“Retaliation is related to nature and instinct, not to law. Law, by definition, cannot obey the same rules as nature.” — Albert Camus
“there’s no point in looking for hundred-dollar bills in the street. Why? Because, were there any hundred-dollar bills, someone would already have picked them up.” — William Poundstone, Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street
Starting with a follow-up to last week’s tech observations:
Last week, President Trump issued executive orders imposing new limits on Chinese social-media apps TikTok and WeChat. The orders are intended to stop Americans or those subject to US jurisdiction from engaging in transactions with the China-based owners of the apps, effective 45 days from last Thursday. This raises the possibility that US citizens will be unable to download the apps.
From the Financial Times (emphasis added):
“The maker of the popular game Fortnite launched a legal challenge to Apple and its practice of taking a 30 per cent cut of app revenues, after the game was thrown out of the App Store for trying to get round the policy.
Epic Games on Thursday introduced its own payment mechanism for players making in-app purchases, violating App Store rules and prompting the iPhone maker to take action.
In a lawsuit launched within minutes of Apple’s retaliation, Epic alleged the company “imposes unreasonable restraints and unlawfully maintains a total monopoly” over the distribution of apps used on Apple devices.
Fortnite is among the top grossing apps of all time, free to download but earning revenues estimated at $34m a month from in-app purchases of items such as tools and outfits. Apple takes a 30 per cent cut.”
From the Wall Street Journal:
“Apple and Google yanked “Fortnite,” one of the world’s most popular videogames, from their app stores in an escalating battle over the fees they charge developers to distribute their software and process in-app purchases.”
Tencent controls 40 per cent of Epic Games. Tencent is also the owner of WeChat.
China could be firing warning shots aimed at engaging US tech companies to appeal President Trump’s executive orders.
And it may well be working.
From the Wall Street Journal:
“More than a dozen major U.S. multinational companies raised concerns in a call with White House officials Tuesday about the potentially broad scope and impact of Mr. Trump’s executive order targeting WeChat, set to take effect late next month.
Apple Inc., Ford Motor Co., Walmart Inc. and Walt Disney Co. were among those participating in the call, according to people familiar with the situation.”
If the situation escalates further, Apple is probably the US company with the most to lose. For instance, if Tencent pulls WeChat from the App Store, iPhone sales in China will in all likelihood collapse. WeChat is not just an app in China, it is a part of the way of life as most of the Mainland knows it. Dare we say, no smartphone manufacturer, not even Apple, can overcome WeChat not working on its operating system.
The current escalation in the US-China conflict could just be President Trump trying to shore up his voter base ahead of the Presidential elections. If so, the issues will die down just as quickly as they escalated. If not, however, the profitability profile of US (Chinese) tech companies with a not-so-insignificant share of revenues coming from China (the US) will change dramatically.
For now, the escalation in tensions between Washington and Beijing is a time to be caution, but eventually it is just another wall of worry the market needs to climb.
In the near term, 4 to 8 weeks, we think a reduction equity exposure / increase in cash is warranted. The goal being to use cash to buy the dips on bouts of increased volatility. Beyond this interim period, we think markets can continue moving higher.
Why do we think the market continue going higher still?
Consider, the not-so-unimaginable case of long-term US treasury yields going to zero. If in concert with a total collapse in bond yields, earnings yields of the highest quality companies — overwhelmingly consisting of US tech companies — also collapse, say to 1 per cent. That implies that high quality names will trade at 100 times price-to-earnings.
That may seem unfathomable to many but if there is scarcity of yield and a scarcity of high-quality assets in the market, the highest quality assets with yield will eventually be bid up to ridiculous levels. It may not be 100x but it is probably a lot higher than current levels.
For these reasons and for reasons explained previously, we cannot get on board with rotations out of growth names and into value names. At least not yet.
Investor Predicament
Investors, whether institutional or retail, either explicitly or implicitly require returns of around 6 to 8 per cent on annualised basis. In a world where every developed market 10-year government bond yields less than 1 per cent, investors face quite the predicament in achieving their goal.
Interest rates are meant to reflect the return-on-investment environment, but when central banks use monetary policy to stimulate or tighten economic activity, they are trying to get interest rates drive rather than reflect the environment. Cutting interest rates has the cascading effect of increased leverage and reduced savings and productive capital formation. Increased leverage in the context of declining productive capital formation necessitates a further decrease in interest rates otherwise the leverage quickly becomes unsustainable.
This is the process that has been rinsed and repeated countless times over since the market crash in October 1987, leaving an overindebted economic system that is being further leveraged and surviving only by net new injections of liquidity in a low interest rate environment.
As long as leverage continues to be piled upon leverage, the overall return on capital will tend towards zero. The remaining assets that are still generating positive returns on capital will become more valuable.
The only way for investors to have any chance of achieving their return objectives is to front-run the flow of capital into assets still generating positive yield. That is why we have had the great rush into equities the last few months and why pension funds, such as CalPERS, and university endowments, such as those managed by the Yale Investment Office, have announced they will be increasing allocations to private equity and venture capital.
The greater fool theory is at play. As long as we know that, we can remain nimble and continue tactically dipping in and out markets.
Thank you for reading!
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.