Note to Readers: This article about George Risk Industries is part of a series of business profiles that are normally restricted to paid subscribers. I am making this article available to all readers as a micro-cap case study. Previous profiles include DaVita, America’s Car-Mart, Investors Title Company, Tractor Supply Company, CarMax, and Burlington Northern Santa Fe. To gain access to the archive and receive future business profiles, including a write-up of Union Pacific later this month, please consider a paid subscription. Thank you!
A small manufacturer is massively overcapitalized but controlled by the founder’s family. Minority shareholders can go along for the ride but may never see a catalyst.
The United States is full of family-controlled businesses that fly well below the radar of most investors. The obvious reason is that most of these companies are very small and privately held. The cost of being a public company is very expensive for many small businesses and it can be time consuming to interact with shareholders. If you have a small business that is generating sufficient free cash flow to fund all expansion opportunities and pays good dividends to the family, there is no reason to go public.
In most cases, if you observe a family-run business that you would like to invest in, you’ll have to approach the controlling shareholder at the local Rotary Club. But some of these businesses are publicly traded and available to anyone with a brokerage account and enough patience to purchase thinly traded stock. Such is the case for a manufacturer of security products located in the small town of Kimball, Nebraska.
George Risk founded the company bearing his name in 1965. The company started by manufacturing push-button reed switches and soon branched out into security products that still represent its main line of business today. When George Risk died in 1989, his son Ken Risk took over as President and CEO and served in that capacity until his death in 2013. The company is now led by Ken Risk’s daughter, Stephanie Risk-McElroy. Today, George Risk Industries (GRI) has a market capitalization of $56.8 million with Risk family interests controlling ~60% of the shares.
I first came across GRI in 2010 when I was eager to emulate Warren Buffett’s strategy during his partnership years. GRI reminded me of Dempster Mill Manufacturing Company, one of Mr. Buffett’s early investments. At a superficial level, GRI seemed similar because it is also located in a small town in Nebraska, albeit on the other side of the state. However, from a more substantive perspective, GRI was massively overcapitalized with excess cash and a large securities portfolio. It was a net current asset value stock, also known as a “net-net”.
Intrigued by the company, I wrote George Risk Industries: A Potential Bargain With Limited Downside Risk in January 2010 and followed up with Reader Questions on George Risk. After watching the stock for months, I decided not to invest and presented my reasoning in George Risk Industries Resembles Buffett’s Dempster Mill But Lacks a Catalyst.
One of the benefits of writing about investments is the ability to travel back in time many years later. Did I get the general situation right in the original write-up and were my reasons to pass on the investment sound? Did I make the correct decision?
While my initial understanding of the business was sound enough, my decision to not invest seems a bit more suspect. I did present good reasons for passing, such as firm family control, but I also cited lack of “liquidity” when what I really lacked was the patience to put in limit orders and wait weeks or even months for a trade execution.
Then and now, GRI is very thinly traded. However, it was possible and still is possible to put money to work provided that an investor is willing to sit and wait for an execution and is not alarmed by the inability to quickly sell the position. Just as you would not jump in and out of a small private business, you would only invest in a public company like GRI with an indefinite time horizon. You might be buying a stock, but what you are really doing is going into a partnership with the Risk family.
This profile provides a review of GRI’s business model, recent financial results, balance sheet, free cash flow, capital allocation, and the family dynamics that appear to exist. While GRI is no longer a “net-net”, it still represents a reliably profitable operating company with a large portfolio of marketable securities which is certainly not needed to run the business. Trading at ~116% of book value, the valuation is not particularly demanding.
I hope readers will find this micro-cap case study interesting. But I should point out that while the stock does trade, it would be difficult to put large amounts of capital to work. For example, during August 2022, only 20,400 shares traded, and most trading days did not see any volume at all. With the stock trading in the $11-12 range, it would take many months and much patience to put large amounts of money to work.
While none of the profiles I publish are investment recommendations, this is particularly true for such a small, thinly traded stock. I should also note at the outset that I do not own George Risk shares and have no current plans to purchase shares.
GRI is a vertically integrated company that designs, develops, and manufactures a wide array of electronic parts including computer keyboards, proximity switches, security alarm components and systems, pool access alarms, water sensors, electronic switching devices, high security switches, and wire and cable installation tools.
The company publishes a product catalog listing hundreds of parts and offering custom solutions.1 GRI emphasizes product quality and reliability of the components it manufactures which are backed by lifetime warranties. A key marketing message, intended to justify premium pricing, is that failure of a low-cost component can have more expensive ramifications when it causes disruptions or affects a larger system:
The statement, “a switch is a switch”, usually comes from those we refer to as price shoppers. This type of person only seems to consider the actual cost of the contact in computing the cost of installation. The cost of repeated trips to the site of a false alarm, or complaints from customers that their system is not operating correctly, isn’t typically considered. Just what is the expense in a warranty service call? Certainly more than the price of a switch!
GRI’s headquarters and main manufacturing plant is located in a 50,000 square foot facility in Kimball, Nebraska which is supplemented by a 7,200 square foot plant in nearby Gering. The company employs 200 people in a county with a total population of 3,412 people. As we can see from the photo in the introduction as well as the street view feature of Google Maps, the main facility is a modest building in an area of residential, commercial, and industrial structures located in a rural community.
The following video posted by GRI provides a picture of the region, the headquarters building and manufacturing facility, and shows some of the company’s products:
GRI operates in three segments:
- Security alarm products accounted for 86% of revenue in fiscal 2022 which ended on April 30.2 In addition to burglar alarm systems and parts, GRI manufactures products intended to prevent unauthorized use of swimming pools. Security products are primarily sold through distributors and alarm installers. Although the segment has ~1,000 customers, two distributors account for ~60% of sales. However, the company’s relationship with its two key distributors is long-standing and a written agreement exists with one of them.
- Cable and wiring tools accounted for 10.3% of revenue in fiscal 2022. This segment represents the business of Labor Saving Devices, Inc. (LSDI) which was acquired in 2017. LSDI products aim to improve the efficiency of installing wiring and related components. Products primarily serve the audio/visual, electrical, communications, and security alarm markets. Further details on the acquisition of LSDI will be provided in the section on capital allocation.
- Other products accounted for 3.7% of revenue in fiscal 2022. Few details are provided for this segment which is relatively immaterial to overall results.
The majority of GRI products are tied to the housing industry. Sales are affected by the overall state of the housing market and are particularly sensitive to changes in housing starts. Security systems, pool alarms, wiring, and tools to install these products are also used during renovation of existing homes. This leads me to believe that GRI is sensitive to changes in existing home sales and trends in disposable income that fund renovations and installation of new swimming pools.
The security alarm segment has six major competitors. GRI competes based on price, product design, quality, custom offerings, and emphasizes that all products are made in the United States. GRI is willing to accommodate small custom orders that larger competitors often decline. Additionally, according to the product catalog, GRI is willing to accommodate customers who resell privately labeled products. At the end of 2019, one major competitor went out of business which contributed to a significant increase in sales in fiscal 2021 despite the effects of the pandemic.3
Although GRI’s financial results since the pandemic have remained satisfactory and the company was able to operate throughout the lockdowns, management has noted that certain raw materials have become more expensive and difficult to obtain. Perhaps to hedge against future shortages, the company is holding larger quantities of raw materials. Management reports that wages have also been increasing. To mitigate these cost pressures, GRI implemented a 10% price increase on January 1, 2022.3
When I first studied GRI’s business in 2010, I came away with the impression that the company has longstanding relationships with suppliers and customers and some degree of pricing power, with much of this due to reputation within the industry. The situation appears to be similar today. While GRI is fully impacted by raw materials inflation, I suspect that the company’s status as a major employer in a small town limits wage pressure to some extent.4 The proof of GRI’s business model is in the pudding, so let us now turn our attention to the company’s recent operating history.
Recent Financial Results
GRI is a relatively straight forward business that has similar economics across its operating segments. Notable developments in recent years that have materially influenced results include the acquisition of LSDI in October 2017. At the end of 2019, a competitor went out of business. These events had the effect of increasing GRI’s sales, with the majority of the effects seen in fiscal 2019 and fiscal 2021.
The following exhibit displays GRI’s income statements for the past decade. Results for the first quarter of fiscal 2023 which ended on July 31 have not been released.5
Management’s goal is to generate a gross margin of 50%. As we can see, over the years the gross margin has indeed fallen within a few percentage points of that goal. In fiscal 2022, gross margin fell to 48.3% which was the result of inflationary pressure in raw materials and wages. GRI’s price increase of 10% on January 1, 2022 only impacted the final four months of fiscal 2022. Since GRI is a smaller reporting company, it has yet to release results for the first quarter of fiscal 2023 which ended on July 31.6
Operating margin has exceeded management’s target of 20% on a consistent basis for several years. The operating margin of 27.2% in fiscal 2022 was fairly close to the ten year average operating margin of 26.8%. Management does not provide much narrative in the annual report and does not host earnings calls, so we do not really have a way of knowing whether the operating margin is likely to trend down toward 20% in the future. However, management’s stated goals have not changed in over a decade so this could be a case of under promising and overdelivering.
The company’s large portfolio of marketable securities will be discussed in detail in the next section. We can see the effects of holding that portfolio in the other income section of the exhibit:
- GRI collected $8,574,000 of dividends and interest over ten years.
- Realized gains on sale of securities totaled $1,834,000 over ten years.
- Unrealized gains on equity securities totaled $3,068,000 over the past four years. GRI has been required to recognize unrealized gains and losses on equity securities via the income statement since 2018. Previously, unrealized gains and losses on equity securities flowed through other comprehensive income.7
During fiscal 2020, GRI applied for a $950,000 Paycheck Protection Program (PPP) loan from the federal government. This loan was fully forgiven during fiscal 2021 which accounts for the majority of the boost to other income during that year. The forgiven amount of the loan was not considered taxable income.
The corporate income tax cut that went into effect in calendar 2018 is fully reflected in GRI’s results starting in fiscal 2019. GRI has historically paid significant income taxes with the main deviation from the statutory rate due to the dividends received deduction and domestic production tax benefits. As a result, GRI’s tax burden was materially reduced by the corporate tax cut which has boosted net income.
It is helpful to differentiate between the results GRI posts from its business operations and the results related to its large portfolio of marketable securities. Focusing on GRI’s operating income allows us to understand the strength of the underlying business and strips away the volatility caused by the marketable securities portfolio and one-time non-operating windfalls like the forgiven PPP loan.8
We will return to GRI’s operating income in the next section when we consider the company’s underlying earnings power relative to capital required to run the business. For now, we will turn our attention to the company’s balance sheet.
GRI has a fortress balance sheet and is overcapitalized relative to the requirements of its operating business. This was true when I first looked at the company a dozen years ago and is even more true today. The company’s investment portfolio has increased from $20,280,000 on April 30, 2012 to $30,979,000 on April 30, 2022. In addition to the investment portfolio, the company has $6,078,000 of cash on the balance sheet. The following exhibit shows the evolution of the balance sheet over the past decade:
Shareholders equity has increased from $30,115,000 to $49,042,000 over the ten year period. Current assets account for 93% of total assets on the balance sheet. Until fiscal 2018, the company had no intangible assets, but the acquisition of LSDI added $1,763,000 of intangibles that are being amortized over fifteen years. The company is debt free. GRI owns its facilities and has no lease obligations.
As of April 30, 2022, there were 4,931,188 shares of common stock outstanding. Additionally, there were 4,100 shares of preferred stock outstanding which are convertible at the option of the holder into five common shares. Preferred stock is entitled to a dividend of $1 per share annually before common dividends can be paid. However, apparently this immaterial requirement has been waived since substantial common dividends have been paid throughout the ten year period. It does not appear that the preferred stock has any additional rights beyond conversion and dividends.
The following exhibit displays the common share count and important metrics on a per-share basis. As we can see, the share count has been declining as a result of repurchases which will be discussed more fully in the capital allocation section.
GRI shares last traded at $11.52 which is ~116% of book value and ~119% of tangible book value per share at April 30, 2022. Over the ten year period, book value per share compounded at ~5.2%. Marketable securities, which represents excess capital, account for $6.28 per share. Current assets minus all liabilities were $9.23 on April 30, 2022.
The following exhibit from the fiscal 2022 10-K shows the composition of GRI’s marketable securities portfolio. GRI delegates responsibility for the securities portfolio to a money manager who has discretionary authority to place trades. While the money manager is described as an “expert”, no performance figures are given for historical returns on the different asset classes that the company holds.9
As a thought experiment, let us consider what GRI’s balance sheet might look like if it was restructured with the aim of retaining sufficient capital to run the business and to distribute excess cash and securities to shareholders. The following exhibit is what I might hypothetically propose in a conservative restructuring. The rows highlighted in yellow differ between the actual balance sheet on April 30, 2022 and my proposal:
Let’s consider the logic behind each of the proposed changes:
- We would leave $2 million of cash on the balance sheet and distribute the excess ~$4 million to shareholders.
- The entire securities portfolio would be liquidated with the after-tax proceeds distributed to shareholders. This would zero out both the investments and securities asset and the $1,807,000 deferred tax liability associated with unrealized gains within the portfolio.
- I have left the $344,000 investment in a land partnership intact. In 2002, GRI purchased an interest in land located in Winter Park, Colorado. The liquidity of this non-operating asset is not clear based on the company’s disclosures.
- The net effect of these changes would leave GRI with $15,792,000 of shareholders equity.
- Total distribution to shareholders would be $33,250,000, or ~$6.75 per share.
Although I did not alter the dividend payable current liability, I would note that dividends represent a discretionary obligation that would likely be revisited in light of the new capital structure. Current liabilities excluding the dividend payable is just $951,000 relative to $15,432,000 of current assets, of which $2 million would be held in cash. It seems to me that the restructured balance sheet remains very conservative, especially in light of the company’s proven cash flow generation capabilities which should not be impeded in the least by these proposed changes.
The restructured balance sheet reveals the high quality of GRI’s operating business. Operating income in fiscal 2022 was $5,648,000. If we apply the company’s blended statutory tax rate of 28.8% to operating income, we arrive at net income of ~$4 million.10 We can conclude that a restructured GRI would have earnings power of ~$4 million supported by equity of ~$16 million translating into a return on equity of 25%.
Free Cash Flow and Capital Allocation
Let’s turn our attention to GRI’s free cash flow and how management has allocated the cash. The exhibit below shows selected data that paints a clear picture regarding GRI’s cash flow generating capabilities over the past decade:
Over the ten year period, GRI generated $22,834,000 of free cash flow. The majority of free cash flow was returned to shareholders via $17,596,000 of dividends and $1,098,000 of share repurchases. In October 2017, GRI acquired LSDI for $3.2 million, of which $3 million was paid in cash and $200,000 was paid in GRI stock.
Cash flow from operations excludes the effect of realized investment gains and losses from the securities portfolio but includes the after-tax proceeds of interest and dividends. Over the ten year period, GRI received $8,574,000 of interest and dividends.11 If the marketable securities portfolio is divested, GRI’s free cash flow would decline by the after-tax value of the foregone dividend and interest income.
Cash flow for two of the fiscal years in the exhibit requires further elaboration:
- In fiscal 2018, GRI acquired LSDI. During that fiscal year, cash flows from operations was unusually low. According to the 2018 10-K, inventories increased by $980,000, the majority of which was inventory acquired as part of the LSDI transaction. Accounts receivable increased by $701,000 which was partly due to receivables acquired as part of the LSDI transaction.
- In fiscal 2022, GRI increased inventories by $2,430,000 which was driven by having more raw materials on hand due to supporting higher sales and inflation of inventory costs. This reduced cash flow from operations and free cash flow.
Aside from the LSDI transaction and higher sales starting in late fiscal 2020 due to a competitor going out of business, GRI’s sales have been relatively stagnant. Management has clearly recognized that there are limited expansion opportunities and has elected to return the vast majority of free cash flow generated over the past decade to shareholders.
From management’s discussion of share repurchases over the years, it appears that most buybacks occur as a result of shareholders initiating a transaction rather than GRI buying shares on the open market. In the past, GRI has written about trying to find “lost” shareholders. The company does not have an independent stock transfer agent and maintains all shareholder records internally. Surprisingly, there were 1,108 stockholders of record as of April 30, 2022.
One gets the sense that management would repurchase more shares if these small stockholders could be “found” or if they contact the company with an offer to sell. Absent more repurchase opportunities, management opts to return cash via dividends.
GRI management has expressed an interest in acquiring businesses in annual reports and they finally took action in October 2017 by purchasing LSDI which was owned by Roy Bowling, an early member of the GRI board of directors who had the following to say when the transaction was announced:12
“I am pleased and proud to hand over the 35-year legacy of Labor Saving Devices, Inc. to such a high-quality company. As a former board member, I have great respect for the history and tradition of George Risk Industries, Inc. I would not have sold my business to anyone else.”
Management paid $3.2 million in exchange for what is now the Cable and Wiring Tools segment. This segment generated $580,000 of operating income on $2,130,000 of revenue in fiscal 2022. From the limited information available, it appears that the LSDI acquisition was a sensible one that complements GRI’s existing product lines and can be cross sold to customers. However, the transaction obviously came about due to local connections. Aside from LSDI, GRI has not been successful making additional acquisitions. This calls into question the need for the large securities portfolio to act as “dry powder” for future acquisitions.
GRI is a family-run operation with nearly six decades of history which is currently run by Stephanie Risk-McElroy, the granddaughter of the company’s founder. Through trusts controlled by Bonita Risk, Ms. Risk-McElroy’s mother, the Risk family controls ~60% of shares outstanding.
Although not without its quirks, the company’s operations appear to be managed competently. Ms. Risk-McElroy earned $152,000 in fiscal 2022. Bonita Risk, who is a director of the company and also serves as an employee, earned $189,000 in fiscal 2022. In addition to Stephanie Risk-McElroy and Bonita Risk, the company has three non-employee directors who each earn $200 per year in director fees.
In the past, there were small related-party transactions in which Bonita Risk rented a building to the company for $18,420 per year, but this issue was resolved in November 2019 when Bonita Risk sold the building to the company for $200,000. The company does have a banking relationship and holds ~$5 million with a local financial institution run by one of the non-employee directors.
It is apparent that the Risk family could extract far more from GRI in compensation but chooses not to do so. Without being aware of local real estate conditions in Kimball, it isn’t possible to know if the resolution of the building lease situation was equitable, but the numbers certainly seem reasonable to me. Having a banking relationship with a director of the company is probably a function of local business ties in a small community.
While the family seems to be doing a fine job managing the business, I take issue with the presence of the large marketable securities portfolio. It does not appear to serve a legitimate purpose and since management has no special competence running an investment portfolio, that task is outsourced to a money manager. The family might prefer to keep this money within the business for a “rainy day” or to defer taxes.
With the Risk family in firm voting control, any attempt to bring about change with respect to the securities portfolio would have to be done through persuasion. No outside shareholder can gain voting control to force the issues. Even if an outside shareholder could force the issue, it probably is not wise to do so since the Risk family is clearly an important part of the value of the operating business.
Given all of these caveats, is there any reason to own shares?
- In the balance sheet section, I estimated that $6.75 per share could be distributed to shareholders without disrupting the company’s operations.
- At that point, the operating business would likely generate ~$4 million of net income using only ~$16 million of capital.
- This would amount to ~$0.80 per share of net income.
- Shares last changed hands at $11.52 on September 6.
- Deducting $6.75 of distributable cash and marketable securities from $11.52 leaves us with $4.77 per share attributable to an operating business that has earnings power of $0.80 per share. This is a valuation of ~6x net income.
Of course, the $6.75 per share is not likely to be distributed to shareholders. It will remain invested by the company. However, we can still mentally view the operating business in the same way with the understanding that it does not need and is not using the excess capital on the balance sheet.
The question is whether one wishes to partner with the Risk family or not. With the family likely to hold a controlling interest in GRI for a long time, returns for a “partner” will amount to dividends plus the accumulation of value within GRI.
The current dividend is $0.50 per share representing a yield of 4.3%. The dividend has been regularly increased over the years. Over the past decade, book value per share has compounded at 5.2%. To purchase shares, one should be comfortable with these sorts of numbers and not anticipate “unlocking value” except potentially by persuading the family to distribute the excess capital.
Hopefully this case study was intellectually interesting even if it does not represent an investable opportunity for most readers. GRI seems like the sort of situation that Warren Buffett would have looked at in the 1950s, although I have no idea if he would have accumulated shares or used his skills of persuasion in an attempt to distribute the securities portfolio. My guess is that he would not have been interested without the prospect of gaining control of the company and being able to control the portfolio.
This article first appeared in Rational Reflections which is a reader supported publication. This business profile is free for all readers. To receive additional profiles and to gain full access to the archives, please consider signing up for a paid subscription. Thank you!
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No position in George Risk Industries.
- GRI Product Catalog, page 14. Downloaded on September 7, 2022.
- Unless otherwise stated, all data for fiscal 2021 and fiscal 2022 has been taken from GRI’s Fiscal 2022 10-K.
- GRI’s Fiscal 2021 10-K, p. 8
- However, a counterpoint is that in the Fiscal 2022 10-K, management reports that it “struggles to get enough workers to fill production needs” indicating that wages may have to rise further.
- For readers who are interested in older data, some information is available at the end of my original article on the company which was published in January 2010.
- Based on prior reporting patters, I would expect GRI’s 10-Q covering the first fiscal quarter of 2023 to be posted in mid to late September. I should note that the company seems to have a history of not filing with the SEC on time. For example, the fiscal 2022 10-K was delayed. The 10-Ks for fiscal 2020 and 2021 were also delayed. In the fiscal 2022 10-K, the company has acknowledged that it has a “material weakness” in financial reporting due to the CEO and CFO roles being the responsibility of one person and the board not having an audit committee. This is a small business that seems to struggle with the reporting burdens of being a public company, but I have not seen any evidence of malfeasance.
- For more information on this distortion to net income, I recommend reading Berkshire Hathaway’s Distorted Quarterly Results which I published last month. The same distortion that affects Berkshire Hathaway impacts GRI’s financial statements.
- The question of whether GRI should have applied for a PPP loan is legitimate. Assuming that the company qualified based on the terms of the program, it is difficult to find fault with management despite the fact that GRI is clearly overcapitalized. The situation was indeed uncertain in early 2020, the aid was offered to GRI’s competitors as well as other employers in its local community, and it was responsible to take advantage of it. Was it ethical to accept the forgiveness once the crisis passed? This is a political question beyond the scope of this analysis. I would note, however, that GRI has paid significant federal income taxes over its history, and one could arguably view this as a one-time “tax rebate”.
- I could have attempted to estimate the portfolio returns by asset class, but I think that the bottom line is that the company is claiming no inherent expertise in portfolio management. Delegation of management of the portfolio to a third party is something shareholders could do with their money individually rather than doing so via a portfolio held within GRI.
- The company’s actual tax rate post-restructuring is likely to be somewhat below the statutory blended rate of 28.8% given state income tax deductions and other adjustments, but for simplicity and conservatism, I opted to use the blended statutory rate in the example.
- GRI does not segregate dividends from interest, so it is difficult to determine the effective tax rate that was paid on this income. Dividends from holdings of common stock generally should qualify for 50% dividends received deduction. Interest from municipal bonds are tax free while other interest income would be fully taxable. There is not enough information to ballpark an after-tax figure.
- Source: The History of George Risk Industries
Dollar Slump Halted as Stocks and Bonds Retreat
Overview: Hopes that the global tightening cycle is entering its last phase supplied the fodder for a continued dramatic rally in equities and bonds….
Overview: Hopes that the global tightening cycle is entering its last phase supplied the fodder for a continued dramatic rally in equities and bonds. The euro traded at par for the first time in two weeks, while sterling reached almost $1.1490, its highest since September 15. The US 10-year yield has fallen by 45 bp in the past five sessions. Yet, the scar tissue from the last bear market rally is still fresh and US equity futures are lower after the S&P 500 had its best two days since 2020. Europe’s Stoxx 600, which has gained more than 5% its three-day rally is more around 0.9% lower in late morning turnover. The large Asia-Pacific bourses advanced, led by a nearly 6% rally in Hong Kong as it returned from holiday. Similarly, the bond market, which rallied with stocks, has sold off. The US 10-year yield is up around seven basis points to 3.70%, while European yields are 7-14 bp higher. Peripheral premiums are also widening. The dollar is firmer against most G10 currencies, with the New Zealand dollar holding its own after the central bank delivered was seems to be a hawkish 50 bp hike. Emerging market currencies are mostly lower, including Poland where the central bank is expected to deliver a 25 bp hike shortly. After rising to $1730 yesterday, gold is offered and could ease back toward $1700 near-term. December WTI is consolidating after rallying around 8.5% earlier this week as the OPEC+ decision is awaited. Speculation over a large nominal cut helped lift prices. US and European natural gas prices are softer today. Iron ore is extended yesterday’s gains, while December copper is paring yesterday’s 2.35% gain. December wheat is off for a third session, and if sustained, would be the longest losing streak since mid-August.
The Reserve Bank of New Zealand quickly laid to rest ideas that the Reserve Bank of Australia's decision to hike only a quarter of a point yesterday instead of a half-point was representative of a broader development. It told us nothing about anything outside of Australia. The RBNZ delivered the expected 50 bp increase and acknowledged it had considered a 75 bp move. In addition, it signaled further tightening would be delivered. It meets next on November 23, and the market has more than an 85% chance of another 50 bp hike discounted.
Both Australia and Japan's final service and composite PMI were revised higher in the final reading. Japan's service PMI was tweaked to 52.2 from 51.9. It was 49.5 in August. Similarly, the composite is at 51.0, up from 50.9 flash reading and 49.4 in August. In Australia, the service and composite PMI were at 50.2 in August. The flash estimate put it at 50.4 and 50.8, respectively. The final reading is 50.6 and 50.9 for the service and composite PMI.
Softer US yields weighed on the dollar against the yen. On Monday, it briefly traded above JPY145. Today, it traded at a seven-day low, slightly above JPY143.50. US yields are firmer, and the greenback has recovered and traded above JPY144.50 in early European turnover. The intraday momentum indicators are getting stretched, and the JPY144.75 area may cap it today. The Australian dollar traded to almost $.06550 yesterday but has struggled to sustain upticks over $0.6520 today. Initial support is seen in the $0.6450-60 area. Trade figures are out tomorrow. The New Zealand dollar initially rose to slightly through $0.5800 on the back of the hike but has succumbed to the greenback's strength. It returned little changed levels around $0.5730 before finding a bid in Europe. The US dollar reached CNH7.2675 last week and finished last week near CNH7.1420. It fell to almost CNH7.01 today and bounced smartly. A near-term low look to be in place, a modest dollar recovery seems likely.
UK Prime Minister Truss will speak at the Tory Party Conference as the North American session gets under way. We argued that calling retaining the 45% highest marginal tax rate a "U-turn" was an exaggeration and misreading of the new government. It was the most controversial part of the mini budget apparently among the Tory MPs. This was a strategic retreat and a small price to pay for the other 98% of Kwarteng's announcement. Bringing forward the November 23 "medium-term fiscal plan" (still to be confirmed with specifics) is more about process than substance. The fact that she seems to be considering not making good her Tory predecessor pledge to link welfare payments to inflation suggests she has not been chastened by the cold bath reception to her government's first actions. However, on another front, Truss is changing her stance. As Foreign Secretary she drafted legislation that overrode the Northern Ireland Protocol unilaterally. In a more profound shift, she has abandoned the legislation and UK-EU talks resumed this week Truss is hopeful for a deal in the spring. Lastly, we note that the UK service and composite PMI were revised to show smaller deterioration from August. The service PMI is at 50 not 49.2 as the flash estimate had it. It was at 50.9 previously. The composite remains below 50 at 49.1, but the preliminary estimate had it at 48.4 from 49.6 in August.
Germany's announcement of the weekend of a 200 bln euro off-budget "defensive shield" has spurred more rancor in Europe. Not all countries have the fiscal space of Germany. Two EC Commissioners called for an EU budget response. They seem to look at the 1.8 trillion-euro joint debt program (Next Generation fund) as precedent. This is, of course, the issue. During the pandemic, some suggested this was a key breakthrough for fiscal union, a congenital birth defect of EMU. However, this is exactly what the fight is about. If there is no joint action, the net result will likely be more fragmentation of the internal markets. Still, the creditor nations will resist, and Germany's Finance Minister Linder was first out of the shoot. While claiming to be open to other measures, Linder argued that challenge now is from supply shock, not demand. On the other hand, the European Parliament mandated that all mobile phones, tablets, and cameras are equipped with USB-C charge by the end of 2024. The costs savings is estimated to be around 250 mln euros a year. No fiscal union, partial banking, and monetary union, but a charger union.
The final PMI disappointed in the eurozone. The Big 4 preliminary readings were revised lower, suggesting conditions deteriorated further since the flash estimates. It was small change, but the direction was uniform. On the aggregate level, the service PMI was revised lower to 48.8 from 48.9 and 49.8 in August. The composite reading eased to 48.1 from 48.2 preliminary estimate and 48.9 in August. Italy and Spain, for which there is no flash report, were both weaker than expected, further below the 50 boom/bust level. France was the only one of these four that had a composite reading above 50 and improved from August. Separately, France reported a dramatic 2.4% rise in the August industrial output. The median forecast in Bloomberg's survey was for an unchanged report. Lastly, we note that Germany's August trade surplus was a quarter of the size that economists (median in the Bloomberg survey) expected at 1.2 bln euros instead of 4.7 bln. Adding insult to injury, the July balance was revised to 3.4 bln euros from 5.4 bln.
The euro stalled near $1.00 yesterday, the highest level since September 20. However, it has come back better offered today and fell slightly below $0.9925 in early European activity. Initial support is seen around $0.9900 and then $0.9840-50. The euro finished last week slightly above $0.9800. We suspect that market may consolidate broadly now ahead of Friday's US jobs report. The euro's gains seem more a function of short covering than bottom picking. Sterling edged a little closer to $1.15 but could not push through and has been setback to about $1.1380. The intraday momentum indicators allow for a bit more slippage and the next support area is around $1.1350.
Fed Chair Powell has explained that for inflation, one number, the PCE deflator best captures the price pressures. However, he says, the labor market has many dimensions and no one number does it justice. Weekly initial jobless claims fell to five-month lows in late September. On the other hand, the ISM manufacturing employment index fell below the 50 boom/bust level for the fourth month in the past five. The JOLTS report showed the labor market easing, with job openings falling by nearly a million to its lowest level in 14 months. Yet, despite the talk about the Reserve Bank of Australia's smaller cut as some kind of tell of Fed policy (eye roll) and the drop in JOLTS, the fact of the matter is that the market view of the trajectory of Fed policy has not changed. Specifically, the probability of a 75 bp hike is almost 77% at yesterday's settlement, which is the most since last Monday. The terminal rate is still seen in
Attention may turn to the ADP report due today but recall that they have changed their model and explicitly said that it is not meant to forecast the national figures. Those are due Friday. Also, along with the ADP data, the US reports the August trade figures today. We are concerned that the US trade deficit will deteriorate again and note that dollar is at extreme levels of valuation on the OECD's purchasing power parity model. That may be a 2023 story. What counts for GDP, of course, is the real trade balance, and in July it was at its lowest level since last October. Despite the strong dollar, US goods exports reached a record in July. Imports fell to a five-month low, which, at least in part, seems to reflect the difficult in many consumer businesses in managing inventories. The final PMI reading is unlikely to draw much attention. The preliminary reading had the composite rising for the first time in six months but still below the 50 at 49.3. The ISM services offer new information. The risk seems to be on the downside of the median forecast for 56.0 from 56.9.
Yesterday, we mistakenly said that would report is August building permits and trade figure, but they are out today. Permits, which likely fell for the third straight month, as the tighter monetary policy bits. The combination of slowing world growth and softer commodity prices warns the best of the positive terms-of-trade shock is behind it. The trade surplus is expected to fall for the second consecutive month. Even before the RBA delivered the 25 bp rate hike, the market had been downgrading the probability of a half-point move from the Bank of Canada. Last Thursday, the swaps market had it as a 92% chance. At the close Monday, it had been downgraded to a little less 72%. Yesterday, it slipped slightly below 65%. Further softening appears to be taking place today, even after the RBNZ's 50 bp hike. The odds have slipped below 50% in the swaps market.
After finishing last week slightly above CAD1.38, the US dollar has been sold to nearly CAD1.35 yesterday. No follow-through selling has been seen and the greenback was bid back to CAD1.3585. The Canadian dollar has fallen out of favor today as US equity index futures are paring gains after two strong advances. There may be scope for CAD1.3630 today if the sale of US equities resumes. The greenback has found a base around MXN19.95. The risk-off mod can lift it back toward MXN20.10-15. Look for the dollar to also recover more against the Brazilian real after bouncing off the BRL5.11 area yesterday.
Disclaimerbonds pandemic sp 500 equities stocks monetary policy fed link currencies us dollar canadian dollar euro gdp recovery gold japan hong kong canada european europe uk france spain italy germany poland eu
Plunging pound and crumbling confidence: How the new UK government stumbled into a political and financial crisis of its own making
Liz Truss took over as prime minister with an ambitious plan to cut taxes by the most since 1972 – investors balked after it wasn’t clear how she would…
The new British government is off to a very rocky start – after stumbling through an economic and financial crisis of its own making.
Just a few weeks into its term on Sept. 23, 2022, Prime Minister Liz Truss’ government released a so-called mini-budget that proposed £161 billion – about US$184 billion at today’s rate – in new spending and the biggest tax cuts in half a century, with the benefits mainly going to Britain’s top earners. The aim was to jump-start growth in an economy on the verge of recession, but the government didn’t indicate how it would pay for it – or provide evidence that the spending and tax cuts would actually work.
Financial markets reacted badly, prompting interest rates to soar and the pound to plunge to the lowest level against the dollar since 1985. The Bank of England was forced to gobble up government bonds to avoid a financial crisis.
After days of defending the plan, the government did a U-turn of sorts on Oct. 3 by scrapping the most controversial component of the budget – elimination of its top 45% tax rate on high earners. This calmed markets, leading to a rally in the pound and government bonds.
As a finance professor who tracks markets closely, I believe at the heart of this mini-crisis over the mini-budget was a lack of confidence – and now a lack of credibility.
A looming recession
Truss’ government inherited a troubled economy.
Growth has been sluggish, with the latest quarterly figure at 0.2%. The Bank of England predicts the U.K. will soon enter a recession that could last until 2024. The latest data on U.K. manufacturing shows the sector is contracting.
Consumer confidence is at its lowest level ever as soaring inflation – currently at an annualized pace of 9.9% – drives up the cost of living, especially for food and fuel. At the same time, real, inflation-adjusted wages are falling by a record amount, or around 3%.
It’s important to note that many countries in the world, including the U.S. and in mainland Europe, are experiencing the same problems of low growth and high inflation. But rumblings in the background in the U.K. are also other weaknesses.
Since the financial crisis of 2008, the U.K. has suffered from lower productivity compared with other major economies. Business investment plateaued after Brexit in 2016 – when a slim majority of voters chose to leave the European Union – and remains significantly below pre-COVID-19 levels. And the U.K. also consistently runs a balance of payments deficit, which means the country imports a lot more goods and services than it exports, with a trade deficit of over 5% of gross domestic product.
In other words, investors were already predisposed to view the long-term trajectory of the U.K. economy and the British pound in a negative light.
An ambitious agenda
Truss, who became prime minister on Sept. 6, 2022, also didn’t have a strong start politically.
The government of Boris Johnson lost the confidence of his party and the electorate after a series of scandals, including accusations he mishandled sexual abuse allegations and revelations about parties being held in government offices while the country was in lockdown.
Truss was not the preferred candidate of lawmakers in her own Conservative Party, who had the task of submitting two choices for the wider party membership to vote on. The rest of the party – dues-paying members of the general public – chose Truss. The lack of support from Conservative members of Parliament meant she wasn’t in a position of strength coming into the job.
Nonetheless, the new cabinet had an ambitious agenda of cutting taxes and deregulating energy and business.
Some of the decisions, laid out in the mini-budget, were expected, such as subsidies limiting higher energy prices, reversing an increase in social security taxes and a planned increase in the corporate tax rate.
But others, notably a plan to abolish the 45% tax rate on incomes over £150,000, were not anticipated by markets. Since there were no explicit spending cuts cited, funding for the £161 billion package was expected to come from selling more debt. There was also the threat that this would be paid for, in part, by lower welfare payments at a time when poorer Britons are suffering from the soaring cost of living. The fear of welfare cuts is putting more pressure on the Truss government.
A collapse in confidence
Even as the new U.K. Chancellor of the Exchequer Kwasi Kwarteng was presenting the mini-budget on Sept. 23, the British pound was already getting hammered. It sank from $1.13 the day before the proposal to as low as $1.03 in intraday trading on Sept. 26. Yields on 10-year government bonds, known as gilts, jumped from about 3.5% to 4.5% – the highest level since 2008 – in the same period.
The jump in rates prompted mortgage lenders to suspend deals with new customers, eventually offering them again at significantly higher borrowing costs. There were fears that this would lead to a crash in the housing market.
In addition, the drop in gilt prices led to a crisis in pension funds, putting them at risk of insolvency.
The International Monetary Fund, which bailed out the U.K. in 1976, even offered its figurative two cents on the tax cuts, urging the government to “reevaluate” the plan. The comments further spooked investors.
To prevent a broader crisis in financial markets, the Bank of England stepped in and pledged to purchase up to £65 billion in government bonds.
Besides causing investors to lose faith, the crisis also severely dented the public’s confidence in the U.K. government. The latest polls showed the opposition Labour Party enjoying a 24-point lead, on average, over the Conservatives.
So the government likely had little choice but to reverse course and drop the most controversial part of the plan, the abolition of the 45% tax rate. The pound recovered its losses. The recovery in gilts was more modest, with bonds still trading at elevated levels.
Putting this all together, less than a month into the job, Truss has lost confidence – and credibility – with international investors, voters and her own party. And all this over a “mini-budget” – the full budget isn’t due until November 2022. It suggests the U.K.‘s troubles are far from over, a view echoed by credit rating agencies.
David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.recession covid-19 subsidies bonds government bonds housing market pound lockdown recession recovery interest rates european europe uk
Roubini: The Stagflationary Debt Crisis Is Here
Roubini: The Stagflationary Debt Crisis Is Here
Authored by Nouriel Roubini via Project Syndicate,
The Great Moderation has given way to…
The Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of slow-motion negative supply shocks. US and global equities are already back in a bear market, and the scale of the crisis that awaits has not even been fully priced in yet.
For a year now, I have argued that the increase in inflation would be persistent, that its causes include not only bad policies but also negative supply shocks, and that central banks’ attempt to fight it would cause a hard economic landing. When the recession comes, I warned, it will be severe and protracted, with widespread financial distress and debt crises. Notwithstanding their hawkish talk, central bankers, caught in a debt trap, may still wimp out and settle for above-target inflation. Any portfolio of risky equities and less risky fixed-income bonds will lose money on the bonds, owing to higher inflation and inflation expectations.
How do these predictions stack up? First, Team Transitory clearly lost to Team Persistent in the inflation debate. On top of excessively loose monetary, fiscal, and credit policies, negative supply shocks caused price growth to surge. COVID-19 lockdowns led to supply bottlenecks, including for labor. China’s “zero-COVID” policy created even more problems for global supply chains. Russia’s invasion of Ukraine sent shockwaves through energy and other commodity markets. And the broader sanctions regime – not least the weaponization of the US dollar and other currencies – has further balkanized the global economy, with “friend-shoring” and trade and immigration restrictions accelerating the trend toward deglobalization.
Everyone now recognizes that these persistent negative supply shocks have contributed to inflation, and the European Central Bank, the Bank of England, and the US Federal Reserve have begun to acknowledge that a soft landing will be exceedingly difficult to pull off. Fed Chair Jerome Powell now speaks of a “softish landing” with at least “some pain.” Meanwhile, a hard-landing scenario is becoming the consensus among market analysts, economists, and investors.
It is much harder to achieve a soft landing under conditions of stagflationary negative supply shocks than it is when the economy is overheating because of excessive demand. Since World War II, there has never been a case where the Fed achieved a soft landing with inflation above 5% (it is currently above 8%) and unemployment below 5% (it is currently 3.7%). And if a hard landing is the baseline for the United States, it is even more likely in Europe, owing to the Russian energy shock, China’s slowdown, and the ECB falling even further behind the curve relative to the Fed.
Are we already in a recession? Not yet, but the US did report negative growth in the first half of the year, and most forward-looking indicators of economic activity in advanced economies point to a sharp slowdown that will grow even worse with monetary-policy tightening. A hard landing by year’s end should be regarded as the baseline scenario.
While many other analysts now agree, they seem to think that the coming recession will be short and shallow, whereas I have cautioned against such relative optimism, stressing the risk of a severe and protracted stagflationary debt crisis. And now, the latest distress in financial markets – including bond and credit markets – has reinforced my view that central banks’ efforts to bring inflation back down to target will cause both an economic and a financial crash.
I have also long argued that central banks, regardless of their tough talk, will feel immense pressure to reverse their tightening once the scenario of a hard economic landing and a financial crash materializes. Early signs of wimping out are already discernible in the United Kingdom. Faced with the market reaction to the new government’s reckless fiscal stimulus, the BOE has launched an emergency quantitative-easing (QE) program to buy up government bonds (the yields on which have spiked).
Monetary policy is increasingly subject to fiscal capture. Recall that a similar turnaround occurred in the first quarter of 2019, when the Fed stopped its quantitative-tightening (QT) program and started pursuing a mix of backdoor QE and policy-rate cuts – after previously signaling continued rate hikes and QT – at the first sign of mild financial pressures and a growth slowdown. Central banks will talk tough; but there is good reason to doubt their willingness to do “whatever it takes” to return inflation to its target rate in a world of excessive debt with risks of an economic and financial crash.
Moreover, there are early signs that the Great Moderation has given way to the Great Stagflation, which will be characterized by instability and a confluence of slow-motion negative supply shocks. In addition to the disruptions mentioned above, these shocks could include societal aging in many key economies (a problem made worse by immigration restrictions); Sino-American decoupling; a “geopolitical depression” and breakdown of multilateralism; new variants of COVID-19 and new outbreaks, such as monkeypox; the increasingly damaging consequences of climate change; cyberwarfare; and fiscal policies to boost wages and workers’ power.
Where does that leave the traditional 60/40 portfolio? I previously argued that the negative correlation between bond and equity prices would break down as inflation rises, and indeed it has. Between January and June of this year, US (and global) equity indices fell by over 20% while long-term bond yields rose from 1.5% to 3.5%, leading to massive losses on both equities and bonds (positive price correlation).
Moreover, bond yields fell during the market rally between July and mid-August (which I correctly predicted would be a dead-cat bounce), thus maintaining the positive price correlation; and since mid-August, equities have continued their sharp fall while bond yields have gone much higher. As higher inflation has led to tighter monetary policy, a balanced bear market for both equities and bonds has emerged.
But US and global equities have not yet fully priced in even a mild and short hard landing. Equities will fall by about 30% in a mild recession, and by 40% or more in the severe stagflationary debt crisis that I have predicted for the global economy. Signs of strain in debt markets are mounting: sovereign spreads and long-term bond rates are rising, and high-yield spreads are increasing sharply; leveraged-loan and collateralized-loan-obligation markets are shutting down; highly indebted firms, shadow banks, households, governments, and countries are entering debt distress.
The crisis is here.
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