Stocks Await Their Tipping Point

If you really think about it, Fed Chairman Ben Bernanke has this Clark Kent thing going on. By night, he is a soft-spoken family man, more blue collar than blue blood—an academic who carries a Jos. A. Bank charge card. By day, he flexes monetary superpowers, including the ability to conjure up trillions of dollars to buy Treasuries and mortgages.

One thing SuperFed can’t do—at least not directly—is goose the economy and popular confidence by buying stocks. It can, however, do this transitively, by inducing what Wall Street likes to call a “pain trade”—forcing investors out of the perceived safety of risk-lite Treasuries. Then, if all goes as planned, they will find themselves maxing opportunity out of yield-sapped corporate bonds, including higher-risk junk bonds. Bernanke, you see, is making investors grovel for return. And if they grovel long enough, they are bound to finally make that capital-structure leap of faith to the stock market. Retirement-account values will go up. Companies will have more valuable currency with which to make acquisitions. Hiring and consumption could well take heart.

Fifteen years after Bernanke’s predecessor Alan Greenspan famously warned of irrational exuberance in markets, the long-awaited great migration back to equities (following the 2000s’ two growling bear markets) has yet to happen. But if things continue apace, and Bernanke keeps doing what he’s doing, it could take hold any day now.

“We’ve come from financial depths that none of us have ever seen,” says Meg Green, chief executive officer of Meg Green & Associates, an Aventura (Fla.) wealth manager. “As night follows day, though, there’s light at the end of the tunnel. Riding the market waves should become second nature, letting longer-term portfolios travel on an upward trend.”

In the meantime, it’s been all fixed-income, all the time. (Not that stocks have been banished to Vladivostok. The Standard & Poor’s 500-stock index is up 14 percent so far this year, and has more than doubled off its financial-crisis low.) Investors have plowed just under half a trillion dollars into bond funds this year, according to EPFR Global. Thanks in large part to record-low borrowing costs brought on by the largesse of the Federal Reserve and its overseas counterparts, the bond market is putting the finishing brushes on an all-you-can-eat year. Corporate bond sales from the U.S. to Europe and Asia have crossed 2009’s record to reach $3.89 trillion, up from $3.29 trillion last year and $3.23 trillion in 2010, according to data compiled by Bloomberg. In the U.S. alone, issuance also set a record, hitting $1.45 trillion, compared with $1.13 trillion last year.

Amid that feeding frenzy, the extra yield investors demand to own corporate bonds over Treasuries is at a mere 2.23 percentage points, compared with 3.51 at the end of last year, according to Bank of America Merrill Lynch’s Global Corporate & High Yield index. “Junk” is no longer a pejorative.

As the corporate bond market gets its dregs scraped, repeatedly, Wall Street’s capacity to transact the stuff is being strained. An average of $16.93 billion of investment-grade and high-yield bonds traded every day this year, while the value of outstanding corporate bonds rose to $5.72 trillion. Last year’s average daily trading volume of $15.73 billion occurred amid $4.86 trillion of debt outstanding.

Mark Freeman, chief investment officer of Westwood Holdings Group in Dallas, thinks this pigout is primed to relocate to equity markets, which have yet to revisit their records. “A group of investors, which I refer to as ‘bond market refugees,’ have to find a new home in order to meet their income needs,” he says. To underscore how crowded a trade he believes bonds have become, Freeman highlights that the investment-grade universe trades at a price-earnings multiple of 58, while junk bonds change hands at 16 times earnings. He says that “if corporate earnings can show any growth at all next year, which I believe they will, it is very unlikely the Standard & Poor’s 500 index will continue to trade at a p/e of 13, especially given that it has a higher yield and the potential for earnings growth—something bonds cannot offer.” Of the emerging risk-reward calculus, Freeman says: “Given the current environment, bond investors will eventually find high-quality, dividend-paying stocks as an attractive alternative.”

The question is, can the Fed pain trade last long enough—and without a shock that’s out of its control—to push investors en masse into the stock market. For all Bernanke’s superpowers, he’s not omnipotent.

In a Dec. 17 report entitled The “Bond Bubble”: Risks and Mitigants, Fitch Ratings noted that if interest rates were to revert rapidly to early-2011 levels, a typical, 10-year investment-grade corporate bond could lose 15 percent of its market value, while a 30-year equivalent would take a 26 percent hit.

Such a blindsiding—you can actually lose money in bonds?—would spoil the long-awaited rapprochement with equities.

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European Banks Postpone Their Diet

European banks pledged last year to cut more than $1.2 trillion of assets—about 3 percent of their total—to help them weather the sovereign-debt crisis. Bank executives said they would sell divisions and loans and rein in lending to reduce short-term funding needs and increase capital. Instead, the banks have grown fatter.

Lenders in the euro area increased assets by 7 percent to €34.4 trillion ($45 trillion) in the year ended July 31, according to data compiled by the European Central Bank. BNP Paribas (BNP) and UniCredit (UCG), the biggest banks in France and Italy, expanded their balance sheets in the 12 months through the end of June.

They have ECB President Mario Draghi to thank. His decision nine months ago to provide more than €1 trillion in three-year loans to regional banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage banks to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more aid from the central bank. “Deleveraging isn’t taking place, especially in Spain and Italy,” says Simon Maughan, a bank analyst at Olivetree Securities in London. “The fact that we haven’t got on with it, or very slowly, suggests that when the time comes we’ll need another ECB injection to roll over the first one.”

Analysts had expected that European lenders would have to shrink as regulators requested higher capital, and investors, who became less convinced that governments would be able or willing to bail out their largest banks, demanded bigger returns for lending to those firms. The International Monetary Fund forecast in an April report that banks would shrink by as much as $3.8 trillion and curb lending. The IMF estimates such cutbacks could reduce euro-area gross domestic product by 1.4 percent.

Thanks to the ECB program, lending to households and companies in the euro area held steady this year. Total loans rose to €18.6 trillion as of July 31 from €18.5 trillion at the end of 2011, according to data from the ECB. The central bank said in its monthly report released Sept. 13 that the “supportive impact” of the longer-term refinancing operation, or LTRO, “prevented abrupt and disorderly deleveraging, which could have had severe consequences for the economy.”

Some lenders used the ECB’s loans to purchase sovereign bonds. Since they earn more on the bonds than they pay on the loans, banks can reap about €12 billion of profit a year, according to estimates by Nikolaos Panigirtzoglou, an analyst at JPMorgan Chase (JPM) in London. For lenders in southern European countries, that strategy could backfire. Prices of bonds sold by the governments of Spain and Portugal fell to record lows this year because of concern on the part of investors that those nations would require bailouts.

Banks have sought to sell performing loans, which carry higher prices, or some of their best businesses, to avoid taking too big a loss. Societe Generale (GLE) sold its U.S. asset-management unit, TCW Group, last month to private equity firm Carlyle Group (CG) for less than the $880 million the bank paid for it in 2001, according to people familiar with the transaction. The Paris-based lender also is close to selling €800 million of mortgages to insurer Axa’s real estate unit at a discount of less than 10 percent of face value, people with knowledge of the deal said last month. “We have started the disposal program, and we’re going to carry on that in the next few quarters,” said Societe Generale Chief Executive Officer Frederic Oudea in a Sept. 12 interview.

Other banks are moving far more cautiously. The delays could lead to what Alberto Gallo, a London-based analyst at Royal Bank of Scotland (RBS), calls the “Japanification” of the banking system, a prolonged period during which lenders are slow to clean up their balance sheets. “We’ve gone from a risk of an accelerated deleveraging to the opposite,” he says. “It’s a better scenario for the economy, although it shouldn’t translate into complacency.”

The bottom line: After pledging to shrink their balance sheets by $1.2 trillion, European banks increased assets to $45 trillion in the year through July.

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Chinese Private Equity Firms Flex Their Muscles

Not that long ago, Blackstone Group (BX), TPG Capital, Goldman Sachs Group (GS), and other foreign buyout specialists had little trouble muscling out local rivals for deals in China. Today, Chinese firms dominate the private equity landscape. Investments by Chinese firms in the world’s second-biggest private equity market rose to $7.8 billion last year, overtaking for the first time the $7.4 billion that came in from U.S. and European funds, according to Asian Venture Capital Journal.

The shift coincides with China’s stepped-up efforts to develop homegrown private equity firms such as Beijing-based Hony Capital. Local firms enjoy privileges over foreign rivals when it comes to regulations and access to funding in yuan, also known as renminbi. “Renminbi fund managers have a huge advantage in terms of speed of execution as well as easier exit opportunities within China,” says Chris Meads, Hong Kong-based global head of investment at Pantheon, a London private equity company that has invested $2.7 billion in Asia. “Deal flow is being diverted to renminbi funds because it’s just easier for them.”

The Chinese government treats local businesses that receive capital in U.S. dollars or other foreign currency as foreign-invested enterprises, which means additional layers of required approvals from regulators, even for actions as routine as opening a retail store. “Many Chinese companies realize taking money from any foreign-currency fund will result in more restrictive scrutiny, and they just can’t stand the red tape,” says Jessie Jin, a Shanghai-based partner at venture capital firm GGV Capital in Menlo Park, Calif.

To counter this challenge, Goldman Sachs announced its first yuan fund in China in May, followed by Morgan Stanley (MS) a week later. In February, TPG Capital, the Fort Worth-based buyout firm, said it raised 4 billion yuan ($630 million) in a first round of fundraising for its renminbi fund, 90 percent coming from private investors in China. “For the global players aiming for a large market share in China, without renminbi funds, you probably feel more or less insufficient,” says Eric Zhang, a Beijing-based managing director at Carlyle Group, which runs a private equity fund with the Beijing municipal government.

Whether renminbi investments by foreign managers get the same regulatory treatment as domestic private equity funds is subject to interpretation by local authorities. China hasn’t formulated nationwide rules governing the private equity industry because there is little cooperation among regulators, including the National Development and Reform Commission, the China Securities Regulatory Commission, and the People’s Bank of China, the central bank. Global funds also have been tripped up by currency-conversion restrictions, GGV’s Jin says. Companies receiving investments in foreign currencies can’t exchange them for yuan all at once. They need separate approvals to convert portions of those funds to pay employees or buy equipment, she says.

Domestic private equity firms have an edge over global rivals because they’re more focused on just one market, says Hony Capital Chief Executive Officer John Zhao, who raised 10 billion yuan last year for the firm’s second renminbi fund, doubling the size of a previous one in 2008. “Our decisions will be quicker” than foreign funds, he says.

Executives from Carlyle and Goldman Sachs counter that big Chinese companies still prefer to deal with well-known foreign investors because of the expertise they provide in listing abroad as well as orchestrating cross-border acquisitions. “To stay competitive, we need a local fund and a local team, but we always have to deliver value on top of capital,” says Stephanie Hui, a Hong Kong-based managing director at Goldman Sachs’s private equity unit.

Despite the increased local competition, executives at global private equity firms say they’re still finding opportunities to invest in transactions that give them managerial control. Buyout deals in China more than doubled last year, to the highest level ever, data compiled by consulting firm Bain show. Leveraged buyouts increased to $7.5 billion, from $5.9 billion in 2010, according to Preqin, a London-based data provider.

While global firms face multiple bidders for good businesses in China, the number of target companies also is rising, says Goldman Sachs’s Hui. “There are still attractive deals for foreign investors in China,” Pantheon’s Meads says. “They have to work a lot harder than they have in the past to get them.”

The bottom line: Since 2008 the number of Chinese private equity firms has almost doubled to 129. Foreign firms face regulatory and funding challenges.

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