As you may have heard, GM shocked the markets last week with its very weak earnings, and its shares dropped almost 12% in one day. What happened on the bond market was actually more interesting, and also more symptomatic of the current state of the world economy in general and the US economy in particular.
Today comes the news that GE Capital pulls $2bn GM credit facility (FT, 22 March). The short version: the smarter rats are leaving the sinking ship.
Below, some thoughts on:
- the amazing power of rating agencies and how they misuse it
- too much money in the markets and the "flight to garbage"
- the backlash
Massive problems for the ungainly giants (FT, 22 March)
(btw this article is a very interesting take on "big is beautiful" which I recommend)
Fortune favours the large, and consolidation among leading companies is inevitable. There is no more firmly held belief in popular thinking about business. In banking and pharmaceuticals, in oil and insurance broking, in the motor industry and telephony, the future is said to lie with a small number of large global players. Chief executives across industry have followed the maxim of Jack Welch, the former General Electric boss, that unless you are number one or two in your industry, you are dead.
There used to be a phrase for it - the aspiration "to be the General Motors of this industry". Not any more. Last week, GM forecast another set of disappointing results: the latest in a 30-year history of disappointing results. The ratings agencies threaten to call its securities junk.
You have probably heard more about the drop in share prices than about that last item. For market commentators, the big news is that they are actually talking about downgrading GM. Standard & Poor's, the biggest rating agency, put GM on "negative watch", which means that they expect their next rating evaluation to go down, in that case from the lowest rung of "investment grade" to the highest of the "speculative" (or "junk") ratings. Such a rating has been seen as long overdue by many commentators (see box below), but resisted by GM (as it would increase its cost of funding) and by the market more generally (having the biggest debtor of the market downgraded would trigger massive reallocation of portfolios, with many unpredictable consequences, as many portfolio managers are not allowed, either by federal regulations, or by their own internal rules, to hold "speculative" rated paper). Markets are finally coming to terms with reality. GM's debts are increasingly unsustainable.
An inch from junk (FT, 18 March)
General Motors is teetering on the brink of a downgrade to junk bond status. This week's profits warning could push it over the edge. GM could survive a ratings downgrade. But the loss of investment grade status could force it to change the way it organises and funds its business.
The impact is unlikely to be confined to GM itself. If the company is downgraded, the shock waves could rock the entire corporate bond market. GM has $300bn (£156bn) debt, of which only one-third is secured asset-backed debt. The jury is still out on whether the corporate bond market can smoothly swallow an issuer of this size.
Rating agencies have an amzing power because so many fund managers rely (blindly sometimes, it would appear) on these ratings for their investment decisions, although such ratings are made by private entities, paid by the issuers of the debt, and are not regulated in any way. This creates herd-like movements on markets, it generates unhealthy conflicts of interest (a rating downgrade is always bad news for a borrower, as it increases the interest rate applicable to its debt, and yet the borrower is the client of the rating agency, not the fund managers). When the rating has a macro-economic effect because it applies to hundreds of billions of dollars (which happens for a few countries and a smaller number of corporate borrowers), the management of such issues becomes, quite frankly, tricky, as it can be argued that these ratings influence economic policy and thus become heavily politicised.
As this happens in a context of where interest rates have been very low for a long time, with the world awash in liquidity (and investors desperate to find good returns thus investing in increasingly risky paper), but the trend now being to a tightening of such interest rates (the Fed being widely expected to increase its rates by another 0.25% this afternoon), and there is a growing risk that the riskiest investments / the weakest borrowers are going to suffer and possibly bring their creditors with them. High tides lift all boats; we are now in the phase when the sea is going out and we will see who is really in good financial shape as oppsoed to being propped up by cheap money.
GM, oil and the turn of the monetary tide (John Plender, FT 21 March)
The combination of rising US government bond yields, a strong oil price and the threat that credit rating agencies would downgrade General Motors to junk bond status prompted a sudden loss of risk appetite. Or, in the inelegant phrase occasionally favoured by this column, the flight to garbage went into reverse. Emerging markets, with the exception of those in Asia, took the brunt of an otherwise indiscriminate selling wave. Is this the turning point in a credit cycle marked by a manic hunt for yield?
I believe that there may well be a turning point this year and it could be traumatic. But I am not yet convinced that this is it. Monetary conditions in the US, even after the Federal Reserve's interest rate increases since last June, are loose despite the policy of "measured" tightening. A world glutted with excess savings is still awash with liquidity. While the rise in US Treasury yields has done its bit to tighten financial conditions, the bond market has not yet exercised its right to be seriously unmeasured. That suggests that, while carry traders who borrow at low rates to invest in higher yielding assets will have a less comfortable life and riskier assets may be more prone to sporadic panicky evacuations, this may not be enough to spring a systemic shock.
Could General Motors change this plot line? Since I castigated the credit rating agencies last year for failing to downgrade GM's debt to junk, they have woken up. GM paper will soon be downgraded. Such a huge addition to the junk market will cause ructions, with many smaller borrowers being crowded out. Yet the move has been so well-signalled that many market participants will surely have hedged against that eventuality. What could turn this into a trauma would be if it coincided with other shocks such as volatile behaviour by the currency or bond markets. That would encourage over-borrowed traders to engage in the time-honoured dash for the same side of the boat.
Even without a systemic shock, the turning of the credit tide will leave many participants exposed, among them some banks that made pricey acquisitions or heavy investments in branches when interest rates were at historic lows. Nor should we forget that the hefty proprietary trading profit revealed by the big US investment banks last week are largely the product of a freakish cycle in which US monetary policy has granted an astonishingly generous gift to all in the financial community. The laws of financial gravity will not be suspended indefinitely.
The real problems of GM is that it is not making money from selling cars. It has essentially become a huge consumer-credit company / pension fund with an attached manufacturing operation: it makes all of its money from lending money to consumers buying their cars, but it has massive pension liabilities (it has 2.5 pensioners per worker currently, and that ratio is set to worsen yet). In all logic, its management is more focused on financial issues than on manufacturing, and this shows, in terms of market share, profitability and other similar criteria.
(Go read this fascinating account comparing GM to Harley-Davidson, whose market value has just overtaken that of GM, and who has been more successful in regenrating its manufacturing business by focusing on its brand: GM faces life in the slow lane as Harley roars past (FT, 21 March))
In any case, as the initial GE story shows, and as this additional story (Investors bet on GM downgrade chances (FT, 22 March)) shows, the market is beginning to price the GM risk as pretty close to "junk" already, thus underlining both the weakness of the company and increasing wariness of the rating system in current conditions.
There is so much money flying around that the macro-economic effects of changing investment patterns will be both massive and unpredictable, with likely episodes of strong volatility. The smarter investors see the dangers ahead, but worry that their movements (when they are significant players) will trigger the crisis they are trying to avoid. The fact that everybody focuses on the financial side of business means that less attention is given to the underlying manufacturing or service part of the company which makes the crisis in such activities get steadily worse, and weakens the base on which the financial games are played (I am not criticising these games per se, they do bring value, as I am paid to know... but it is a question of balance, as in everything). Equilibrium becomes increasingly hard to maintain, until....
There are so many warning signs:
- currency movements
- tensions on the oil market
- all the risks associated with increasing interest rates
- the US-China trade unbalance, and all risks of trade wars
All are linked to cheap money and reckless federal spending, feeding a consumer boom based on virtual real estate and other financial asset price increases, hoovering in imports from all of Asia, paid in federal IOUs, fuelling the growth boom of China and others which in turn creates all the current tensions on the commodity markets.
It is all unsustainable, and GM is only the biggest and weakest collateral damage, but it is a sign of things to come.