This week's interesting finds

First quarter commentaries are now live! 

This quarter, George Droulias discusses the three key levers that we believe drive a business’ worth, while Frank Mullen talks about the importance of remaining disciplined when managing credit in the face of market exuberance. 

This week in charts 

China 

Gold 

Capital Expenditures (CapEx)

Employment 

Private equity

LBO loans 

A $10 Billion Copper Mine Is Now Sitting Idle in the Jungle 

When the group of mining executives arrived at Panama’s regal Palacio de las Garzas, they were ushered past the ornate, wood-paneled ceremonial rooms and straight to the private office of the president. 

This was December 2016, before the upswell of anti-mining protests that would throw the country into chaos, and the team from First Quantum Minerals Ltd. were greeted as old friends. After all, they were building the country’s most important project since the Panama Canal had been opened a century earlier. 

But as they compared notes on the progress of their Cobre Panama copper mine, the president issued a warning. 

First Quantum had lucked into an unusually sweet deal in Panama, he said. Sooner or later, the company would have to agree on new terms with the government and pay more taxes. What was left unsaid: it would be better to do it sooner, under a business-friendly government like his, than to gamble on Panamanian politics. 

The stakes were high. The mine was set to be the centerpiece of Panama’s economy, generating between 4% and 5% of its gross domestic product and employing one in every 50 workers in the country. For First Quantum, which had borrowed heavily to construct a mine in the dense Panamanian jungle, it simply had to succeed. 

Philip Pascall was unmoved. A swashbuckling Zimbabwean who had built First Quantum from scratch by making bold bets that few others had the stomach for, he brushed aside the president’s warning and quickly moved the conversation away from tax. 

It was a gamble that would prove disastrous. Today, the $10 billion mine is sitting idle, shuttered by nationwide protests over a new tax deal signed in October. First Quantum’s share price has plunged by roughly half, and the company is being circled by predatory rivals. 

This account of how First Quantum's flagship investment fell apart is based on interviews with more than a dozen people involved in the project over a decade. 

It is in part a tale of First Quantum’s hubris, as the company’s bosses sought to build the mine fast and keep costs low, despite unsettled tax disputes and legal issues. Pascall dismissed private warnings not only from Panama’s government but also from his own advisors that the tax deal put his company in a vulnerable position. 

But it is also a story that resonates far beyond the walls of First Quantum’s offices and the borders of Panama, highlighting a dilemma at the heart of the global transition away from fossil fuels. While governments are pushing to secure the raw materials to build electric vehicles, solar panels and high-voltage cables required for the energy transition, few of their citizens want the mines needed to produce them. 

The fate of Cobre Panama is one of the central questions facing the miners, traders and hedge fund managers who have gathered in Santiago in Chile for the copper industry’s annual Cesco Week event. 

“If I was a copper mining company looking at Latin America, would I want to sink a 50-year operation into one of these countries where there is this rising risk?” said Gracelin Baskaran, a research director and senior fellow for the Energy Security and Climate Change Program at the Center for Strategic and International Studies. 

“If the sector is risk-averse, they don’t invest. And if they don’t invest, we don’t have what we need for an energy transition.” 

Charismatic Leader 

Trailblazing projects like Cobre Panama have long been a hallmark of First Quantum’s business. Headquartered in Canada, the company was founded in 1996 by Philip Pascall and his brother Matt. 

The brothers developed copper mines in countries like Zambia and the Democratic Republic of the Congo, regions with low investment grades where few of its competitors dared to venture. While mines can often take decades to build, the Pascalls cultivated a reputation for getting their projects done ahead of schedule. 

In a rare interview in 2013, Philip Pascall described the ethos of his firm to The Australian: “We dare where others don’t, we try new things out, learn from our experiences and have earned a reputation for delivering not only to budget, but before schedule in an industry prone to overrunning both.” 

Their boldness was rewarded in the 2000s, as demand from China supercharged the price of copper. By the early 2010s, First Quantum had become a multibillion-dollar success story. With cash to spend and growing ambitions, Philip set his sights on a deposit in Panama, a country until then little touched by the mining industry. 

The firm launched a $5.5 billion takeover of the deposit’s owner, Inmet Mining Corp., that quickly turned hostile after the smaller firm twice rejected First Quantum’s approaches. 

The end result was a $10 billion mining complex larger than the size of San Francisco, isolated in Panama’s tropical rainforest, and capable of producing more than 350,000 tons of copper in a year — enough to build about five million electric vehicles. In an industry where many of the largest deposits have been depleting for decades, it was a rare example of a major new mine. 

And the timing seemed fortuitous. China’s industrialization was being supplanted as the major driver of projected copper demand by a new juggernaut — the energy transition. The electric vehicles, charging stations and high-voltage cables needed to electrify the world’s transportation will all require lots of copper. Mining executives started talking about the gap between the amount of copper that would be needed to reach net zero and the anticipated supply from the world’s existing mines. The world would need dozens of new copper mines, they said. 

First Ore 

First Quantum’s success had much to do with its leader, Philip Pascall, and rapport he forged with Juan Carlos Varela, Panama’s president from 2014 to 2019. The two men would dine together, with Philip sometimes supplying wine from his brother’s vineyard in Cape Town. 

Varela was eager to see Cobre Panama built. He kept a piece of the first ore rock mined from Cobre Panama in his office. The night before the mine opened in 2019, he joined First Quantum staffers at a luxury resort on Panama’s southern coast to dine on sushi and toast the project’s completion. 

Still, the honeymoon wouldn’t last. Even before Varela left office in 2019, Cobre Panama faced increasing scrutiny. The project’s tax requirements were enshrined in an outdated contract struck in 1997 — a time of record-low copper prices — long before the deposit’s value was fully realized. The details of the contract, which First Quantum inherited from the concession’s previous owners, required the miner to pay a 2% royalty rate on minerals revenue — a sweet deal for a metals producer. 

Pascall had ignored Varela’s admonitions about the tax deal. In the years before Cobre Panama opened, both Varela and a former Supreme Court justice and board member for the mine’s local subsidiary had pressed Pascall to start arranging a contract that would satisfy the country’s higher tax demands. Insiders at the company said First Quantum’s leadership never acquiesced to Varela’s demands, but Varela didn’t force the issue either, instead allowing First Quantum to proceed with a lenient tax arrangement. 

The tax benefits became hard to ignore once the mine opened. In 2019, Cobre Panama’s first full year of operation, the mine's royalty payments to Panama were a sixth of what First Quantum paid to Zambia for its Kansanshi mine. (In that period, though, Zambia's tax rate was notably high for foreign mining firms). 

The disparities were enough to draw the ire of a new government. When Varela’s business-friendly administration was replaced by the centre-left party of Laurentino Cortizo, the new administration moved to secure a better tax deal for the country. 

Cortizo didn’t maintain the same friendly relations with First Quantum. He had steered Panama through a cataclysmic recession caused by the Covid pandemic, that saw employment fall drastically and inflation spike while container ships sat idle in the Panama Canal. Now he needed to refill the government’s coffers, and First Quantum, the country’s biggest investor, became an obvious target. 

The government pushed for significantly higher royalties as well as a minimum annual flat tax of $375 million. When the company pushed back, Panama threatened to shutter the mine altogether. 

“They were tough negotiations,” said Robert Harding, First Quantum’s chairman. “We were trying to protect our interests and they were trying to protect theirs.” 

After long delays and standoffs and over four years of negotiations, the government and company reached a tentative agreement in March last year. First Quantum acquiesced to the bulk of Panama’s demands in exchange for a 20-year extension on the mine’s operating contract. 

Hostility Brews 

To the outside world, it looked like the crisis had been averted. Months passed in relative calm, and the mine kept churning out huge amounts of copper. 

Yet on the ground, hostility was brewing. Panama was already seething with discontent over inflation, high unemployment and corruption, and there was long-standing resentment over Cobre Panama’s environmental impact and its contribution to the economy. With a national election looming, the mine became a focal point for all the country’s ills. 

In October, when Panama’s congress approved the new contract with First Quantum in what should have been a formality, the decision fueled an uprising of protests that paralyzed large swathes of the country. 

One of the driving forces behind the opposition was a powerful and confrontational construction union called Suntracs, which has a history of clashing with companies operating in Panama. The group had sought early on to take part in the mine’s construction, and Suntracs members subsequently stormed the gates of the mine and assaulted employees at least three times between 2015 and 2018. Now Suntracs played a key role in stirring up protests and pushing labor issues to the forefront. 

Across the country, protesters blockaded highways and rallied in the cities. Local boats, some of them operated by Suntracs, blocked access to Cobre Panama's coastal port for weeks, preventing First Quantum and its suppliers’ ships from docking. 

As the civil unrest raged, First Quantum had largely lost touch with the government’s decision making, according to employees who spoke with Bloomberg News. The close-knit relationship Philip had once maintained with Varela was virtually absent between Cortizo and Philip’s son Tristan, who had taken over from his father as CEO after overseeing Cobre Panama's construction as the project's general manager. 

When Cortizo called for a national referendum on the mine’s operating contract in October — a short-lived idea meant to calm mass demonstrations — Tristan Pascall and First Quantum’s other top executives were provided no advance notice. The soft-spoken executive largely conducted damage-control from the company’s London office, eventually visiting Panama briefly in late November following Cortizo’s call to shutter the mine. But Panama’s course was set. The mine produced its last ton of copper in November and has been sitting idle ever since. 

Cautionary Tale

For the wider mining industry, the story of First Quantum in Panama has become a cautionary tale. 

“It’s just a reminder that it’s so, so important that there’s mutual trust, and that what we’re doing is in the interest of all constituents,” said Jakob Stausholm, Chief Executive Officer of Rio Tinto, whose predecessor was ousted after the company irreparably damaged an ancient Indigenous heritage site in Australia. “You cannot run the risk of turning a blind eye to that side of the business.” 

In Panama, First Quantum has embarked on a media blitz ahead of presidential elections in May, hoping that it can gain enough popular support to persuade the next government to allow the mine to restart. The company says it’s spending $15 million to $20 million per month to preserve the site, and has committed to reforesting more than 11,000 hectares of Panama’s rainforest — double the area impacted by mining. 

Yet some analysts have predicted the shutdown could last a year or longer, while a question mark hangs over who will ultimately own the mine. The project has attracted interest from the likes of Barrick Gold Corp., a much larger mining firm that boasts a history of dealmaking in challenging jurisdictions. 

Cobre Panama’s closure was one of the key catalysts behind a global shortage of copper ore currently gripping the industry, which in turn has drawn bullish investors into the market and helped pushed metal prices to the highest point in nearly two years. The mine accounted for roughly 1.5% of the world’s supply of copper. 

And the closure of Cobre Panama has intensified warnings from the mining industry that future supplies of metals like copper may not be sufficient to meet the needs of the energy transition. The International Energy Agency has predicted that by 2030, mines in production or currently under construction will only meet half of global demand for battery metals like lithium and cobalt. Copper mines, meanwhile, are projected to meet 80% of global demand in that same time frame. 

The operation is “only one example of the geopolitical climate within which today’s copper and other commodity mining operations exist,” said Andrew Kireta Jr., president and CEO of the Copper Development Association, a US-based industry group. 

“If we proceed with a business-as-usual approach, these supply constraints and others will impact the US’s ability to meet the projected steep demand acceleration for copper to build out clean energy infrastructure and transition to electric vehicles.” 

US FTC preparing to sue to block $8.5 bln takeover of Capri by Tapestry, NYT Dealbook reports

The deal, which would bring together top luxury labels such as Tapestry's Kate Spade, Stuart Weitzman and Capri's Jimmy Choo and Versace, received regulatory clearance from the European Union and Japan on Monday. 

The FTC's five commissioners are expected to meet this week to discuss the case, a move that could precede a formal vote on whether to file a lawsuit, according to the report. 

The merger aimed to create a U.S. fashion powerhouse to compete better with bigger European rivals amid a slowdown in luxury spending. 

This week’s fun finds 

Our internal hot sauce challenge club received a hot tip this week to test The End. Flatline hot sauce followed by Stingin’ Hotter Honey, Red Lava edition. The End left everyone thinking “What did we ever do to you?” 

Before

After

Reviews: 

• “Why is it black?”
• “It tastes like burning rubber smells”
• "Are you crying?"

This week's interesting finds

This week in charts 

European spreads 

US Treasury 10-year yield

Construction equipment 

Automotive

Asset allocation 

Inflation 

Pharmaceuticals 

China Tells Telecom Carriers to Phase Out Foreign Chips in Blow to Intel, AMD 

SINGAPORE—China’s push to replace foreign technology is now focused on cutting American chip makers out of the country’s telecommunications systems. 

Officials earlier this year directed the nation’s largest telecom carriers to phase out foreign processors that are core to their networks by 2027, a move that would hit American chip giants Intel and Advanced Micro Devices, people familiar with the matter said. , people familiar with the matter said. 

The deadline given by China’s Ministry of Industry and Information Technology aims to accelerate efforts by Beijing to halt the use of such core chips in its telecom infrastructure. The regulator ordered state-owned mobile operators to inspect their networks for the prevalence of non-Chinese semiconductors and draft timelines to replace them, the people said. 

In the past, efforts to get the industry to wean itself off foreign semiconductors have been hindered by the lack of good domestically made chips. Chinese telecom carriers’ procurements show they are switching more to domestic alternatives, a move made possible in part because local chips’ quality has improved and their performance has become more stable, the people said. 

Such an effort will hit Intel and AMD the hardest, they said. The two chip makers have in recent years provided the bulk of the core processors used in networking equipment in China and the world. 

Shares of Intel dropped 3.6% to $36.27 in early trading Friday while AMD fell 4.2% to $163.27. 

Beijing’s desire to wean China off American chips where there are homemade alternatives is the latest installment of a U.S.-China technology war that is splintering the global landscape for network equipment, semiconductors and the internet. American lawmakers have banned Chinese telecom equipment over national-security concerns and have restricted U.S. chip companies including AMD and Nvidia from selling their high-end artificial-intelligence chips to China. 

Chinese authorities have in turn been pushing for years to remove foreign suppliers from critical supply chains, seeking to source products from grains to semiconductors locally as national-security concerns rise. Similar orders requiring Chinese state-linked entities to shift their buying to local tech alternatives have resulted in U.S. software and hardware firms including Microsoft and Dell Technologies gradually losing their grip on the market, The Wall Street Journal has reported. 

China has also published procurement guidelines discouraging government agencies and state-owned companies from purchasing laptops and desktop computers containing Intel and AMD chips. Requirements released in March give the Chinese entities eight options for central processing units, or CPUs, they can choose from. AMD and Intel were listed as the last two options, behind six homegrown CPUs. 

Computers with the Chinese chips installed are preapproved for state buyers. Those powered by Intel and AMD chips require a security evaluation with a government agency, which hasn’t certified any foreign CPUs to date. Making chips for PCs is a significant source of sales for the two companies. 

China Mobile and China Telecom are also key customers of both chip makers in China, buying thousands of servers for their data centers in the country’s mushrooming cloud-computing market. These servers are also critical to telecommunications equipment working with base stations and storing mobile subscribers’ data, often viewed as the “brains” of the network. 

The two chip giants have the lion’s share of the overall global market for CPUs used in servers, according to data from industry researcher TrendForce. In 2024, Intel will likely hold 71% of the market, while AMD will have 23%, TrendForce estimates. The researcher doesn’t break out China data. 

China’s localization policies could diminish Intel and AMD’s sales in the country, one of the most important markets for semiconductor firms. China is Intel’s largest market, accounting for 27% of the company’s revenue last year, Intel said in its latest annual report in January. The U.S. is its second-largest market. Its customers also include global electronics makers that manufacture in China. 

In the report, Intel highlighted the geopolitical risk it faced from elevated U.S.-China tensions and China’s localization push. “We could face increased competition as a result of China’s programs to promote a domestic semiconductor industry and supply chains,” the report said. 

Geopolitics already cloud the outlook for Intel and AMD’s China operations. Intel said in January that $3.2 billion, or 6% of its revenue in 2023, was dependent on U.S. government export control authorization, an amount the company expected may increase in future years. 

China contributed 15% of AMD’s revenue last year, according to the company’s annual report. That was down from 22% in 2022 after AMD was restricted by U.S. authorities from selling its high-end AI chips to China. 

China will form the bulk of demand for wireless communications equipment over the next few years, said Earl Lum, the founder of telecommunications consulting firm EJL Wireless Research. The country is seeking to move from 5G to even faster network speeds, and global telecom operators outside of China are slowing down their purchases, he said. 

Local CPU substitutes have made large strides in recent years, with companies including Huawei Technologies’ HiSilicon and Hygon Information Technology, as well as entities including the National University of Defense Technology, gaining ground. 

Chinese chips aren’t always considered as good, people familiar with the matter said, but they have been winning over Chinese telecom customers. 

When China Telecom bought some 4,000 artificial-intelligence servers last October, 53% were powered by Intel’s CPUs. The rest used Huawei’s Kunpeng processors, according to a tender document. In some earlier tenders seeking to buy servers, Intel made up a much higher proportion. 

Companies Reconsider Research Spending With Tax Deal Held Up in Senate 

Large U.S. companies are pressing lawmakers to revive expired tax breaks for research and development spending, as a political stalemate keeps some finance executives wrestling with those investments. 

Lawmakers hoped April’s tax filing deadline would spur action, but with a bill proposing the change stalled in the Senate, expectations are waning for a deal soon. 

The political wrangling comes as large public companies say the law as it stands is costing them hundreds of millions or billions of dollars, while some owners of small and medium-size businesses say they wonder if their firms will survive. 

The tax change went into effect in 2022. Under a provision in the 2017 Tax Cuts and Jobs Act designed to generate revenue to help pay for cutting the corporate tax rate, companies must deduct research costs over five years for domestic research costs and over 15 years for those incurred abroad, rather than immediately. 

Companies of all sizes have been urging lawmakers to reverse the law. The House passed a bipartisan bill in January to restore immediate domestic research deductions retroactively from 2022, but Republicans have held up the bill in the Senate over details of child-credit changes, their inability to amend the bill and the prospect of a better deal if the GOP wins a Senate majority in November’s election. 

Hyster-Yale, which in its last fiscal year booked revenue of $4.1 billion, spends around $100 million a year on R&D, and the law change that went into effect in 2022 increased its tax bill by about $25 million a year. “So that’s $25 million less that I have to invest back into my business, whether it’s R&D, whether it’s plants and equipment, hiring new people,” Minder said. 

Like many others, Hyster-Yale’s executives expected the law would be repealed. That hope is fading, and what’s more, the repeal in the current bill runs only through 2025, so it’s a stopgap, said Minder, also his company’s treasurer. 

“In the lack of certainty from D.C., we have to make certainty for ourselves,” said Minder, adding companies that invest heavily in research, like Hyster-Yale, may need to reconsider how much to allocate for R&D and where that money is spent. The company spends around 80% of its research budget in the U.S. and the remainder elsewhere, according to the CFO. 

“We have people here in the U.S., we have facilities, processes, R&D here, and we much prefer to keep it that way,” Minder said. “But even if we get this temporary measure, we have to have a plan B. Do we have to act on it? No, but we can’t be in this spot again come 2025.” 

Other companies likewise are considering future R&D outside the U.S., where incentives can be more favorable, said Rohit Kumar, a former Senate GOP leadership aide who now is a co-leader of the national tax practice at accounting firm PricewaterhouseCoopers. It also means companies have “dramatically” slowed research spending since the law took effect, he said, pointing to U.S. Bureau of Economic Analysis data showing R&D spending declined last year after growing 6.6% on average over the previous five years. 

“It’s sort of natural that if Congress makes something more expensive to do, companies will do less of it,” Kumar said, adding the situation worsens with each estimated tax payment date. Companies make estimated tax payments to cover liabilities throughout the year, with the next date for large companies on April 15. “Every payment date that we go through where we don’t address this, you take more R&D money out of the economy,” he said. 

Steve Valenzuela, CFO at Alarm.com, is frustrated by the holdup in the Senate. Roughly 30% of the technology provider’s revenue, which last year was $881.7 million, goes to R&D, he said. The law change increased Alarm.com’s 2023 tax bill by around $43 million. 

Valenzuela said Alarm.com can cover the increase, but the company would prefer to invest those dollars into its business. He also said the change in the law has him thinking about whether to spend more in other areas of the business such as sales and marketing. 

For Jack Henry & Associates CFO Mimi Carsley, the longer the bill sits in the Senate, the less likely it becomes law this year. Carsley is preparing the financial technology company’s tax payment this month along with a plan for the full tax year as though the law remains unchanged. 

R&D is central to Jack Henry’s business, and while the law isn’t likely to affect current spending, it may prompt reduced investment in other areas and increase the rate of return required for new projects, a measure known as hurdle rates, according to Carsley. 

“Even in the largest companies, you’ve had the combination of higher interest rates plus this extra hit from a cash perspective,” she said. Jack Henry’s tax bill rose between $70 million to $80 million in its last fiscal year because of the change. “Hurdle rates will have to go up for projects as a result.” 

This week’s fun finds 

Pringles and Crocs Just Dropped a Limited-Edition Shoe Collection, and Yes, There Are Lots of Mustaches Involved 

Crocs is on an absolute roll with its food-focused partnerships, and its latest collab announcement will surely make chip fans happy. 

On Thursday, the shoe company announced an all-new set of kicks with Pringles. And no, it's not just slapping mustaches on everything, but rather, it's making footwear that's actually useful to everyone who can't go a single step without their chips.

This week's interesting finds

This week in charts 

Education

 

Trades

Housing 

Property valuation changes 

Ratios

Household debt 

Bankruptcy

Unemployment 

Policy rate decisions 

What Makes Housing So Expensive? 

Buying a home is by far the largest purchase most of us will make, and paying the rent or mortgage will be our largest monthly expense. In the post-pandemic home-buying boom, the median sale price of a new home peaked at almost $500,000 dollars, just under seven times the median household annual income that year (though it has since fallen). Most new homebuyers will pay around 30% of their income on their mortgage, and the median renter in the bottom quintile of income spends 60% of their income on rent. 

People concerned about building more housing are right to pay attention to zoning and land use rules: over 100 million Americans live in places where most of the cost of residential property comes from the land itself. But they should not neglect the physical costs of building homes, which are overall more important. Unfortunately, as we’ll see, reducing these physical costs is far from straightforward. 

We can divide the costs of a new home into roughly three buckets: “hard costs” (physically constructing the home), “soft costs” (design, administration, marketing, and other non-physical construction costs), and the costs of land. Per the NAHB, on average hard costs are about 56% of the total costs, soft costs (including builder profits) are about 25%, and land costs are about 18%. 

The cost of housing comes from a variety of sources. In most cases, for both new construction and existing housing, the largest line item is the cost of constructing the home itself. For new construction this is on average 80% of the cost of a home (including hard and soft costs), while for existing construction it's still in the neighborhood of 60-70%. 

It’s only in dense urban areas that the cost of land begins to dominate the cost of new housing, driven by regulatory and zoning restrictions that limit how much housing can be built in a given area. Another way of looking at it is that in the areas that we need housing the most, zoning and regulatory factors are responsible for the lion’s share of housing costs. 

U.S. Home Sales Jumped 9.5% in February 

Home sales rose in February from the month prior, marking the first time in more than two years that sales increased for two consecutive months. 

Sales of existing homes, the majority of purchases, surged 9.5% to a seasonally adjusted annual rate of 4.38 million, the National Association of Realtors said Thursday. 

Economists surveyed by The Wall Street Journal had estimated sales of previously owned homes to fall 1.3% in February. 

The momentum in sales over the last two months comes just ahead of the spring selling season and follows one of the most sluggish periods for the housing market in recent history. 

Home sales in 2023 fell to the lowest levels in nearly 30 years. Since 2022, higher mortgage rates, high home prices and limited inventory have stifled sales, which were still down 3.3% from a year earlier in February. 

But mortgage rates that have dropped since last fall and a now-rising inventory of homes for sale are giving some buyers more choices. 

“Additional housing supply is helping to satisfy market demand,” said Lawrence Yun, NAR’s chief economist. 

The most expensive homes saw the biggest increases in sales. Homes sold for more than $1 million shot up 37% in February, compared with the same month a year ago. Sales of homes priced from $750,000 to $1 million rose 23%. 

Thirty-year fixed mortgage rates have been trending down following a recent peak of 7.79% in October. The rate averaged 6.87% for the week ended March 21, according to Freddie Mac. 

Home buyers in February also benefited from a more than 10% increase in the number of homes available for sale, compared with the same month a year ago, NAR said. 

Demand, however, appears to be outstripping supply, leading to rising prices that will inevitably push some buyers out of the market. The national median existing-home price rose 5.7% in February from a year earlier to $384,500. That was a record high price for the month of February, NAR said. All four regions of the country analyzed by NAR saw price increases. 

“Homeowners are in a happy situation with the rise in prices,” said Yun on a Thursday press call. “But home buyers are frustrated.” 

Prices rose most in the Northeast, even though sales dropped more there than any other region, a development NAR attributed to still-lagging inventory. 

Home buyers already feeling priced out shouldn’t expect affordability to greatly improve this year, said Charlie Dougherty, a director and senior economist at Wells Fargo. 

“At the end of the day, you’re still looking at home prices that have risen 45% since January 2020 and incomes that haven’t risen as much,” he said. “The sales rebound is unlikely to be all that energetic.”

There are some signs that sellers are adjusting their expectations or capitulating more often on price. A smaller share of homes sold in February went for more than asking price, compared with a year ago, NAR said. And nearly 14.6% of homes listed for sale in February had seen a price cut, an increase from the same month last year, according to a report from Realtor.com. 

Christine Quinn dropped the price of her mother’s house in Fairhope, Ala., more than once before selling it last month for $580,000. “The season was not a great time to sell,” she said. “I’m relieved that we’ve sold it.” 

In Denver, Matthew Hingst bought a one-bedroom apartment in February for 1.7% below the listing price. The seller also gave him $3,000 to make small repairs. “I feel like the buyer has a lot more power to be able to ask for things,” Hingst said. 

The height of the sales market typically comes in the spring and economists said results during those months will hinge in part on whether buyers can get more relief from mortgage rates. Federal Reserve officials have said they expect to cut the federal-funds rate at least three times this year. Those cuts could precede lower borrowing costs for home buyers. 

Also still unclear is how NAR’s $418 million agreement to settle claims that the industry kept agent commissions artificially high will affect home sales. Rules about how agents are compensated are scheduled to change in July. 

Yun said real-estate agents have raised the possibility that the new rules might squeeze first-time buyers, who might have to come up with money to pay an agent if sellers choose not to cover the cost. First-time buyers accounted for 26% of home purchases in NAR’s latest survey, matching the lowest figures ever measured for that cohort of purchasers, Yun said. 

This week’s fun finds 

Newest member of the Analytics and ESG team, Jack Bruton served up some Detroit-style pizza for his moai on Friday. The wait was worthwhile - it came with 25 lbs. of wings and his friend’s award-winning hot sauce. Well done! 

2024 Total Solar Eclipse 

On April 8, 2024, a total solar eclipse will cross North America, passing over Mexico, the United States, and Canada. A total solar eclipse happens when the Moon passes between the Sun and Earth, completely blocking the face of the Sun. The sky will darken as if it were dawn or dusk. 

If you’re looking for something fun to do this weekend, check out how to make a pinhole camera. 

You don't need fancy glasses or equipment to enjoy one of the sky's most awesome shows: a solar eclipse. With a few simple supplies, you can make a pinhole camera that lets you watch a solar eclipse safely and easily from anywhere. 

All you need is: 

• 2 pieces of white card stock 
• Aluminum foil 
• Tape 
• Pin, paper clip or pencil

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.

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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.

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