Wednesday, June 19, 2013

What Does the End of QE Mean for Wine?

Everyone likes Fridays. This Friday is a little more special so I decided to post a non-Sunday blog for the first time. Why the deviation? Because Friday is the day we receive the most hours of sunlight in 24 hours .... and then its all downhill after that.

While that sounds a little gloomy phrased up that way, consider that its coming from someone who has been following and predicting the movements in the economy and wine business the past few years. Its been enough to make anyone gloomy especially since I've been consistently right. (Editors note: Please don't wake me and remind me of a forecast that was wrong. Thank you.)

Anyway, something happened yesterday that is making me put on economic sunglasses to protect my eyes: The Fed announced the economy is looking pretty darned good, inflation is in check, and unemployment is coming down to manageable levels. Add to that the US Credit Rating was raised back to AAA about 10 days ago and that is down right exciting right? What did the markets do? The Dow dropped 200+ points and the 10 year Treasury Bill rose 13 basis points. In fact the 10 year, which is the benchmark used for vineyard and acquisition financing has increased about 40 basis points since May. So what gives? If this is good news why is the market off and what does that mean for the wine business?


In conjunction with the other good news, the Fed announced they were going to pull the monetary sucker out of the Market's mouth of the toddler-like economic recovery, and targeted an end to their Quantitative Easing program starting early in 2014 and ending mid-year. The market has been feasting on cheap money for a long time and the announcement and timing was just a little more firm than many suspected, putting a damper on the investors mood.
 
Along with the announcement, the US dollar strengthened because there is now a higher return realized from investing in US$. In addition, the dollar also gained strength because the announcement demonstrated the US is not like Japan and won't be forever in a weak growth environment. A stronger dollar will mean we should see cheaper imports and that's a risk in a business that is running at balance to short in grapes and juice.

The announcement also signals an end to a cycle that has led to the lowest rates in the history of the US, and created a refinance stampede from wineries and vineyards in the past couple years. While the short term rates are for the present still low, the long end of the yield curve is trending up as noted to the left, and rates should continue to go higher based on this announcement. At some point in the next 24 months, it appears we are likely to see the short end of the rate curve start to rise as well.
 
Higher long term interest rates normally mean stabilized land values as higher interest costs mean larger property payments and a property can only produce so much in the way of cash flow so that lowers the sales price of land. In the case of vineyards, that may or may not prove out because the supply of vineyards is also lowish, and there has been a rush by many in the business to acquire new producing vineyards to support their programs driving land values higher. If this signals higher consumption levels, wineries will be looking for even more land. That's a long discussion and will have to wait for another Sunday.
 
The good news in all of this is the US Consumer is indeed making headway coming back and our economy is leading the World in showing recovery. Employed and confident consumers buy more wine, and higher priced wine. Higher bottle pricing will be needed if the wineries are going to be able to pass on the higher price of grapes that growers have been taking during the first half of this year. Consumers aren't quite there yet in being willing to spend more on wine but hopefully we will see that soon. That too is a blog post for another day.
 
Bottom line is the consumer is coming back so we might start spending our way back to prosperity .... which has always amused me ... that we can eat our way to prosperity, consume the worlds goods and be the envy of most other countries in the process. Doesn't that seem unnatural in some economic Darwinian way?

Back on point, this announcement signals rate increases will be coming. A 6% prime rate isn't that unusual. What happens to your winery's profitability if we see short term rates go up 3.00% in the next couple years at the same time consumers demand is growing and imports are cheaper?
 
Hopefully you've already locked in your capital and rate structure and got your piece of the cheap long term real estate money Ben Bernanke has been handing out, so your business wont be subject to a cycle of growth financed by higher priced debt in a margin strained wine industry.
 
Its a lot to digest and this barely touches the subject on the business and the changes we are going to see in this next cycle. For now I'd suggest you enjoy Friday because its all down hill after that ........... ( I'm talking about the hours of sunlight of course .....)
 

What do you think about the Feds announcement? Please sign in and offer your thoughts.

15 comments:

  1. I can't help but wonder what the point of all that cheap money was, since no one I know was able to get any.
    Perhaps all the big wineries enjoyed restructuring themselves with 1% interest rates, but none of the sub-conglomerates, were able to qualify. Neither Inventory nor real estate was good enough as collateral, for multi-million $$ operations I know of, and some are STILL unable to Re-Fi existing loans to lower rates, with ZERO cash out.

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    1. Thanks for the post Anon 9:06. Your perspective is reflective of underwater homes, but really not my experience as a banker in the wine business. Bankers always look for businesses that make profit to make payments, in the same way they look at your salary to make a home loan. If you don't have a salary, you wont find a home loan. In the same way, if the home is underwater you aren't going to find a larger enough home loan.

      Wineries large and small have benefited from the refinance craze in the past couple of years and that sets up stronger operations for the years ahead if some of that capital were taken as a fixed rate option. Those wineries shared the common trait of having enough profit to repay their debt, and collateral that had a strong enough appraisal to support the loan size.

      My experience is wineries who haven't refinanced and are in a good position to do so, probably have the problem of a large prepayment penalty facing them. But even in those cases, we've found successful ways to help.

      The banking market is quite competitive and looking for business these days, and very low rates and spreads over matching treasuries for A and B rated credit. I have yet to see a 1% loan though, especially since the cost of funds for a 10 year loan today is closer to 2.3%. It would be hard for a bank to make money paying 2.3% for the money and turn around and lend it out for 1.00%. The normal spreads are going to fall in the 200 - 300 basis point range depending on the risk of the deal and deal structure.

      Thanks again for posting your perspective. I appreciate it.

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  2. It's great that large business entities were able to make use of the cheap money made available to them, and they were able to restructure their financing to relieve debt load.
    Not so for the average US consumer. That increase in buying that's been seen recently is fueled in part by credit spending, and unless real income grows, how long will support for increasing wine prices last?

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    1. Todd - thanks so much for logging in with a name. So much nicer to call you Todd versus Anon X:XX. The average US consumer has indeed suffered, mostly because of the drop in home equity and thats where they had most of their wealth. For the first time last month in years, the number of underwater homes in the US dropped below 20%, and the consumer is in fact showing a resurgence. Many many consumers have been able to refinance however, just like the business. The consumers who haven't been able to refinance have been those out of work and those whose home is underwater. In both cases, the trends are improving and the sun is bright.

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  3. Spot on comments, Rob. The cheap money window is closing. Our children and grand children will probably not see such rates again. Even if rates go high (I do remember the late 1970's and early 1980's), business will go on. Imports may cost less due to exchange, but borrowing costs may rise in other producing countries, which may be some sort of offset. Howard R.

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    1. Thanks for the post Howard. For us macro nerds, these are interesting times. Where will our kids end up? Will they have this debt load on their backs? I say, who cares. Just don't cut my social security and medicare or I am going to live with them, and they will be sorry..... another Blog discussion for another day I'm afraid.

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  4. Rob, I think you should be named best business/industry blog. You are always ahead of everyone else with your analysis, and you seem to be right more often than not.

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    1. From one gloomy guy to another, that's a real ray of sunshine WC. Thanks. I will elect you my campaign manager. :o)

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  5. Rob,

    Do you expect a movement towards consolidation, either by smaller wineries going bankrupt or larger wineries scooping up these smaller wineries? The theory being that larger, more profitable wineries were able to refinance, while the smaller, less profitable might not be as credit worthy. Related to those small wineries, do you expect those wineries that buy their grapes (versus owning their own vineyards) to experience lower prices due to lower land costs (supply side) or are grape prices more a function of the demand side?

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    1. Andy - bankruptcies seldom happen in the wine business. Transitions do take place and are at a record pace these days. Smaller wineries have been getting acquired by larger ones, and vineyards have been getting purchased by insiders so as to control their own supply in a short market. The phenomenon has been going on for years and is something we called attention to probably 5-6 years ago. There are many reasons for this but interest rates probably wont speed up the process. More likely higher acquisition financing would slow it down a bit.

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  6. Another rough day for the markets after Ben's comments yesterday. The Dow Jones Industrial Average shed 353.87 points, or 2.3% to 14758.32 which is the biggest percentage drop since November 2011.

    The yield on the 10-year Treasury note reached 2.419%, its highest since August 2011. Since 4/26 when the yield was at its low of 1.70%, the benchmark bond has climed nearly 3/4 of a point. Each increase in that rate will increase a borrowers refinancing costs by the same amount.

    Mortgage backed securities were hit even harder today because if the Fed isn't buying Freddie and Fannie bonds, its unclear who will buy new originations. The 30 residential benchmark was above 4.14% today. As noted above in the blog, that will send a chill on residential values and purchases because of the leverage in home loans. For instance, if mortgage rates rise to 4.5%, that would increase a borrower's costs such that it would slash the amount of money he or she could afford to spend on a home by 11.25%. That is according to Scott Buchta, head of fixed-income strategy at Brean Capital. A 5% mortgage rate would reduce that buying power by 16.25%.

    Consistent with the blog discussion, there has been a world-wide sell off in currencies strengthening the dollar, because the "carry trade" or interest rates paid on our currency are going up. That makes foreign currencies less valuable.

    Just bringing a ray of sunshine to the day to add to the copious amount of daylight we are going to have tomorrow.

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  7. Rob, I enjoy your good sense in relation to the wine industry and also your economic analysis.

    Here is how I see it from afar, as an Australian. Looks like QE has been pushing funds directly into the stock market. Bonds and deposit rates have been abysmal. The stock market has been the only hope of ensuring that liquid assets can maintain their value. That depends upon the market rising continuously. Price of gold is on the slide. Again, this heats the market. US dollar has been appreciating pulling in more funds from overseas. This maintains the value of the US Dollar.

    But, at the first sign of better yields on fixed interest investments the bubble is pricked and stocks collapse.

    The peculiar thing is that as soon as the Dow slides a currency collapse occurs elsewhere so the US Dollar rises making it more difficult to re-build the US economy. Imports cheaper, exports less competitive. The US Government is up to its neck in debt internally and the external balance of payments is hopelessly out of whack so the US is very dependent upon maintaining the value of the US dollar.

    The only thing holding this house of cards together is the increasing value of the US Dollar. That phenomenon is the really surprising thing to me. Why does the rest of the world swallow US Dollars when the collateral that this borrower can offer is evaporating so fast. This has to end badly.

    Responsible bankers must be looking for an appreciating currency backed by a productive nation with cheap and energetic labour, ever expanding export capacity and an ability to balance both external and internal accounts. China. At some point the US dollar will collapse. Then, it will be seen that even the US has to behave with propriety. Balance the books.

    QE has been digging a hole. At some point the US will fall in. Then the market for expensive wine will evaporate.

    What say you?

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  8. Thanks for the post Erl. I follow much of your analysis and agree with many of your points. One of those I don't agree with is the conclusion.

    In the great depression many in the US predicted similar things about the luxury good markets.... and back then Luxury really meant something. While we can debate about the unemployment rate back then, the reality is about 80% of the country was still employe. The wealthy retained their wealth and did spend on luxuries and that market expansed dramatically post-WWII.

    Bottom line, consumers aren't homegenous. On average, they still can't afford expensive wine. So how is it that expensive wines have a higher growth rate than inexpensive wines? People have wealth and spend it.

    With respects to the hole we're digging, the real problem is entitlements like Social Security and Medicade as well as the interest on the National Debt. The balancing act the Government will be dealing with is using higher rates to squash inflation, but doing that without paying higher interest on the Nation's debt. If there is a hole to fall in, I'm guessing its going to be inflation.

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  9. Just because (the editorial) you weren't able to refi at low rates doesn't mean no one did! I was able to refi at 2.875% for 15 years, my home/business will be paid for about the time I am looking to retire...as you mentioned initially fiscal indicators are largely up, and you haven't discussed all the capital on the sidelines apparently looking for a sign from god to jump into business expansion and development...2012 was perhaps my best year ever and 2013 is up double digits over that, cannot complain!

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    1. Thanks for the comments WM11. Appreciate logging in and voicing your thoughts.

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