Please, click here to read this article in pdf format: january-4-2009

“A View from the Trenches” is back and today, I would like to raise a few macro points on what to look for in 2010. Essentially, if I had to describe 2010 in one sentence, I would say that 2010 will be the year of the “capital structure game”. We need to elaborate on this immediately:

The capital structure of a firm is: “…A mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds…Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure…When people refer to capital structure they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is…” (www.investopedia.com ).
When I included “the” waterfall graph in both the first and last letters of 2009 (refer: www.sibileau.com/martin/2009/04/14 and www.sibileau.com/martin/2009/12/24 ), I wanted make as visual as possible the idea that inflation is not a one time event resulting from a relationship between money supply and output gap, as conceived by mainstream economists. Instead, inflation is a process where it is very clear that money and credit expansion are “non-neutral”: Not all prices rise at the same time and by the same degree. Therefore, inflation creates a “distortion” within an existing set of relative prices. This is why inflation is so disruptive to an economy.

Back to the first paragraph, I think that 2010 will be the year of the capital structure game, because the set of relative prices that will be the most distorted is precisely that of the components of a firm’s capital structure.

If we take the simpler view that the spectrum of liabilities of a firm is split into debt and equity, in 2010, it will be very clear that the value of equity is only a function of the value of debt. As central banks reduce their stimulus programs or unwind them and as governments continue to run into fiscal deficits, both of them will significantly affect the markets in which they operate (i.e. Treasuries, Agency debt, mortgage-backed securities, state/provincial and municipal debt).

In 2009, this was not so visible because quantitative easing policies took us out of an imminent and very serious risk of massive defaults. As this risk negatively affected debt and equity, when it finally waned, both debt and equity rallied, albeit at different speeds, of course. In 2010, most companies will have refinanced their short-term debt. However, with central banks unwinding their quantitative easing policies, the decrease in demand for fixed income securities together with the huge issuance of governments’ debt will put pressure on rates. As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity.

In December, I associated this process with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD).

Companies choose to finance their operations or projects with debt or equity for a reason. When their respective markets are distorted, non-efficient decisions are made. That will be the case in 2010, with more companies taking debt for M&A, or share buybacks. Investment banks will love the action and financials and energy should have a good year. Gold should find it hard to outperform, unless some political event breaks the existing “entente” among central banks. I don’t think such a political event would come from either US/Canada, Europe or Japan.

Martin Sibileau