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Six-year win streak snapped
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Episode 35 | Kyle Bass
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Week in Review
S&P's six-year win streak snapped

The fate of the S&P 500’s six-year win streak came down to the final trading day of the year, and a 0.9% loss saw the index finish in negative territory for the first time since 2008. The S&P lost 0.7% in 2015 and the Dow fell 2.2%, while the Nasdaq outperformed with a 5.7% gain. The small-cap Russell 2000 was the weakest index, dropping 5.9%.

Oil prices finished the year down more than 30%, with West Texas Intermediate (WTI) crude settling down 2.7% this week just above $37/barrel. Yields on the 10-year US treasury ended the year at 2.27%, climbing three basis points on the week and only 10 basis points on the year despite the Fed’s first rate hike in nine years.  

US Economic Data

Economic data is light during the holiday season, but both consumer confidence and home prices climbed more than expected. On a negative note, the ISM Chicago manufacturing survey fell to a six and a half year low while pending home sales fell for the third time in four months. Initial jobless claims jumped to their highest level since July, but remain historically low. US holiday retail sales grew 7.9% while online sales grew 20%.

Puerto Rico announced it would make scheduled January 1 payments on its general obligation (GO) debt but default on other bonds. Puerto Rico has been a stain on the otherwise sterling resume of municipal bonds, which were the best performing asset class in 2015, returning over 3%.

Asia

The Nikkei 225 rallied 1.4% for the week, snapping a four-week losing streak and extending its 2015 gain to 9.07%. The Bank of Japan (BoJ) said gross domestic product (GDP) growth could get a 1.0% boost from the 2020 Tokyo Olympics over the next three years thanks to building projects and tourism.

With aggressive monetary and fiscal policy aimed at stoking its moribund economy, the Japanese yen has weakened 35% against the dollar over the past four years. According to Bloomberg consumer purchasing power data, the yen is the cheapest among all major currencies and nearly 40% undervalued against the dollar, which has boosted Japanese equities. 

Chinese stocks, as measured by the Shanghai Composite index, closed out a highly volatile year with a 9.4% gain. However, Hong Kong’s Hang Seng China Enterprises Index, which tracks shares in Chinese companies, dropped 19% in 2015. The divergence between the two indexes was the first in more than a decade, likely reflecting the impact of historic structural intervention into markets by the Chinese government aimed at stemming the tide of extreme volatility.

The Chinese yuan fell 4.5% on the year against a basket of global currencies, its worst performance since 1994, as the government slowly allows the currency to float more freely. On this week’s Wall Street Week, Kyle Bass said he believes the Chinese government will pursue even more substantial devaluation of the yuan over the next 12-18 months.

Europe

European markets were little changed in light trading during the holiday-shortened week as the Stoxx Europe 600 finished the week down a marginal 0.04%. Holiday retail sales data from the UK was positive while housing prices rose 0.8% in December and 4.5% for the year.

Emerging Markets

Brazil’s government reported a primary budget deficit of around $5 billion in November amid recession and government gridlock caused by widespread corruption. The country saw its debt downgraded to junk by S&P and Fitch in 2015, causing the country’s main equity index to decline 13% for the year.

Plummeting oil prices weighed on the Russian economy and ruble all year, with the currency finishing the year at lows versus the dollar

Week Ahead

  • Monday: ISM manufacturing index 
  • Wednesday: International Trade data, FOMC minutes
  • Thursday: US jobless claims
  • Friday: US employment situation report
Episode Playback
Kyle Bass discusses implications of the next great financial crisis
Did you miss Sunday's show featuring hedge fund manager Kyle Bass? Watch the full episode, clips and more at WallStreetWeek.com
Episode Feature
Kyle Bass pokes the big pharma bear

Kyle Bass, who made his name – and a fortune – shorting subprime mortgage-backed securities (MBS) prior to the 2008 financial crisis, has never been afraid to challenge conventional wisdom. Even so, his recent challenge of abusive patents in the pharmaceutical industry marks an interesting, ambitious turn for a manager typically focusing on event-driven and global macro investments. Biotechnology has been one of the best performing sectors of US equity markets since early 2009, but Bass believes the pharmaceutical industry’s profits are excessively derived from archaic patent laws that allow price gouging.
 
After getting tipped off about the problem in 2014 by one of the top patent lawyers in the country, Bass saw an opportunity to both make money and solve a societal problem. He devised a plan to identify companies guilty of abusing patent laws, short the stocks and challenge the patents. Bass launched a special purpose investment vehicle within Hayman Capital and created the Coalition for Affordable Drugs, an organization that would lead the petitions on patent challenges in the US Patent and Trademark Office. He also inked Erich Spangenberg, an intellectual-property expert, as a consultant to act as a “real party of interest” in the petitions.
 
Bass, an outspoken advocate of free markets and critic of interventionist Fed policy, does not begrudge pharmaceutical companies seeking to profit from groundbreaking drug research. However, he says the fact drug companies spend disproportionately on marketing compared to research and development is evidence of perverted values within the industry.
 
“Look at the [research and development (R&D)] pipeline and look at what they spend on it. Global pharmaceutical companies spend three times their R&D budget on marketing every year. They have gross margins higher than that of Google. You can't watch TV without an ad coming on TV.”
 
The issue with drug prices stems from the way patents can be extended through loopholes.
 
“What we started realizing is when pharmaceutical companies have patents that have these 20-year lifespans, and they're about to roll off patent, if they just change the dosage. Let's say a dosage was 10 milligrams twice a day. They go to 20 milligrams once a day, it's a new patent. And they keep that monopoly that's government-backed, for another, five, six, seven years... There are some stupid things out there that we're trying to change."
 
When he launched the patent campaign earlier this year, Bass knew it was ambitious to take on a powerful industry with deep pockets and political influence. But after a year in which his batting average on patent challenges fell short of expectations –Bass says he expected to bat 80% but is currently closer to 50% – he admits in hindsight he wasn’t fully aware of the magnitude of the task.
 
“It's not been fun… [Pharmaceutical companies] have dramatically increased their lobbying budgets. They have hired 100 lobbying teams to fight us alone. They have basically spent everything they can spend to fight us, and it's been a tough fight, I'll tell you that.”
 
While helping reduce drug prices on the surface could be considered a noble cause, the project undertaken by Bass and Spangenberg is not without its share of critics. Spangenberg has a reputation as a “patent troll,” someone who acquires technology patents for the sake of suing companies for infringement. He has employed such a strategy in the past against high-profile names like Apple and Exxon-Mobil, becoming a four-letter word in Silicon Valley. Bass’ critics say he is attempting to profit from fear and panic selling created by patent challenges, but he insists he has no interest in settling cases or simply making a quick buck.
 
Perhaps in an attempt to move the needle of public opinion further in their direction, Bass and Spangenberg have even taken on patent challenges in which they have no financial interest. Bass held a contest among legal teams at Hayman to find the most egregious patents among the 11,000 chemical molecules in the drug orange book, with the promise to challenge the most abusive patents even if there was no way to bet against the companies holding them. One byproduct of that contest has been a petition filed against Propofol, the drug on which Michael Jackson overdosed. It is a World Health Organization essential medicine and anesthetic for about 80% of surgeries in the U.S. The only intellectual property protecting the drug from rolling off patent and potentially seeing its price fall by as much as 90% is the silicon rubber stopper on the vial that administers the medicine, Diprivan.
 
While the task has been daunting, Bass said being perceived as the “good guy” has been a welcome change compared to his role betting against the housing market in 2007.
 
“When we were in the housing market, many people thought we somehow caused the global financial crisis. And that literally had nothing to do with anything - it was all going to happen with or without us. What we were doing in the subprime market was, to bring it down to layman's terms, is we were playing fantasy football. We were putting on contracts that were bets on existing bonds that other CDO managers are willing to take the bets on. So, it was professional on professional. In this case in the drugs, when I win everybody wins. The only person that loses are the shareholders and the management teams of the companies that I'm challenging.”
 
Prescription drug prices have become a hot-button issue both on Wall Street and the campaign trail, but before Hillary Clinton tweeted about Martin Shkreli or short-sellers exposed potential channel stuffing at Valeant, Bass believes he was ahead of the curve. Despite early setbacks, he appears resolute in following through on his mission. Asked by host Anthony Scaramucci whether he intended on turning the tide over the next few years, Bass replied: “I didn't enter this to not win.”
 
More on Bass’ patent campaign:

http://www.wsj.com/articles/hedge-fund-manager-kyle-bass-challenges-jazz-pharmaceuticals-patent-1428417408

http://www.wsj.com/articles/hayman-capitals-kyle-bass-vows-to-continue-drug-patent-challenges-1441320971

http://www.bloomberg.com/news/articles/2015-08-24/kyle-bass-s-petitions-challenging-two-acorda-patents-rejected

http://dealbook.nytimes.com/2015/02/11/kyle-bass-wields-new-weapon-in-challenging-drug-makers/

http://www.reuters.com/article/celgene-lawsuit-hedgefund-idUSL1N11Y1S120150928

http://www.businessinsider.com/kyle-bass-gets-institution-for-lialda-ipr-2015-10

http://www.nytimes.com/2015/11/29/business/working-to-lower-drug-costs-by-challenging-questionable-patents.html

Investment Primer
Debt destruction, monetizing the debt and non-performing loan cycles

What is debt destruction?

Debt destruction is a phenomenon in which negative earnings or wage growth impair a borrower’s ability to service debts. It can occur on the level of a household, corporation or sovereign nation. The amount of debt you owe remains constant, growing with interest, but your ability to pay off that debt depends on the amount of money you have coming in. If a person or company borrows money without using that capital to create a future income stream, debt can spiral out of control. Economists aim to, at almost all costs, avoid deflationary spirals that can lead to hard-to-escape debt destruction cycles. The global economy recovered from the 2008 financial crisis largely on the back of new debt, so today's central bankers are particularly conscious of maintaining growth and avoiding debt destruction when making policy decisions.

On Wall Street Week, host Anthony Scaramucci and guest Kyle Bass discussed the concept.

KYLE BASS: "Globally we all went to the gas pedal with creating money, and now we have this interesting kind of debt-led deflationary bust that we're seeing emanate from Asia, and come across the globe today. Whether it's crude oil, or copper, or iron ore, you name it. Anything that China used to build the cities and bridges to nowhere in 2009, is now kind of coming home to roost. In the end what happens is that the currencies end up settling the score."

ANTHONY SCARAMUCCI: "I think that's super important for us to explain to viewers. What happened was you had a tremendous amount of excess liquidity. It led to overcapacity in factory buildup, overcapacity in creating cities in China, and now you've got all this excess capacity that's putting pressure on prices. So, that's creating deflation. And you should be worried about deflation because why?"

KYLE BASS: "Well, because of the amount of debt that exists in the world. When you have deflation in environment where the debts are so large, the debts grow when the currencies deflate."

ANTHONY SCARAMUCCI: "This is something I have been talking about, an economic term called "debt destruction." What ends up happening is the debt stays constant while wages are going down. So, the average American owing $200,000 of debt, with a $50,000 income - if their income goes down or gets cut in half, their capacity to service that debt has also been halved. Or in real terms, their debt has actually doubled."
 
What is monetizing the debt?

Debt monetization is a process in which a sovereign government issues bonds to finance deficit spending, and then a central bank buys and holds that debt to maturity. Debt monetization increases the money supply and often stokes inflation, which improves borrowers’ ability to service their debts as earnings and incomes grow.

The exchange between Scaramucci and Bass continued, touching on the concept of monetizing the debt.

ANTHONY SCARAMUCCI: "Okay, so what do [deflationary pressures] mean for the markets?"
       
KYLE BASS: "I just think we're going to grow a little slower.  And you're seeing that.  I think U.S. corporations' profit margins have hit their peak.  I think you're going to see both minimum wage and wages actually move up a little bit.  And I think you're going to see profits come down…As we know, China many years ago attached their currency to the dollar. I think they hitched their wagon to our star very smartly back then, because our goal in the United States was to depreciate our dollar through inflation. So, we issue debt to the rest of the world. We depreciate our dollar."

ANTHONY SCARAMUCCI: "You're monetizing the debt.  So, basically you're able to pay the debt back with dollars that are worth less than the ones that you borrowed."

What is a non-performing loan cycle?

A non-performing loan cycle, or banking loss cycle, is a period in which banks are forced to write off the value of a significant portion of loans that borrowers are not able to pay back. These cycles often occur after periods of rapid debt-driven economic expansion in which aggregate demand does not grow enough to satisfy a dramatic increase in supply/capacity. 

For example, in an effort to maintain government-mandated 7% annual economic growth, Chinese banks provided loans for the construction of "ghost cities" that were never inhabited. This excess capacity put downward pressure on prices (deflation) and increased the number of bad loans on bank balance sheets.

Bass believes the crisis will come to a head in the next 12-24 months, and the Chinese government will be forced to issue and buy back bonds through the People's Bank of China in order to recapitalize the banking system - similar to the way Congress and the Fed bailed out US financial markets after the 2008 financial crisis. He also believes the Chinese government will be forced to significantly devalue the yuan currency during that timeframe. 

Bass continued:

KYLE BASS: "So now the real problem is China has hitched their wagon to our star, and their currency is effectively appreciated about 60 percent versus the rest of the world since 2005. There was a labor arbitrage between U.S. labor rates and Chinese labor rates. And the free and open global economy, call it free trade, enabled that arbitrage to normalize itself.

China's effective exchange rate moving up versus the rest of the world made their goods and services a little bit more expensive each year. Now it's kind of that labor arbitrage is gone, and if that labor arbitrage is gone, and their banking system has expanded 400% in seven years, without a non-performing loan cycle. My view is that we're going see a non-performing loan cycle.

ANTHONY SCARAMUCCI: "So, Jim Chanos was on this show a few months back very negative on China because of many of the things that you're saying. Are you short China?"

KYLE BASS: "Well, so we're not short Chinese equities, per se. But we're very invested in the Chinese currency given this thesis we think you're going to see a pretty material devaluation. And we think it's gonna be in the next 12 to 18 months."

...KYLE BASS: "China, which I think is the big one that's going to have a non-performing loan cycle.  So, if you're asking me which inning we're in in the [emerging market] selloff, I think we're probably in the mid-fifth inning. Maybe entering the sixth. But we still have three tough innings to go, maybe four."

Week Links
What We're Reading
Alternative Investments

The Year the Hedge-Fund Model Stalled on Main Street (WSJ, Sarah Krouse)
 
Alternative assets loom as best bet (FT, John Authers)

Taxes
 
For the Wealthiest, a Private Tax System That Saves Them Billions (NY Times, Noam Scheiber, Patricia Cohen)
 
Really rich people are suddenly paying quite a bit more in taxes (Washington Post, Jim Tankersley)

Year in Review

Here Are the Best- and Worst-Performing Assets of 2015 (Bloomberg, Julie Verhage)
 
The Best and Worst of the US Economy in 2015 (Bloomberg, Michelle Jamrisko)
 
2015: The Year in Charts (NY Times, Steven Rattner)

Personal Finance
 
Investment Advice That Will Pass Time’s Test (ThinkAdvisor, Bob Seawright)

The Year Nothing Worked: Stocks, Bonds, Cash Go Nowhere (Bloomberg, Lu Wang)

Geopolitics

 
Election forecasting: Prediction 2016 (The Economist)
 
2016—The Year of “Never Closer Union” (Medium, Dan Davies)

Technology

The Stratechery 2015 Year in Review (Stratechery, Ben Thompson)
 
Want to See Technology Taking Over Finance? Look at China (WSJ, Gillian Wong, Juro Osawa)
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