Vol. 33, No. 16 Two Wall Street, New York, New York 10005 www.grantspub.
com AUGUST 7, 2015
Fault lines in credit
In writing off all but tag ends of its
Nokia acquisition of little more than a
year ago, Microsoft produced a $7.5 bil-
lion demonstration of the evanescence
of modern business value. Creative de-
struction may be salutaryit is salutary.
Still and all, destruction costs money.
Creditthe promise to pay mon-
eyis the subject of this unfolding
narrative. Junk bonds are in the fore-
ground, money is in the background.
No further need to reach for a certain
kind of yield, we are about to contend;
higher speculative-grade yields are
coming to you. In advance, we are pre-
pared to assign a cause to the downturn
that hasnt fully materialized yet. Six
carefree years of Fed-engineered zero-
percent funding costs will prove the
fundamental reason for the next gust
of defaults. The prospective rise in the
federal funds rate will turn out to be a
causative footnote.
The credit cycle is a mass migration
of the mind. It begins with the col-
lective fear of losing money, point A.
It ends with the collective fear of not
making money, point B.
Point A finds lenders and borrow-
ers nursing the wounds of the bust
that followed the boom. The peni-
tents resolve to be more careful if
only the market will give them an-
other chance. They do not disavow
leverageit is, after all, the raison
detre of speculative-grade finance.
They rather pledge to employ it more
prudently. They will henceforth lend
at rates that are sensibly aligned with
the evident risks of the correspond-
ing borrower. No more updating their
Facebook status when they ought to
be reading prospectuses, either.
The passing years leach away mem-
ories of the bust. Bankruptcy filings
become rarities as prosperity spreads
its blessings. The return of the itch to
speculate means that, for the profes-
sional investor, generating gains takes
precedence over avoiding losses. Lever-
age creeps (at length, it gallops) back
into the market, and pricing comes to
favor the seekers of funds, rather than
the providers of funds. Point B is the
apex of optimism.
Point A of the present cycle we may
pinpoint as March 2009, the nadir of
stocks and credit. Point B, we shall
guess, has just passed. The crystalliza-
tion of boom-time optimism occurred
on July 16. The oversubscribed sale
of more than $1 billion of debt by the
Ba-1-rated City of Chicago was the red
letter event. A two-line quotation in
the Chicago Tribune before the sale took
place could speak for broad swaths of
American speculative-grade finance.
Grants on vacation
Grants Interest Rate Observer, taking its
summer vacation, will resume publication
with the issue dated Sept. 4, 2015.
It sounds like we dont have much
of a choice, said Alderman Nicholas
Sposato, concerning the feasibility of
the then prospective issuance. This is
a way to at least put our finger in the
hole in the dike for now. The fingers
in the dike, duly inserted, belong to
Americas fiduciaries.
For many a moon, the prices of junk
bonds failed to register bad news.
That has begun to change. Thus, the
Bon-Ton Stores 8s of June 2021, is-
sued at par in May 2013, were quoted
at 84 as recently as mid-May of this
year; they change hands today at 75, a
price to yield 14%. One might reason-
ably argue that the prospects for U.S.
consumer spending should be pretty
good, given rising employment, grow-
ing wages and falling energy prices,
colleague David Peligal observes. The
Bon-Ton clientele is not high end, so
its demographic should benefit more
on the margin. The fact that the bonds
are sinking is perhaps telling you some-
thing about changing perceptions of
credit risk.
A July 30 report on the junk market
by Michael Contopoulos et al. at Bank
of America/Merrill Lynch makes a per-
suasive case that, if the top in the junk
market is not in, it is likely not far off.
The future is what it used to be is
the promising title. Plainly, the au-
thorswho include Neha Khoda and
Rachna Ramachandranare alert to
the cyclical facts of life.
Reversion to the mean is the fore-
most cyclical fact. Trees dont grow to
the sky; the cure for high prices is high
prices, and the cure for low prices is
low prices. The junk market, though it
has suffered a rocky couple of weeks
thereby trimming returns in the year
(Continued on page 2)
 2 GRANTS / AUGUST 7, 2015
(Continued from page 1)
Too quiet out there
15%
Moodys trailing 12-month issuer default rate
for global speculative-grade debt
12
9 9
default rate
6 6
3 3
0 0
1/70 1/75 1/80 1/85 1/90
source: Moodys
to date to little more than 1%has by
no means corrected the manifold ex-
cesses that are so much in need of cor-
recting, the authors assert. Not only is
the market not out of the woods, Con-
topoulos et al. insist, it is not even in
the woods yet.
Well, the market is in the woods
of debt. Over the past several years,
speculative-grade companies have re-
leveraged, somewhat of an anomaly
during periods of decent growth, low
default rates and strong equity mar-
kets, the report observes. The authors
relate that they have looked at leverage
in its many different facets: We have
run the numbers using unadjusted
EBITDA, adjusted EBITDA including
and excluding energy, metals and min-
ing, and materials. . . . The conclusion
is the same, no matter how the data are
sliced, they find: [C]ompanies have
re-levered to an extent not seen since
the late 1990s.
Apocalyptic, the BofA/Merrill team
is not, bearish it is: In our view, com-
modity, rate, liquidity and, most im-
portantly, fundamental pressures have
yet to fully affect the market, and when
they do, we expect further price loss
across a broader set of companies.
Naturally, all cycles are different.
Radical monetary experimentation is
the standout characteristic of this one.
Zero-percent funding costs have pulled
forward consumption and pushed back
distress. They have reduced the re-
turns to skepticism, securities analy-
sis and due diligence. They have
Copyright 2015 by Grants Financial Publishing, Inc. Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute.
15%
12
default rate
1/95 1/00 1/05 1/10 6/30/15
prolonged the commercial lives of mar-
ginal businesses that, were they forced
to finance themselves at normal inter-
est rates, might be pushing up daisies
in some reorganization proceeding.
At the spring 2014 Grants Confer-
ence, Martin Fridson, now chief invest-
ment officer at Lehmann Livian Frid-
son Advisors, imagined the next wave
of speculative-grade defaults. It would
begin in 2016, he projectedthat is, it
would likely begin in 2016 if past were
prologue. The wrinkle was that, in this
day of monetary activism, the past may
not be prologue. Thus, in 2009, 13.3%
of the speculative-grade issuer universe
defaulted. It was far and away a record
for any year in the 45 years since the
data were first collected. Yetremark-
ablyin 2010 the default rate subsided
to 3.3%, slightly below the long-term
average of 4.6%. I would submit that
is physically impossible, said Fridson,
still amazed at this occurrence a half-
decade after it happened. But it did
actually happen, and I think that the
only conceivable explanation is the
Feds extraordinary intervention.
Contopoulos et al. compare 2015 to
1998, a year best remembered, if at all,
for the flameout of Long-Term Capi-
tal Management. The year 1998, like
2015, saw plunging oil prices, swings in
quarterly GDP readings of as much as
four percentage points, apprehension
over a Fed tightening cycle and flat-
tish junk-bond returns. Front and cen-
ter, too, was the concentrated issuance
of speculative-grade debt in a certain
favored industry. The fair-haired seg-
ment of 1998 was telecommunications,
that of the present is, or rather was,
commodities. High yield typically
overbuilds in one industry before real-
izing stress in that sector, the BAML
report observes.
We would amend that statement.
Credit markets tend broadly to over-
build. They tend especially to over-
build when tempted by governmen-
tally suppressed interest rates. Junk
bond yields beginning with the num-
ber five and sovereign debt yields
beginning with the number one-half
of one have proven temptations im-
possible to resist.
Intimations of trouble in telecom
did not, at first, trouble the broad junk
market. Investors wrote it off as a spec-
ulative outlier. Only gradually did they
lose faith in industries and companies
that they had previously assumed to
be safe. Skepticism proved contagious
once it set in. It is this heightened
skepticism that ultimately feeds into
capital markets, creating a re-pricing
of risk and ultimately a lack of desire
to fund risky companies, the authors
say, and they add: Were seeing simi-
lar behavior today. A year ago, weakness
was isolated to metals and mining and
pockets of retail. This idiosyncratic
weakness bled into energy in the fall,
and now is beginning to affect wireline,
technology and financial companies.
Advanced Micro Devices is an ex-
ample of a speculative-grade issuer to
which the market has belatedly given
the fish-eye. Incorporated in 1969 and
public since 1972, AMD is a Silicon
Valley senior citizen. It designs and
markets semiconductors for use in per-
sonal computers. As recently as 2012,
the companys PC-centered business
designated computing and graphics
generated revenue of $4.7 billion and
operating income of $129 million. That
was as good as it got. In the first six
months of 2015, AMD logged revenue
of just $911 million and operating in-
come of minus $222 million.
A second AMD division, the en-
terprise, embedded and semi-custom
unit, is both profitable and growing,
though it is not so profitable, nor so fast
growing as to lift the corporate whole.
Companywide revenue and earnings
per share both peaked in 2011. EPS
turned negative in 2012 and has not
returned to the black. Second-quarter
2015 results featured dwindling sales,
 GRANTS / AUGUST 7, 2015 3

declining cash and rising inventories.

Revenue declined by 35% vs. the previ- NEW this conference:
ous 12 months, a plunge that included
a 54% drop-off in the legacy PC seg-
Webcasting the full days events!
ment. Not only is PC demand falling, Go to grantspub.com/conferences
but AMD is also taking a smaller share
of what remains. So its quite pos-
sible, Peligal points out, that AMD
only generates total 2015 revenue of
slightly more than $4 billion. If true,
it would be down by a little more than
25% from 2014. The closest debt matu-
rity is March 2019, which, at this rate,
may be closer than it seems.
Fall 2015 Conference
It falls to management to keep up
a brave faceif not management, Tuesday, Oct. 20, 2015 The Plaza, Manhattan
who?and AMDs chief financial of-
ficer, Devinder Kumar, tried to put
the minds of dialers-in at ease on the
second-quarter conference call. As far
Martin Wolf,
as the financing is concerned. . . , he Financial Times economics columnist,
said, I monitor the capital markets debates
pretty closely and if the need arises,
obviously, well access the capital mar- James Grant:
ket. . . . If you think about it, with the Resolved: Monetary experimentation
cash that we have, we also have ABL
[asset-backed revolving credit accom- has gone dangerously far.
modation] availability that we put in
place in the late part of 2013 and thats
not all fully tapped out. Speakers include:
In his expressed optimism con-
cerning the hospitality of the credit Wences Casares,
markets, Kumar recalled the words of Xapo
Chicagos Alderman Sposato. Willing
fingers plugging leaky dikes is all very Jim Chanos,
well in the bullish portion of the credit Kynikos Associates, LP
cycle. The gentlemen will find that
the fingers are hard to come by in the Stanley Druckenmiller,
bearish portion. It seems to usto re- Duquesne Family Office, LLC
peatthat were in it.
Its no news at all that the PC busi- Thomas S. Gayner,
ness is in long-term decline. What is Markel Corporation
new is the bond markets recognition
of that fact. The stock market has John Hathaway,
long been fully briefed. AMD com- Tocqueville Asset Management
mon is heavily shorted and hugely ex-
pensive to borrow (a trader we know James Litinsky,
was offered 25,000 shares at a cost
of 16 % of the share price per an-
JHL Capital Group
num). It trades at around $2 a piece,
lurching higher in response to peri-
Michelle Leder,
odic recalls of borrowed shares. Alto- Footnoted.com
gether, some 24% of the companys
633 million-share float is sold short.
On July 28, Moodys slashed the rat- Avoid disappointment! Register online now.
ing on four issues of senior unsecured In person: $2,150, includes breakfast, lunch and cocktail reception.
AMD notes to Caa2 from Caa1, the Webcast: $1,750 gets you the complete virtual experience, including
new rating being four notches from the ability to participate in a live Q&A.
C, which means finis. As a result of
For information, call 212-809-7994, during business hours.
projected operating losses, said the
agency, credit metrics will be very
weak, with negative EBITDA relative
Register or download a form at www.grantspub.com/conferences
 4 GRANTS / AUGUST 7, 2015

Bonds tag along their inevitable insolvency. If, as the

$50 $50 court held, benefits once promised
AMD stock price
but now unpayable cannot be rene-
gotiated, bondholders may be out in
40 40
the cold. The negative outlook, said
Moodys in May when downgrading
Americas third-largest city to junk,
also reflects our expectation that
30 30 Chicagos credit quality will weaken as
price per share

price per share

20
10
0 0
1/95 1/97 1/99
source: The Bloomberg
to $2.5 billion of adjusted debt, and
negative free cash flow.
The senior unsecured AMD 7s of
2024, which had changed hands at 85,
a price to yield 9.5%, as recently as
July 2, are quoted at 68 today, a price
to yield 13%. The problems that have
lately come to light were not previ-
ously in the darkcertainly, not when
the 7s came to market in June 2014. As
those securities flew out the window
and into the hands of yield-famished
investors at 100 cents on the dollar, the
AMD share price was quoted at just $4.
Here was a broad hint that something
was wrong. Whatever the bull case on
the stock might have beensomething
to do with intellectual property assets?
With a hoped-for upturn in the PC
market? A potential takeoverthe bull
case on the bonds was as modest as the
bull case for a corporate debt security
has ever been. To wit: If all goes well,
youll recover your principal at maturity
while earning the coupon in the inter-
im. The upside is par. The downside is
default with uncertain recovery.
August 4, 2015:
$2.13
1/01 1/03 1/05 1/07 1/09 1/11 1/13
robatic this time around because the
need has been greater. The need must
explain Chicagos otherwise inexplica-
ble success last month in placing $743
million of 7.55% taxable general obliga-
tion bonds due 2042 and $346 million
of 5.5% general obligation tax-exempt
bonds due 2039. The creditworthiness
of the issuer in no way accounts for it.
Our friend Michael Lewitt, propri-
etor of the monthly Credit Strategist,
points out that a July 24 court decision
by the Cook County Circuit Court
scuttles plans of Mayor Rahm Eman-
uel to restructure the citys pension
funds in such a way as to postpone
Junkland gets the memo
105
AMD 7s of July 1, 2024
95
85
bond price
unfunded liabilities of the municipal,
laborer, police and fire pension plans
grow and exert increased pressure on
20
the citys operating budget.
Lewitt: Why any responsible man-
ager would think that an 8% taxable
10 yield on a 27-year bond or a 5.7% tax-
exempt yield on a 24-year bond is suf-
ficient compensation for the risk of
owning Chicagos debt is a total mys-
tery, particularly in view of the recent
1/15 experience of those who rushed to buy
Puerto Ricos 8% Series A general obli-
gation bonds due 2035 in March 2014.
Those bonds are guaranteed tickets to
the boneyard.
Something is changing, as the BAML
analysts observe. Caa spreads widened
in the first four months of the year,
even as the broad junk market rallied.
Not that such cracks have yet defaced
much of the surface area of the spec-
ulative-grade marketas recently
as a week ago, the ex-commodity por-
tion of high yield was still yielding less
than 6%. Team BAML adds that the
evident complacency is no bullish sign
but a worrying one, just a delay of the
inevitable and an indication that there
is room to move lower in price. They
105
95
85

bond price

At least, that was the pre-ZIRP

value proposition. Radical monetary
policy transformed the arithmetic. 75 75
A 7% yield to a 10-year maturity is a
kings ransom compared to the Trea-
surys 2%-and-something 10-year pa-
per. Then, too, the argument goesor 65 65
wentthe Fed would lift the funds
rate most deliberately, if at all.
Creditors have reached for yield as 55 55
long as there have been yields to reach 9/11/14 12/15 3/11/15 6/11 7/30
for. The reaching has been more ac- source: The Bloomberg

point a finger of blame to where, in this
publications estimate, it ought to be
pointed: By inducing reach-for-yield
behavior, the Fed may have incentiv-
ized the market to overlook funda-
mentals, creating sensitivity to those
metrics when macro liquidity begins to
dry up. Given the near doubling in the
size of the market since 2008, we think
crowded trades are likely to unwind,
meaning both high yield as an asset
class as well as crowded sectors.
As the market has grown larger, fail-
ure has become rarer. Over the past
12 months, according to Moodys, just
2.3% of the market, measured as a
percent of all speculative-grade issu-
ers, has defaulted, one of the lowest
rates since the start of record keeping
in 1970. The narrative just presented
would suggest that the default rate is
headed much higherthat if it were a
stock, you would want to own it.
Invited to freshen up his forecast
that the next default cycle is right
around the corner, Fridson replies that
he stands by it. Next yearsome time
next yearhe expects a multi-year
period in which the default rate is at or
above the long-term average of 4.6%
to get underway.
I still think it is possible, Fridson
tells Grants. The market right now
is sayingby my interpretation
that the default rate will run about
3% over the next 12 months. That
gets you into the first half of 2016. .
. . The Fed may be able to stave that
off through continuing Herculean ef-
forts, but then again, maybe not. With
everything they are doing, maybe we
will still see some natural, cyclical
economic forces play out.
It happened in Vietnam last year, ac-
cording to a July 20 dispatch in The New
York Times, when, in the wake of a debt
crisis, 78% of registered companies in
compensation in dollars per hour
Ho Chi Minh City went broke. But
the creation of new companies has
since gathered pace, the paper said;
so far, 26% more new companies have
been formed this year than in the same
period last year.
Weak companies will fail; thats
normal, said Tran Anh Tuan, the act-
ing president of the Ho Chi Minh City
Institute for Development Studies, a
government planning agency. They
can learn from failure. Thats a good
way to develop.
Over to you, Janet Yellen.
Dueling indices
How, demands Fred Kalkstein, bro-
ker at Janney Montgomery Scott, could
the governments Employment Cost
Index for the second quarter have reg-
istered the smallest sequential gain in
three decades, up by a mere 0.2%. How
was it possible in the sixth year of a
business expansion during which 12.2
million jobs were created? How can
the ECI have risen by just 0.2% when,
in the first quarter of the plague year
2009, that very index registered a gain
of 0.3%? How is it possible?
The Fed seems not to wonder. To
explain the ECI-derived data, the
mandarins have developed the theory
of pent-up wage cuts. Employers,
so the thinking goes, are loath to re-
duce compensation in a slump. Maybe
theyre too tenderhearted. But they
dont forget. The cuts they didnt
implement stack up like traffic on the
Long Island Expressway.
[T]he accumulated stockpile of
pent-up wage cuts remain and must
be worked off to put the labor market
back in balance, contend Mary C. Daly
and Bart Hobijn of the Federal Reserve
Bank of San Francisco. In response,
businesses hold back wage increases
and wait for inflation and productivity
growth to bring wages closer to their
desired level. Since it takes some time
to fully exhaust the pool of wage cuts,
wage growth remains low even as the
economy expands and the unemploy-
Whom do you believe?
$34
Employer Costs for Employee Compensation (left scale)
vs. Employment Cost Index (right scale)
33
32
31
30
29
28
27
26
25
3/05
source: Bureau of Labor Statistics
GRANTS / AUGUST 7, 2015 5
ment rate declines. Janet Yellen has
cited the Daly and Hobijn doctrine in
her speeches.
From here on, its Kalkstein who
deserves the plug. The data are the
trouble, as he persuasively shows. The
Employment Cost Index is a less infor-
mative measure of wage and benefit
pressures than an alternative govern-
ment index called the Employer Costs
for Employee Compensation (ECEC).
The ECI treats the landscape of the la-
bor market as if it were frozen in place.
The ECEC treats that landscape as if it
were ever changing. The ECEC, which
takes more time to calculate than does
the ECI, has been rising faster than the
ECI. It would seem to deserve at least
as much attention as the ECI.
Built into the ECI is the assump-
tion that the structure of markets has
remained as it was in 2013. The ECEC
measures the current cost of employee
compensation to reflect how, and in
what form, the labor market might have
evolved. Suppose that recent employ-
ment growth happens solely in better
paying jobs. The ECEC, picking up on
the change, will show a rise in average
compensation. The ECI will not because
it will capture no such movement toward
high-quality work. In the same vein, the
ECEC is more likely than the ECI to
reflect a migration to lower-paying jobs.
Businesses, like the people who work for
them, live and breathe and adapt.
The second-quarter ECEC is slated
for publication on Sept. 10. In the first
(Continued on page 8)
135
130
ECEC
125
120
ECI
ECI index level
115
110
105
100
95
90
3/07 3/09 3/11 3/13 6/15
6 GRANTS / AUGUST 7, 2015

Credit Creation
There they go again
10%
U.S. mortgage rates (left scale) vs

9
Federal Reserve Balance Sheet
(in millions of dollars) 8

July 29, July 22, July 30,

mortgage rate in %
2015 2015 2014 7
The Fed buys and sells securities
Securities held outright $4,239,745 $4,244,822 $4,137,038 6
Held under repurchase agreements 0 0 0
and lends 5
Borrowingsnet 201 192 245
and expands or contracts its other assets 4
Maiden Lane, float and other assets 216,668 216,053 226,498 Bankrate.com U.S.
30-year fixed
The grand total of all its assets is: 3
Federal Reserve Bank credit $4,456,614 $4,461,067 $4,363,781 1/00 1/02 1/04 1/06 1
Foreign central banks also buy, source: The Bloomberg
or monetize, governments:
Foreign central bank holdings of Treasurys
and agencies $3,327,998 $3,340,353 $3,309,299
Try this
Low, low mortgage rates are a double
blessing, at least to the would-be house
European Central Bank Balance Sheet* buyer. The first reason is obvious: They
make a house more affordable. The sec-
(in millions of euros) ond, as paid-up subscriber Michael Har-
July 31, 2015 June 26, 2015 July 25, 2014 kins is wont to observe, is less intuitive.
The borrower builds equity faster by pay-
Gold 364,458 383,966 334,431 ing a low rate than he does a high one.
Cash and securities 1,400,206 1,279,223 959,215 A $100,000, 30-year mortgage will
serve as a financial test dummy. At a 4%
Loans 543,636 555,596 507,819 rate of interest, the mortgagors first-
Other assets 228,292 233,162 242,847 year payment comes to $5,729, of which
$1,761 is devoted to principal amor-
Total 2,536,592 2,451,947 2,044,312
tization. Compare and contrast a 10%
*totals may not add due to rounding mortgage rate. Ones first-year payment
comes to $10,531, of which just $556 is
MOVEMENT OF THE YIELD CURVE earmarked for principal amortization.
4.0% 4.0% Harkins performs this interest-rate parlor
trick for his financially sophisticated din-
3.5 3.5 ner guests. Most refuse to believe him
(check the math).
3.0 8/4/15 3.0 ZIRP- and QE-powered real-estate
5/6/15 bull markets are once again interrupt-
2.5 2.5
8/4/14 ing the sleep patterns of conscientious
central bankers. The functionaries slash
yields

yields

2.0 2.0
interest rates to induce the kind of infla-
1.5 1.5
tion they prefer. What they get instead is
the kind of inflation that the asset-own-
1.0 1.0 ing portion of the community prefers.
Thus, the central banks of Sweden
0.5 0.5 and Norway have reduced policy rates to
minus 0.35% and 1%, the central banks
0.0 0.0 of Denmark and Switzerland to an iden-
3 month 6 month 2 year 5 year 10 year 30 year
tical negative 0.75%. For one reason or
source: The Bloomberg

Cause &
230
s. house prices (right scale)
210
S&P/Case-Shiller Composite-20
Home Price Index 190
170
index level
150
130
110
. Home Mortgage
national avg
90
1/08 1/10 1/12 1/14 7/15
at home
another, real estate prices have shot
higher. Swedish house prices showed a
13% spike in the 12 months to May. Nor-
wegian house prices climbed 6.6% in the
12 months to June. Copenhagen apart-
ment prices have soared by 25% in a year.
Swiss home prices, according to the UBS
Swiss Real Estate Bubble Index, are the
toppiest since 1991.
What, then, should a central bank
governor do? Do notnotraise inter-
est rates: [R]ough calculations show
that the size of rate increase needed to
do so might also boost unemployment
and push down inflation, a trio of econ-
omists prescribe in a new Federal Re-
serve Bank of San Francisco Economic
Letter. Thus, using this type of policy
tool may cause the central bank to de-
viate significantly from its goals of full
employment and price stability. The
Fed would seem to prefer the certainty
of job losses after a bubble burst than
the possibility of job losses before a
bubble becomes inflated.
[W]hile monetary policy may not be
quite the right tool for the job, it has
one important advantage relative to su-
pervision and regulationnamely that
it gets in all of the cracks, former Fed
governor Jeremy C. Stein cracked at a
St. Louis Fed research symposium in
February 2013.
GRANTS / AUGUST 7, 2015 7
Effect
Annualized Rates of Growth
(latest data, weekly or monthly, in percent)
3 months 6 months 12 months
Federal Reserve Bank credit 0.5% -0.5% 2.3%
Foreign central bank holdings of govts. 7.0 4.0 1.3
European Central Bank 31.2 35.4 22.7
Commercial and industrial loans (June) 10.9 13.0 12.4
Commercial bank credit (June) 6.6 8.2 7.7
Asset-backed commercial paper 13.1 9.7 -14.5
Currency 3.0 5.6 6.6
M-1 4.4 8.4 6.4
M-2 5.1 6.5 5.7
Money zero maturity 6.4 7.0 6.4
Reflation/Deflation Watch
Latest week Prior week Year ago
FTSE Xinhua 600 Banks Index 13,020.43 14,023.91 8,879.56
MoodysIndustrial Metals Index 1,500.86 1,507.66 2,043.31
Silver $14.75 $14.49 $20.41
Oil $47.12 $48.14 $98.17
Soybeans $9.81 $9.91 $12.25
Rogers Intl Commodity Index 2,434.59 2,478.52 3,565.94
Gold (London p.m. fix) $1,098.40 $1,080.80 $1,285.25
CRB raw industrial spot index 448.52 447.20 531.50
ECRI Future Inflation Gauge (June) 100.5 (May) 101.3 (June) 104.8
Factory capacity utilization rate (June) 78.4 (May) 78.1 (June) 79.1
CUSIP requests (July) 1,741 (June) 1,564 (July) 1,873
Feds reverse repo facility (billions) 132.0 79.4 101.0
Grants Story Stock Index* 103.6 103.9 116.1
*Index=100 as of 7/31/2013
Grants Never-Never Index** 180.7 187.6 196.9
**Index=100 as of 1/4/2013
EFFECTIVENESS OF THE MONETARY POLICY
M-2 and the monetary base (left scale) vs. the money multiplier (right scale)
$16 10x
money multiplier
8
in $ trillions
12
8 6
4 4
0 2
6/04 6/06 6/08 6/10 6/12 6/14 6/15
M-2 monetary base money multiplier
8 GRANTS / AUGUST 7, 2015
(Continued from page 5)
quarter, the ECEC showed sequential
growth of 1.1%; the ECI registered a
rise of 0.7%. In the fourth quarter of
2014, the ECEC showed a sequential
gain of 2.9%; the ECI registered a rise
of 0.5%. Wait till the FOMC finds out.
If the ECEC is the better barome-
ter of wage and benefit compensation,
there are changes afoot in the labor
market. Either they will take the form
of rising wages (and perhaps of rising
prices) or of lower business operating
margins. You can pick your poison.
Global verbiage glut
From time to time, Ben S. Bernanke,
central banker turned blogger and capi-
tal-introduction professional, vouchsafes
his latest thoughts on a concept of his
own devising, the global savings glut.
By the former chairmans telling, an ex-
cess of savings in emerging markets is the
cause of ultra-low interest rates the world
over (it isnt the Feds doing). Could that
be true? Yesor perhaps no. As with the
nonstop talk about secular stagnation or a
commodity super cycle or the drawdown
in international monetary reserves, you
start to wonder what the words signify.
Not much, is the thesis of the essay
now in progress.
Buying low and selling high is rather
the point. So saying, we dont mean to
deny that the emerging world is in a jam
or that the difficulties are not traceable
to macroeconomic causes. Our focus is
What goes up...
12%
emerging market forex reserves as percent of world GDP
10
8 8
world GDP
6 6
4 4
2 2
0 0
1/95 1/97 1/99 1/01
source: IMF
rather on the investment opportunities
that angry headlines usually surface. Five
discrete investmentstwo pairs of un-
loved emerging stocks and a Brazilian
corporate bondare featured below.
Each is cheap, each has meriteach
had merit even before its price was
sawed in half in sympathy with the
goings-on in Turkey, Greece, Brazil,
Russia, South Africa, Argentina, Co-
lombia, China, etc. (India, one of the
former so-called BRICs, is a bullish
breed apart). The sawing suffices to
show how macroeconomic problems
can overwhelm business fundamentals.
It turned out that in 2007-08, the only
relevant American fundamental was
the broad mispricing of credit. In 2014,
the defining Russian fundamental was
the looming bear market in oil (would
that we had seen it coming; see, for in-
stance, Grants, Aug. 8, 2014). Perhaps,
in 2015, its the long-delayed conse-
quences of the suppression of money-
market interest rates that will set mar-
kets on their ear.
Still, cheap business value is a rare com-
modity. It warrants a certain tolerance for
macroeconomic dislocation. If it werent
for the dislocation, the value wouldnt be
there for the plucking in such profusion.
In Mondays Financial Times, the CEO of a
Brazilian truck manufacturer was quoted
as saying, In my professional life, Ive al-
ready passed through 17 [economic] cri-
ses. He must have been grateful for so
many buying opportunitiesand for so
many reciprocal selling opportunities
even if he didnt think to mention it.
12%
10
world GDP
1/03 1/05 1/07 1/09 1/11 1/13 4/15
What pulled the rug out from under
the emerging markets is still a topic of
learned macroeconomic debate. Com-
modity prices have broken as the dollar
has rallied. EM stocks and currencies
have plunged. The burden of servicing
dollar-denominated debt outside the 50
states is becoming more onerous. These
are the symptoms of the problem. What
is the cause?
Recalling that booms not only precede
busts but also cause them, one turns to
the Peoples Republic. On the upswing,
China suppressed the renminbi-dollar
exchange by buying dollars. It printed
the renminbi with which to do the buy-
ing. In consequence, in China, money-
supply growth accelerated, interest rates
declined, official dollar holdings soared
and factory chimneys smoked.
Now, the processes are reversing. Of-
ficial dollar holdings are dwindling, eco-
nomic growth is decelerating, capital is
fleeing. Well, capital appears to be flee-
ing the Peoples Republic. To explain
the ambiguity on this point requires a
short, instructive detour.
The IMF reports that foreign currency
reserves held by emerging economies
plunged by $533 billion to $7.5 trillion in
the 10 months till April. Nothing like it
has ever been seen before. It was far and
away the steepest decline since the start
of record keeping in 1995.
One is worried, of course. The data
must signify something, theyre so big.
And they do signify something. What
they signify is how little anyone really
knows about the cross-border flows of hot
money. That $533 billion is a raw, unpro-
cessed datum. It requires adjustment for
the changing value of the dollar, against
which other currencies are valued, and it
requires adjustment for variations in the
composition of international reserves. It
happens that the IMF has hard informa-
tion on the makeup of only one-third of
international currency reserves. The oth-
er two-thirds it must guess about.
The uncertainties reduce the careful
analyst to expressing the size of reserve
flows not as a single point but as a range
of possibilities. In this case, the range
may be expressed as between $533 bil-
lion on the high side and $44 billion on
the low side. As you could drive a truck
through the difference, you hesitate be-
fore saying much more than the not al-
together informative, emerging market
currency reserves have declined.
Irresolution similarly set the tone
of a report in Mondays Financial Times

on supposed capital flight from China:
Analysts broadly agree that China has
experienced capital outflows on an un-
precedented scale. But they disagreed
about their size, causes and risk to the
economy. Note well: other than size,
causes and risk.
No sense, then, on too great insis-
tence on quantitative macroeconomic
diagnosis. Some policy errors have cre-
ated a deflationary undertow, others an
inflationary over lift. The dollar surges,
EM currencies buckle. Country-specific,
heterogeneous problems have yielded
uniform, homogeneous outcomes of one
particular kind: Bear markets dot the EM
landscape. Records are beginning to fall.
Thus, for instance, the Malaysian ring-
git and Indonesian rupee have fallen by
16.9% and 12.7% against the dollar in the
past year to levels not seen since the end
of the Asian financial crisis in 1998.
Turbulence mixes badly with lever-
age. It is not farfetched to expect some
thunderclap of a bankruptcy in the EM
world. With regard to China, a Hong
Kong-based friend of this publication,
asking not to be named, advises colleague
Evan Lorenz that Chinas fast-growing,
$30.5 trillion asset banking system is at
risk. Deposit growth is very weak right
now, our source relates. Maintaining
that growth requires you to take more li-
ability risk.
On form, muses Russell Napier, an
independent strategist and co-founder
of Electronic Research Exchange, down-
turns in emerging markets tend not to
stop until theres a major default. Ob-
serve, says Napier, how very much like
Mahathir Mohamad, prime minister of
Malaysia during the Asian financial crisis,
the president of Turkey, Recep Tayyip
Erdogan, is beginning to sound with his
railing against the interest rate lobby
and his accusations of treason against
this nation.
If Turkey imposed exchange con-
trols, that is a de facto default, Napier
says. Turkey is one of the biggest com-
ponents of the emerging markets debt
index. I think it would be tantamount
to the BNP Paribas closing those three
mortgage-backed securities funds in
2007. People would realize the lack of
liquidity and the higher credit risk and
things would come to a halt very quickly.
Weve lent money to emerging markets
before, but weve never lent it to them
in this form of bonds, which are theoreti-
cally liquid through open-ended funds. It
is the holding of them through open-end-
Not in the plan
75
ruble exchange rate (left scale) vs. price of oil (right scale)
70
65
60
rubles per dollar
55
50
45
40
35
8/1/14 10/3
source: The Bloomberg
ed funds which is dangerous if someone
does impose capital controls or if some-
one defaults.
So theres no guarantee that whats
cheap may not become cheaper. If the
point needed proving, the gold-mining
stocks would nail it down. They have
wasted away to the point that we at
Grants, their close and loyal friends,
hardly recognize them by sight on our
brokerage house statement (note for the
file: Buy more at the bottom). Then, too,
American equity values remain Uber-
ized. A sell-off in New York would likely
not be seen as a bull market catalyst in
Bogota, Sao Paulo or Moscow.
Herewith our picks to click (or, in the
case of the Russians, to re-click) at some
indeterminate date: Avianca Holdings SA,
the Colombian airline (AVH is the ticker
for the New York-listed American Depos-
itory Receipt); Grupo Nutresa SA, a top
Colombia-based food distributor, proces-
sor and marketer (the peso-denominated
common shares are listed in Bogota); the
senior debt of General Shopping Brasil
S.A., a financially leveraged owner and
operator of Brazilian shopping malls; and
a pair of Russian equities that may be fa-
miliarperhaps all too familiarto con-
stant readers. They are Sberbank (SBER
on the Moscow and London exchange;
SBRCY is the American Depository Re-
ceipt); and Moscow Exchange (MOEX,
listed on itself).
One year ago, these pages prophesied
that as tensions subside, so will Russian
equities come in for what the comrades
used to call rehabilitation. Tensions
GRANTS / AUGUST 7, 2015 9
$120
110
100
rubles per dollar
90
price per barrel
80
70
60
price of
Brent crude 50
per barrel
40
12/5 2/6/15 4/3 6/5 8/3
have not subsided, the oil price has not
rallied and the ruble has not recovered.
In the past 12 months, Sberbank, Rus-
sias largest bank, has declined by 41% in
dollar terms (it is up 2% in rubles); Mos-
cow Exchange has fallen by 31% in dollar
terms (it has rallied by 21% in rubles).
Each company remains profitable. Each
remains value-laden, and each remains a
kind of call option on normalcy. We re-
main bullish (to declare an interest, your
editor owns Sberbank).
In picking Russia, this publication
failed to pick a winner. Real Russian
GDP is on track to sink by 3.4% this year
as the rate of inflation tops 15%, accord-
ing to a forecast by the IMF. Sberbank
is a mirror to those circumstances: It has
reported sharply lower net income (down
58% in the first quarter; second-quarter
results are due on Aug. 27), higher loan-
loss provisioning, rising non-performers
(now 3.9% of total loans, up from 3.2%
a year ago) and contracting net inter-
est margins in consequence of a central
bank rate that jumped to 17% in Decem-
ber from 8% four months earlier; 11% is
the current rate. Still and all, the bank
remains profitable. In the first quarter,
it earned 12.5% on equity, down from
the 20%-plus returns generated in 2013
and 2012 but more than respectable in
the comparative light of, for instance,
J.P. Morgan Chase & Co., which earned
10.2% on equity in the first quarter.
Sberbank common is priced at 75%
of book value and 6.2 times trailing
earnings; the (shrunken) dividend
delivers a yield of 0.6%. Sberbank pre-
 10 GRANTS / AUGUST 7, 2015

Perpetuity on sale at Explorador Horizon Fund L.P., which

$120 $120 manages $300 million and is based in
price of General Shopping 10% senior unsecured perpetuals
Sao Paulo. General Shopping owns and
110 110 operates 16 shopping malls in southeast
Brazil, mostly in the state of Sao Paulo;
100 100 the founding family, the Veronezis, own
60% of the stock. The rest trades on the
90 90
Brazilian public market.
General Shopping is an example of
a good business chained to a bad cur-
bond price

80
70
60
50
40
11/10 11/11 11/12
source: The Bloomberg
ferred, which confers no voting rights
but holds an identical economic inter-
est to that of the common, is priced at
53% of book value and 4.5 times earn-
ings. It yields 0.9%.
Throughout its post-Soviet history,
observes Boris Zhilin, co-founder and
principal of Armor Capital, Sberbank has
weathered at least two severe stormsin
1998 when Russia defaulted on its sov-
ereign debt following the Asian crisis,
and in 2009 as a result of the Great Re-
cession. Despite that, its book value per
share in U.S. dollar terms posted a com-
pound annual growth rate of 17% from
1997 through the end of 2014 (the ruble
lost about 90% of its value vs. the U.S.
dollar throughout this period). In other
words, painful upheavals notwithstand-
ing, those who held shares of Sberbank
did very well, provided a sufficiently
long-term investment horizon. For the
grandson, then.
Even faster than the ruble exchange
rate has fallen, the earnings of Mos-
bond price
80
70
60
50
40
11/13 11/14 8/4/15
ich is projecting a boost in the payout to
6.10 rubles per share in fiscal 2016.
Dilma Rousseffs Brazil is perhaps a
more inviting place than Vladimir Pu-
tins Russia, but that speaks chiefly to
the weather. With respect to inflation,
the immediate economic outlook and
currency depreciation, the two coun-
tries are very nearly peas in a pod. Which
brings us to the perpetual, 10%, dollar-
denominated debt of General Shopping.
Quoted at 48 cents on the dollar, the
securities yield 20%; at par value, $250
million are outstanding.
We come by the General Shopping
story through our value-seeking friends
Monetary turbulence
$20
Avianca share price (left scale) vs. Colombian peso (right scale)
18
16
rency. Taking in reals, it must pay out
a certain number of dollars. The lo-
cal currencys plunge in depreciation
stresses the balance sheet and intro-
duces the apprehension that partly
explains the bargain price of the bonds
(sky high Brazilian interest rates ex-
plain the rest). General Shoppings B1
senior unsecured debt and corporate
family ratings reflect the good quality
of its portfolio with solid margins and
high occupancy rate as well as the man-
agement teams experience and suc-
cessful track record in development,
judges Moodys in a June bulletin. The
other side of the ratings coin concerns
that sinking currency and the interest-
rate problems that go with it.
The bull story on the General Shop-
ping 10s harps first on operations, sec-
ond on asset coverage. At year-end 2014,
CBRE appraised the value of the assets
at $880 million. If we take all liabili-
ties, Daniel Delabio, Explorador port-
folio manager, tells Grants, were talk-
ing about total debt of $570 million. So
still you have $200 million-plus of value
in excess of liabilities. The market value
of the debt is less than half the value of
3.100
2,900
pesos per dollar
2,700
pesos per U.S. dollar

cow Exchange have risen. They leapt

14 2,500
by 124% in the first quarter (second-
share price

quarter results are due on Aug. 5, the

day after we go to press). On the first- 12 2,300
quarter call, MOEXs management laid
out a five-year plan to boost growth
through initiatives in commodities 10 2,100
trading, over-the-counter derivatives
Avianca Holdings
clearing, risk management and collat- 8 1,900
eral management.
Moscow Exchange is priced at 9.8
times trailing net income; the 3.87 ruble- 6 1,700
per-share payout delivers a 5.5% dividend 11/8/13 5/9/14 11/7/14 5/8/15 8/4/15
yield. J.P. Morgan analyst Alex Kantarov- source: The Bloomberg

the total properties. Its good value even
in a distressed scenario. That is point
one. Point two is that we dont think
it is going to restructure or needs to go
that route. They are not against the wall
to do anything, because cash liquidity is
very high. Today, their cash position is
1.5 times earnings before interest, tax-
es, depreciation and amortization. And
that should be enough to pay interest.
Even if they dont get any new funding,
or any new bank loans for the next two
years, they should be able to pay princi-
pal and interest.
Were talking about the senior debt, to Advent International, a private-equity
Delabio goes on. But they also have
subordinated bonds, where they can pay
coupons in kind. So were talking about
a company that has enough EBITDA to-
day to pay its cash interest payments but
also has the optionality to defer coupons
on the subordinated debt, which would
be in favor of the senior bonds. So a bond
at 48 cents with those dynamics, there is
asset coverage, there is liquidity, there is
seniority to the subordinated bonds, and
you should be able to collect your cou-
pons. With time, this should re-rate, and
the bond should move up in price.
Acronym is the lingua franca of the
EM world. First came the BRICs. They
were succeeded in 2013 by the Fragile
Five. And now, through the offices of
BNP Paribas, come the PICTS, signi-
fying Peru, Indonesia, Colombia, Turkey
and South Africa. As BNP sees the situa-
tion, they are a kind of United Nations of
financial risk.
The intrepid team at Explorador dis-
sents from that top-down fatwa. As of
June, 18.5% of their fund was appor-
tioned to Peru, 13.8% to Colombia. As for
the latter, much of what could go wrong
already has. Before its price collapsed, oil
generated more than half of Colombian
export sales. In the past 12 months, the
Colombian peso has depreciated by 36%,
the third worst performance among the
150 currencies that Bloomberg tracks
(Ukraine and Russia edged out Colom-
bia in the monetary race to the bottom).
The Colombian stock market has fallen
by 59% in dollar terms from its Novem-
ber 2010 peak. Five years ago, the MSCI
Latin American index traded at 15 times
the average of 10 years trailing net in-
come. It trades at 9.6 times that 10-year
trailing average today.
Avianca Holdings S.A., the foremost
Colombian airline, owns regional airlines
in South and Central America. It has sub-
sidiaries in Ecuador, El Salvador, Costa
Rica, Peru, Nicaragua and Honduras.
Its on-time performance stacks up well
against U.S. carriers, indifferently against
neighboring ones. Standard & Poors
rates its debt B-plus for higher-quality
junk; in the 12 months to March 31, op-
erating income covered interest expense
by a slim 1.5 times. The shares are quot-
ed at 4.5 times earnings.
Avianca is a sum-of-the-parts story,
too. On July 13 came word that manage-
ment had sold 30% of its LifeMiles B.V.
subsidiary, a six million member con-
sumer loyalty program, for $343.7 million
the not altogether novel words that the
investor. The purchase price valued the
whole at more than $1 billion. So, says
Delabio, referencing Aviancas overall $1
billion equity market cap, youre almost
getting the stand-alone airline for free.
Yes, he adds, the oil price implosion has
damaged Colombian GDP. It has simul-
taneously raised up Avianca.
One-third of Aviancas costs are tied
to oil, Delabio goes on. And lower [con-
sumer] demand will be offset by lower
oil-related expenses. So we see margins
actually extending from 6% last year to
7.5% this year, and this is below company
guidance. The company is guiding to 8%
to 10% margins for the year, so were be-
ing conservative.
Grupo Nutresa SA, our final EM sub-
mission, is a prosperous, conservatively
financed, $4.1 billion market-cap food
distributor and processor. The Nestle
of Colombia, a bull might call it. It is
an exotic stock: to buy it, an American
high net worth individual must execute
a local share swap with his or her broker.
Read on anyway. Nutresa crystallizes
the problem of the good business yoked
to a bad currency (and to a problemati-
cal macroeconomy).
Nutresa processes and distributes
cold cuts, biscuits, chocolate, coffee, tea,
juice, ice cream and pasta. It is Starbucks
Colombian coffee vendor. It operates ice
cream parlors and hamburger casual res-
taurants. It employs 39,000. As Explora-
dor does the arithmetic, Nutresas food
business changes hands at 17.6 times
next years likely earnings and at 1.5
times book. John Haskell, Exploradors
head of research, reckons that Nutresa
trades at a 37% discount to comparable
worldwide food companies.
Says Haskell: They have a 61% mar-
ket share in Colombia. Their market
share comes about because they have
been advertising for decades in Colom-
bia. Their brand equity provides an in-
GRANTS / AUGUST 7, 2015 11
tangible asset that provides a barrier to
entry. They also have an incredibly dense
distribution network. They have 100,000
individual partners with over one million
points of sale. Theyre not only in Colom-
bia; theyre also across Latin America. . .
. If I were Nestle and looking to enter
Colombia or expand my market share,
I would think seriously about what it
would take to replicate what Nutresa has
built up over decades.
On Tuesday, Dennis Lockhart, presi-
dent of the Federal Reserve Bank of At-
lanta, rattled the world when he uttered
Fed may raise the funds rate. When the
monetary dust finally does settle, Nutre-
sa and its ilk will still be standingthey
might be even cheaper.
James Grant, Editor
Ruth Hlavacek, Copy Editor
Evan Lorenz, CFA, Analyst
David Peligal, Analyst
Harrison Waddill, Analyst
Hank Blaustein, Illustrator
John McCarthy, Art Director
Eric I. Whitehead, Controller
Delzoria Coleman, Circulation Manager
John DAlberto, Sales & Marketing
Grants is published every other Friday, 24 times a
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Vol. 33, No. 16d-ctr Two Wall Street, New York, New York 10005 www.grantspub.com
We have broken out the centerfold story for your reading comfort.
No broken headlines across pages any longer.
Try this at home
Low, low mortgage rates are a double
blessing, at least to the would-be house
buyer. The first reason is obvious: They
make a house more affordable. The sec-
ond, as paid-up subscriber Michael Har-
kins is wont to observe, is less intuitive.
The borrower builds equity faster by pay-
ing a low rate than he does a high one.
A $100,000, 30-year mortgage will
serve as a financial test dummy. At a 4%
rate of interest, the mortgagors first-
year payment comes to $5,729, of which
$1,761 is devoted to principal amor-
tization. Compare and contrast a 10%
mortgage rate. Ones first-year payment
comes to $10,531, of which just $556 is
earmarked for principal amortization.
Harkins performs this interest-rate parlor
trick for his financially sophisticated din-
ner guests. Most refuse to believe him
(check the math).
ZIRP- and QE-powered real-estate
bull markets are once again interrupt-
ing the sleep patterns of conscientious
central bankers. The functionaries slash
interest rates to induce the kind of infla-
tion they prefer. What they get instead is
the kind of inflation that the asset-own-
ing portion of the community prefers.
Thus, the central banks of Sweden
and Norway have reduced policy rates to
minus 0.35% and 1%, the central banks
of Denmark and Switzerland to an iden-
tical negative 0.75%. For one reason or
another, real estate prices have shot high-
er. Swedish house prices showed a 13%
spike in the 12 months to May. Norwe-
gian house prices climbed 6.6% in the 12
AUGUST 7, 2015
months to June. Copenhagen apartment ate significantly from its goals of full em-
prices have soared by 25% in a year. Swiss ployment and price stability. The Fed
home prices, according to the UBS Swiss would seem to prefer the certainty of
Real Estate Bubble Index, are the toppi- job losses after a bubble burst than the
est since 1991. possibility of job losses before a bubble
What, then, should a central bank becomes inflated.
governor do? Do notnotraise inter- [W]hile monetary policy may not be
est rates: [R]ough calculations show quite the right tool for the job, it has
that the size of rate increase needed to one important advantage relative to su-
do so might also boost unemployment pervision and regulationnamely that
and push down inflation, a trio of econ- it gets in all of the cracks, former Fed
omists prescribe in a new Federal Re- governor Jeremy C. Stein cracked at a
serve Bank of San Francisco Economic St. Louis Fed research symposium in
Letter. Thus, using this type of policy February 2013.
tool may cause the central bank to devi-
There they go again
10% 230
U.S. mortgage rates (left scale) vs. house prices (right scale)
9 210
S&P/Case-Shiller Composite-20
8 Home Price Index 190
mortgage rate in %
7 170
index level
6 150
5 130
4 110
Bankrate.com U.S. Home Mortgage
30-year fixed national avg
3 90
1/00 1/02 1/04 1/06 1/08 1/10 1/12 1/14 7/15
source: The Bloomberg
 Grants is Webcasting the
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Cheer up, Herbert!

Grants is Webcasting the Fall Conference!
Questions? Please call 212-809-7994 or email conferences@grantspub.com