Category Archives: On the cover

On the cover

Is there a Bubble in Infrastructure?

Global Economy, On the cover, Sin categoría

Published at @Hedgeye

“Price is what you pay, value is what you get” Warren Buffett

If we look at the latest market transactions, infrastructure assets of all kinds are being sold at multiples that move between twelve and eighteen times EBITDA. The brutal multiple expansion generated in infrastructure assets (the “penultimate bubble”)  coincides exactly with the bubble created by artificially low rates and the monstrous excess liquidity from central banks. In a period when interest rates have fallen more than six hundred times, multiples paid for infrastructure assets have increased five-fold.

Demand for infrastructure is intrinsically linked to financial repression. Faced with the desperate search for a bit of yield, with 9 trillion euros of bonds at negative rates and zero rates, investors look for relatively safe assets, with stable cash flows and acceptable returns.

When a fund or infrastructure company pays these multiples, it has to assume several requisites:

1) That interest rates will remain low for a long time, since these are very long-term investments,

2) That inflation expectations will remain very low, because even if the returns of these assets are adjusted by inflation within the regulation, we all know that when inflation rises, so does regulatory risk,

3) That the regulation of these purchased assets will never worsen in the period of investment, and

4) That  a very low cost of capital (WACC c5%) is adequate for these cash flows.

Investors may take some of these factors into account, but we cannot help thinking that assuming them all is at least highly optimistic, and that the fact that market multiples soar does not mean that prices are adequate.

Another essential element to consider when assessing risk, is the degree of leverage that is used for these transactions. It is easy to fall into the temptation – as we saw in the renewable bubble – of thinking that project equity returns will increase exponentially with higher debt because “money is free”. If the market finances these projects with 80-90% debt and 1.5-2% interest rates “with guaranteed returns,” ROE (Return on Equity) will be very high, which justifies the huge multiples. Until the mirage fades, and even a small decrease in allowed returns destroys the entire equity because it does not cover the cost of debt.

Does this remind you of something? Do you remember when some funds leveraged assets up to 90% in renewable assets because returns were “guaranteed” to achieve ROEs of 15-20%? When revenues decreased ever so slightly, the entire bubble burst.

The problem of captive and very long-term assets is that this optimistic combination of estimates simply cannot be made. And paying 16 times EBITDA requires a lot of faith.

Infrastructure investments soared 14% in 2016 to a record $ 413 billion, doubling since 2009 and exceeding by $ 110 billion the pre-crisis peak of 2008. In Europe, this figure reached a record 555 transactions for $ 97 billion in 2015, 42% in renewable assets, according to Prequin.

Is This Time Different?

Infrastructure funds tell me that this time it’s different. That infrastructure gap in the world is c1.5% of GDP, and that demand and multiples are justified. I heard the same with housing, tech companies, renewables…

Not everything is a huge bubble, though. Some of these investors find a fifth reason to justify valuations. The possibility of increasing efficiencies and controlling costs can make a significant change.

One of the advantages offered by an infrastructure asset is that, with proper management, profitability and quality of service can be improved without demanding tariff increases because multiples paid have been too high.

Of course, many of these investments do not carry such an exorbitant level of debt and if they have a reasonable equity cushion, they will be able to absorb the risk of changes in revenues in the investment period.

What causes the bubbles to explode is the combination of excessive borrowing and perception of no-risk. There has not been a single crisis that was generated from assets that were perceived as high risk. Crises are always created on what we consider “safe”. Because the perception of “extreme safety” leads to excessive indebtedness and accumulation of risk in the allegedly “safe” asset.

The arguments I usually hear about infrastructure risk are the same ones I’ve heard all my life before a bubble:

  • “Infrastructure needs far outstrip supply, so prices cannot go down (think ” house prices never fall”, or ” it’s a new paradigm “).
  • “These are the market prices and if you do not accept them, you lose” (remember “the price is the price”, or “historical valuations are not applicable now”).

An essential factor to justify current valuations is that the last transactions have been made at a higher price. But falling into the ” greater fool theory” can be dangerous. That is why cautious funds use sensitivity analysis and contingency plans. Even worse than accepting any price at face value is estimating a level of liquidity and demand for captive assets that can quickly evaporate. The famous argument of “if you cannot pay, you can always sell in the market at more expensive prices” disappears quicker than the investor thinks, in the face of a slowdown.

Expecting increased guaranteed returns when revenues come from taxpayers is the biggest mistake. Bubbles are not guaranteed.

I can be totally wrong. I hope so. I only beg, I implore, to those who join this race of ever expanding multiples to have a cushion of sufficient equity and management capacity. If I am wrong, investors will continue to have very attractive returns, but if I am right, they will not be part of a bankruptcy domino that may start when the “guaranteed” word disappears.

 

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

 

Image courtesy Google Images

Reversal or Pause for Breath? An opportunity

Global Economy, On the cover, Sin categoría

Reversal or pause for breath?

All economic indicators point to better growth, solid consumption and improved earnings.

Here we explore risks to expectations:

  • Failure to repeal Obamacare.
  • Oil
  • Europe

… And opportunities

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

EU at 60. Much to do

Europe, Global Economy, On the cover, Sin categoría

The European Union is 60 years old today, and it faces enormous challenges.

One wakes up every week with news about the European Union that do not help at all to improve its credibility and popular support. Brussels and the EU seem so detached from the reality of economies and citizens that their top leaders do not even blink or wonder if it is a good idea to say things like “taxes cannot be lowered” (Schaeuble), or that “Brussels dismantles the Spanish government’s excuses to resist raising VAT.” Thank you, Euro-bureaucrats.

It is very dangerous that a European Union, which has unquestionable advantages and must become a global power of growth and prosperity, puts obstacles and expels citizens and companies just to perpetuate a bureaucratic monster.

 

Brussels estimates that increasing VAT would “barely” affect low income families and that the increase in inequality – “only” of 2.6% – could be offset by social transfers. That is, raising VAT “barely” affects low incomes but, as it actually does and also increases inequality, they propose to mitigate it with more subsidies via spending. Bravo. Brilliant. .

For Brussels there is never a negative effect on consumption, employment or economic activity of raising taxes. It never questions government spending. And then they wonder why the EU grows less and has more debt and unemployment than its peers.

The reality, already demonstrated, is that increasing taxes has a direct impact on potential consumption, the purchasing power of families and, in addition, reduces the job creation potential.

Brussels should recognize that it has been wrong for years in its growth and employment forecasts, and analyze why. Applying a bureaucratic directed economy model everywhere impacts growth, prosperity and productivity.

The European Commission loves non-finalist taxes. The so-called “green” ones are a real joke. The consumer still pays the massive “green” subsidies, but they also pay for added “green” taxes. EU citizens pay twice. For the subsidies, and for being so mean as to use a car.

In spending and taxes, the pattern is always the same. For Brussels, to harmonize is raise taxes and spending. It does not question the economic suffocation that takes place in France or other countries. It demands the other EU nations to reach an average -always in tax burden and spending- that France increases disproportionately.

The reality is that, often, the recommendations of the European Commission do not seek to reduce imbalances and promote competitiveness, the creation and attraction of capital and employment. What they do is to perpetuate a “dirigiste” model copied from France that only generates stagnation and greater discontent.

Even in the document where the European Union “explains” why it is not a bureaucratic and excess spending entity, it “clarifies” that “states and local governments will continue to control tax increases” (note that it does not say “manage” or “cut” taxes, but only “increases”). Thank you. It also “explains” that it “only” spends 1% of the wealth of the countries, and that these countries – thank you – spend much more.

The European Union has many enemies, and – let’s be clear – some are at home. Those that defend and justify a model of increasing tax burden and higher interventionism as unquestionnable. Those of us who criticize the EU’s obvious mistakes want a European Union that solves them, not one that follows the ostrich policy of blaming others for its problems.

The tax burden in the European Union has reached historical highs – of 40% of GDP – while ease of doing business deteriorates due to bureacracy and massive regulatory burden. At the same time, while companies and families struggle, the bureaucrats in Brussels reject to make any change that allows the economy to breathe.

The best way to combat those who unjustly criticize the European Union is with actions. Lowering, not raising taxes, as citizens, companies and the ECB demand.

Against the voices accusing the EU of interventionist and bureaucratic, the EU must take action to improve efficiency dramatically and improve ease of doing business. Focus on the countries that grow and are world leaders, not equalize imbalances in a model that only creates stagnation.

We have a golden opportunity in the face of external and internal threats . It is not an opportunity to justify that “there is room” to raise taxes, nor an opportunity to confuse “more Europe” with “more bureaucracy”. It is not an opportunity to attack those who grow, have surplus and create jobs . It is a chance to drastically improve in economic freedom, ease of doing business, open market and increasing disposable income for families, letting job creators do their work.

The EU has in its hands all the tools to be better and more competitive. More Europe is not more bureaucracy.

The European Union cannot continue to settle for being a low growth, high debt, huge tax burden area, penalizing its citizens and companies, the same ones who have bailed-out the bureaucratic leviathan from the crisis.

If we do not wake up immediately from the comfortable deification of bureaucracy and fiscal robbery, the European Union, which is a project worth fighting for, will perish in the face of its own inaction. I do not want it to happen. But I assure you that, if it does happen, I will not blame the EU’s  collapse on the outside enemy excuse, when we have had in our hands all the tools to be stronger, better and more competitive.

Citizens and businesses are not ATMs to pay for political excesses, they are the clients of a European Union that must be at the service of the economic agents who contribute and create jobs, not at the service of bureaucracy.

Daniel Lacalle is a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

Predictions & Estimates for 2017 @focuseconomics

Global Economy, On the cover, Sin categoría

Published at @focuseconomics

Daniel Lacalle is a fund manager who holds a PhD in Economics and has a CIIA financial analyst title. He is author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley) as well as “Escape from the Central Bank Trap” (BEP). He has been ranked as one of the Top 20 Economists in the World by Richtopia and has over 24 years of experience in the energy and finance sectors. As an expert in this field, let’s take a look at what he is foreseeing for the global economy.

1. France to emerge as Europe’s biggest problem?

The previous year was marked by a lot of anti-establishment populist movements, immortalized in the victory of U.S. President Donald Trump and the United Kingdom’s vote to exit the European Union. However, Lacalle believes that these don’t come close to the biggest potential threat to stability in Europe, which is the likely political upheaval in France.

The French elections will be held later on this year and one of the biggest frontrunners is Marine Le Pen who has spoken about starting their own referendum to leave the bloc. Although Le Pen promises that this can be achieved in an orderly fashion, the numbers suggest that this might do more harm than good in the long run. After all, France is running on an unsustainable economic model with a high tax burden and labor market rigidity, keeping it in stagnation.

Read more of Daniel’s thoughts on France here

2. Potential reversal in Spain’s recovery

There’s no denying that the Spanish economy has made great strides in restoring economic growth and employment over the past few years, but this recovery could be threatened by both internal and external forces. For one, Spain has a complicated political landscape that makes reforms challenging to implement. To make things worse, the IMF is requiring Spain to raise some VAT tranches, which could dampen consumer spending just as it is trying to get back on its feet.

Read more on why Daniel believes Spain’s recovery is under threat here

3. Are currency wars over?

Monetary policy seems to have taken the backseat to politics lately, although world leaders like Donald Trump haven’t stopped short of calling out countries like Japan and China for unfairly keeping their currencies weak. However, much of the global economy and central bank policy has evolved these days as rates have been cut to record lows and massive amounts of liquidity have been doled out in response to the financial crisis nearly a decade ago.

This suggests that monetary policy authorities have pretty much used up all the tools in their arsenal to keep internal and external demand afloat, including methods to devalue their currencies. Republicans have pointed out that central banks should no longer use the balance sheet indiscriminately as this would perpetuate bubbles.

Daniel has more on the end of currency wars here 

4. Earnings recession may be over in Europe

On a less downbeat note for Europe, it may be the end of the earnings recession in the region after more than half a decade of dismal results. Morgan Stanley reported that out of 75 companies surveyed, 43% have surpassed estimates by 5% or more while less than 30% disappointed. This trend could carry on and improve, buoyed by rising commodity prices, improved banking performance, upward revisions of global growth, and widespread margin improvement.

Daniel muses further on the subject here

5. What’s next for oil?

Oil has been recently hogging the spotlight as traders are trying to gauge whether or not the OPEC output cut is having a material impact on prices. Although several institutions projected that this could result to a significant reduction in supply, there are other factors such as higher US production that could still yield an overall increase in stockpiles. Apart from that, the complacent environment in which energy price gains are triggered by the inflationary effects of stimulus while overcapacity and debt remain could be a recipe for a crisis.

Read more on oil and ‘Frexit’ in 2017 here