economic surprise indices; then at this point, 3) many will then be looking to fade the rates rally and reapply ‘reflation’ as global data still ‘deeply expansive,’ recent geopol ‘stressors’ again fade to sidelines, the US budget (and this ‘simplicity’ movement with tax policy) takes shape the Fed continues to message ‘statements of intent’ on both hikes and tapering of balance-sheet—in turn, seeing rates again travel higher. 


• One ‘red flag’ continues to be the negative risk-asset price input that is Chinese industrial commodities prices, which are currently ‘rolling over’ (see yesterday’s “LOSING THE IMPULSE” note).  This is due to the market perception that as the economy has strengthened to the point where the PBoC will drive a contraction of liquidity (reduced OMOs) / slow ‘credit stuffing’ efforts, which collectively show extremely high correlation to commodities pricing and global inflation.  In the current macro regime, as global inflation goes, so too does ‘risk-asset’ pricing (this is why I continue to watch Crude like a hawk—which, it should be noted, is HIGHER again despite bearish APIs last night).


• Tactically it will be critical to watch tomorrow’s TIPS auction as a read on ‘risk appetite for inflation.’  If we get a clunker, it’s likely we resume the ‘capitulation’ in the ‘short rates’ camp STAT, which is sure to drive more of the same ‘defensive’ / ‘low vol’ / ‘bond proxy’ equities leadership.  Conversely, if the TIPS auction takes well, it should be read as the ‘reflation camp’ feeling again emboldened after the recent squeeze / cleaner position post ‘stop outs,’ and we’re likely to see $ rotating back into the ‘cyclical beta’ / ‘value’ / ‘small cap’ stuff tied to higher rates.


• This is the reason that ‘growth’ equities (Tech, Cons Discretion a la FAANG / PANE) continues to ‘hold-in’ okay on the week-to-date—because they offer the least ‘binary’ of exposures to this very current ‘reflation’ or ‘deflation’ / ‘cyclical’ or ‘defensive’ coin-flip.


• The biggest risk to ‘growth’ continues to be the seasonal ‘April Effect’ phenomenon where “12m momentum factor mkt neutral” unwinds (as we are currently experiencing), most likely ahead of considerable historical data showing long term alpha generation by ‘defensive shift’ ahead of “sell in May” seasonality.

DEEPER OBSERVATIONS:

One dynamic I’m ‘picking-up’ is the market again attempting to convince itself to turn “cautiously constructive” on Trump tax policy movement, under the guise of an increased focus around “simplicity” and “refocusing of efforts.”

Nearly all would agree that any tax cut is a directional ‘positive’ for risk assets / inflation.  The issue has been the Administration attempting to ‘bite off more than they can chew’ with an entire sweeping re-write of the code / system.  Instead, a much more reasonable—and thus, achievable—approach would be to focus on the corporate tax cut and infrastructure side first to address ‘jobs and the economy.’  Two items out today are speaking to this “simplification” buzz:

1. Axios is reporting that Gary Cohn has “…privately said he’s warming to the idea of eliminating the local and state tax deductions to pay for tax cuts and simplify the code” per inside sources.  Okay, that’s a positive step.

2. Separately, the NYT is running an Op-Ed from a number of conservatives with ties into the Trump Administration (Kudlow, Forbes, Laffer, Moore) which makes the case for more “simplification” with a focus on “jobs and the economy.”  They propose a system where to get to a 15% corp tax cut, you’d 1) allow businesses to immediately deduct full cost of capital purchases 2) impose a low tax on repatriation of foreign profits 3) roll-out the infrastructure bill funded by the repatriation of foreign profits. To make this work, Republicans and the Admin need to “stop insisting on ‘revenue neutrality,’ drop the ‘BAT’ / ‘carbon tax’ talk, and push-back efforts to unwind the complexities of the individual tax system until 2018.  Get ‘this’ out first, as the Op-Ed notes the risk that “…financial markets and American businesses are starting to get jittery over the prospect that a tax cut won’t get done this year. A failure here would be negative for the economy and the stock market and could stall out the “Trump bounce” we have seen since the president’s election.”

US rates—despite very ‘capitulatory’-looking trading behavior yesterday—actually held a key level, as the 2.18% ‘50% Fibo Retracement’ in the UST 10Y of the post Trump move, which wasn’t able to be broken to the downside.  Add in the ‘faint whiff of movement’ again with Trump tax / US fiscal policy today, and risky-assets / rates / notably breakevens are moving nicely higher currently.

With that ‘hold’ in rates, the USD also put in a low and bounced from yday afternoon, which has helped $/Y recover as a broad ‘risk-asset proxy.’  Regarding everybody’s favorite “new” long European equities, we are seeing ‘cyclicals’ as leadership sectors with the aforementioned ‘higher rates’ so far today (Financials, Industrials and Materials as 3 of 5 sectors currently ‘up’ on the session, while ‘duration-sensitive’ / ‘defensives’ REITS, Utilities, Healthcare, Staples and Telco are all in the red).  Not surprisingly then, we can anticipate similar behavior then from US ‘reflation’ equities plays today: value factor, cyclical beta, small caps, leveraged balance sheet etc.

A potential timeline in my head from working with my colleague Mark Orsley is the sense that the ‘rates short’ capitulation is in the 7th inning—with the rates desk noting that the short covering seen was on “decent but not high volume.”  Mark / the desk’s view is that there is still an ultimate ‘wave’ to come…but probably not before we see another move HIGHER in rates back towards that huge 2.30 level to ‘fill the gap.’  Currently Mark notes that rates and USD are all showing the potential for ‘short-term bounces,’ while conversely, gold looks exposed for a similar near-term pullback.  Perversely, it is this point where another rally in rates (perhaps more fading in ‘economic surprises’?) is likely to squeeze and force liquidations of the UST / rates shorts to the 2.05 level…at which time you’d want to be fading this rally and reapplying ‘reflation’ trades.

The global data still being deeply expansive (current), the gradual removal of geopolitical stresses / flashpoints (May), increasing news-flow on the Trump budget and potentially taxes (May+) and continual-messaging from the Fed on their intent to stay firm with desire to taper the balance sheet (coming months) will all conspire to drive rates again higher by late May / early June.

This is where you’d then expect to see the ‘cyclically geared’ stuff to again outperform, which in turn would see the closure of that ‘barbell approach’ I noted earlier this week to ‘get you through’ the next month time-period (long both defensives and secular growth to near-term benefit from the rates reversal lower, but to provide some beta-y upside on a risk ‘relief rally’ around the inevitable geopolitical calming achieved by the end of May).

From the ‘chief risks to outlook’ side: Chinese industrial commodities continue to gain my attention though from a ‘deflationary’ perspective, with further selling almost across the board last night in Shanghai futures

(Aluminum, Copper, Nickel, Tin, Zinc, Lead, Rubber, Silver and Deformed Bar all lower, while Gold saw respite on ‘haven’- angle):

As I outlined yesterday, 1) ‘inflation expectations’ and both 2) energy- and industrials- commodities prices are ubiquitous as factor drivers in the QI cross-asset model.  This drawdown in industrial metals then is an ominous trend, as it points to the fading ‘inputs’ going forward without further liquidity being injected into the system.  A number of clients have highlighted the correlated between Chinese liquidity injections / open market operations / loan and social financing growth and commodities / global inflation measures.

This is why I continue to ‘bring it back’ to this chart of Chinese credit creation and its impact on global inflation via the supply chain:

So as the ‘deflation’ or ‘reflation’ / ‘cyclicals’ or ‘defensives’ binary debate plows on within equities, ‘secular growth’ continues to be the favorite hiding place for those looking to avoid policy- and duration- risk.  Currently though, it’s subject to the ‘April Effect’ phenomenon I’ve been discussing over the course of the month, which shows basically that 12 month ‘momentum longs’ significantly underperform 12 month ‘momentum shorts’ on apparent rebalancing.  As ‘value’ led the 9 months of last year, and ‘growth’ led majority of the current YTD, these two areas are most-susceptible to drawdown as part of this—to the benefit of ‘anti-beta’ (low vol) factor.

This rebalancing is likely based-upon the ‘Sell in May’ phenomenon, where long-term data (Dec 31, 1990 through March 30, 2017) shows better returns from rotating stock holdings into defensives (bonds, ‘low vol’ or staples / defensives) btwn May-Oct. versus outright staying long S&P 500 ‘all year long.”  Per Fidelity:

2017 Retail Bankruptcies Soar To 'Great Recession' Highs

As U.S. equity markets continue their march back toward all-time highs, courtesy of the latest BTFD binge trade, at least one "small" segment of the U.S. economy does not seem to be participating in the rally as 9 brick-and-mortar retailers have already filed for bankruptcy protection in 1Q 2017 alone.  That volume of filings matches the total number of retail bankruptcies for all of 2016 and puts the industry on pace to exceed even the "great recession" highs. Per CNBC:

Nine retailers have filed in just the first three months of 2017, according to data provided exclusively to CNBC from AlixPartners consulting firm. That equals the number for all of 2016. It also puts the industry on pace for the highest number of such filings since 2009, when 18 retailers resorted to that action.

The rising number of retail bankruptcies comes as consumers are making more purchases online, and shifting their spending toward travel and other experiences. Meanwhile, the supply of physical stores continues to outweigh shopper demand, putting pressure on the industry"s profits.

"It"s just kind of this perfect storm where things are coming together, and it"s going to continue for awhile," Deb Rieger-Paganis, a managing director in the turnaround and restructuring practice at AlixPartners, told CNBC.

Many of the early retail victims include companies that were snapped up by Private Equity interests during the last down cycle and aggressively levered.  In addition to the following nine retailers that have already liquidated or are working to reorganize, Payless Shoes and Bebe are also expected to file at some point in the not so distant future.

• Gordmans Stores


• Gander Mountain


• General Wireless Operations (formerly RadioShack)


• HHGregg


• BCBG Max Azria


• Michigan Sporting Goods Distributors


• Eastern Outfitters


• Wet Seal


• Limited Stores

Of course, as Deb Rieger-Paganis, a managing director in the turnaround and restructuring practice at AlixPartners, points out, retail bankruptcies and/or store closures, especially from anchor tenants, can push the whole retail space into a downward spiral as "people don"t like to shop where there"s a lot of vacant space."  So while larger retailers like Macy"s, J.C. Penney, Sears and Kmart have avoided chapter 11 so far in this cycle, they"re all in the process of closing hundreds of stores and those vacancies are likely to have ripple effects through the industry.

Meanwhile, as we pointed out last month (see "America"s Desperate Mall Owners Turn To Grocers, Doctors & High Schools To Fill Empty Space"), America"s mall owners are having such a hard time filling empty retail space that they"re turning to high schools, doctors offices and grocery stores.

Once a shining beacon of American capitalism, malls around the U.S. are failing at an alarming rate due to a combination of shifting consumption patterns, years of underinvestment by mall owners and a spate of retailer bankruptcies over the past 12 months that have left large swaths of once prime real estate empty (see "Number Of Distressed US Retailers Highest Since The Great Recession"). 

Now, as the vacant square footage grows larger, mall owners are being increasingly forced to turn to non-conventional tenants to fill empty space.  Per the Wall Street Journal, the latest target of mall owners is yet another struggling industry, grocers, with everyone from Whole Foods to Kroger looking to snap up square footage at discount prices.

Natick Mall in Natick, Mass., is leasing 194,000 square feet of space vacated by J.C. Penney Co. to upscale grocer Wegmans Food Markets Inc., which is planning to open a store in 2018.

College Mall in Bloomington, Ind., plans to bring in 365 by Whole Foods Market in the fall.

Grocery giant Kroger Co., meanwhile, has purchased a former Macy’s Inc. location at Kingsdale Shopping Center in Upper Arlington, Ohio, and plans to build a new store in its place.

But we"re sure it will all work out just fine and wall street will go on buying those mall reits with reckless abandon...you know, because dividend yields.

RBC Emergency Market Update: "Big Trouble For Consensus Trades"

Markets may not be turmoiling yet, but as per this "emergency" Sunday night "hot take" from RBC"s cross-asset head Charlie McElligott notes, things are certainly starting to break.

SPECIAL EDITION RBC Big Picture: BIG TROUBLE FOR CONSENSUS "REFLATION" TRADES AS "FISCAL POLICY" FEARS CONFIRMED
 
#HOTTAKE: ‘Risk-off’ in a sloppy Asian opening to start the week (ES1 -18 handles, $/Y -100pips to 110.34, UST 10Y ylds at 2.36), as markets digest the scope and viability of the US ‘fiscal policy’ narrative going-forward off the tremors of Friday’s failed healthcare repeal vote. 

“Reflation” themes were already staggering in recent weeks off-the-back of the recent the crude oil sell-off (and the implications for weakened ‘inflation expectations’)—but to now see the longer-term ‘US fiscal policy upside kicker’ looking especially threatened, it is likely that the ‘big three’ trade expressions (longs in US Dollar US Banks and shorts in US Rates) are looking very exposed for an acceleration of recent drawdowns (in conjunction with longs in HY, ‘cyclicals / defensives’ L/S pairs, equities ‘value’ factor, equities high beta, US equities small cap).

‘Long Dollar’ trades are currently seen unwinding ‘real-time’ as ‘the world’s most crowded trade’ and ‘reflation’ proxy earlier this evening broke the convergence of both its 200dma and the 76.4% Fibo Retracement of the entire Dollar move since the US election—exposing significant downside.  Legacy shorts held against the US Dollar in Euro (making 2017 highs vs USD), Yen (making 2017 highs vs USD), Pound and Canadian Dollar are being painfully squeezed as traders are liquidating after ‘processing’ the implications of the Trump Administration’s failed ACA repeal Friday, with many ‘late-comers’ to these trades significantly ‘under water’ already and looking to ‘tap out’ on losers.  Tactical funds and discretionary macro were already pivoting ‘short USD’ last week on the new “policy CONVERGENCE” dynamic, and now with momentum having clearly pivoted in the other direction, one would expect systematic / trend / CTA to be heavily-involved now as well on the short-side of USD trades.

The story that we were getting Friday from some buyside traders and sellside strategists (by-and-large) was that a “no” vote was almost irrelevant to risk-assets, as market participants want the US Administration to ‘move on’ and ‘focus its efforts’ on tax policy anyhow (versus being mired in further debate with the ‘repeal and replace’ of the ACA).  What many were missing here though (and noted by Mark Orsley Friday afternoon) is that the sequencing of ‘healthcare’ and ‘budget’ before ‘taxes’ was intentional and critical, as spending cuts from a repeal of the ACA were effectively a ‘requirement’ against the pending new administration’s tax-plan which will only further increase the deficit.  This is obviously an impediment then to efforts to keep any new tax plan ‘deficit neutral,’ so essentially, the GOP is starting in a bigger hole, some say to the tune of $1T dollars….and this of course is not including the extremely controversial BAT component, which too has lost much momentum over the past two months, despite projections that it could provide upwards of $1T of revenues over a 10 year period in order to fund the individual and corporate tax cut proposals (ironically, the same ‘Freedom Caucus’ of GOP’ers which symbolically defeated the ‘new’ healthcare plan on Friday are also against the BAT…yikes).

What does it all mean?  Some of the talk emanating from DC policy-circles is now of the view that this now means an almost certainty of a ‘watered down’ tax plan, which instead of deep ‘headline’ cuts planned will now feature much more modest cuts (corporates as priority over individuals) and focus on “streamlining” tax code / loopholes.  This is not the ‘joy’ that many of those 2500 S&P targets ‘signed-up’ for.

What is at risk?  I noted many of the ‘consensual longs’ which have already showed significant signs of being de-grossed in recent weeks.  But as we now see a high likelihood of the potential for a rates reversal to accelerate and long duration’ rallies in the face of the ‘rates short’ crowd, there will be major implications within equities too, as ‘low vol’ defensives (REITS / Utes / Staples / Telcos) and ‘anti-beta’ market neutral strategies are certain to see further escalation of their recent strength.  The good news for equities-longs  is that ‘secular growers’ like tech, consumer discretionary and biotech is too likely to benefit from money rotating out of ‘deep cyclicals’and ‘value.’  

Stay tuned…
 
 

Deutsche: The Fed Gave Trump Just Enough Rope To Hang Himself With

There has been no shortage of sellside reactions to last week"s Fed rate hike, which have run the gamut from congratulatory as per BofA and Credit Suisse, to the outright critical, as we showed last week in a note from Goldman Sachs, RBC and SocGen, all of whom accused the Fed of either misleading the market, or soon being being forced to double down on its hawkish message as a result of the dramatic easing in financial conditions as a result of a rate hike.

A somewhat compromise take was provided by JPM"s quant Marko Kolanovic last week who shared the following reaction to the Fed hike:

Fed Put and Buying the Dip: Early this month, the Fed surprised the market by telegraphing a March hike. At the time, investors started speculating whether this was a sudden hawkish turn, or even a politically motivated decision. We think it might have been the move of a prudent monetary Dove. Hiking in March, gives the Fed the option to skip June should there be market turmoil (e.g. related to French elections). Indeed, the market-implied probability of a June hike dropped yesterday from 60% to 50%. After the dovish hike yesterday, extreme short positioning in bonds, and the selloff in rate sensitive assets (such as precious metals and REITs) snapped back. The short squeeze in these assets could have some momentum in the next several days. The dovish Fed outcome implies that the ‘Fed Put’ is likely still alive and well...

Which brings us to the latest, and most whimsical take yet, that of Deutsche Bank credit derivatives expert, Aleksandar Kocic, who usually tends to have some of the more unconvential views on monetary, or any other, policy. He did not disappoint on Monday, when in Deutsche Bank"s latest weekly note, he writes that there are basically two different possible endings to the current economic situation, or as he puts it, "the future is bimodal" with "volatility to be found between politics vs. policy."

Here is a summary of his reaction to the Fed"s third rate hike in a decade

The subtext of the last week"s Fed "package" is a compromise motivated by a desire to extend the comfort zone and to hedge their position against possible fiscal irresponsibility, while, at the same time, not stand  in the way to any possible fiscal stimulus (or its absence) by hiking too aggressively.... Depending on the interplay between degree of political resolve and the Fed actions we could see two distinct paths of resolution of the existing tensions in the mid- or long-run.

And his detailed take:f

Last week, the Fed delivered what appears as a dovish hike, in all likelihood to be followed with two hikes more in 2017 and three in 2018. Such a choice of the Fed action was a compromise driven by the developments in the labor market and the key events in Europe, on one side, combined with the risk associated with the approval of the fiscal stimulus, on the other. The subtext of this compromise can be interpreted as being motivated by the Fed’s desire to extend the comfort zone and to hedge their position against possible fiscal irresponsibility, while, at the same time, not stand in the way to any possible fiscal stimulus by hiking too aggressively.

Despite all the efforts not to create more uncertainty, this is likely to create at least mild ambiguity regarding the long-run. A Fed which is not in a standby position waiting for the fiscal package to arrive and kick in is going to be supportive for USD and higher real rates. The March FOMC “package” (in terms of rate hike, dots, rhetoric and Q&E) implies effectively a real rate rise and is most likely bearish for breakevens, which could diminish the effect of the border tax on the trade deficit and, as such, reduce the impact on growth potential. In addition, having higher real rates increases the costs of borrowing and possibly creates political resistance against deficit expansions and structural steepening of the curve. On top of that, given what we saw in the last weeks, this suggests that the political process around the budget plan and the Legislative package already expected by the market is going to be anything but smooth, which is adding further doubts about its success and timing.

Depending on the interplay of politics and policy -- degree of political resolve and the Fed actions -- we could see two distinct paths of resolution of the existing tensions in the mid- or long-run. On one hand, it appears that the Fed is removing uncertainty around the terminal rate, while on the other, politics is creating a binary outcomes which could have a dramatically different effect on long rates. In that context, we are facing a future with bifurcating back end of the curve. Either political bottlenecks clear and the stimulus gets approved and goes full force leading to higher growth potential with subsequent rise in price levels and structural steepening of the curve, or political tensions effectively sabotage either its arrival or content (or both), and the curve initially bear flattens or even twists with rate shorts capitulation accelerating the rally of the back end.

The above, simply summarized: the Fed has given Trump just enough rope to hang himself with; and since all that matters now is how effective the President will be in passing his political agenda - which is not looking good- should Trump fails, the one of two possible outcomes that is most likely is the one where the "curve bear flattens or inverts", prompting the next, long overdue, recession. 

Oh Sheet, It’s A REIT (The Coming Crisis)

By Chris at www.CapitalistExploits.at

On Wednesday, we took a gander at global real estate and today I"ve got a follow up to that dealing with REITs.

My long term buddy, fellow hedgie and confidant Kuppy, who can be found lurking here, shares his thoughts on the US real estate sector and in particular REITs:

Him: I think people are wrong. There are lots of instances where the Fed has raised rates and nothing bad has happened.

Me: Name one time.

Him: Hmmm…. Oh, crap!!

Yea, we’re getting to that moment where people realize that rates may finally matter in a highly leveraged economy. My good friend Tal, made that point over a year ago.  I hope you took his warning and lightened up on interest rate sensitive assets.

Let’s think of a typical REIT called Ponzi REIT (Ticker symbol PREIT). They’ve been out there for nearly a decade, buying “irreplaceable” Class A assets in “gateway cities.” Every six months, they raise money to buy more assets and through a combination of financial engineering and deferred maintenance, they manage to increase incremental AFFO per share on each transaction. So what if they’re overpaying--buying 4-cap assets if they can fund them at a 3% financing cost—it’s still accretive to the dividend.

Ignoring working capital and taxes, the current balance sheet is $10 billion in assets at cost offset by $5.5 billion in debt for total debt to capital of 55%. So far, it looks like pretty much every property REIT out there. At a 4 yield, they have $400 million of operating income and $165 million of interest expense, for total AFFO of $235 million. They trade at a 4% dividend yield or a $5.875 billion market cap. By magic, $4.5 billion of equity is worth 31% more than book. We’ve covered this before in my section on Ponzi MLPs last year. As always, it’s highly lucrative for investors to continue this charade with future capital raises, until it isn’t.

Now, interest rates are rising. Let’s say that PREIT’s assets are no longer valued by the market as 4-caps, but are instead 6-caps. Keep in mind that this would still be dramatically below average cap rates over the past few decades. Now, the $400 million in operating income is only worth $6.667 billion and with $5.5 billion in debt, total debt to capital is 83%. That’s a VERY leveraged balance sheet. Even worse, the assets are funded with 5-year paper. When that re-sets to 5% interest rates, interest expense bumps up to $275 million a year and AFFO declines to $125 million a year. At a new market 6% dividend yield, this is now only worth $2.08 billion. Essentially, a small change in interest rates just destroyed 65% of the equity value of PREIT.

All of this assumes that the revenues at PREIT stay the same. What if rents decline? It’s no secret that there’s a massive oversupply of commercial property being built. If rents or occupancy decline, you could be looking at a situation where dividends could be cut. Heck, interest coverage itself may come into doubt. I know that lots of investors keep talking about interest rates not mattering in the property sector because rents will go up with a stronger economy. Rents will need to go up a whole lot to keep pace with cap rates going from 4 to 6. We all know that isn’t going to happen. Especially in sectors like retail where tenants are increasingly downsizing. Finally, REITs are unusually bad vehicles for dealing with debt re-payment when the ponzi scheme goes in reverse as REITs cannot retain earnings to de-lever and instead must raise capital by issuing equity--often at highly disadvantageous prices. At least MLPs were able to cut dividends and de-lever. Look at 20 year charts of many large REITs. Notice how long it took them to recover from the highly dilutive equity raises that most undertook in 2008 and 2009.

Of course, I’m not the first guy doing this math. Look at the charts of various smaller REITs that aren’t being propped up with broad market ETF inflows. These things are getting nuked—particularly in the retail sector. I suspect that this contagion eventually spreads to other REITs as well. Where will they bottom? My guess is a whole lot lower and this will put stress on many other sectors of the economy. For instance, it is still a head scratcher why banks have recently been so strong, as they will bear the brunt of this decline in asset values.

I continue to have very few long positions and continue to wait for bargains. As I survey what few positions I have, I realize that I don’t want property assets—even if they’re dramatically undervalued and underleveraged Mexican hotel REITs that will benefit from a weaker Peso. If REIT investors start to liquidate assets, nothing will be immune. Over the past few days, I’ve sold the majority of my positions in my 2 Mexican REITs for roughly 10% gains after accounting for an appreciation of the Peso. I think these are good long-term holds, but I’m waiting for more of a crack-up before wading back into anything property related. I have a feeling that I’ll be increasingly active in busted property REITs at some point in the future. For now, they mostly look like the Ponzi MLPs that I wrote about last year. Guess it’s time to start educating myself on a few of them.

What fun this all is...

Have an awesome weekend and maybe, just maybe lighten up on that RE exposure, heh.

- Chris

"Everyone has a plan "till they get punched in the mouth." — Mike Tyson

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"The Retail Bubble Has Burst" - Summarizing The Dark 4Q Earnings Commentary Of Retail CEOs

Amazon"s willingness to sell almost any product imaginable at a loss, combined with a massive bubble in retail real estate square footage courtesy of decades of low interest rates seems to finally be catching up with the traditional bricks-and-mortar retailers of America. 

As evidence, Scott Krisiloff of Avondale Asset Management compiled the following sample of relatively downtrodden commentary from America"s largest retail CEOs, all of who seem to be throwing in the towel on hopes of any near term upside for their industry:

Everything is not awesome, in fact, it"s kind of awful

“Our industry is the midst of a seismic shift, and, of course, you read the headlines. In fact, many of you write the reports, we’re operating in an incredibly challenging environment. All across the retail industry, many of our competitors are aggressively rationalizing their assets. They are closing stores, exiting markets. They’re cutting costs just to keep their heads above water. We’ve not seen this number of distressed retailers since 2009 in the Great Recession.”   - Target CEO Brian Cornell

Cheap debt created a massive retail real estate bubble that is now bursting right before our eyes

“Retail square feet per capita in the United States is more than six times that of Europe or Japan. And this doesn’t count digital commerce. Our industry, not unlike the housing industry, saw too much square footage capacity added in the 90’s and early 2000’s. Thousands of new doors opened and rents soared; this created a bubble, and like housing, that bubble has now burst. We are seeing the results; doors shuttering and rents retreating. This trend will continue for the foreseeable future and may even accelerate.” —Urban Outfitters CEO Richard Hayne (Retail)

Profitability "race to the bottom" is on as brick-and-mortar stores make "investments" (a.k.a. "slashes prices") to drive volume

“We certainly view 2017 as a year of investment. In 2018, we’ll continue to transition as these different initiatives begin to mature. As we get into 2019 and beyond, we certainly expect stability and a return to growth…We’ve got to invest to grow. We’ve got to reimagine our stores. ” —Target CEO Brian Cornell (Retail)

“we plan to do what any good portfolio manager would. Invest resources in the most promising opportunities, diversify to lower risk, and increase liquidity…Our highest priority is where we’ve had the most recent success, digital” —Urban Outfitters CEO Richard Hayne (Retail)

Inflation may not be as strong as advertised

“Regarding deflation, overall, primarily in the US, we have seen deflation in the 1%, 1.5% range in February. Departments such as foods, sundries, frozen foods, liquor meat, dairy showed the most deflation on the foods and sundries side. On the non-food side consumer electronics continue to be deflationary, primarily in the TV category…The collective view is inflationary, or less deflationary, for the next few months and maybe a little inflationary, but it’s a crap shoot.” —Costco CFO Richard Galanti (Retail)

“we also have to acknowledge the ongoing challenges facing our industry. Our customers are facing a difficult retail environment due to deflation and increased competition. We view deflation as cyclical, inflation will come back at some point but while it’s here, it’s leading to some very real challenges for us and our retail customers.” —UNFI CEO Steven Spinner (Food Distributor)

Retail real estate glut + Market share loss to online = Disaster for REITs

“This would be fine if the increase in DTC sales were wholly additive, but they’re not. Digital shopping is partially replacing store shopping and thus is negatively impacting store traffic and store generated sales. Flat to negative store ‘comps’ are causing occupancy deleverage and eroding four-wall margins.” —Urban Outfitters CEO Richard Hayne (Retail)

But, chin up because this is all "good news" as retail shares will tank and create opportunities for those on wall street who survive

“these inflection points come around every generation or so. And strong retailers endure, while others, well, they don’t. Pick your era defining change throughout history from downtown department stores to suburban malls, catalogs, e-commerce.” —Target CEO Brian Cornell (Retail)

* * *

Meanwhile, as we pointed out earlier this week, the biggest losers in this retail melt down will inevitably be the investors in America"s massively levered REIT companies. 

In fact, the latest note from one of the world"s most vocal mega-bears, Horseman Capital"s Russell Clark, perfectly summarized the slow-motion train wreck that is currently wreaking havoc on mall REITs in a note titled "Mall Rats":

“Intriguingly we have started to see volumes of real estate transactions for shopping malls fall. This means that the number of transactions to buy or sell properties is beginning to decline. Last time this happened, rents began to fall a year later.

His full note is below:

MALL RATS

Shopping mall REITS have been a fantastic investment over the years. Not only have they provided investors with large capital gains, they have also typically offered above market dividend yields. My interpretation of the REIT model is that the operator collects rents from a diverse number of retailers. This is then passed on to the end investors after costs and financing. The REIT manager reduces risk by diversifying the retailers paying rent, and by also spreading the risk geographically. If the REIT manager can acquire more real estate assets at a yield higher than what it needs to pay out as dividend yield, then the REIT can issue more shares and grow indefinitely. Mall REITs have generally done well, except during the financial crisis.

However, it seems to me that North America could well have too many shopping malls. On a per capita basis, the US has twice the space of Australia and 5 times that in the UK.

One source of REITs revenue growth comes from acquiring more malls. Intriguingly we have started to see volumes of real estate transactions for shopping malls fall. This means that the number of transactions to buy or sell properties is beginning to decline. Last time this happened, rents began to fall a year later. Perhaps it’s a sign that buyers believe rents have some downside risk?

Many people in the market are aware of the problems that the large department stores in the US are currently facing, and their resultant plans to retrench. This affects two of the largest shopping mall REITs that have the department stores as tenants. The reality is that the shopping mall REITs charge extremely low rents to the department stores. The large shopping malls use the department stores to lure traffic, and then make their money from higher rents charged to speciality retailers. Often the per square foot rent of the specialty retailer can be 30 times or higher that paid by the anchor tenant. Looking at the top 2 shopping mall operators, they disclose their top rent payers. Recent share prices performance of 8 shared tenants has been poor, and management commentary has seeming implied that they may also be looking to reduce store count.

It should also be pointed out that many tenants have a clause in their lease to reduce rents should an anchor close a store. Thus, even though the loss of rent due to an anchor closing is minimal, the knock-on effect of reduced rents from the remaining tenants is a serious concern for the REITs.

One of the other problems that shopping mall REITs face is that the size that the large department stores take up is more than 400 million square feet. The largest and most successfully specialty retailer is TJ Maxx which currently has 100 million square feet. It is difficult to see any single retailer quickly being able to fill the space made vacant by department store closures.

Back in the lead up to the financial crisis we found that the share prices of REITs and their tenants were very closely related. Recently we have seen tenants share price weaken again, but REITS remain relatively strong.

Investors are advised to exercise caution with the shopping mall REITs

With The S&P At Record Highs, Investors Pull Cash From US Stocks In 4 Of The Past 5 Weeks

A curious dichotomy has emerged in global fund flows.

According to the latest flow report from BofA"s Michael Hartnett, "it"s risk-on in Bonds, it"s inflation-on in Stocks, and EM is now playing role of cyclical catch-up trade." In short, in the last week the Trump Trade has emerged from the dormancy in which it had faded for the past month.

But when one looks at where the money is flowing, it is going everywhere except where one would expect, as US stocks continue to be shunned, based on EPFR data.

Here are the details.

• First in bonds, there has been a dip in bond yields which has incited big buying of IG bonds ($7.6bn...biggest since Aug’16), HY bonds ($1.9bn...note price-action in corporate bond markets remains resolutely "risk-on" as cross-asset signal – Chart 1), renewed interest in EM debt (inflows 5 of past 6 weeks), and 9th consecutive week of inflows to TIPS ($1bn…biggest week for TIPS since Trump election); in contrast, dip in Treasury yields coincides with largest outflows from Treasury funds YTD.


• Then, in stocks there has been inflows to equity funds investing in value, Europe, Japan (like TIPS, largest week of inflows for Japan since election), materials, and financials;


• Paradoxically, Emerging Markets have also gained as a Trump"s "economic nationalism" had, at least until yesterday, proben to be dollar-negative not dollar-positive (biggest hit to consensus positions YTD), which has has made EM the contrarian Q1 winner...EM stocks and bonds have seen $11bn inflows YTD as investors start chasing this cyclical laggard. This trend may reverse however now that the dollar has resumed its grind higher.

Yet despite the latest weekly euphoria, BofA finds outflows from equity funds investing in US stocks, amounting to another $1.6 billion across ETFs and mutual funds, the 4th week of outflows in the past five. Among the sectors shunned are growth, telcos, consumer sector; i.e. redemption from "deflation assets", inflows to "inflation assets."

Still, despite this ongoing outflow from the US, the S&P continues to levitate to ever higher all time highs, making one wonder once again, if the latest record push is more a function of short covering (something we saw vividly earlier this week), and/or stock buybacks.

Some more grandular details:

Asset Class Flows

• Bonds: 7 straight weeks of inflows ($13.3bn)


• Equities: 6 straight weeks of inflows ($6.3bn) ($7.8bn ETF inflows vs $1.4bn mutual fund outflows)


• Precious metals: $1.9bn inflows (inflows in 3 of past 4 weeks)


• Money-markets: $10.2bn outflows

Fixed Income Flows

• Inflows to HY bond funds in 10 of past 11 weeks ($1.9bn)


• Inflows to EM debt funds in 5 of past 6 weeks ($2.5bn)


• 7 straight weeks of IG bond inflows ($7.6bn)


• 13 straight weeks of inflows to bank loan funds ($1.2bn)


• 9 straight weeks of inflows to TIPS funds ($1.0bn)


• $0.9bn outflows from govt/tsy funds

Equity Flows

• EM: 5 straight weeks of inflows ($1.0bn)


• Japan: 5 straight weeks of inflows ($3.4bn)


• Europe: small $0.1bn inflows (3 straight weeks)


• US: $1.6bn outflows (outflows in 4 of past 5 weeks)

By sector: $1.9bn inflows to US value funds vs $1.0bn outflows from US growth funds; 4 straight weeks of outflows from REITs ($0.4bn); inflows to materials in 13 of past 14 weeks ($2.4bn); inflows to energy in 9 of past 10 weeks ($0.4bn)

* * *

Hartnett then rhetorically asks again, as he did earlier in the week, if it is time to sell and answers: 

"No. We remain bullish risk assets: Feb 10th marks one-year anniversary of lows in oil $26/bbl, SPX 1810, inflation expectations, and highs in VIX 30 and HY spreads 900bps; catalysts for furious 12-month rally = Positioning, Profits, Policy; our Positioning gauge up from 0 to 6.1, our Profit proxy up from 1.5 to 6., but neither at euphoric levels. And Policy (easy global money & Trump fiscal stimulus) remains risk-friendly H1.

Finally, as we head into this one last hurrah for stocks, here are BofA"s "Icarus trade targets":

• SPX 2500,


• oil $70/b,


• GT30 3.5%,


• DXY 100;

With every passing day, these targets look less and less ridiculous.

Mexico On Sale (And How Best To Play It)

By Chris at www.CapitalistExploits.at

Ok, this is getting a bit ridiculous.

Ever since Americans picked the bully over the crook, and the Mexican Peso began acting like a penny stock just after the promoters begin dumping stock, I"ve been literally inundated with questions about Mexico. It seems I"ve got a lot of American readers super keen to look for value where others fear to tread. A good thing!

I did point out back in early December what I thought about the long Mexico trade and in particular the long MXN trade idea.

I showed this chart of the iShares MSCI Mexico Capped ETF (EWW) which is a decent enough proxy for the Mexican stock market. Today it"s pretty much unchanged from when I first showed it to you over a month ago.

Here"s what I said then:

The reason I chose to show you this chart, one going all the way back to the GFC, is because I want you to see the forest and not get caught up in the gnarly branches and roots of the trees, and as such realise that despite all the brouhaha crossing your news feeds. Trump’s election is IRRELEVANT to this market. The trend was in place well before Trump began lashing out at the Mexicans and Chinese for stealing America’s rice bowls KFC.

So that was, and still is, my macro thesis and how Mexico plays into it.

Sure, the Peso is cheap and by many accounts the greenback is not, but this is knee jerk, first level thinking to simply buy something when it"s cheap. When digging down into the bowels of the market to try figure out what"s driving capital flows and liquidity, I come to a different view.

This is the nexus of the articles I wrote about the eurodollar market. I urge you to drink lots of coffee and read it as well as the subsequent two articles: "The Eurodollar Market: It"s Not Working" and "Collateral Damage", in which I explained my thesis as to why we"ve been experiencing deflation during ridiculous monetary expansion. A lot of my investment thesis stems from those articles and the knock on effects.

I"d planned to get some thoughts on Mexico when speaking with Mark Yusko today as he"s recently back from a trip there, however the conversation went long on other topics and so that"ll have to wait for another day. Maybe I"ll hit record and publish it as a podcast, which could be fun.

Instead, today I thought to bring you my buddy Kuppy"s (Harris Kupperman) take on Mexico because it"s a topic we"ve discussed quite a bit. And since Kuppy is a great stock picker (and I"m more of a macro guy), I thought I"d share with you his thoughts on how best to play the Mexico on sale story.

Enjoy!

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I am writing to you from Santiago de Queretaro, Mexico, where the whole country is having a yuuuuge Donald Trump victory sale. Mexico is one of my favorite countries to visit. It combines a laid back attitude, friendly people and an outstanding culinary tradition.

It also helps that it’s currently one of the cheapest places on the planet—one of many reasons that I’ve spent 5 weeks here recently (Yucatan and Central Mexico thus far).

Mexico has always been known as an affordable place with cheap beer and tacos, but the last two years have taken that dynamic to an extreme.

Where else is the brand new AC Marriott $42 per night? In touristy San Miguel de Allende, we booked a 2,500 foot, 2 bedroom suite on the main square for $75 a night. Food for two with a bottle of mezcal is about $30 at the most posh of restaurants.

It’s verging on silly.

Between the two thirds decline in the Mexican Peso over the past two years and an over-dramatized fear of violence, the tourist economy is basically running on free. They’re just happy to see you and thankfully, my Mexican fiancé can translate my pathetic gringo Spanish as we travel around.  

5-year peso chart: 2/3 of the value is gone in just the last 2 years

If you don’t have a trip planned to Mexico, get working on it. I don’t think it will stay this cheap for long.

Let’s start with the obvious question—is it dangerous?

I tend to like statistics as opposed to jaundiced media reporting. The USA has a 4.5 per 100,000 homicide rate. Mexico is pushing 20, or about four times as bad. Given that I’m not terribly scared in America, four times worse doesn’t seem that bad.

When you dig into the numbers, you realize that much of this crime is drug related. In fact, if you aren’t involved in narco-trafficking, the homicide rate isn’t much worse than that of the USA.

Furthermore, most of the violence seems clustered in a few cities and states. I wouldn’t go to Baltimore or East St. Louis on vacation, why go to the Mexican version? Strip that all out and Mexico is on par with most of America.

Unfortunately, a few dramatic incidents have cost Mexico millions of visitors a year. Eventually, perceptions will adjust to reality and the tourists will flock back—especially given how affordable it is.

I have now taken two trips to Mexico during the past 10 weeks. The whole time, I’ve kept asking myself, “How do you play this?” It’s so cheap.

Despite threats of change from Trump, I know this is an overreaction. Mexico is sure to bounce back and keep growing--though, the economy may shift slightly from manufacturing towards tourism due to how cheap it is to visit.

The thing is, just because something is cheap, that doesn’t mean there’s always a “play.”

There’s an old adage in finance that you don’t buy the currency of Spanish speaking countries. Pull up a 10-year chart of any of these countries and it will be obvious why that adage has weight—pull up a 50-year chart and you won’t even be able to zoom in to where we are today. The peso has overshot recently, but it’s not an asset I want to own.

What about assets benefitting from a weakening currency?

In property, if you can borrow at a reasonable rate in a depreciating currency and get paid rent in US dollars, you’re going to make a fortune. Unfortunately, for most foreign property companies, rents are long-term and struck in depreciating local currencies.

However, the hotel sector is largely immune to this. They can adjust their room rates daily.

Fibra Hotel (FIHO12: Mexico) and Fibra Inn (FINN13: Mexico) have both borrowed in Mexican pesos. Right now, the rates they’re receiving are silly. Look up some of their hotels on the internet: $20 here, $30 there.

This is because there is a lag in how fast they can re-price room rates to take advantage of the decline in the peso—especially as many of their customers are business travelers with budgets in pesos.

However, their costs are mostly fixed, the assets were built with pre-depreciated currency—they’re now worth much more in current pesos than it cost to build them. The supply of new hotels will slow as it costs much more in current pesos to build new ones—all the old ones have a massive competitive advantage until room rates fully reset.

Meanwhile, due to Trump’s victory and the decline in the peso, Mexican hotel REITs are being priced like something awful is about to happen—instead, a weaker peso is a huge boon to them.

In terms of valuations, I don’t think annualizing current quarter cash flow is the correct measure to look at—as room rates in Mexican pesos will likely rise in future quarters.

That said, they trade at about ten times pro-forma AFFO and pay pro-forma Q4 dividends around 9% adjusted for stabilization of new assets. That’s very cheap for a property company with minimal leverage. With mostly fixed costs, I can model these companies to be trading for more like 6 to 8 times AFFO looking forward a year—due to a normalization of hotel rates on a fixed cost structure.

A more typical measure of valuation in the hotel industry is price per room. Adjusting debt for rooms still under construction, these companies trade at enterprise values of around $30,000 to $35,000 a room, while comparable rooms cost at least twice that to construct in Mexico. This would imply that they trade for less than half of replacement cost.

Interestingly, the Mexican hotel market is much more fractured than the US market. As the market consolidates, there are lots of hotels that can be purchased for 10 cap rates—even before economies of scale at a larger REIT increase the returns.

Given the low leverage at both of these companies and how cheap debt is, there is likely to be continued growth as these companies take advantage of distressed players and make highly accretive acquisitions.

Fibra Inn priced in US dollars since the IPO

Fibra Hotel priced in US dollars since the IPO

In summary, I have started small positions in each—I’m looking for further declines before I really add size.

Deep down, I don’t think they’ve bottomed yet. However, they’re very cheap based on almost any metric you can use. They have growth pathways and the re-adjustment of room rates over the next few quarters should flow through the cash flow statements.

Meanwhile, due to dividends, you’re paid well to wait. No one ever gets the exact bottom and Mexico is stunningly cheap, incredibly close for Americans and I expect that travel will increase as a result.

Over the next few quarters, one of two things will happen—either Trump and Mexico will reach an acceptable solution on trade where the currency recovers and average daily room rates reflect something closer to historical rental rates in Mexico when priced in US dollars or the cheapness of the country drives more tourists and occupancy increases, while room rates are re-priced closer to previous dollar rates.

Either way, I see RevPAR in US dollar equivalents increasing dramatically over the next few quarters.

In any case, I’m celebrating Trump’s victory with cheap cerveza, a cheap hotel room and two very undervalued REITs. I continue to seek out other opportunities in Mexico (stay tuned).

Disclosure: Long FINN13 and FIHO12

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That"s it for today folks. Have a great week!

- Chris

"Mexico"s making a fortune off the United States." — Donald Trump

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The Great Rotation Ends: Largest US Equity Outflows In 4 Months; Biggest Treasury Inflows Since July

While the S&P500 market may remain pinned just why of all time highs, this appears to be from ongoing short covering, and is not - at least in the latest week - the result of new money entering the market. Quite the opposite: according to the latest BofA fund flow analysis based on EPFR data, in the latest week, US equities saw $6.3 billion in outflows, the largest weekly redemption from US mutual funds and ETFs in four months, since before the presidential election. And as investors pulled cash out of US stocks, they quickly reallocated it back into bonds, with all major classes seeing inflows, with notable mentions for government bonds, which had the biggest inflows since July 2016, and TIPS, where the demand for inflation protection is now the highest since the great China reflation scare of 2011 (it proved quite transitory).

Here are the details from BofA:

Bottom-line: investors continue to position for reflation via TIPS over munis, HY over gold & Japan over US equities; but the re-positioning feels grudging and flows have yet to show big asset allocation capitulation out of bonds into stocks

The first week of Trump: flows show largest weekly bond fund inflows in 4 months ($8.6bn), tiny equity fund inflows ($0.2bn) and precious metal outflows ($0.2bn) On bonds: inflows to HY bond funds in 8 of past 9 weeks; inflows to bank loan funds in 25 of past 26 weeks; inflows to TIPS in 31 of past 33 weeks (Chart below)…all reveal relentless bid for yield & inflation-protection; but note this week’s govt bond fund inflows were biggest since Jul’16

On equities: largest EM equity fund inflows in 3 months ($1.0bn); largest 3-week inflows to Japan equity funds in 16 months ($8.8bn); inflows to materials funds in 11 of past 12 weeks = clear bias towards reflation/inflation BofAML GWIM ETFs: last week our private clients added to risk (bank loans, financials & HY) & inflation plays (precious metals, TIPS) and sold down defensive/yield-plays (lowvol, dividend-income, munis, REITs & staples)

* * *

Asset Class Flows

• Equities: tiny $0.2bn inflows ($5.5bn mutual fund outflows vs $5.6bn ETF inflows)


• Bonds: $8.6bn inflows (largest in 4 months) (5 straight weeks)


• Precious metals: $0.2bn outflows (outflows in 10 of past 11 weeks)

Fixed Income Flows (Chart 2)

• Inflows to HY bond funds in 8 of past 9 weeks ($1.5bn)


• 5 straight weeks of IG bond inflows ($3.6bn)


• 11 straight weeks of inflows to bank loan funds ($1.1bn)


• 7 straight weeks of inflows to TIPS funds ($0.5bn)


• First outflows from EM debt funds in 4 weeks ($0.4bn)


• Largest govt bond fund inflows since Jul’16 ($1.4bn)

Equity Flows

Japan: strong $3.1bn inflows (inflows in 4 of past 5 weeks)

EM: $1.0bn inflows (largest in 3 months)

Europe: small $0.2bn inflows

US: $6.3bn outflows (largest in 4 months)

By sector: largest healthcare outflows ($1.0bn) from healthcare in 10 months (outflows in 8 of past 9 weeks); largest tech inflows in 14 months ($1.0bn); inflows to materials in 11 of past 12 weeks ($0.6bn)

Malls Owners Rush For The Exits As Mall-Backed CMBS Defaults Soar

Last week we wrote about the epic collapse of the Galleria Mall at Pittsburgh Mills which sold for $100 after once being appraised for $190 million shortly after being opened in 2005 (see "Pittsburgh Mall Once Worth $190 Million Sells For $100").  Unfortunately for mall owners, while the Pittsburgh Mills Galleria is an extreme example, crashing mall valuations are hardly an anomaly these days.  In fact, just a few weeks ago Commercial Real Estate Direct wrote about the Foothills Mall in Tuscon, Arizona which was valued at $115mm in 2006 and backs a $75mm CMBS loan but recently appraised for just $18mm...or just a slight 75% loss for lenders.

As pointed out by the Wall Street Journal earlier today, mall CMBS defaults are up all across the country with liquidations up 11% YoY.

In the period from January to November 2016, 314 loans secured by retail property were liquidated, up 11% from the same period a year earlier, according to data from Morningstar Credit Ratings.

“We’re seeing a boatload of these kinds of properties coming to market,” said James Hull, managing principal of Augusta, Ga.-based Hull Property Group, which purchased five malls from foreclosure sales in 2016. “There have been some draconian losses for the enclosed mall business.”

And while we"re frequently reminded of the stunning "Obama recovery" by the mainstream media, retailers seem to represent the one "tiny segment" of the U.S. economy that failed to participate in that recovery as evidenced by the soaring delinquency rates of loans backing retail properties.

Despite a strengthening economy in 2016, the delinquency rate for loans backing retail property rose by 0.6 percentage point last year to 5.76%, according to Trepp LLC, a real-estate data service. Special servicers, which deal with troubled commercial mortgage securities, managed $3.1 billion worth of mall-backed loans last year, up from $2.9 billion in 2015, according to Trepp.

This year is off to a shaky start. Earlier this month, Sears said it would close 150 stores, and Macy’s gave more details of a plan to close 100 stores.

Limited Stores Co. said it plans to close all 250 stores and filed for chapter 11 bankruptcy protection last week.

Meanwhile, as Barclays" U.S. REIT team points out, the key question for mall owners in 2017 isn"t whether rent concessions will be granted to tenants, but rather, just how deep the cuts will have to be in order to maintain occupancy.

A key topic going forward will be the extent of rent concessions provided in order for malls to maintain occupancy.  We think rent concessions could accelerate in 2017 as retailers continue to prune their store bases and at the margin, restaurant openings slow.  Many malls backfilled space in recent years with non-apparel offerings, like restaurants - which increase mall traffic, without cannibalizing sales.

Overall, we expect mall REITs to issue cautious outlooks for 2017, with a wait and see approach to the year.  This will be against the backdrop of many retailers also reporting their holiday results and 2017 guidance, which are likely to be conservative.  We believe both these factors will contribute to negative investor sentiment.

Alas, while mega malls were once the destination of choice for America"s misunderstood youth, we fear that they"re bound to suffer the same fate as the big hair, hoop earrings and creepy mustaches that once frequented their food courts in the 80s.