This week's interesting finds

Cymbria’s 2023 annual report 

Cymbria’s most-recent annual report is now available for your reading pleasure. You can find insights on how Cymbria navigated the last year and updates on our largest holding, EdgePoint Wealth Management. 

This week in charts

Manufacturing

 

Small-caps 

Automotive 

Energy 

Housing

US small-caps suffer worst run against larger stocks in more than 20 years 

US small-cap stocks are suffering their worst run of performance relative to large companies in more than 20 years, highlighting the extent to which investors have chased megacap technology stocks while smaller groups are weighed down by high interest rates. 

The Russell 2000 index has risen 24 per cent since the beginning of 2020, lagging the S&P 500’s more than 60 per cent gain over the same period. The gap in performance upends a long-term historical norm in which fast-growing small-caps have tended to deliver punchier returns for investors who can stomach the higher volatility. 

The unusually wide spread between the two closely watched indices has opened up in recent years as small-cap stocks with relatively weak balance sheets and modest pricing power have been especially hurt by high inflation and a steep rise in borrowing costs, according to analysts, putting off many investors. 

The S&P has climbed steadily since early November, with strong earnings and investor excitement about the artificial intelligence boom driving huge gains for the likes of Nvidia and Meta. 

In contrast, the small-cap rally that gathered pace in the final months of 2023 has petered out this year, expanding an already wide gap in performance. Utilities and telecoms groups such as broadband company Gogo, Vertex Energy and Middlesex Water are among stocks that have been hit. 

Aside from a brief period of outperformance in 2020 during the early stages of the coronavirus pandemic, small-cap stocks have lagged their larger peers since 2016. 

In the 2000s, before global interest rates sank to close to zero following the financial crisis, thinly-traded and under-analysed stocks had on average outperformed the biggest companies. Analysts attribute this pattern to a combination of market inefficiency and the explosive growth potential of tomorrow’s market leaders. 

“When you get small-caps right, you’re not right by 20 per cent more than the Street, your earnings and revenue estimates could be double where the consensus is . . . That leads to a more significant price gain,” said Tuorto, whose portfolio is dominated by stocks including Shake Shack and Wingstop, as well as retailers. 

Although there are signs that the equity market rally is beginning to broaden out beyond the biggest tech stocks, stubborn inflation and a resilient jobs market have recently contributed to an acceptance among traders that interest rates may stay higher for longer than they had anticipated just a few months ago. 

In a worst-case scenario where the Federal Reserve is forced to keep rates on hold for months to come or even raise them, smaller companies are likely to be the hardest hit. Roughly 40 per cent of debt on Russell 2000 balance sheets is short-term or floating rate, compared with about 9 per cent for S&P companies. 

Fourth-quarter earnings for Russell 2000 companies, about 30 per cent of which are unprofitable, fell 17.6 per cent year-on-year, according to LSEG data. Earnings for S&P companies, in contrast, rose by about 4 per cent, although a large portion of the gain was driven by the so-called Magnificent Seven tech stocks. 

However, barring a recession, small-cap profits are expected to improve as rates start to come down. Fed chair Jay Powell last week left rates unchanged and signalled a preference to cut by three-quarters of a percentage point this year, pushing the Russell 2000 up by a percentage point more than the S&P on the day. 

Flawed Valuations Threaten $1.7 Trillion Private Credit Boom 

Colm Kelleher whipped up a storm at the end of last year when the UBS Group AG chairman warned of a dangerous bubble in private credit. As investors dive headfirst into this booming asset class, the more urgent question for regulators is how anybody could even know for sure what it’s really worth. 

The meteoric rise of private credit funds has been powered by a simple pitch to the insurers and pensions who manage people’s money over decades: Invest in our loans and avoid the price gyrations of rival types of corporate finance. The loans will trade so rarely — in many cases, never — that their value will stay steady, letting backers enjoy bountiful and stress-free returns. This irresistible proposal has transformed a Wall Street backwater into a $1.7 trillion market. 

Now, though, cracks in that edifice are starting to appear. 

Central bankers’ rapid-fire rate hikes over the past two years have strained the finances of corporate borrowers, making it hard for many of them to keep up with interest payments. Suddenly, a prime virtue of private credit — letting these funds decide themselves what their loans are worth rather than exposing them to public markets — is looking like one of its greatest potential flaws. 

Data compiled by Bloomberg and fixed-income specialist Solve, as well as conversations with dozens of market participants, highlight how some private-fund managers have barely budged on where they “mark” certain loans even as rivals who own the same debt have slashed its value. 

In one loan to Magenta Buyer, the issuing vehicle of a cybersecurity company, the highest mark from a private lender at the end of September was 79 cents, showing how much it would expect to recoup for each dollar lent. The lowest mark was 46 cents, deep in distressed territory. HDT, an aerospace supplier, was valued on the same date between 85 cents and 49 cents. 

This lack of clarity on what an asset’s worth is a regular complaint in private markets, and that’s spooking regulators. While nobody cared too much when central bank interest rates were close to zero, today financial watchdogs are fretting that the absence of consensus may be hiding more loans in trouble. 

“In private markets, because no one knows the true valuation there’s a tendency to leak information into prices slowly,” says Peter Hecht, managing director at US investment firm AQR Capital Management. “It dampens volatility, giving this false perception of low risk.” 

The private-lending funds and companies mentioned in this story all declined to comment, or didn’t respond to requests for a comment. 

Code of Silence? 

Private credit was embraced at first for shifting risky company loans away from systemically important Wall Street banks and into specialist firms, but the ardor’s cooling in some quarters. Regulators are doubly nervous because of the economy’s febrile state. These funds charge interest pegged to base rates, which has handed them bumper profits — and made their borrowers vulnerable. 

“As interest rates have risen, so has the riskiness of borrowers,” Lee Foulger, the Bank of England’s director of financial stability, strategy and risk, said in a recent speech. “Lagged or opaque valuations could increase the chance of an abrupt reassessment of risks or to sharp and correlated falls in value, particularly if further shocks materialize.” 

Values are especially cloudy outside the US, because of poor transparency. And it’s the same for loans made by funds that don’t publish quarterly updates or where there’s a single lender with no one to judge them against. 

Tyler Gellasch, head of the Healthy Markets Association, a trade group that includes pension funds and other asset managers, says policymakers have been caught napping. “This is simply a regulatory failure,” says Gellasch, who helped draft part of the Dodd-Frank Wall Street reforms after the financial crisis. “If private funds had to comply with the same fair value rules as mutual funds, investors could have a lot more confidence.” 

The Securities and Exchange Commission has nevertheless begun to pay closer attention, rushing in rules to force private-fund advisers to allow external audits as an “important check” on asset values. 

Red Flags 

The thinly traded nature of this market may make it nigh-on impossible for most outsiders to get a clear picture of what these assets are worth, but red flags are easier to spot. Take the recent spike in so-called “payment in kind” (or PIK) deals, where a company chooses to defer interest payments to its direct lender and promises to make up for it in its final loan settlement. 

An equally perplexing sign is the number of private funds who own publicly traded loans, and still value them much more highly than where the same loan is quoted in the public market. 

In a recent example, Carlyle Group Inc.’s direct-lending arm helped provide a “second lien” junior loan to a US lawn-treatment specialist, TruGreen, marking the debt at 95 cents on the dollar in its filing at the end of September. The debt, which is publicly traded, was priced at about 70 cents by a mutual fund at the time. Most private credit portfolios “remain above their public market peers,” the BoE’s Foulger noted in his speech on “nonbank” lenders. 

And it’s not just the comparison with public prices that is sometimes out of whack. As with Magenta Buyer and HDT there are eye-catching cases of separate private credit firms seeing the same debt very differently. Thrasio is an e-commerce business whose loan valuations have been almost as varied as the panoply of product brands that it sells on Amazon, which runs from insect traps and pillows to cocktail shakers and radio-controlled monster trucks. 

As the company has struggled lately, its lenders have been divided on its prospects. Bain Capital and Oaktree Capital Management priced its loans at 65 cents and 79 cents respectively at the close of September. Two BlackRock Inc. funds didn’t even agree: One valuing its loan at 71 cents, the other at 75 cents. Monroe Capital was chief optimist, marking the debt at 84 cents. Goldman Sachs Group Inc.’s asset management arm had it at 59 cents. 

The Wall Street bank seems to have made the shrewder call. Thrasio filed for Chapter 11 on Wednesday as part of a debt restructuring deal and one of its public loans is quoted well below 50 cents, according to market participants. Oaktree lowered its mark to 60 cents in December. 

“Dispersions widen when a company is falling into distress as well as when a lot of funds are marking the same asset,” says Bloomberg Intelligence analyst Ethan Kaye. “When a company is either stressed or distressed, it becomes less certain as to what future cash flows might look like.” 

In an analysis of Pitchbook data from the end of September, Kaye found that in one in 10 cases where the same debt was held by two or more funds, the price gap was at least 3%. When three of four funds own the same loan, something that’s common in this industry, the differences get starker still. 

Distressed companies do throw up some especially surprising values. Progrexion, a credit-services provider, filed for bankruptcy in June after losing a long-running lawsuit against the US Consumer Financial Protection Bureau. Its bankruptcy court filing estimated that creditors at the front of the queue would get back 89% of their money. Later that month its New York-based lender Prospect Capital Corp. marked the senior debt at 100 cents. 

In data pulled together by Solve on the widest gaps between how a lender marks its loans versus other parties’ valuations, Prospect’s name appears more regularly than most. BI finds that smaller firms in general appear to mark their loans more aggressively. 

Private Fans

For private credit’s many champions, the criticism’s overblown. Fund managers argue that they don’t need to be as brutal on marking down prices because direct loans usually involve only one or a handful of lenders, giving them much more control during tough times. In their eyes, the beauty of this asset class is that they don’t have to jump every time there’s a bump in the road. 

Some investors point as well to the shortcomings of the leveraged-loan market, private credit’s biggest rival as a source of corporate finance, where Wall Street banks gather large syndicates of mainstream lenders to fund companies. 

“There are a lot of technicals that influence the broadly syndicated loan market, like sales encouraged by ratings downgrades or investors getting out of certain sectors,” says Karen Simeone, managing director at private markets investor HarbourVest Partners. “You don't get this in private credit and so I do think it makes sense that these valuations are less volatile.” 

Direct lenders also use far less borrowed money than bank rivals, giving regulators some comfort that any market blowup could be contained. They typically lock in cash they get from investors for much longer periods than banks, and they don’t tap customer deposits to pay for their risky lending. They tend to have better creditor protections, too. 

Third-party advisers such as Houlihan Lokey and Lincoln International are increasingly assessing loan marks, adding scrutiny, though it’s paid for by the funds and is no panacea. “We don't always get unfettered access to credits,” says Timothy Kang, co-lead of Houlihan’s private credit valuation practice. “Some managers have access to more information than others.” 

In the US, direct lenders often set up as publicly listed “business development companies,” requiring them to update their investors every quarter. BDCs do give better visibility on their loan prices but their fund managers are paid according to the portfolio’s worth so there’s an incentive to mark debt high.

This week’s fun finds 

These pizza-covered watches are a cheesy April Fools joke made real 

Here’s a story of what happens when an April Fools day joke becomes reality – and why a startup British watchmaker just revealed a new collection with dials inspired by pizza toppings. 

To understand how such a watch came to be, we need to wind the hands back to 1 April 2023, when Studio Underd0g published a video featuring Richard Benc and Andrew McUtchen – founders of Studio Underd0g and Time + Tide, respectively – teasing a new watch collection inspired by pizza. 

Within a few hours, the Studio Underd0g website had received 20,000 visitors and 800 pizza enthusiasts had expressed interest in purchasing the quirky watch. Fast-forward to the present day, and the Pizza-Party collection is real. 

One watch is called the Pepper0ni, with a cheesy dial featuring meat, olives and mushrooms, and the other watch is called Hawaiian, with the iconic (not to mention controversial) toppings of ham and pineapple. Underd0g says of the Hawaiian: “We have no doubt that the Pepper0ni may have ruffled a few feathers in Switzerland by making a mockery of their beloved industry, so why not double down and wind up some Italians too?”. 

Priced at £550, both watches surround their dial with a crispy crust – sorry, I mean a beige tachymeter – and both feature a 38.5mm stainless steel case housing a Seagull ST-1901 automatic chronograph movement, visible through the exhibition case back. The watches are both water resistant to 50 metres and they have 50 hours of power reserve. 

Finally, and just to make them even more quirky, the watches cannot be bought online. They can’t even be bought from a shop or a boutique. Instead, they are only available to purchase directly from Richard Benc or Andrew McUtchen in person. So they’re hand-delivered, just like a takeaway pizza. No word on whether the watches will be presented on a sheet of greaseproof paper in a cardboard box, but I wouldn’t bet against it! 

The Studio Underd0g website has details of where to find the watches through 2024. The first opportunity was in Australia on 19 January (sorry, we’re a bit late to the pizza party on this one), but the next is in Leeds on 8 February, followed by London on 9 March, San Francisco in May, Chicago in July, Geneva in September and New York in October. Further opportunities will take place in Manchester, Oxford, Birmingham, Toronto and Dubai, but the dates for these haven’t yet been announced.

This week's interesting finds

EdgePoint’s worst-kept secret – Our credit franchise

While the environment in which we operate will change, our investment approach remains consistent - we'll always treat bonds like business owners lending to businesses.

This week in charts

Standard of living

Inflation

 

China

Fund flows

Fund performance

Market capitalization

Yields

Public software

Exports

Uranium

The Bank of Japan’s tricky path to normalisation

For market watchers, the prospect of Japan’s interest rates rising into positive territory became more unnerving with each passing year. The longer borrowing costs remained below zero, the more traders and investors — at home and abroad — became accustomed to it. A reversal of that status quo risked upsetting financial stability. But on Tuesday, after eight years in the negative, the Bank of Japan governor Kazuo Ueda pulled it off in smooth style. He raised rates from -0.1 per cent, to a range of 0 to 0.1 per cent, and called time on yield curve control. Global markets took it all in their stride.

    That is down to the BoJ’s prudent choreography. It gradually loosened its approach to YCC in prior meetings to avoid abrupt market moves. Its decision was well signalled, allowing traders time to price it in. The central bank also decided to continue buying Japanese government bonds and made clear that rates would not march higher any time soon.

Outright tightening still seems far off. Most analysts do not expect recent wage growth to be maintained, and near-term inflationary momentum has waned. The BoJ nonetheless needs to continue to tread carefully. Markets will want to decipher the central bank’s plan for normalisation, so its next steps take on even greater importance. Financial exposures, forged during the BoJ’s ultra-loose era, have not gone away.

First, in the hunt for better than near-zero returns at home, Japanese institutions, including pension funds, life insurance companies and banks, have become major international investors. International portfolio investments were over $4tn at the end of 2023. Japan is the largest foreign holder of US government debt. Higher yields back home could tempt Japanese investors to retrench, reducing demand for US and European government debt in the process. Higher hedging costs have already prompted some to do so. The yen has also been the funding currency for carry trades, where investors borrow in low-cost yen and swap it for higher-yielding dollars.

The second source of risk comes from Japan’s public finances. At around 2.5 times the size of its economy, Japan’s debt is vulnerable to any uptick in yields and reduced bond-buying by the BoJ. Institutional investors with significant asset holdings in Japanese bonds could face losses if domestic rates move higher. For commercial banks, higher rates will boost net interest margins, but regulators are alive to the risk of Silicon Valley Bank-style dynamics from any losses on assets. Indeed, few bankers have experience of a rising rate environment. Borrowers accustomed to low rates could also face difficulty.

Third, in their search for yield some Japanese banks have engaged in riskier lending abroad. For instance, shares in Tokyo-based Aozora Bank recently slumped after it flagged losses tied to its US commercial property book. These exposures could have a knock-on effect at home.

For now, any major repatriation of investments or unwinding of the carry trade is unlikely. US bond yields are still significantly more attractive. A sharp and rapid step-up in the BoJ’s policy rate, which could also drive a significant appreciation in the yen, is off the table too. In any case, the central bank appears willing to intervene to support financial stability. But vigilance is important. Even if Japan’s policy rates do not move unpredictably, America’s might. That will affect spreads, exchange rates, and hedging costs. Other economic shocks could alter Japan’s domestic growth, inflation and public finance outlook.

The BoJ made a significant step on Tuesday. But the journey to normalising Japan’s monetary policy remains a long slog. Financial threats lurking after years of sub-zero rates have so far been tamed — in no small part down to the central bank’s clear and careful approach. That must now continue.

Corporate defaults at highest rate since global financial crisis, says S&P

More companies have defaulted on their debt in 2024 than in any start to the year since the global financial crisis as inflationary pressures and high interest rates continue to weigh on the world’s riskiest borrowers, according to S&P Global Ratings.

This year’s global tally of corporate defaults stands at 29, the highest year-to-date count since the 36 recorded during the same period in 2009, according to the rating agency.

Subdued consumer demand, rising wages and high interest rates, which hurt more indebted companies, had all contributed to the increase in the number of companies struggling to repay their debt, S&P said.

“What’s going on is exactly what’s been going on since the [Federal Reserve] began to raise interest rates” in March 2022, said Torsten Slok, chief economist at investment group Apollo. “Default rates are rising . . . because higher interest rates continue to bite harder and harder on highly levered companies.”

Companies to have defaulted in February included US ferry and cruise operator Hornblower, US software group GoTo and UK cinema group Vue Entertainment International.

Although the majority of defaults were in the US, Europe’s eight since January is twice as many as in any year since 2008, and more than double the number seen in the same period of 2023.

Three US healthcare companies — Radiology Partners, Pluto Acquisition and Cano Health — defaulted last month, in part due to the implementation of the No Surprises Act, which came into force in 2022 and caps the amount that providers can charge for treatments that patients did not choose and for which they are not insured, S&P said.

Fourteen, or roughly half, of the companies that have defaulted across the globe this year were classified by S&P as “distressed exchanges” — agreements that typically involve creditors receiving assets worth less than the face value of their debt, in a scenario that can help borrowers and private equity sponsors avoid expensive bankruptcy proceedings.

Consumer-sensitive stocks are most exposed to the potential for further defaults in 2024, according to S&P analyst Ekaterina Tolstova. Chemical and healthcare companies may also be at risk over the coming months given the sectors’ high concentration of poorly rated incumbent companies with negative cash flow, she added.

However, an improving macroeconomic outlook and hopes that interest rates will decline in the second half of the year mean S&P expects Europe’s default rate to stabilise at about 3.5 per cent by year end — in line with 2023’s figure.

This Week’s fun finds

The adventure #PROJECT360 starts here

Interactive climbs are now possible for the first time in the history of alpinism. Experience the most famous routes of the world in a 360° view.

Please use a smart phone or a tablet of the latest generation or an up-to-date browser for a perfect 360° experience.
 

This week's interesting finds

Investment Team 2024 spring reading list 

Feeling lucky? The Investment Team shares a virtual pot of gold for readers and listeners alike just in time for St. Patrick's Day. 

This week in charts 

Global buyouts 

Energy 

Manufacturing 

Private equity 

Interest rates

ETFs

Zombie car factories on the rise in China as buyers opt for EVs 

In 2017, Hyundai invested $1.15bn in a new factory in Chongqing, southwestern China, with the goal of reaching an annual output of 300,000 internal combustion engine cars. 

But six years later, the rapid switch by Chinese consumers to electric vehicles has stalled sales, forcing the automaker to sell the factory in December for less than a quarter of the investment value. 

That plant is one of the hundreds of zombie factories that analysts are predicting over the next decade in the Chinese auto market, the world’s biggest across sales, production and, since last year, exports. In 2023, China produced 17.7mn internal combustion engine cars, a 37 per cent fall from its prior peak in 2017, according to data from Automobility, a Shanghai consultancy. 

Bill Russo, the former head of Chrysler in China and founder of advisory firm Automobility, said that the “precipitous decline” of internal combustion engine car sales means as much as half of the industry’s installed capacity — around 25mn units of 50mn units annual capacity — is not being used. 

While some older factories will be repurposed for plug-in hybrids or pure battery electric vehicles, others will never produce another car, posing a problem for both foreign and Chinese companies. Many auto groups in China, Russo said, ultimately face two choices: “Leave the factory mothballed or crank out some volume and send it to Russia, send it to Mexico.” 

Hyundai’s exit from Chongqing comes as combined car sales in China by Hyundai and its Kia affiliate fell to 310,000 last year from nearly 1.8mn in 2016, as a result of free-falling sales of internal combustion engine cars.

An intense price war across the Chinese auto sector is only heaping more pressure on legacy automakers, including top foreign players Toyota, Volkswagen and GM, which have been slower to release popular low-cost EV and hybrid models and are quickly losing market share to companies such as BYD and Tesla. 

Until recently, foreign auto groups could only enter the Chinese market as a joint venture with a local partner. Of 16 joint ventures between Chinese and foreign carmakers, only five had a capacity utilisation rate higher than 50 per cent while eight were below 30 per cent, according to a report by Chinese media outlet Yicai Global. 

In response to the worsening domestic market situation, Chinese companies have been ramping up exports of cheap petrol-powered cars to Russia, a market that many international carmakers have quit in the wake of that country’s full-scale invasion of Ukraine. 

Yet analysts question whether those sales deliver meaningful profits to the Chinese groups, for how long they can continue, or if other developing markets can help soak up Chinese non-EV exports. Foreign brands, too, are increasingly trying to export more from their Chinese factories. But, experts say, in doing this companies risk undercutting their own factories in other markets. 

Growth, VW believes, will mostly come from the hundreds of smaller Chinese cities that usually have a population of 3mn or below. That is in part because car ownership in the bigger, more developed cities is high and restrictions on buying new petrol-powered cars are already in place. But another key factor is the lack of charging infrastructure in poorer cities, which has frustrated EV industry growth. 

“The number of cars in China is still very low. While the average here is just 185 vehicles per 1,000 inhabitants, there are almost 800 vehicles per 1,000 inhabitants in the USA and around 580 in Germany,” said VW. 

VW last year announced €5bn worth of investments in China as it targets ramping up production of EVs. It has started converting some factory lines in China to produce EVs. And the group will also work to “gradually hybridise the internal combustion engine models and thereby convert them into an electrified new energy vehicle fleet,” the company added. 

But VW is an outlier in deciding to double down on the Chinese market — spending by most other foreign automakers in China has ground to a halt. 

Industry executives say that the biggest pressure on all legacy automakers in China stems from the rise of new EV factories, which take a radically different approach to car manufacturing. 

In Hefei, west of Shanghai, a factory owned by Nio demonstrates this challenge. The factory, opened in late 2022, is designed around founder William Li’s bet that EV customers will increasingly want cars with customised features, rather than a mass market product from a dealer. 

The factory offers different configurations — both physical design and software features — among its eight different Nio models. Cars can be delivered in China around three weeks after they are ordered, or 90 days to customers in Europe. 

Nio’s Hefei factory will soon have the capacity to produce 300,000 vehicles annually — the target for Hyundai’s Chongqing factory less than 10 years ago. 

John Jiang, the Nio factory manager who previously worked with GM in China, says all carmakers in China are in a fight for survival: “not every brand can succeed in the end”. 

Delivery Drones Are Gaining a Clearer Commercial Flight Path 

Cassidy Shorland, a council member in Logan, Australia, wanted a refreshing treat on a hot day recently, but didn’t want to get in his car and leave the office. So Shorland opened a DoorDash delivery app, clicked on a mango-flavored juice from a nearby smoothie chain, then walked outside as a big white-and-yellow drone came into view and lowered a tethered box holding his juice. 

Shorland, 47, is one of the customers in the small municipality near Brisbane who routinely order things from rotisserie chickens to pain medicine delivered by drone. 

It’s the kind of routine service that has mostly eluded drone operators in the U.S. as they’ve navigated regulatory obstacles, community unease and challenging economics over the past decade in a bid to bring new technology to the puzzle of last-mile delivery. 

Industry executives say they have an improved landscape in 2024, however, after federal regulators recently granted several drone-delivery companies permission to fly more freely. That has led several retailers, restaurants and healthcare systems to expand their services across the U.S. 

Still, logistics experts caution drones have a long way to go before they become entrenched in commercial parcel distribution in the U.S. 

For the average e-commerce order, “it’s actually relatively hard to beat the delivery costs that you would get, for instance, out of a big brown, yellow or white delivery van out there,” said Matthias Winkenbach, director of research for the Massachusetts Institute of Technology’s Center for Transportation and Logistics. 

Attention to drone delivery heated up for many companies during the Covid-19 pandemic, when a surge in online orders pushed more goods into trucks, cars and bikes, adding congestion and pollution on roads. Advocates say the technology is environmentally friendly since the devices typically are battery-powered, reducing emissions for filling orders. 

The Federal Aviation Administration, overseer of the nation’s skies, in the past year has given companies including Wing, a unit of Alphabet, and autonomous drone operator Zipline permission to fly their drones beyond so-called visual line of sight. The requirement that drones remain in sight of a human operator has been a major hurdle for drone operations. 

Robin Riedel, a partner at the McKinsey consulting firm, said the federal approvals pave the way for expansion of airborne delivery. 

Retail giant Walmart, which has been among the companies most aggressively seeking to embed drones in its delivery operations, said it will begin offering drone delivery this year to about 75% of the population of the Dallas-Fort Worth region. Amazon.com, which has delivered goods by drone to customers in some U.S. cities since 2022, plans to launch its latest drone model later this year across three U.S. states, as well as in Italy and the U.K. 

Fast-food restaurant Chick-fil-A recently began delivering orders by drone to customers within 1.2 miles of one of its restaurants in central Florida. And Zipline plans to start delivering prescriptions next year on behalf of healthcare provider Cleveland Clinic. 

Drone delivery has expanded more rapidly outside the U.S. McKinsey estimated that more than one million commercial drone deliveries were completed around the world last year, of which about 157,500 were in North America. 

Industry experts say regulatory restraints will be lowered as communities grow more accustomed to airborne parcels zipping by homes. Residents and regulators have raised concerns about safety, privacy and noise as the whirring devices fly over people’s homes and backyards. 

Drone operators say they are testing and building quieter devices. They have also been working on what’s known as detect-and-avoid technology that teaches the devices to go around obstacles including other aircraft. 

This week’s fun finds 

The 50 best Irish films ever made, in order 

Donald Clarke and Tara Brady's definitive list has more than a few surprises 

No sane person will sincerely claim that the ranking of cultural entities is anything other than a sophisticated parlour game. 

When it comes to Irish film, however, the debate will invariably focus less on relative placings – whether Garage is better than The Quiet Man – than on how we are defining our terms. Is The Quiet Man Irish at all? It was financed by an American studio and set in a fanciful version of the real nation. 

Our rules are looser than some may prefer. Significant numbers of Irish personnel is a factor. Notable levels of Irish funding scores you a few more points on our jerry-rigged scale 

This is not a ranking of Irishness. Once a film has qualified it competes equally with all others. Some may reasonably think our top film among the least Irish of the bunch. So be it

This week's interesting finds

Cymbria’s 16th annual investor day

We hope you can attend the 16th annual Cymbria Day on Wednesday, May 15, 2024. This year's event will once again be hosted in-person at Koerner Hall and available through livestream. Registration is now available.

Register here

This week in charts 

Equities 

Fixed income

Bankruptcy 

Semiconductors

Capacity

Fuel

China’s Exports Rise, Cheering Beijing—and Foreshadowing a Backlash 

SHANGHAI—China’s exports started the year on strong footing, offering a possible pathway for Beijing to hit its aggressive growth target this year while raising the likelihood of increased trade tensions. 

China’s outbound shipments rose 7.1% in the January-February period when compared with a year earlier, accelerating from a 2.3% increase in December, according to data released Thursday by Beijing’s General Administration of Customs. 

While the increase was comfortably higher than the 3% increase expected by economists surveyed earlier this week by The Wall Street Journal, the market was prepared for the strong reading after senior Chinese officials disclosed the data one day ahead of the scheduled release. 

On Wednesday, China’s commerce minister and the head of the country’s state planning agency told reporters in a briefing on the sidelines of China’s annual legislative meetings that the country’s exports grew by about 10% in the first two months of the year from a year earlier. 

They didn’t specify at the time whether they were speaking in yuan or dollar terms, but Thursday’s official data release showed outbound shipments rising 10.3% in yuan terms during the January-February period when compared with a year earlier. 

Beijing combines economic data for the first two months of the year to iron out distortions caused by shifts in the timing of the Lunar New Year holiday, when many business operations are suspended. 

The early disclosure marked the second time this year that officials have front-run the official release of key economic indicators. At Davos in January, Chinese Premier Li Qiang told global business elites one day ahead of schedule that the Chinese economy grew 5.2% in 2023. 

The ahead-of-schedule data disclosures come amid an effort by senior Chinese officials to allay concerns about the state of the world’s second-largest economy, which faces challenges including a protracted property slump, persistent deflationary pressures and weak consumer demand, in addition to continued geopolitical tensions with the West. 

At their press briefing on Wednesday, Chinese officials paired their early release of the official data with a warning that the export data would likely soften in March. They also hinted at monetary-easing moves to keep Beijing on track to realizing the growth target that officials unveiled on Tuesday. 

While its target of “about 5%” growth was unchanged from a year earlier, that goal was much easier to meet last year, when economic growth was being measured against a 2022 in which the economy was being ravaged by harsh lockdowns aimed at curbing the fast-spreading Omicron variant of the coronavirus. 

For this year, most outside economists have penciled in growth expectations of less than 5%, maintaining those forecasts even after the government released its target and announced new policies to meet that goal. 

In its annual legislative meeting, Beijing said it would issue ultralong special treasury bonds this year to drive tepid investment, but the government stopped short of concrete measures to boost consumer spending or help lift its beleaguered property sector out of the doldrums. 

“We think the 5% growth target is relatively ambitious while the support provided by policies introduced in the government report was relatively mild,” Wang Tao, chief China economist at UBS Investment Bank, said in a briefing Thursday. 

The faster-than-expected growth of China’s export sector in January and February at least gives Beijing some stability in the shorter term, coming on the back of positive year-over-year readings in November and December. Before that, exports had fallen for six straight months. 

Exports were a critical growth driver during the three years in which China’s economy was battered by the pandemic. Beijing’s policies gave priority to keeping factories and businesses open, allowing the country long known as the world’s factory floor to continue churning out goods as manufacturers around the world went offline. 

As the impact of Covid-19 finally faded, Chinese exports ceased to serve as a contributor to overall economic growth and instead became a drag. China’s export sector last year posted its first annual decline since 2016. 

Even if exports can maintain their strong start this year, there are limits to how much outbound shipments alone can carry an economy as large as China’s. 

“The Chinese economy is big. It’s hard to rely on external demand to totally offset the weakness in domestic demand,” said Ding Shuang, a China economist for Standard Chartered Bank. 

Thursday’s trade data release showed flickers of hope on that front. China’s imports, treated by some economists as a proxy for domestic demand, rose 3.5% in year-over-year terms in the first two months of the year, better than December’s 0.2% rise and the 2.2% growth anticipated by surveyed economists. 

That brought China’s trade surplus in the first two months of the year to $125.16 billion, the customs bureau said. 

Even as Chinese officials sought to talk up economic prospects for the year ahead, they also warned of worsening global trade conditions. Chinese Commerce Minister Wang Wentao told reporters on Wednesday that foreign trade this year still faces “extremely severe” conditions, with protectionism on the rise. Both the European Union and the U.S. have opened probes into Chinese-made electric vehicles, one of the country’s most promising export industries. 

Taken as a whole, China’s exports to the U.S. rebounded to 5% growth in the January-February period from a 6.9% decline in December, while the trend line of falling year-over-year exports to Europe narrowed, according to Wall Street Journal calculations based on Thursday’s data release. 

Standard Chartered’s Ding said China’s improving export profile in relation to the U.S. and Europe, coupled with the competitive prices of Chinese goods, could exacerbate trade frictions. 

In the U.S. Senate, calls have risen for higher tariffs and other restrictions to be imposed to keep Chinese-made EVs from making inroads in the world’s largest economy. This month, Republican senators have introduced several bills that would, among other things, impose new tariffs on Chinese-made autos and stop what Sen. Marco Rubio described as an attempt by Beijing to “flood the U.S. market with artificially cheap vehicles.” 

Frackers Are Now Drilling for Clean Power 

Oil-and-gas companies are accelerating investments in geothermal energy, betting the technologies that fueled the shale revolution can turn the budding industry into a large producer of clean power. 

The new geothermal industry is the result of a surprising confluence of interests among the oil-and-gas, technology and green power industries. The heat that the drillers find underground can be used to generate a steady, round-the-clock supply of carbon-free electricity, which is coveted by tech companies for their power-hungry data centers. 

Finding pockets of underground heat is relatively easy in places with lots of geothermal activity, including parts of the U.S., Indonesia and New Zealand. When the heat is deeper in the earth, it is more difficult and more expensive to find. Those constraints have kept the sector’s share of U.S. electricity generation at less than 1%. 

Technological advances in well drilling, modeling and sensor technology are expected to change that: The Energy Department estimates geothermal energy could power the equivalent of more than 65 million U.S. homes by 2050. 

 New funding for a startup called Fervo Energy follows drilling results showing declining costs in the sector. 

The industry began changing about five years ago, when companies like Google launched efforts to run their operations on renewable power 24/7 and found that wind and solar, which can’t supply uninterrupted power, couldn’t get there on their own. 

“It created this huge market momentum around looking at something new,” said Tim Latimer, Fervo’s chief executive. “That’s what allowed us to put geothermal on the map for the first time in a long time.” 

Geothermal energy is more typically used for heating and cooling. Instead of heat, this process relies on the steady underground temperature a short distance below the surface. That reduces the amount of heating and cooling needed on hot and cold days. 

Fervo, by using horizontal drilling and pumping water underground through fractures in rock in a process similar to fracking, found that many more parts of the world could economically generate electricity from geothermal energy. 

After the water is heated up deep underground, it returns to the surface, where it transfers the heat to another liquid with a lower boiling point. That generates steam, which spins turbines for generating electricity. Geothermal power is currently much pricier than wind, solar and natural gas power, putting pressure on the industry to reduce costs. 

Fervo is raising $244 million from investors including Devon, billionaire former Enron trader John Arnold, Liberty Mutual Investments and commodity trader Mercuria. Devon is putting in $100 million, one of the biggest such investments by an oil-and-gas company in a clean-energy startup. 

BP was among the investors that recently put $182 million into Canadian startup Eavor Technologies, which counts Chevron among its early backers and tries to simplify geothermal by essentially burying a large radiator deep underground and circulating fluid through it. Chesapeake Energy recently made an early stage bet on a startup called Sage Geosystems that is led by a former Shell executive. 

Old oil-and-gas wells could be retrofitted to produce geothermal power, while existing wells can extract geothermal energy alongside fossil fuels, potentially helping accelerate the industry’s growth. 

Oil companies understand subsurface geology, have experience building infrastructure projects and have cash available to deploy. That is why Chevron is joining with other companies and pursuing geothermal pilot projects in Japan, Indonesia and the U.S., said Barbara Harrison, vice president of offsets and emerging technologies at Chevron New Energies. 

“We are choosing to pursue direct investment in novel geothermal technologies in a way that we’ve not directly invested in wind or solar,” she said. 

About 60% of Fervo’s roughly 80 employees have an oil-and-gas background, said Latimer, a Texas native and former drilling engineer for BHP Billiton. 

Fervo said drilling costs for its first four horizontal wells for a project in Utah fell to $4.8 million per well from $9.4 million a couple of years ago at its first commercial project in Nevada. The company aims to soon reach electricity costs around $100 per megawatt hour. 

Fervo recently began sending electricity from the Nevada operation to the local grid to power Google data centers and other local projects. In Utah, it hopes to produce enough electricity to power hundreds of thousands of homes. 

This week’s fun finds 

The Zebra’s Stripes 

An online exhibit that explores theories on why the zebra has stripes. 

Black and White 

Are zebra stripes just a random creation of nature? If not: What is their function? Which evolutionary advantage do they confer? 

Tax time

This week's interesting finds

This week in charts 

Energy 

Emissions 

Exports

Employment

Equities 

Flawed Valuations Threaten $1.7 Trillion Private Credit Boom 

(Bloomberg) -- Colm Kelleher whipped up a storm at the end of last year when the UBS Group AG chairman warned of a dangerous bubble in private credit. As investors dive headfirst into this booming asset class, the more urgent question for regulators is how anybody could even know for sure what it’s really worth. 

The meteoric rise of private credit funds has been powered by a simple pitch to the insurers and pensions who manage people’s money over decades: Invest in our loans and avoid the price gyrations of rival types of corporate finance. The loans will trade so rarely — in many cases, never — that their value will stay steady, letting backers enjoy bountiful and stress-free returns. This irresistible proposal has transformed a Wall Street backwater into a $1.7 trillion market. 

Now, though, cracks in that edifice are starting to appear. 

Central bankers’ rapid-fire rate hikes over the past two years have strained the finances of corporate borrowers, making it hard for many of them to keep up with interest payments. Suddenly, a prime virtue of private credit — letting these funds decide themselves what their loans are worth rather than exposing them to public markets — is looking like one of its greatest potential flaws. 

Data compiled by Bloomberg and fixed-income specialist Solve, as well as conversations with dozens of market participants, highlight how some private-fund managers have barely budged on where they “mark” certain loans even as rivals who own the same debt have slashed its value. 

In one loan to Magenta Buyer, the issuing vehicle of a cybersecurity company, the highest mark from a private lender at the end of September was 79 cents, showing how much it would expect to recoup for each dollar lent. The lowest mark was 46 cents, deep in distressed territory. HDT, an aerospace supplier, was valued on the same date between 85 cents and 49 cents. 

This lack of clarity on what an asset’s worth is a regular complaint in private markets, and that’s spooking regulators. While nobody cared too much when central bank interest rates were close to zero, today financial watchdogs are fretting that the absence of consensus may be hiding more loans in trouble. 

Code of Silence? 

Private credit was embraced at first for shifting risky company loans away from systemically important Wall Street banks and into specialist firms, but the ardor’s cooling in some quarters. Regulators are doubly nervous because of the economy’s febrile state. These funds charge interest pegged to base rates, which has handed them bumper profits — and made their borrowers vulnerable. 

Values are especially cloudy outside the US, because of poor transparency. And it’s the same for loans made by funds that don’t publish quarterly updates or where there’s a single lender with no one to judge them against. 

The Securities and Exchange Commission has nevertheless begun to pay closer attention, rushing in rules to force private-fund advisers to allow external audits as an “important check” on asset values. 

Some market participants wonder, however, whether the fog around pricing suits investors just fine. Several fund managers, who requested anonymity when speaking for fear of endangering client relationships, say rather than wanting more disclosure, many backers share the desire to keep marks steady — prompting concerns about a code of silence between lenders and the insurers, sovereign wealth funds and pensions who’ve piled into the asset class. 

One executive at a top European insurer says investors could face a nasty reckoning at the end of a loan’s term, when they can’t avoid booking any value shortfall. A fund manager who worked at one of the world’s biggest pension schemes, and who also wanted to remain anonymous, says valuations of private loan investments were tied to his team’s bonuses, and outside evaluators were given inconsistent access to information. 

Red Flags 

The thinly traded nature of this market may make it nigh-on impossible for most outsiders to get a clear picture of what these assets are worth, but red flags are easier to spot. Take the recent spike in so-called “payment in kind” (or PIK) deals, where a company chooses to defer interest payments to its direct lender and promises to make up for it in its final loan settlement. 

This option of kicking the can down the road is often used by lower-rated borrowers and while it doesn’t necessarily signal distress, it does cause anxiety about what it might be obscuring. “People underestimate how dangerous PIK products are,” says Benoit Soler, a senior portfolio manager at Keren Finance in Paris, pointing out the sometimes enormous cost of deferring interest: “It can embed a huge forward risk for the company.” 

 And yet the value of loans even after these deals is strikingly generous. According to Solve, about three-quarters of PIK loans were valued at more than 95 cents on the dollar at the end of September. “This raises questions about how portfolio companies struggling with interest servicing are valued so high,” says Eugene Grinberg, the fintech’s cofounder. 

An equally perplexing sign is the number of private funds who own publicly traded loans, and still value them much more highly than where the same loan is quoted in the public market. 

Private Fans 

For private credit’s many champions, the criticism’s overblown. Fund managers argue that they don’t need to be as brutal on marking down prices because direct loans usually involve only one or a handful of lenders, giving them much more control during tough times. In their eyes, the beauty of this asset class is that they don’t have to jump every time there’s a bump in the road. 

Some investors point as well to the shortcomings of the leveraged-loan market, private credit’s biggest rival as a source of corporate finance, where Wall Street banks gather large syndicates of mainstream lenders to fund companies. 

Direct lenders also use far less borrowed money than bank rivals, giving regulators some comfort that any market blowup could be contained. They typically lock in cash they get from investors for much longer periods than banks, and they don’t tap customer deposits to pay for their risky lending. They tend to have better creditor protections, too. 

In the US, direct lenders often set up as publicly listed “business development companies,” requiring them to update their investors every quarter. BDCs do give better visibility on their loan prices but their fund managers are paid according to the portfolio’s worth so there’s an incentive to mark debt high. 

Investors Face $30 Billion Cost Hit as US Markets Move to T+1 

Settling trades in one day instead of two — under a system dubbed T+1 — will strain the business of loaning and recalling shares used for short selling, require financing to ensure deadlines can be met and, along the way, risk telegraphing pending stock sales to people betting prices will fall, the researchers found. 

The resulting impact could amount to about $24 billion in securities lending costs, their report estimated. Investors in foreign-exchange markets could also face $6.2 billion in added costs. 

“The shorter settlement cycle pushes centralized costs, which the banks and the clearinghouses are now managing, onto institutional investors,” Larry Tabb, head of market structure research at Bloomberg Intelligence, said in an interview. “It’s also leaking a lot of information to folks who borrowed securities as well as increasing operational pressure just to execute a trade.” 

US regulators aim to speed up settlement times in late May to lower the risk that buyers or sellers might default on transactions before they’re completed. While investors will get their assets faster, and sellers can redeploy their cash sooner, the transition is widely acknowledged to pose big operational challenges for the industry. 

‘Information Leakage’ 

The largest cost may come from quickly recalling shares that have been loaned to bearish investors — who may glean that sales are afoot. “Information leakage” alone may cost investors $17 billion annually, Bloomberg Intelligence estimated. 

“Recalling securities before they’re sold increases leakage by not only informing custodians that investors are preparing to sell, but also giving notice to the borrowers, who are already short,” 

Cutting the days between trading and settlement could also lead to more failed trades, which would leave investors on the hook for $4.1 billion, the researchers found. They estimate that 10% more borrowings could fail under T+1, “increasing both fail-funding costs and overall borrowing rates as urgency increases.” 

US banks, brokerages and investors will have to review all of their post-trade technologies and procedures to ensure they’re ready for the new pace of stock trading. The changes also pose a challenge to investors outside the US who need to buy dollars as part of their equities trades. 

The shortened settlement cycle will require a change in behavior from all market participants who are forced to adapt to the tighter window. The time will be even less for European and Asian market participants operating in different time zones. 

The FX market, which still settles in two days, also faces increased costs associated with the move to T+1, as traders are given a shorter window to convert foreign currency to dollars in order to buy stock on US venues. 

This week’s fun finds 

What would happen if we didn’t have leap years? 

An interactive piece where CNN answers the question that was on many people’s minds this February 29: Why do we add an extra day?