Consumer Stocks: The Long and Short of it

 

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, American publisher and author

 

“When thinking about the future, it is fashionable to be pessimistic. Yet the evidence unequivocally belies such pessimism. Over the past centuries, humanity’s lot has improved dramatically – in the developed world, where it is rather obvious, but also in the developing world, where life expectancy has more than doubled in the past 100 years.” – Bjørn Lomborg, Danish author and President of Copenhagen Consensus Center

 

“What day is it?” asked Pooh.

“It’s today,” squeaked Piglet.

“My favourite day,” said Pooh.

Alexander Alan Milne

 

American consumers are the driving engine of the US economy – consumer spending is estimated to represent about two-thirds of US economic output. If sentiment surveys and retail sales are anything to go by then the American consumer, and by extension the US economy, is in rude health.

Consumer sentiment, as tracked by the University of Michigan, in September jumped to its second-highest level since 2004.

According to the Commerce Department, US retail sales increased by 6.6 per cent year-over-year in August – running well ahead of inflation. Month-on-month growth, however, was disappointing with August sales only increasing 0.1 per cent over July – whilst somewhat unsatisfactory, monthly comparisons tend to have a very low signal-to-noise ratio and are therefore misleading to read into, in our opinion.

Given the robust retail sales and soaring consumer sentiment, one would expect investors to be all bulled up on consumer stocks. Yet, as we compare the level of short interest across the constituents of the S&P500 Index we find that the greatest concentration of shorts (relative to free float) is in consumer related stocks. Investors remain circumspect about the prospects of consumer focused companies due to the potential impact of (i) rising interests on the disposable income of US consumers, and (ii) escalating trade tensions between the US and China on the companies’ supply chains, which in turn could meaningfully increase their cost of goods.

The below chart shows the average level of short interest (as a percentage of free float) by industry group. (Consumer related industry groups are highlighted in yellow.)

 

Average Short Interest across S&P500 Index by Industry Group 1Source: Bloomberg

The above chart shows that all but one of the consumer related industry groups has a higher level of short interest than the average level of short interest for a stock in the S&P500 Index. Moreover, the top three most shorted industry groups are all consumer related.

To further dissect the level of short interest across consumer related stocks, we focus in on the constituents of the SPDR S&P Retail $XRT and iShares US Consumer Goods $IYK exchange traded funds.

 

Retail

The average level of short interest for $XRT constituents is 7.5 per cent of free float. The most shorted sub-industry groups are food retail (something we have written about recently in The Challenge for Food & Beverage Retail Incumbents), automotive retail, and drug retail.

Average Short Interest across $XRT by Sub-Industry Group 2Source: Bloomberg

American department store chain Dillard’s is the most shorted stock amongst the constituents of $XRT with short interest making up a whopping 66.2 per cent of free float. The high level of short interest in the stock has not been rewarded by a declining price this year – the stock has generated a total return of 31.5 per cent year-to-date (as at market close on 19 September, 2018).

A further seven constituents have short interests that exceed 30 per cent of their free float, namely: Overstock.com (45.7 per cent), JC Penney (45.7 per cent), GameStop (39.6 per cent), Camping World Holdings (39.3 per cent), Hibbett Sports (36.4 per cent), The Buckle (36.0 per cent) and Carvana (31.3 per cent). The performance of these stocks has been more mixed with online retail company Overstock.com down 58.8 per cent year-to-date while online car dealer Carvana has generated an astonishing 208.3 per cent return year-to-date.

Many of the heavily shorted retail stocks appear to us to be the companies investors view as the mostly likely to be “Amazoned” in the near term.

 

Top 30 Most Shorted $XRT Constituents 3Source: Bloomberg

 

Total Return Year-to-Date of the Top 30 Most Shorted $XRT Constituents 4Source: Bloomberg

 

Generally, being short retail stocks has not been rewarding this year. The price return of $XRT is 14.2 per cent year-to-date versus 9.6 per cent year-to-date for the S&P500 Index.

 

Scatter Plot of Short Interest versus Year-to-Date Total Return for $XRT Constituents 5Source: Bloomberg

Note: Chart excludes Dillard’s and Caravan

 

Consumer Goods

The average level of short interest for $IYK constituents at 6.2 per cent of free float is lower than for $XRT constituents but still significantly higher than the average for the S&P500 Index. The most shorted sub-industry groups are tires & rubber, home furnishings and housewares & specialties.

Rising mortgage rates and the home buyer affordability index at ten-year lows are the likely reasons for the high levels of short interest in the home furnishings and housewares & specialties segments.

Average Short Interest across $IYK by Sub-Industry Group 6Source: Bloomberg

 

Only two stocks amongst the $IYK constituents have a short interest to free float ratio exceeding 30 per cent: B&G Foods (32.7 per cent) and Under Armour (31.8 per cent).

Generally, being short consumer goods stocks has been more rewarding than being short retail stocks. $IYK is down 3.5 per cent year-to-date. (We wrote about our concerns relating to the consumer goods sector last year in Unbranded: The Risk in Household Consumer Names.)

 

Top 30 Most Shorted $IYK Constituents 7Source: Bloomberg

 

Total Return Year-to-Date of the Top 30 Most Shorted $IYK Constituents 8Source: Bloomberg

 

Scatter Plot of Short Interest versus Year-to-Date Total Return for $IYK Constituents 9Source: Bloomberg

 

 

Investment Perspective

 

There is, we think, no clear playbook when it comes to heavily shorted stocks. Some portfolio managers we have interacted with in the past have occasionally gone long ‘consensus shorts’. Their track record is middling; they have done very well at times but also been burnt badly at other times.

Our approach is to identify heavily shorted stocks where we have a differentiated view on the prospects of near term earnings, valuation or the potential for the company to be acquired and to go long those stocks. (These lessons have been hard learned over time as in the past we have found ourselves far too closely aligned with consensus – as George S. Patton is known to have said: ‘If everyone is thinking alike, then somebody isn’t thinking’.)

In the instances our positioning and views prove correct, the high level of short interest acts like leverage and greatly amplifies returns in a relatively short amount of time.

Earlier this year we went long Under Armour based on our view that consensus earnings expectations had been deflated to such a degree that there was very little chance for the company to disappoint – with the stock price languishing at multi-year lows we deemed there to be little downside even if the company disappointed. As it transpired, the consensus view was indeed far too bleak and the stock quickly re-rated higher as the company outdid lowball expectations.

More recently, on 24 July, we went long and remain long kitchenware and home furnishings company Williams Sonoma $WSM. Short interest for the stock stands at over 20 per cent of free float, the company generated a best-in-class operating return on invested capital of 18.4 per cent in 2017 and trades at around consensus forward price-to-earnings of 15.4 times.

The retail and consumer goods sectors remain our preferred areas to search for heavily shorted stocks where we may have or develop a differentiated view.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Financial Misery and the Flattening Yield Curve

 

“Every day is a bank account, and time is our currency. No one is rich, no one is poor, we’ve got 24 hours each.” – Christopher Rice, bestselling author

 

“He tried to read an elementary economics text; it bored him past endurance, it was like listening to somebody interminably recounting a long and stupid dream. He could not force himself to understand how banks functioned and so forth, because all the operations of capitalism were as meaningless to him as the rites of a primitive religion, as barbaric, as elaborate, and as unnecessary. In a human sacrifice to deity there might be at least a mistaken and terrible beauty; in the rites of the moneychangers, where greed, laziness, and envy were assumed to move all men’s acts, even the terrible became banal.” – Excerpt from The Dispossessed by Ursula K. Le Guin

 

“A bank is a place that will lend you money if you can prove that you don’t need it.” – Bob Hope

 

Before we get to the update, just a quick comment on the New York Times op-ed “I Am Part of the Resistance Inside the Trump Administration” written by a hitherto anonymous member of the Trump Administration, which we suspect many of you have already read. Our reaction to the piece is that an “elite” politician issuing an editorial in a highbrow broadsheet and talking of resistance against the President is far more likely to stoke populism than to weaken it. Moreover, as angry as President Trump may appear to be about the editorial on television, it gives him just the kind of ammunition he needs to drum up the “us against them” rhetoric and rouse his core supporters to turn up to vote during the forthcoming mid-term elections.

Moving swiftly on, this week we write about US financials.

 

Financials have not had a great year so far. The MSCI US Financials Index is up less than one per cent year-to-date, tracking almost 7 per cent below the performance of the S&P500 Index. While the equivalent financials indices for Japan and Europe are both down more than 11 per cent year to date.

At the beginning of the year, investors and the analyst community appeared to be positive on the prospects for the financial sector. And who can blame them? The Trump Tax Plan had made it through Congress, the global economy was experiencing synchronised growth, progress was being made on slashing the onerous regulations that had been placed on the sector in the aftermath of the global financial crisis, and banks’ net interest margins were poised to expand with the Fed expected to continue on its path of rate hikes.

 

So what happened?

We think US financials’ under performance can in large part be explained by the flattening of the US yield curve, which in turn can result in shrinking net interest margins and thus declining earnings. The long-end of the US yield curve has remained stubbornly in place, for example 30-year yields still have not breached 3.25 per cent, and all the while the Fed has continued to hike interest rates and pushed up the short-end of the curve.

 

Why has the long-end not moved?

There are countless reasons given for the flattening of the yield curve. Many of them point to the track record of a flattening and / or inverted yield curve front running a recession and thus conclude with expectations of an imminent recession.

The Fed and its regional banks are divided over the issue. In a note issued by the Fed in June, Don’t Fear the Yield Curve, the authors conclude that the “the near-term forward spread is highly significant; all else being equal, when it falls from its mean level by one standard deviation (about 80 basis points) the probability of recession increases by 35 percentage points. In contrast, the estimated effect of the competing long-term spread on the probability of recession is economically small and not statistically different from zero.”

Atlanta Fed President, Mr Raphael Bostic, and his colleagues on the other hand see “Any inversion of any sort is a sure fire sign of a recession”. While the San Francisco Fed notes that “[T]he recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession”.

Colour us biased but we think the flattening of the yield curve is less to do with subdued inflation expectations or deteriorating economic prospects in the US and far more to do with (1) taxation and (2) a higher oil price.

US companies have a window of opportunity to benefit from an added tax break this year by maximising their pension contributions. Pension contributions made through mid-September of this year can be deducted from income on tax returns being filed for 2017 — when the U.S. corporate tax rate was still 35 per cent as compared to the 21 per cent in 2018. This one-time incentive has encouraged US corporations to bring forward pension plan contributions. New York based Wolfe Research estimates that defined-benefit plan contributions by companies in the Russell 3000 Index may exceed US dollars 90 billion by the mid-September cut-off – US dollars 81 billion higher than their contributions last year.

US Companies making pension plan contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference this year is the tax rate cut and the financial incentive it provides for pulling contributions forward.

Given that a significant portion of assets in most pension plans are invested in long-dated US Treasury securities, the pulled forward contributions have increased demand for 10- and 30-year treasuries and pushed down long-term yields.

Higher oil prices, we think, have also contributed to a flattening of the yield curve.

Oil exporting nations have long been a stable source of demand for US Treasury securities but remained largely absent from the market between late 2014 through 2017 due to the sharp drop in oil prices in late 2014. During this time these nations, particularly those with currencies pegged to the US dollar, have taken drastic steps to cut back government expenditures and restructure their economies to better cope with lower oil prices.

With WTI prices above the price of US dollars 65 per barrel many of the oil exporting nations are now generating surpluses. These surpluses in turn are being recycled into US Treasury securities. The resurgence of this long-standing buyer of US Treasury securities has added to the demand for treasuries and subdued long-term yields.

 

Investment Perspective

 

A question we have been recently asked is: Can the US equity bull market continue with the banking sector continuing to under perform?

Our response is to wait to see how the yield curve evolves after the accelerated demand for treasuries from pension funds goes away. Till then it is very difficult to make a definitive call and for now we consider it prudent to add short positions in individual financials stocks as a portfolio hedge to our overall US equities allocation while also avoiding long positions in the sector.

We have identified three financials stocks that we consider as strong candidates to short.

 

Synovus Financial Corp $SNV 

 

SNV

 

Western Alliance Bancorp $WAL

 

WAL 

Eaton Vance Corp $EV

 

EV

 

 This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

US Stocks: Long, Short and Interesting

“We often plough so much energy into the big picture, we forget the pixels.” – Silvia Cartwright

As highlighted last week, the focus is on equities this week. Instead of the usual text heavy approach, we do a quick run through of more than a handful of US stocks including some that we already hold, would like to add to our holdings, and consider as candidates for the short side.

The approach we have taken is as thematic as we could possibly make it. Stocks that do not fall under a theme have been left out of today’s piece, we will aim to issue a follow-up piece in the next week or two to cover  individual stocks that we are monitoring but do not neatly fit under a clear investment theme at present.

[Note that our typical investment horizon ranges from 6 to 18 eighteen months for any position. With the caveat that if a stock significantly re-rates higher or lower due to a material development or otherwise, we may exit the position sooner.]

Semiconductors and Fabrication

In AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote:

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

Supply related concerns and forward earnings expectations reaching unreasonable levels have certainly slowed the upward march of semiconductor stocks; and we are seeing weakness across the semiconductors and fabrication spectrum. We consider the following stocks as potential candidates for shorting.

ON Semiconductor $ON

A spin-off of Motorola, $ON supplies semiconductor products across a wide spectrum of end-uses including those for power and signal management, logic, discrete, and custom devices for automotive, communications, computing, consumer, industrial, LED lighting, medical, military/aerospace and power applications.

As per Bloomberg, there are 21 analysts recommendations for the stock, 14 of them buys, an 5 holds and only 2 sells.

If the company disappoints, as we suspect that it will, a flurry of downgrades could well push the stock much lower.

ON.PNG

Cypress $CY

$CY designs and manufactures programmable system-on-chip integrated circuits, USB and touchscreen controllers, and programmable clocks for the automotive, industrial, home automation and appliances, consumer electronics and medical products industries.

CY.PNG

Entegris $ENTG

$ENTG  designs and manufactures contamination control, microenvironment, and specialty materials products and systems to purify, protect, and transport critical materials used in the semiconductor device fabrication process.

As per Bloomberg, the stock current trades almost 30% below the average target price of the 11 analysts that cover the stock.

ENTG.PNG

Marvell Technology $MRVL

$MRVL designs analog, digital, mixed-signal and microprocessor integrated circuits for storage, telecommunications, cloud storage and consumer markets.

MRVL.PNG

Retail

According to data released earlier this week, retail sales rose a seasonally adjusted 0.5 per cent in July from the prior month, well ahead of economists’ forecasts for a 0.1 per cent increase.

Year-over-year retail sales are up a robust 6.4 per cent, tracking well ahead of inflation, as measured by the consumer price index.

Low unemployment levels combined with the windfall from tax cuts is contributing to strong consumer sentiment and high levels of spending across the majority of retail categories.

We have already witnessed Walmart $WMT reporting  its strongest US sales growth in more than a decade, which sent the stock soaring higher. We have been long $WMT since September last year and at the time of initiating the positioning, we wrote:

$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential

WMT.PNG

Another retail name we have been long  is Dollar General $DG, we initiated a position in the stock in November last year.

DG.PNG

We still expect further upside in both $WMT and $DG and continue to hold them. Generally, we continue to see strength across the retail complex and may look to add long positions in at least two more stocks.

Burlington Stores $BURL

$BURL operates more than 630 off-price department stores across the US.

The company is expected to report quarterly earnings on 22 Aug with consensus analyst estimates for earnings growth of 33 per cent for the quarter, and 37 per cent growth for the full year. Annual earnings estimates were recently revised upward.

BURL.PNG

Dunkin’ Brands Group $DNKN

$DNKN is a restaurant holding company and franchiser of two chains of quick service restaurants: Dunkin’ Donuts and Baskin Robbins. The company franchises over 20,000 Dunkin’ Donuts and Baskin Robbins ice cream parlours in the US and across 60 international markets.

DNKN.PNG

Payment Processing

Driven by the rise of global e-commerce and internet-connected mobile devices, physical money is being snubbed in favour of cards and other digital payment options. According to Capgemini, global non-cash transactions are expect to grow at CAGR of 10.9 per cent between 2015 and 2020 and reach US dollars 725 billion.

This secular trend toward ever increasing non-cash transactions is in favour of payment processors – both the near ubiquitous players (e.g. VISA and MasterCard) and niche solutions providers.

We added FleetCor Technologies $FLT to our long trade ideas in June.

$FLT is an independent provider of specialised payment products and services to commercial fleets, major oil companies and petroleum markets.

The company’s payment cards provide significant savings and benefits to local fleets, including purchase controls, lower fraud, and specialised reporting. Penetration levels for the payment cards are relatively low at around 50% and there is significant potential for the company to gradually increase penetration levels.

We continue to hold the stock.

FLT.PNG

Cardtronics $CATM

We will be looking to add $CATM as a second name under the payment processing theme.

$CATM is the world’s largest non-bank ATM operator and a leading provider of fully integrated ATM and financial kiosk products and services.

The company owns Allpoint, an interbank network connecting ATMs. Allpoint offers surcharge-free transactions at ATMs in its network and operates in the US, Canada, Mexico, United Kingdom, and Australia.

Allpoint is in the business of supporting any financial institution provide an ATM network to rival the very largest banks. Allpoint today offers more than 55,000 surcharge-free ATMs to over 1,000 financial institutions.

$CATM’s has recently updated its strategy to increasingly focus on expanding Allpoint’s network and penetration amongst financial institutions.

The company’s strategy update has been accompanied by a strong level of insider buying.

CATM.PNG

Energy Infrastructure and Mid-Stream Services

In April we issued a piece on the opportunities arising out of the infrastructure bottlenecks in shale patch in the US – Oil: Opportunities Arising from Infrastructure Bottlenecks

At the time we identified two industrial equipment suppliers that could benefit from increased demand originating from the shale patch: SPX Flow $FLOW and Flowserve $FLS. Although the stocks have yet to perform we continue to see significant opportunities in the energy infrastructure space and hold on to them.

FLS.PNG

FLOW.PNG

Given the scale of the opportunity in the sector, we think there is a lot of room to add additional names to better play the overall theme.

IDEX Corp $IEX

$IEX is engaged in the development, design, and manufacture of fluid handling systems,  and specialty engineered products.Its products include pumps, clamping systems, flow meters, optical filters, powder processing equipment, hydraulic rescue tools, and fire suppression equipment, are used in a variety of industries.

IEX.PNG

UGI Corp $UGI

$UGI is a holding company with interests in propane and butane distribution, natural gas and electric distribution services.

UGI.PNG

Targa Resources Corp $TRGP

$TRGP  is one of the largest providers of natural gas and natural gas liquids in the US. The company’s operations are predominantly concentrated on the Gulf Coast, particularly in Texas and Louisiana.

TRGP.PNG

Digitalisation

Digitisation is the process of converting information from a physical format into a digital one. When this process is utilised to automate and / or enhance business processes and activities, it is referred to ‘digitalisation’.

Digitalisation is concerned with businesses adopting digital technologies to create new revenue streams and / or improving operational processes. Digitalisation is not something new, businesses have been actively engaged in digitalising their operations for decades. The rise of big data, Moore’s law continuing to hold true as it relates to integrated circuits and the ever dropping cost of electronic components, however, has meant that its adoption has started to accelerate in recent years.

Amazon’s supermarket with no checkouts is an example of an outcome when a business fully embraces digitalisation.

We currently do not have any open positions under this theme. We are looking to add longs in two names.

Trimble $TRMB

$TRMB developer of Global Navigation Satellite System receivers, laser rangefinders, unmanned aerial vehicles , inertial navigation systems and software processing tools. The company is best known for its for GPS technology.

The company provides integrated solutions that enable businesses to to collect, manage and analyse complex information.

$TRMB is renowned for having deep domain knowledge of the industries it provides integrated solutions for and generally caters markets ripe for or undergoing rapid digitalisation.

TRMB

Zebra Technologies $ZBRA

$ZBRA  is in the business of  enterprise tracking and manufactures and sells marking, tracking and computer printing technologies primarily to the retail, manufacturing supply chain, healthcare and public sectors. Its products include direct thermal and thermal transfer printers, RFID printers and encoders, dye sublimation card printers,  handheld readers and antennas, and card and kiosk printers.

The  company achieved an adjusted EPS of US dollars 2.48 a share in the second quarter, up 64 per cent year-over-year. Sales rose 13 per cent to US dollars 1.012 billion. The company beat consensus estimates of  US dollars 2.23 in EPS and sales US dollars $989 million.

ZBRA.PNG

Software as a Service (SaaS)

We quote from venture capitalist Marc Andreessen’s seminal essay from 2011:

“This week, Hewlett-Packard (where I am on the board) announced that it is exploring jettisoning its struggling PC business in favor of investing more heavily in software, where it sees better potential for growth. Meanwhile, Google plans to buy up the cellphone handset maker Motorola Mobility. Both moves surprised the tech world. But both moves are also in line with a trend I’ve observed, one that makes me optimistic about the future growth of the American and world economies, despite the recent turmoil in the stock market.

In short, software is eating the world.”

Mr Andreessen’s words ring just as true today as they did back in 2011. Software, specifically SaaS, has continued to proliferate and we have increasingly witnessed the rise of SaaS companies that provide solutions tailored to the needs of individual industries or specific functions within a business.

We are looking to go long two names under this theme.

Paycom $PAYC

$PAYC designs and develops cloud-based human capital management software solutions to support businesses in managing the entire employment life cycle.

$PAYC is a highly disruptive company that is successfully displacing entrenched incumbents across the payroll management space.

Businesses tend to use software to make their employees’ lives easier and to reduce their day-to-day administrative burden. Ask any business, big or small, they will tell you that compliance is a major headache. And there is a lot businesses have to comply with, particularly in the US. Payroll software allows businesses to comply with tax and other payroll related laws. $PAYC started life as a payroll management software provider.

$PAYC’s software solutions have long since evolved beyond payroll management and include applications for talent management, recruitment and general human capital management. Payroll management is serves as the company’s entry product for new customers and the added solutions provide $PAYC with the opportunity to gradually up sell existing customers.

PAYC.PNG

Veeva Systems $VEEV

$VEEV is a cloud-computing company focused on providing solutions for the sales and marketing functions within the pharmaceutical and life sciences industries. The company’s software helps pharmaceutical companies manage customer databases, track drug developments, and organize clinical trials. The software has been widely adopted by ‘Big Pharma’.

The company’s lower-cost and tailored approach has enabled it to upend the on premise software providers such as SAP and Oracle in the pharmaceutical and life sciences sectors.

While the company maintains its core focus in life sciences, it is gradually broadening its products’ functionality to enable it to up sell existing clients and to potentially enter into new industry segments.

VEEV.PNG

Plenty of names for you to chew on for this week. If you would like to discuss any of the names in more detail or to talk you through our more detailed investment cases, feel free to reach out to us over email or by direct message on Twitter.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Continued Strength in the US Dollar | China’s Line in the Sand | Germany Between a Rock and a Hard Place

 

“One benefit of summer was that each day we had more light to read by” – Jeanette Walls, American author and journalist

 

“The best of us must sometimes eat our words.” – J. K. Rowling

 

“Increasingly, the Chinese will own a lot more of the world because they will be converting their dollar reserves and U.S. government bonds into real assets.” – George Soros

 

We have a mixed bag here for you this week folks with commentary on:

  • The strength in the US dollar
  • China’s response to Trump’s latest threats to escalate the trade war
  • Germany’s energy needs placing it between a rock and a hard place

 

Continued strength in the US dollar

A number of you have messaged us about the recent strength in the US dollar and our take on it. For the benefit of all readers, we briefly wanted to touch upon where we stand after the latest move higher by the greenback.

Back in March – Currency Markets: “You can’t put the toothpaste back in the tube” – we wrote:

 

The major central banks of the world are now in a competitive game. While markets may enter an interim phase where the Fed’s hawkish posturing leads to a strengthening dollar, this phase, in our opinion, is likely to be short-lived.

 

The line in the sand beyond which we would consider our view to be invalidated is a sustained move above 96 on the US dollar index.

 

At the time we wrote the above, we were unaware of how or why the 96 level was going to prove to be a significant level for the US dollar. However, we felt that psychologically it was a critical level for market participants. The dramatic plunge in the Turkish lira today, the sentiment being displayed across key media outlets and the general tone on Twitter all seem to validate that around 96 on the DXY is indeed an important level.

For now all we would add is that we are in wait and see mode. If the US dollar continues to move higher or remains above the 96 for a prolonged period (6 to 8 weeks), we would have to accept that our bearish view on the US dollar was wrong. If, however, the greenback fails to sustain above 96 we would likely look to put on carry trades in emerging market currencies and go long the euro and Japanese yen.

Until we have more clarity we will remain on the side lines.

 

China’s Line in the Sand

Last week, the People’s Bank of China (PBoC) imposed a reserve requirement of 20 per cent on some trading of foreign-exchange forward contracts, effectively increasing the cost of shorting the Chinese yuan. The move has offset some of the pressure from President Trump’s threats to further escalate the trade war and has brought stability to the currency.

Official statements indicate that the PBoC made the move to reduce both “macro financial risks” and the volatility in foreign exchange markets.  To us the move by the PBoC, however, suggests that China is not yet ready to trigger a sharp devaluation of its currency in the trade war with the US.

What is more confounding, however, is figuring out what China can do to respond to the threats of further escalation of the trade war by the Trump Administration. Initially China tried to appease Mr Trump by:

  • Lavishly hosting him in China;
  • Offering to increase imports from the US to reduce its trade surplus;
  • Proposing to gradually opening its local markets to US corporations; and even
  • Engaging in commercial dealings in favours of Mr Trump’s family;

Failing at that, China has tried to respond by:

However, China’s retaliatory efforts have not swayed Mr Trump either.

The problem, as we described in Trade Wars: Lessons from History, is one of creed:

 

President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain.

 

Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

The only way we see the Trump Administration relenting in its push to corner the Chinese is if Trump the “dealmaker” takes control of proceedings. That is, in his desire to make a deal and claim victory, President Trump tells his band of trade warriors and security hawks to take a backseat and instead strikes a deal with China that involves a combination of China buying more from the US and opening up its markets to more foreign ownership (something we suspect China wants to do any way, but on its own terms).

 

Germany: Stuck Between a Rock and a Hard Place

President Trump began his visit to the annual summit of NATO allies in June this year by breaking from diplomatic protocol and verbally attacking Germany:

 

“We’re supposed to protect you from Russia, but Germany is making pipeline deals with Russia. You tell me if that’s appropriate. Explain that.”

 

In May 2011 Germany decided to abandon nuclear power in favour of greener sources of energy such as wind and solar. Nuclear power accounted for almost a fifth of Germany’s national electricity supply at the time Chancellor Angela Merkel announced plans to mothball the country’s 17 nuclear power stations by 2022 following the Fukushima Daiichi nuclear disaster in 2011.

Germany, however, failed in its attempt at adequately fulfilling a greater proportion of its energy needs through alternative sources of renewable energy. And the direct consequence of Chancellor Merkel’s decision to drop nuclear power has been that Germany has become increasingly dependent on Russia’s plentiful natural gas supplies.

Germany has a difficult decision to make. Does it choose to maintain its geopolitical alliance with the US and abstain from Russian gas or does it choose cheap gas and re-align itself geopolitically?

German Foreign Minister Heiko Maas’ interview on 9 August suggests that Germany may well be leaning towards the latter (emphasis added):

 

“Yes, in future we Europeans will have to look out for ourselves more. We’re working on it. The European Union has to finally get itself ready for a common foreign policy. The principle of unanimity in line with which the European Union makes its foreign policy decisions renders us incapable of taking action on many issues. We’re in the process of transforming the European Union into a genuine security and defence union. We remain convinced that we need more and not less Europe at this time.”

 

Russia is under US sanctions. China is under pressure from the US. And now Germany – in no small part due to its massive trade surplus with the US – finds itself in the cross-hairs.

What if Russia, China and Germany were to form an economic, and dare we ask political, alliance? Something that would have seemed far-fetched less than a year ago, does not seem to sound so crazy anymore.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Trade Wars: Lessons from History

 

“There is nothing new in the world except the history you do not know.” – Harry Truman

 

“Give us a protective tariff and we will have the greatest nation on earth” – Abraham Lincoln

 

“If a nation expects to be ignorant and free, in a state of civilisation, it expects what never was and never will be.” – Thomas Jefferson

 

At the Luzhniki Stadium in Moscow last week, France defeated Croatia in the final of 2018 FIFA World Cup. As the French toasted their second FIFA World Cup triumph, pundit upon pundit and football fan after football fan debated the manner of France’s victory and the controversial decisions that went France’s way. Our small group of friends and colleagues also got caught up in a debate on whether the referee rightly or wrongly rewarded the penalty that led to France’s second goal. Our debate was not limited to those of us that watched the match together but rather extended to our WhatsApp groups and roped in friends from all over the world.

It is often said that it is human nature to see what we want to see and ignore that which goes against our expectations.

As our arguments for and against the penalty went round and round in circles, we decided to watch replays of the incident from the match to try and settle which side of the debate had more merit. The funny thing is as we watched the replays the conviction levels on either side of the debate became even stronger. By some means what each of us saw, or at least thought we saw, reaffirmed our predisposition.

Of course, whether it was a penalty or not (it wasn’t) does not really matter. The record books will show that the French defeated the Croats by four goals to two. There will be no asterisk next to the record to note that arm chair fan Joe Schmoe disputed the validity of France’s victory due to the award of a dubious penalty.

Reflecting upon the harmless nature of our argument, we think of the oft quoted words of Winston Churchill:

“Those who fail to learn from history are doomed to repeat it.”

Powerful statements can often hide as much as they reveal.

Can we learn what actually happened from studying history? Unlike the final score of a football match, the record of any past event that cannot be definitively quantified is likely to be clouded by the prejudices of historians and distorted by our individual partisanship.  And if we do not truly know what happened, can we really be doomed to repeat it?

Reality or not, below we examine the recorded history of American protectionism, reflect upon the successful adoption of the ‘American System’ by China and consider the possible outcomes of the rising trade-related tensions between the US and China.

 

American Independence and British Retaliation

On 18 April 1775, a clash between the British redcoats and the local militia at Lexington, Massachusetts, led to the fighting that began the American War of Independence.

Fifteen months after fighting began the American colonists claimed independence from the British and Thomas Jefferson drafted the Declaration of Independence.

The British did not take the colonists’ declaration lying down and made attempts to forcibly regain control over America. Economic warfare was one of the tools used by the British to inflict pain upon the Americans.

Britain closed off its markets to American trade by raising tariffs on American manufactured goods. US exports to England and its colonies fell from an estimated 75 per cent of total exports prior to the Declaration of Independence to around 10 per cent after it. The sharp fall in trade brought on an economic depression in the US.

Britain did not stop at just tariffs. It wanted to halt the US’s transformation from its agrarian roots to an industrialised nation and in this pursuit it went as far as outlawing skilled craftsmen from overseas travel and banning the export of patented machinery.

 

The American System

The American System, also known as the American School of Economics, is an economic plan based on the ideas of Alexander Hamilton, the first Secretary of the Treasury of the United States, which guided the US national economic policy from first half of the 19th century till the early 1970s. The system is widely credited as having underpinned the US’s transformation from an agrarian frontier society to global economic powerhouse.

The American System is rooted in the mercantilist principles presented by Alexander Hamilton to Congress in December 1791 in the Report on the Subject of Manufactures. The three basic guiding economic principles of the system demanded the US Government to:

  1. Promote and protect American industries by selectively imposing high import tariffs and / or subsidising American manufacturers;
  2. Create a national bank to oversee monetary policy, stabilise the currency and regulate the issuance of credit by state and local banks; and
  3. Make internal improvements by investing in public infrastructure – including but not limited to roads, canals, public schools, scientific research, and sea ports – to facilitate domestic commerce and economic development.

These guiding principles are based on Alexander Hamilton’s insight that long-term American prosperity could not be achieved with an economy dependent purely on the financial and resource extraction sectors. And that economic self-sufficiency hinged upon the US Government intervening to protect and to support the development of captive manufacturing capabilities.

Alexander Hamilton’s ideas were not immediately accepted by Congress – Congress was dominated by Southern planters, many of whom favoured free trade. One Thomas Jefferson, in particular, vehemently opposed Hamilton’s protectionist proposals.

Congress and Jefferson became much more receptive to Hamilton’s ideas in the aftermath of the Anglo-American War of 1812, during which the British burnt down the White House. The government’s need for revenue and a surge in anti-British fervour, in no small part, made favouring Hamilton’s proposals politically expedient for Congress.

In 1816 Congress passed an import tariff, known as the Dallas Tariff, with the explicit objective of protecting American manufacturers and making European imported goods more expensive. The legislation placed import duties of 25 per cent on cotton and wool textiles and manufactured iron; 30 per cent on paper and leather goods and hats; and 15 per cent on most other imported products. Two years later, and in response to predatory dumping of goods by the British, Congress further increased import duties.

American industry blossomed after the imposition of tariffs and vested interests lobbied to keep or even increase import duties. With the public strongly in support, Congress continued raising tariffs and American import duties rose to around 40 per cent on average by 1820.

Also in 1816, Congress created the “The President, Directors, and Company, of the Bank of the United States”, commonly referred to as the Second Bank of the United States, and President James Madison gave it a 20-year charter to handle all fiscal transactions for the US Government, regulate the public credit issued by private banking institutions, and to establish a sound and stable national currency.

The third and final tenet of the American System, federally funded internal improvements, was never fully adopted. Nonetheless, the US Government did end up using a part of the revenues generated from the import duties and the sale of public lands in the west to subsidise the construction of roads, canals and other public infrastructure.

Abraham Lincoln, Theodore Roosevelt, and many of the other great leaders from American history supported the American System. That is, they were all protectionists. Republican protectionist instincts used to be so ingrained that even if there was the slightest liberalisation of trade made by the Democrats, it would be reversed as soon as the Republican regained power. For instance the Revenue Act of 1913, passed during the early days of President Woodrow Wilson’s administration, which lowered basic tariff rates from 40 to 25 per cent, was almost entirely reversed after Republicans regained power following World War I.

It is only as recently as 1952, upon the election of Dwight D. Eisenhower, do we find a notable Republican leader that favoured free trade over protectionism.

Coincidentally, or not, President Eisenhower’s willingness to betray the Republican protectionist heritage in favour of free trade policies just so happened to be around the same time funding of the Marshall Plan ended. By 1952, the economy of every participant state in the Marshall Plan had surpassed pre-war levels; economic output in 1951 of each and every participant exceeded their respective output in 1938 by at least 35 per cent.

Happenstance or not, the economic recovery of Western Europe and its growing alliance with the US, created powerful inducements to free trade and overall wealth creation.

 

China’s Adoption of The American System

In 1978, China initiated the transformation of its economy towards a more liberal and market-based regime. The reforms, as it would become glaringly apparent over the following decades, were predicated on promoting exports over imports by adopting a combination of mercantilist and protectionist policies. The government supported exporters by waiving duties on materials imported for export purposes, creating dedicated export-processing zones, and granting favourably priced loans for capital investment. At the same time, the government supported the creation of national champions and industry leaders by limiting (or altogether prohibiting) foreign participation in strategic industries. These steps were in adherence with the first tenet of the American System.

The Chinese government also tightly managed monetary policy and kept its currency artificially undervalued through the combination of capital controls and intervention, driving capital exports and the build-up of trade surpluses – the second tenet.

A significant portion of government directed investment in China, especially since the early 1990s, has been in increasing the amount and improving the quality of public infrastructure. Investment was directed into all forms of public infrastructure including but not limited to developing power and telecommunications networks, public buildings, dams, rural road networks, manufacturing facilities, and academic institutions – the third tenet.

Much as the US economy flourished under the mercantilist tenets of the American System, China too has flourished over the last four decades by adopting the very same system.

Just as the Republicans in America were willing to make a turn toward free trade as the global economic environment became conducive to a US led global order, the Chinese leadership is beginning to espouse the virtues of free trade as its version of the Marshall Plan, the Belt and Road Initiative, gathers steam.

The Chinese leadership has guided its economy to such great heights based on, we suspect, their acute understanding of American economic history. It is China’s demonstrated adherence to the American System, which leads us to believe that just as Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

Investment Perspective

 

Chinese Premier Li Keqiang and his cabinet unveiled the “Made in China 2025” strategic plan in May 2015. The plan lays out a roadmap for China take leadership role in 12 strategic high-tech industries and to move up the manufacturing value chain. The Council on Foreign Relations believes Made in China 2025 is a “real existential threat to US technological leadership”.

Just as the British insisted upon the US remaining an agrarian society in the 18th century, President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain. Short of going to war, the Trump Administration is even following the same playbook by imposing tariffs, blocking technology transfer and withholding intellectual property.

President Trump, however, appears ready to go further and even upend the global trade system and call into question the US dollar’s global reserve currency status. Mr Trump’s stated objective is to revive the US’s industrial base. This objective, however, is unachievable in a global trade system in which the US dollar is the world’s reserve currency. The privilege of having the world’s reserve currency comes with the responsibility of consistently running current account deficits and providing liquidity to the rest of the world.

 

Imposition of Tariffs

Unlike any other currency, the global reserve currency cannot be easily devalued. As we discussed in Don’t wait for the US Dollar Rally, its Already Happened, as the US dollar weakens international demand for the greenback increases. For this reason, it is probably easier for the US to pursue alternative means that have the same effect as a devaluation of its currency.

The imposition of tariffs, from foreign manufacturers’ perspective, is the equivalent of a devaluation of the US dollar. For US based buyers and consumers, tariffs lower the relative prices of US manufactured goods with respect to foreign manufactured goods. Tariffs, however, are only effective if their imposition does not result in an equivalent relative increase in the price of the US dollar. It is perhaps no coincidence then that the Chinese yuan started to tumble as soon as the US moved to impose tariffs on Chinese goods. And in response Mr Trump is turning on the Fed and its tightening of monetary policy.

 

The Nuclear Option

Mr Trump always has the nuclear option in his bid to revive industry in the US. He can attempt to overturn the global trade system and the status of US dollar as the world’s reserve currency by limiting the amount of US dollar available to the rest of the world – pseudo-capital controls. If this were to happen, any and every foreign entity or nation that is short US dollars (has borrowed in US dollars) will suffer from an almighty short squeeze. In response, China specifically would have to take one of two paths:

  1. Open up its economy to foreign investment and sell assets to US corporations to raise US dollars.
  2. Loosen capital controls to allow the settlement of trade in yuan.

 

A G2 Compromise

The final, and in our minds the most painless, alternative to the above scenarios is that of a G2 compromise i.e. China and the US come to an agreement of sorts that results in China making significant concessions in return for the US maintaining the current global trade system.

What such a compromise will look like we do not know but it most definitely involves a weakening of the US dollar.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.