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Posted: 09 Apr 2021 04:50 AM PDT

National Review

Semiconductor Cycle: Is This Time Different?

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the semiconductor shortage, funds considering new prime brokers, Amazon workers say no to union, and a look at the capital cycle. To sign up for the Capital Note, follow this link. Chip Shortage Since late last year, a shortage in computer chips has slowed production of everything from cars to video-game consoles, as semiconductor manufacturers struggle to keep up with growing demand. The shortage is so severe that President Biden has pledged to take action to boost output. Meanwhile, chipmakers are ramping up capacity, with Intel, Applied Materials, and Taiwan Semiconductors all projecting significant increases in capital expenditures over the next few years. The shortage has led to a rally in semis stocks, driving the PHLX Semiconductor Index up 17 percent for the year, well outperforming other technology verticals. However, the history of the semiconductor industry suggests investors should be cautious before buying into the sector. Computer chips perennially see volatile cycles, whereby supply shortfalls lead to excessive capital investment and eventual oversupply. Because manufacturers must project output at least nine months in advance, supply tends to lag demand, causing major fluctuations in investment and returns. In response to the chip shortage, Intel announced plans to enter the foundry business, producing chips designed by other businesses. Applied Materials, one of the sector's best performers, is forecasting $85 billion in spending on fabrication equipment by 2024. As elucidated in Capital Returns: Investing through the Capital Cycle, "No part of the technology world has been more prone to cyclical booms and busts than the semiconductor industry. In good times, prices pick up, companies increase capacity, and new entrants appear, generally from different parts of Asia." We are currently in the "good times" phase of the capital cycle, but analysts should be wary of extrapolating the good times out into the future. While the PHLX Semiconductor Index has skyrocketed of late, its performance before the COVID-19 pandemic has been highly volatile and weak overall. Some argue that this time is different. A recent Goldman Sachs note points out "severe supply tightness across a wide range of device types and the sense of urgency on the part of governments to re-design/onshore supply chains will support a cycle that is 'stronger for longer' compared to past upturns." On this view, government support will lengthen the semis cycle, while fundamental changes such as reshoring weaken the link between growing capital investment and diminishing returns. Yet that sense of "urgency" could just as easily contribute to excessive capital investment, driving down returns for chipmakers. An analyst at Raymond James argues government intervention "could potentially lead to structural oversupply over time, which could depress industry profitability despite subsidies." And while reshoring may be a boon to certain manufacturers, it is unlikely to benefit the industry as a whole. The much-discussed chip shortage is just an organic outgrowth of semiconductor cycle. Around the Web Hedge funds reconsider prime brokers after Archegos blowup Executives are weighing up whether to switch lenders they use as their prime brokers — banks that offer a range of services including stock lending, leverage and trade execution. The head of one London-based hedge fund said the firm had "initiated an internal process" to evaluate its prime broking relationships in the wake of the Archegos debacle. The top concern was reputation, particularly whether their clients believed they were "associated with the bad people" in the sector, the person said. Amazon Workers in Alabama Vote Against Forming a Union Amazon.com Inc. employees in Alabama voted not to unionize, handing the tech giant a victory in its biggest battle yet against labor-organizing efforts that fueled national debate over working conditions at one of the nation's largest employers. An estimated 71% of the Bessemer, Ala., warehouse workers who cast ballots voted against joining the Retail, Wholesale and Department Store Union, according to the National Labor Relations Board, which on Friday finished counting all the votes that weren't challenged. The federal agency has yet to certify the results but noted that the challenged ballots aren't enough to exceed the vote margin against unionization. Random Walk Earlier we discussed the semiconductor cycle. Capital Returns: Investing through the Capital Cycle, a compendium of reports by Marathon Asset Management, explains how capital flows can influence returns at the industry level: Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter's process of "creative destruction" – as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing. High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don't want to lose market share. Besides, CEO pay is often set in relation to a company's earnings or market capitalization, thus incentivizing managers to grow their firm's assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum! Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sexy sectors (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers' incentives are skewed to short-term payoffs (bonuses), it's inevitable that their time horizon should also be myopic. It's not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly. — D.T. To sign up for the Capital Note, follow this link.

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Posted: 09 Apr 2021 04:43 AM PDT

Bloomberg

Biggest CLO Buyer Plots Return, Joining BofA and Pimco in Market

(Bloomberg) -- Many of the biggest whales in collateralized loan obligations are returning to the $900 billion market after spending much of last year on the sidelines, a shift that could make one of Wall Street's biggest credit machines run even hotter.Japan's Norinchukin Bank, formerly the biggest buyer in the CLO market, has begun looking at deals again, according to people with knowledge of the matter. Wells Fargo & Co., absent for much of 2020, is back. Fidelity Investments has already upped its holdings in pursuit of higher yields. And Bank of America Corp., previously just an occasional buyer in the market, has purchased billions of dollars of the bonds and plans to add more.The return of big players is an important step in the resurgence of the CLO market, which had been in the doldrums for much of last year. Investor demand for these securities translates to more money flowing into leveraged loans, the raw material that is packaged into CLOs. That inflow can help private equity firms finance more -- and potentially riskier -- leveraged buyouts. It helps business owners borrow to extract dividends from their companies. It can also fuel the kind of excess in corporate lending that regulators have been warning about for years.But CLOs came out of the pandemic without the mass downgrades that investors had feared, a performance that has helped fuel a resurgence in demand for them and their relatively high yields. Bank of America has set up a program to steadily purchase top-rated CLOs, according to people with knowledge of the matter who aren't authorized to speak publicly. According to Morgan Stanley research, Bank of America had just $80 million of CLOs at the end of last year.Norinchukin Bank, often referred to as Nochu, held $73 billion of CLOs at its peak, multiples of what any other institution had. But the bank has been largely absent from buying new CLOs since 2019, when Japanese authorities clamped down on purchases of the instruments. The bank's holdings have been dropping since late that year. That trend accelerated this year because many CLOs refinanced or reset their liabilities, and Nochu was often replaced as an investor in the process, according to people with knowledge of the matter. A representative for the bank declined to comment.JPMorgan Chase & Co. and Wells Fargo -- which have long been among the largest buyers of CLOs -- have also increased their holdings this year, according to other people with knowledge of the matter. (JPMorgan had $29 billion of the securities at the end of last year, while Wells Fargo had $25 billion, according to Morgan Stanley.) Smaller banks including PNC Financial Services Group Inc. and Toronto-Dominion Bank also heightened their investments."The pendulum has swung dramatically," said Lauren Basmadjian, head of the U.S. loans and structured credit business at Carlyle Group Inc. "A lot of investors who were absent back in 2020 returned in size."Pacific Investment Management Co., Blackstone Group Inc. and Fidelity have been buying more of the instruments, according to people with knowledge of the matter. Pimco is adding on risk, shifting from the shorter-dated AAA bonds that accounted for most of its purchases in 2019 to 2020 to buying securities with a range of ratings, according to one of the people. State Street Corp. has also begun to purchase European CLOs.Deploying DepositsAsset managers sold more than $108 billion of U.S. CLOs in the first quarter, counting refinancings, resets, and reissues, setting a new quarterly record. Until now, many of the buyers kicking up their allocations have been from the U.S.For banks, demand is being driven by the massive amount of deposits they've received during the pandemic as low interest rates have expanded the money supply. Lenders in the U.S. banking system had $17.8 trillion of deposits as of the end of December, a surge of more than $3 trillion from the same period a year earlier, according to data from the Federal Deposit Insurance Corp.Much of this money isn't being lent out, forcing banks to invest in securities instead. A Morgan Stanley research team led by Charlie Wu expects reserves held at the U.S. central bank to expand by another $2 trillion this year."The big news is that the U.S. banks have stepped up and some have returned," said Dagmara Michalczuk, a portfolio manager at Tetragon Credit Partners. "It's been the marginal, incremental buying from new and returning investors stepping in that is making the difference."Many investors are coming back to the CLO market after sitting out for much of 2020, when money managers feared that the pandemic would trigger a wave of ratings downgrades for loans, decimating the value of riskier parts of collateralized loan obligations. Those rating cuts never really came, and now the economy is in recovery mode, resulting in more CLO upgrades than downgrades.Supply IndigestionThe sheer volume of securities that CLO managers are producing now, both from new sales and from refinancing existing transactions, appears to have overwhelmed the increased appetite of investors. Risk premiums on AAA rated portions of CLOs, known as the discount margins, have edged higher, averaging around 1.08 percentage point as of Wednesday compared with 1.03 percentage point in mid-February, according to Palmer Square CLO data compiled by Bloomberg."The fact that spreads are marginally wider and not significantly wider really speaks to the all the demand brought on by the Fed's keeping rates low," said Dave Preston, head of structured credit research at AGL Credit Management.Most market participants see that slowdown as a blip, and there is a swelling pipeline of upcoming deals."It's fairly common to take a pause and reevaluate at the end of the first quarter," said David Moffitt, co-head of Investcorp's US credit management business. "I don't see this as a rotation out of the CLO asset class. I see this more as a pause in the pipeline."CLOs continue to offer more yield relative to investment-grade corporate bonds. A company bond rated in the A tier, or four to six levels above junk, averages a risk premium of around 0.7 percentage point, according to Bloomberg Barclays index data, or about 0.38 percentage point less than a AAA rated CLO. And CLOs tend to carry floating rates, meaning their yields will rise as the Federal Reserve hikes.Strong CLO issuance has translated to greater sales of leveraged loans. Companies priced more than $145 billion of leveraged loans in the first three months of 2021, including new loans and refinancings, the highest quarterly level since at least 2013.In addition to Nochu's planned return to CLOs, Japanese firms including Japan Post and Mizuho Financial Group Inc. are also continuing to invest, or increasing their investments. Sumitomo Life Insurance Co. has begun buying European CLOs recently, after previously focusing mainly on the U.S. market for the securities. The return of the nation's investors to the market is a key variable for how strong demand will be in the future."If Japanese banks come back into the fray it will be a game changer for AAA spreads," said Nikunj Gupta, head of European new issue CLOs at Deutsche Bank in London.For more articles like this, please visit us at bloomberg.comSubscribe now to stay ahead with the most trusted business news source.©2021 Bloomberg L.P.

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