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good morning. McDonald’s played an outsized role in this year’s US presidential election. Kamala Harris and Tim Walz boasted about working at McDonald’s to hone their working-class integrity, and Donald Trump went to a Pennsylvania franchise on Sunday to flip burgers. Yesterday, McDonald’s stock fell nearly 6% in after-hours trading after the company said an E. coli outbreak was linked to its food. A metaphor for the current state of American politics? Please contact us via email: robert.armstrong@ft.com and Aiden.reiter@ft.com.
The term vigilante for insurance premiums and deposits
Government bond term premiums are rising again and are attracting market attention. For those who overslept the relevant parts of the bond class, who can blame you? A term premium is the yield offered by a single long-term bond over the expected yield of a series of short-term bonds. Typically, it is the difference between the yield on a 10-year Treasury note and the yield on 10 consecutive one-year Treasury notes.
This time, there is a clear consensus on what the long-term premium suggests, and investors are concerned about the sustainability of the U.S. fiscal situation.
“The term premium reflects investors’ willingness to lend money to the U.S. government over the next 10 years,” said Thorsten Slok of Apollo. If it rises (as it is currently doing), it would indicate that investors are more concerned about financial sustainability. “The reason[for higher premiums]is that people are concerned about their financial situation and are selling $10,” said BNP Paribas’ Calvin Tse. Tse particularly blames rising expectations for a landslide victory for the Republican Party in next month’s U.S. elections, which he believes would result in a much larger budget deficit than a Harris victory and a divided government. are.
In other words, the rise in term premiums is the work of the Bond Vigilantes, a ruthless gang that once kept the government honest but is widely believed to have retired.
While this interpretation makes sense in itself, it oversimplifies a complex and opaque situation. This is a graph of two standard term premium estimates. Each is an acronym for the economist who created them. The ACM model is built solely on yield data. KW layer for yield prediction.
The first and perfectly obvious point to make here is that while term premiums have risen, they are not far outside the range of recent measurements and remain very low by historical standards. (The average going back to 1990 is more than 1.1 percent per year). 0.8% for the ACM model and 0.8% for the KW model). We must always keep in mind the idea that the term premium is a measure of financial sustainability and is waving particularly red flags at the moment.
The second, more slippery point is that an increase in term premiums can mean a variety of things. A year ago, when premiums were last rising sharply, Unhedged wrote a series of articles about this, noting, among other things:
Term premiums can result from a mismatch between demand and supply of long-term bonds. Fiscal alarmism (is that a word?) is just one possible reason for this discrepancy. These include changes in demand from commercial banks, central banks, or foreign investors (such as Japan) depending on local financial conditions.
If the negative correlation between stock and bond returns breaks down, term premiums may also rise. If bonds do not hedge stocks, investors would like to receive more compensation for holding bonds. And this tends to happen when inflation is high and central banks have to raise interest rates (see: Scary 2022). So if economic data picks up and investors become more concerned about inflation and believe the Fed may have to reverse course and tighten policy again, the term premium will rise. It’s natural. That’s exactly what’s happening now.
Indeed, if everyone knows that the secular bull market in bonds is over, it makes sense for term premiums to rise. Currently, no one expects much from capital gains on long-term bonds. They want yield.
We will wait for more definitive movement in the term premium before celebrating the return of bond vigilantes.
Say “Fire the CEO” instead of “Fire the CEO”
A few days ago, Unhedged wrote about activist investor Starboard Value’s bizarre tilt toward Pfizer. Yes, Pfizer has a problem, but that’s exactly the problem with the pharmaceutical industry. The company is not growing and does not have any new drugs that are expected to become profitable soon. The only real solution to this kind of problem is to develop or buy drugs that really work. This depends on the results of strong clinical trials, but it simply cannot survive by will. It takes time and luck.
All of this is far from what activists do best: improving capital allocation, separating non-core businesses, and eliminating unprofitable product lines. Sure, Pfizer could have bought another company or bet on another molecule, but that’s just the bottom line: “Next time, get the drug that will make you a lot of money!” There is no point in crying out. If a drug development strategy needs a reboot, it will be a project that comes to fruition years after activist investors have exited.
We suggested that one thing Starboard could do was to seek the removal of CEO Albert Bourla. This is an immediate action that demonstrates the company’s commitment to taking time-consuming, difficult and necessary turnaround-type efforts. In other words, stock prices can move within the activist investor’s time frame.
Yesterday, Starboard detailed its investment case for Pfizer at a conference (slide deck can be found here). The presentation did not call for Bourla’s removal, but it came very close. Productivity in drug development in recent years has been abysmal, the magazine said, and Bourla himself told investors early in his tenure that they should be judged on this very basis. Therefore, the presentation concluded as follows: “Boards need to actively hold management accountable for reaping appropriate returns from future R&D and M&A.” That sounds like code for “fire Bourla” to us. . Only the last tagged “forward” leaves room for another interpretation.
A strategically interesting question is why the Starboard team decided to use the code in the first place. They may be calculating that it will make a greater impression on the market if the board explicitly raises the issue of management change first. They may be right about this. Furthermore, the company may be calculating that making it clear could solidify the board’s resolve. Again, this seems correct. But there is absolutely no doubt as to what Starboard’s strategy is.
Pfizer stock didn’t move yesterday. We expect Starboard to drop the code soon.
A book I read often
Compete against Nobel Prize winners.
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