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Currency Markets: “You can’t put the toothpaste back in the tube.”

“When you strip away the genre differences and the technological complexities, all games share four defining traits: a goal, rules, a feedback system, and voluntary participation.” Reality is Broken: Why Games Make Us Better and How They Can Change the World by Jane McGonigal

“The dollar used to be a gold standard currency. And the dollar is really good in the last century, I mean in the 19^th century.” – John Forbes Nash Jr.

“The thought experiment of Adam Smith correctly takes into account the fact that people rationally pursue their economic interests. Of course they do. But this thought experiment fails to take into account the extent to which people are also guided by noneconomic motivations. And it fails to take into account the extent to which they are irrational or misguided. It ignores the animal spirits.” – Animal Spirits by George A. Akerlof

When US Treasury Secretary Steven Mnuchin uttered the words “A weaker dollar is good for trade,” at Davos in January, he broke rank and became the first US Treasury Secretary in almost three decades to talk down the US dollar. And in one fell swoop he ended the cooperative monetary policy game major central banks had been engaged in since the renminbi devaluation scare in January 2016 and transformed it to a competitive game.

Mr Mnuchin’s comments sent President of the European Central Bank (ECB) Mario Draghi and Governor of the Bank of Japan (BOJ) Haruhiko Kuroda into a state of frenzy. Both were quick to react and proceeded to talk down their respective currencies – Mr Draghi hinted at the ECB delaying its exit from monetary easing while Mr Kuroda‘s language became decidedly dovish.

Capital markets, to state the obvious, do not like volatility. Markets like boring. The cooperative monetary policies of the last two years have been exactly that, boring. As central banks sucked volatility out of currency markets, capital markets of all forms became buoyant. Tech stocks climbed higher. Emerging markets came out of their prolonged slump. Cryptocurrencies soared. Even the much maligned commodity markets rallied. Coincidentally, most markets peaked soon after the détente between global central bank was broken by Mr Mnuchin.

Should we be surprised that a member of the US administration led by President Donald Trump has done away with the niceties of a globally coordinated détente and unleashed competition amongst global central banks? Mr Trump is nothing if not competitive and he is doing his part in stoking global competitive spirits as he did in announcing his plans to impose tariffs on steel and aluminium imports.

One man voluntarily abstaining from the competitive game it seems is newly-appointed Federal Reserve Chairman Jay Powell. Chairman Powell, by striking a hawkish tone during his inaugural testimony on 27 February, extended an olive branch to his fellow central bankers and they gladly obliged. Mr Kuroda this morning suggested that the BOJ could exit from its easy monetary policy as early as next year. The central banks, it seems, want to return to the comfortable climes of a cooperative game world.

The market appears to be giving Messrs Powell and Kuroda due credit with the dollar moving sharply higher after Mr Powell’s hawkish comments and the yen strengthening following Mr Kuroda’s remarks. While the central banks will do their utmost to re-establish a cooperative regime, the reality is “you can’t put the toothpaste back in the tube”. 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.

Investment Perspective

One major central bank that has conspicuously remained on the side lines during the recent sharp moves in currency markets is the People’s Bank of China (PBOC). The PBOC rarely, if ever, publicly expresses its desired direction for the renminbi. Its statements are generally limited to reaffirming its commitment to promoting a stable exchange rate regime. The PBOC, however, has been known to actively intervene in markets to influence the direction of its currency – such intervention too has been absent recently.

The PBOC, we think, finds itself at a difficult crossroads with respect to the renminbi. Much like the one the BOJ was at with respect to the yen in the late 1980s. The BOJ, in hindsight, favoured short-termism and opted to keep monetary policy far too easy, which sent Japanese asset prices rocketing higher. The Japanese boom, as well known, was followed by an all-mighty bust. The Chinese Communist Party (CPC), it is said, thinks in decades not years – so one would think that the Chinese will not follow in the footsteps of Japan. Short-termism, however, can afflict anyone and there is, we think, a non-zero probability that China goes down the path of too much easing, which would send Chinese asset prices sharply higher. For this reason we would maintain some allocation to Chinese equity markets.

The more probable scenario, we think, however, is that of the PBOC opting to strike a balance between tightening and opportunistic easing and the PBOC may even let the renminbi strengthen some more – especially if said strengthening is driven by US dollar weakness as opposed to PBOC’s interventions.

As we argued in our piece on China in January, China wants to increase its influence in Asia and that stability is a necessary condition in order to achieve further influence. Therefore, given China’s global ambitions, we think it is unlikely that the PBOC repeats the mistakes the BOJ made in the late 1980s. And if this indeed turns out to be the case, given the current differential in US and Chinese interest rates and bond yields, the Yuan carry trade may be amongst the best trades to put on today.

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.

LNG Shipping

“A war of ideas can no more be won without books than a naval war can be won without ships. Books, like ships, have the toughest armour, the longest cruising range, and mount the most powerful guns.” – Franklin D. Roosevelt

“There are no rogue ships; there are only rogue shipowners.” – Maritime Double Shots by Barista Uno

“Twenty years from now, you will be more disappointed by the things you didn’t do than those you did. So throw off the bowlines. Sail away from safe harbour. Catch the wind in your sails. Explore. Dream. Discover.” – P.S. I Love You by H. Jackson Brown Jr.

Buy what the British government is selling. Buy what the Chinese government is telling you to buy. These are two pieces of sage advice we received from a certain Mr Wang, whom we had the good fortune of being introduced to early on in our investing careers. Mr Wang is, in today’s parlance, a private equity investor. To us he is both a mentor and an enigma.

Mr Wang speaks the Queen’s English, read mechanical engineering at one of the elite American universities, and started off his career in merchant banking in the City of London during the Thatcher years. Mid-career he packed up his bags and moved to China to set up his proprietary investment practice, which he continues to manage today.

Over the years we have turned to Mr Wang for advice on investment matters related to China and he, to our collective memories, has never failed to tell us to buy what the government is telling you to buy. What does that mean? What is the Chinese government telling us to buy and how?

Mr Wang attributes much credit for his, by almost any standard, very successful track record in China to always following the Chinese government’s lead. The Chinese government uses the National Congress – held every five years – as a platform to communicate it strategic and economic priorities. The National Congress, Mr Wang says, is where and when Communist Party tells the whole world where and what to invest in in China.

At last year’s plenum, Mr Xi Jinping emphasised that pollution control is a key priority for the Chinese government. Going forward, China will pursue a development model that fosters, in Mr Xi’s words, a “harmonious co-existence between man and nature”. Somewhat predictably, the authorities hired environmental inspectors from around the country following the National Congress. These inspectors were swiftly dispatched into the China’s industrial heartland in a rush to meet year-end air pollution targets. Thousands of polluting factories were forced to shutter or curtail capacity. Officials in their desperation even forced households to switch from coal-fired to gas-based heating without ensuring the ample availability of natural gas for the freezing winter months. Natural gas prices duly doubled.

Natural gas is not easily transportable over long distances. Where natural gas cannot be delivered by land, it must be liquefied and delivered by ship in the form of liquefied natural gas (LNG). Basic economic theory dictates that for shipping of LNG to make economic sense natural gas prices at the point of delivery must be sufficiently higher than prices at the point of dispatch to compensate for the costs involved in liquefaction, transportation, and regasification. The Chinese crackdown on air pollution and coal-based heating resulted in a sharp increase in the differential between Henry Hub gas prices and Asian gas prices. For example at the peak of the Chinese winter in December last year, the differential between the Japan-Korea Marker and Henry Hub reached three-year highs at USD 8.11 per MMBtu. Well above the USD 4 to 5 per MMBtu differential estimated to make LNG transportation between the US and Asia economically viable. While the spread has come off the highs, it has on average remained more than 50 per cent higher through 20 February this year as compared to the same period last year and also remained above the economic viability threshold for LNG transportation.

Chinese imports of LNG during the fourth quarter of last year surged 54 per cent in a scramble to meet fuel shortages amid peak winter demand and the drive to decrease coal use for household heating.

Chinese Monthly LNG Imports China LNG Imports Source: Bloomberg

While the surge in demand was unprecedented, Chinese demand for LNG will only continue to grow. Already, 40 per cent of its gas needs are fulfilled through LNG imports. The country understands its reliance on LNG imports and has plans to construct new LNG import terminals and develop pipeline infrastructure to be able to transport gas further inland. At the same time, globally 100 million metric tonnes of liquefaction capacity is projected to be added annually from 2018 through 2020. Chinese demand is coming at a time where the world is flush with LNG supply and the supply is only going to increase. LNG producers have every incentive to ship their product to China, none more so than US producers.

The US Department of Energy projects that US LNG production capacity will quadruple by the end of 2019, making the US the world’s third largest producer of LNG, placing it behind only Qatar and Australia. Moreover, the International Energy Agency expects the US to become the world’s leading LNG producer within a decade.

US Monthly LNG Exports

Source: Bloomberg

The natural gas and liquefaction production capacity to be delivered over the coming years, particularly in the US, means that there could potentially be a global LNG supply glut. In such a scenario US natural gas prices and by extension LNG prices are unlikely to sustainably re-rate to the upside. Low Henry Hub rates and high Asian demand, however, are the perfect combination for a sharp pick-up in the demand for LNG carriers.

We think LNG carriers are one of the ways to play the Chinese pivot towards cleaner energy.

Investment Perspective

Spot charter rates for benchmark LNG carriers averaged USD 46,000 per day during 2017, a 37 per cent increase over average rates achieved during 2016. And in December, driven by the surge in Chinese demand, spot rates averaged approximately USD 70,000 per day – the highest level reached in over three years.

Last year was also the first time in over three years that LNG carrier supply growth trailed demand growth. Demand growth is expected to outstrip supply growth once again in 2018. Despite the improving supply and demand dynamics, absolute carrier capacity still significantly exceeds absolute LNG shipping demand. This, however, could reverse by as early as 2020. Some analysts even estimate that available capacity could be as much as 30 per cent below demand in 2020.

LNG carriers are highly specialised and complex tank ships that are designed to store LNG at -160 degrees centigrade. Typically, LNG carriers require two and a half years of build-time. Meaning that charter rates are the only means by which the market can rebalance until such time that new vessels are delivered. Given that new vessel orders, as a percentage of the existing fleet, are at around five-year lows, vessel orders would quickly have to gather speed to avoid a supply deficit during 2020 – assuming demand expectations are reached. Compounding the problem is the 30 per cent decline in global shipyard capacity since 2011 – a meaningful pick-up in new vessel orders – LNG carriers or otherwise – could result in much higher build costs and longer build-times.

LNG Tanker Order Book (Percentage of Total LNG Tanker Fleet)Source: Bloomberg

One of the major challenges LNG carrier operators have faced during the recent period of excess capacity is the unwillingness of charterers to commit to time charters – a time charter is the hiring of a vessel for a specific period of time. As demand for LNG shipping, particularly between the lucrative US-Asia routes, picks up, the supply surplus shrinks and new liquefaction capacity comes online, charterers – in this case likely to be LNG producers – will increasingly want to commit to time charters, which would not only reduce the financial risk for carrier operators but also drive spot rates up to much higher levels.

The LNG carrier industry is relatively concentrated – the top ten operators control 49 per cent of total capacity. If the larger players are able to show some restraint in ordering new vessels, they could reap the rewards of much higher daily rates for many years.

We are closely following LNG carriers such as Golar LNG ($GLNG), GasLog Limited ($GLOG), and shipping broker Clarkson PLC $CKN.LN to potentially add them to our list of long trade ideas.

The Incumbent’s Challenge

“Washington is an incumbent protection machine. Technology is fundamentally disruptive.” – Eric Schmidt

“I ordered a soda – caffeine-free, low sodium, no artificial flavours. They brought me a glass of water.” – Robert E. Murray, Chief Executive Officer of Murray Energy Corporation, one of the largest independent operators of coal mines in the United States

“Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.” – Rob Siltanen, the creative genius behind the much celebrated commercial “To the Crazy Ones” that launched Apple’s Think Different campaign

When Mr. Warren Buffet decides to buy a stock it is a big deal. When he decides to sell a stock, however, it is a much, much bigger deal. We have just learnt that Mr. Buffet dumped most of his IBM’s shares during the fourth quarter last year. IBM is no ordinary company. It is a stalwart of the technology industry. It generates over sixty percent return on equity. Sixty per cent! Oh and by the way 2017 marks the twenty-fifth consecutive year of US patent leadership for IBM.

Unfortunately for IBM, invention does not always equal innovation. And it most certainly does not equal disruptive innovation.

IBM’s seemingly obsessive pursuit of patents, to us, is symptomatic of a zero-sum view of the world. That is, we think underlying IBM’s hunger for patents, is a convoluted assumption that by having a larger share of patents issued will somehow translate into them capturing an increasing share of the value generated by the technology sector. Value, however, is not finite. And technological progress is certainly not a zero-sum game.

A faltering technology company is not exactly news. Casualties in the technology sector are par for the course. IBM is not the first technology company to struggle and it is unlikely to be the last.

Disruption of long-standing and successful consumer staple businesses, however, is far more interesting. PepsiCo – the bluest of the blue chip consumer staple companies – is one company whose trajectory we are following with much intrigue especially after we outlined our bear case for household consumer brands last year.

When PepsiCo announced its USD 15 billion stock buyback plan, shortly after disclosing full year and fourth quarter 2017 earnings, our toes curled a little. PepsiCo is trading at 21x price to trailing earnings and 20x price to consensus 2018 earnings. Surely there are better ways to put the cash to work? It was only a few days prior to announcing the buyback plan that the company introduced Bubly, its new brand of sparkling water, which in and of itself is not a groundbreaking development but an encouraging sign of the company coming to terms with changing consumer preferences nonetheless. And it also signaled that the company was willing to invest in new markets.

The relatively small size of new or emerging markets is a well-documented hurdle for large companies. Investing in small markets just does not move the needle when it comes to meeting Wall Street’s quarterly earnings expectations; pursuing large-scale share buybacks does . Moreover, executives destined for the C-suite do not get there by slogging it out in risky, small-scale pursuits. As anyone who’s worked in an organisation of meaningful size will tell you, projects that do not have a strong sponsor get orphaned very quickly. The harsh reality, however, is that all great businesses start off small and it is therefore paramount that incumbents find ways to overcome their structural inability to enter small markets.

PepsiCo’s recent introduction of Bubly, while a relatively positive sign, is also yet another example of a large company playing catch-up due to their failure in either understanding or pursuing the potential of a small market. The company is entering the US sparkling water market only after LaCroix has proven that it is a big market and has established itself as a clear market leader.

An inability to timely enter high-growth potential markets is far from PepsiCo’s only challenge. The company is under attack on multiple fronts.

JAB, the investment vehicle backed by Germany’s Reimann family, bought Dr Pepper Snapple (DPS) for USD 19 billion last month. JAB plans to merge DPS with its coffee interests to create a giant distribution network to better compete against the likes of PepsiCo and Coca-Cola.

Consumer attitudes towards sugary sodas are also quickly shifting. Sugar is widely acknowledged as enemy number one when it comes to western dietary habits. We can see this PepsiCo’s soda sales in the US, which continue to decline despite a new marketing blitz to promote the company’s soft drink brands.

Investment Perspective

PepsiCo like other great consumer goods companies has leveraged its products’ strong brand identities in combination with far reaching distribution to make its products available to as many consumers as possible. Awareness and availability are perhaps the company’s widest and most effectively exploited moats. The company has proven to be a great investment for long-term, buy-and-hold type investors over the years.

The second-order effects of technological innovation, however, are such that we think the effectiveness of PepsiCo’s moats is eroding fast. People are watching far less television and spending less time reading newspapers and magazines. Instead, they are on YouTube, Facebook, Snap, or watching Netflix. Traditional mass media is great at creating awareness and shaping consumer preferences at a mass scale, which is exactly what consumer product companies needed to keep their their brands at the top of consumers’ minds. So much so that they came to monopolise advertising slots during peak programming. The sky-high prices paid for Superbowl half-time advertising slots just go to show the value of mass media to consumer products companies. It also demonstrative of the fact that traditional media advertising is deeply rooted in a zero-sum world.

The major strength of social media and digital advertising platforms, in contrast to traditional media, is targeting niche consumer groups based on precisely defined criterion. Such platforms are far better suited to products that have very high levels of appeal to a niche group – making them ill-suited as advertising platforms for large consumer product companies. The increasing popularity of social media and other non-traditional forms of media, in our opinion, will result in the increasing awareness of niche brands relative to the awareness of mass consumer brands. We see this as a secular trend that will have a profoundly disruptive impact on incumbent consumer product businesses like PepsiCo.

We do not, however, expect the incumbents to go down without a fight. Unfortunately, the following quotes from senior executives of PepsiCo suggest that, while they do realise they are in a fight, they are still stuck in a zero-sum world and do not yet understand the new rules of engagement:

“We have patents on the design, the cutter, the mouth experience. This is multiple layers of IP.” – Dr. Mehmood Khan, Vice Chairman and Chief Scientific Officer of PepsiCo

“The consumer has turned the definition [of healthy] upside down. If it is non-GMO, natural, or organic, but high in sodium and high in sugar and fat, it’s okay.” – Indra Nooyi, Chairwoman and Chief Executive Officer of PepsiCo

Active management, we think, is as much about avoiding losers as it is about picking winners. We think PepsiCo and other businesses like it are squarely in the loser camp.

Beyond the Minsky Moment: The Wisdom of Crowds or the Madness of Mobs?

“I must say a word about fear. It is life’s only true opponent. Only fear can defeat life. It is a clever, treacherous adversary, how well I know. It has no decency, respects no law or convention, shows no mercy. It goes for your weakest spot, which it finds with unnerving ease. It begins in your mind, always … so you must fight hard to express it. You must fight hard to shine the light of words upon it. Because if you don’t, if your fear becomes a wordless darkness that you avoid, perhaps even manage to forget, you open yourself to further attacks of fear because you never truly fought the opponent who defeated you.”

– Excerpt from Life of Pi by Yann Martel

Doctor: You do not fear death. You think this makes you strong. It makes you weak.

Bruce: Why?

Doctor: How can you move faster than possible, fight longer than possible, without the most powerful impulse of the spirit? The fear of death.

Bruce: I do fear death. I fear dying in here while my city burns. And there’s no one there to save it.

Doctor: Then make the climb.

Bruce: How?

Doctor: As the child did – without the rope. Then fear will find you again.

― The Dark Knight Rises (2012)

The Minsky Moment – a term coined by Paul McCulley of PIMCO that refers to the central concept underlying American economist Hyman Minsky’s theory on the inherent instability of financial markets – has been ubiquitously quoted by just about every major research publication and financial periodical in the aftermath of the Global Financial Crisis. Based on yesterday’s market action, we may have just witnessed another Minsky Moment. And it was not pleasant. Many of you will have experienced fear – we certainly did – and felt your neurologically programmed fight or flight reflex kick-in. While fight or flight responses have their benefits, such responses tend not to be helpful at times of stock market crashes. We overrode our urges to react, turned off our screens, silenced our Twitter feed and spent the rest of the day reading – everything and anything except the financial news.

As we immersed ourselves, once again, into the frantic and frenzied world of financial markets this morning some of the reactions from the media, sell-side, FinTwit and the like have been predictable, the usual suspects – risk parity funds, the Fed, Goldman Sachs, the US government and algorithmic traders – have all been blamed in one form or another. The question, for market participants, however, is not whose fault it is but what, if anything, should we be doing with our portfolios at this juncture.

In the process of portfolio construction we, as analysts, make, in effect, choices amongst several different competing hypotheses. Analysis of competing hypotheses involves:

identifying the evidence and assumptions with diagnostic value in assessing the likelihood of each hypothesis; and

outlining future milestones that may indicate whether events are following the expected path or not.

In our opinion, one’s view on the medium-term direction of the US dollar is central to the type of portfolio that one constructs today. So the hypothesis and its alternative in this case are:

Hypothesis: We are in a structural lower US dollar environment

Alternative hypothesis: The US dollar has bottomed and is headed higher

Over the last few months we have written about or initiated trade ideas related to a number of themes, most notably Europe’s domestic recovery, the potential for a strong rally in agriculture commodities, rising inflation in the US and higher oil prices. Central to all of these investment themes is the view that we are in a structurally lower US dollar environment. This view is predicated on a number of factors, including but not limited to:

The US faces a public pension funding gap estimated to be USD 3.85 trillion. This funding gap may never be filled but it certainly will not be filled if we have a strong US dollar and declining equity markets. History has shown time and again that elected officials and unelected rulers, alike, have long understood the benefits of tampering with the value of their currency. Given the choices available we expect President Trump to be an advocate of a weak dollar policy. A weaker dollar improves the profitability of US large caps, which in turn should be supportive of equity markets.

The weakening of the US dollar over the course of 2017 suggests that both US growth and higher short-term interest rates had been priced in; the market, however, did not fully appreciate the economic recovery underway in the rest of the world. The surprise was amplified by the prospects of earlier than anticipated tightening of monetary policy by the ECB.

The US budget deficit is forecast to exceed USD 1 trillion in 2019 and the Congressional Budget Office expects US budget deficits to continue to grow.

The US dollar is very much in a bear market at the moment. As with any bear market we should expect bear market rallies, which can be sharp and painful – especially when positioning is stretched in one direction. For our weak dollar hypothesis to be nullified we would need to see at least one of the following:

continued strength in the US dollar from now till the end of summer i.e. a period of at least six months;

a reversal in US fiscal policy; or

a sharp acceleration in monetary policy tightening by the Fed.

At this stage and given the sharp decline in the US dollar, cyclical rallies are par for the course. The recently enacted tax reform is likely to increase the flow of capital into the US and at the same time boost capital spending and the profitability of US companies. Moreover, if the Republicans are able to consolidate power in the mid-term elections, this too should temporarily strengthen the US dollar – somewhat counter intuitively we think a consolidation of power would strengthen the case of a weaker US dollar as President Trump would have more leeway in increasing fiscal deficits.

Investment Perspective

The question then is what type of portfolio should one have under a structurally weak US dollar environment. In broad strokes, our thinking is as follows:

US bonds have more value than other developed market bonds. Any bond allocation should be tilted towards the US with a bias towards shorter duration instruments.

International equities have more value than US equities. Use periods of intermittent US dollar strength to build positions in mid-cap equities in Europe and add to our exposure to Japan.

Within US equity markets, give preference to large caps over small- and mid-caps. A weaker dollar has an outsized impact on the profitability of large caps relative to domestically focused small and mid-cap businesses.

Commodity and commodity producers should benefit from a weaker dollar and, as previously discussed, higher capital spending arising both from the US and from China’s Belt and Road Initiative.

Oil, after speculative positioning re-adjusts to less frothy levels, should benefit from a lower US dollar and robust global demand.

Emerging markets to outperform developed markets.

In the final analysis, we consider the recent surge in market volatility as a signal for the shift in momentum as opposed to the start of a bear market. The analogue of the fifteen year US dollar cycle best captures our thinking:

Dollar Index Analogue – 15 Year Cycle (Normalised) DXY normalised Source: Bloomberg

Similarly, consider the fifteen year cycle analogue of the ratio of the MSCI Emerging Market Index to the S&P 500 Index.

MSCI EM Index to S&P 500 Analogue – 15 Year Cycle (Normalised) MXEF SPX Source: Bloomberg

The Risks for this Bull Market

“It was the best of times, it was the worst of times.” – Charles Dickens

“We must expect reverses, even defeats. They are sent to teach us wisdom and prudence, to call forth greater energies, and to prevent our falling into greater disasters.” – Robert Edward Lee, commander of the Army of Northern Virginia in the American Civil War from 1862 until his surrender in 1865

“Some risks that are thought to be unknown, are not unknown. With some foresight and critical thought, some risks that at first glance may seem unforeseen, can in fact be foreseen. Armed with the right set of tools, procedures, knowledge and insight, light can be shed on variables that lead to risk, allowing us to manage them.” – Daniel Wagner, co-author of Global Risk Agility and Decision Making

In Our Thoughts On and Investment Ideas for 2018 we struck a distinctly bullish tone reflective of our top convictions over a six to twelve month investment horizon. We would be remiss, however, to ignore the potential risks that could stop this bull market in its tracks.

The MSCI All Cap World Index is up fourteen months in a row and barring a calamitous fall today, it will extend this unprecedented streak to fifteen months. While the bull market can continue, the momentum of month-over-month gains is unlikely to last. It is in the moments when this momentum breaks do we need to assess whether it is an ordinary market correction or a shift in market regime. Below, we consider some of the key events that we think would signal a shifting regime and not just a mere correction.

The European Central Bank (ECB) tightens earlier than expected

The path forward for ECB monetary policy has been clearly laid out. The ECB will first end its asset purchases and only after that will rate hikes commence. Mario Draghi, at the Governing Council’s meeting on 25 January, indicated that based on current projections, the first rate hike could occur around mid-2019 with a very low probability of a rate hike in 2018. His admission that the asset purchase programme could end entirely in September this year instead of being tapered over the course of the fourth quarter, however, does create some policy uncertainty.

Given the robustness of the Eurozone’s recent economic performance – stronger than what the Governing Council expected for the second half of 2017 – and the potential for rising wage pressures, particularly in Germany, if the ECB abruptly ends asset purchases in September, as opposed to tapering, and starts to hike rates ahead of schedule, equity markets could face strong headwinds.

Germany – Unemployment Rate vs. Wages & Salaries Annual Growth Germany wages Sources: German Federal Statistical Office, Bloomberg

Take, for example, the case of Italy, which has seen the absolute cost of servicing its debt drop by 7.7 per cent between 2010 and 2016 while general government debt outstanding has increased by 19.8 per cent. Crudely speaking, the ECB’s asset purchase programme has translated into a 23 per cent reduction in the interest rate Italy pays on its debt. By the same token, the ECB also holds close to a fifth of all outstanding Italian government debt. Monetary policy normalisation by the ECB could send Italian debt servicing costs meaningfully higher and severely dent Italian growth and business sentiment, both of which are at their highest levels since the Euro crisis. By extension, under such a scenario, the same challenges would apply to other peripheral states in the Eurozone.

Italy – Interest Expenditure vs. General Government Debt Outstanding Italy debt Sources: ISTAT, Bloomberg

As discussed in Europe: A Domestic Recovery Story, given the still high levels of unemployment across the Eurozone and relatively low levels of friction in European labour mobility, we expect nominal wage growth to remain subdued until there is a significant tightening of the labour market. And this, we think, will keep the ECB from abruptly ending its asset purchases and raising short-rates ahead of schedule. Moreover, with coalition formation negotiations underway in Germany, there is the not so trivial possibility that Chancellor Angela Merkel will have to forfeit control of the finance ministry in favour of the pro-European Social Democratic Party of Germany in order to secure one more term. If this indeed does happen, German policy is likely to be far less hawkish than it was under Wolfgang Schäuble, which may well serve to embolden the ECB in prolonging or at least seeing through their accommodative policy. We, therefore, see little risk of the ECB abandoning its accommodative policy ahead of schedule.

Rising oil prices

The sharp drop in oil prices in late 2014 has had a huge impact on global liquidity. Part of the money previously used to pay for oil imports has been redirected towards productive investments as well as increasing consumption, which in turn has contributed to a revival in global trade and capital investment. While oil at USD 70 per barrel will not derail the synchronised global economic growth we are witnessing today, a major supply disruption or rising geopolitical tensions in the Middle East boiling over to armed conflict may well push oil prices over the USD 100 per barrel level and that would put a real squeeze on global liquidity.

A 40 to 50 per cent increase in oil prices from today’s levels would result in inflationary pressures picking up and force the Fed, the ECB and quite possibly the Bank of Japan to tighten monetary policy. An environment of rising oil prices and tightening monetary policy tends not to be favourable for financial assets.

We think being long equities of non-Middle Eastern oil exporters, such as Russia and Malaysia, is the simplest means of neutralising this risk.

Inventory build-up causes the business cycle to roll over

Business cycles do not die of old age. They roll over when businesses are forced to liquidate excess levels of inventory and write-off excess capacity built up during periods of strong economic growth. The prolonged prevalence of deflationary forces, however, has discouraged businesses, particularly in the developed world, from making capital investments and acquiring excess levels of inventory. While at the same time, access to cheap capital, has encouraged businesses to, instead, undertake financial engineering. A lack of capital investment and low levels of inventory mean that there is little excess capacity to write-off and no surplus inventory to forcefully liquidate. Without write-downs or liquidation, the business cycle continues, albeit unimpressively.

US tax reform, higher short-term interest rates and rising commodity prices, however, have tilted the balance in favour of making capital investments and building up inventory as opposed to undertaking financial engineering. Given that business inventory levels are depleted and productive capacities have shrunk, especially after Chinese supply-side reforms, if companies become overzealous to the extent rising commodity prices lead to rising demand the business cycle would in all likelihood come to an abrupt end.

The Fed gets ahead of the curve

“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”

– Excerpt from Monetary Regimes and Inflation, Peter Bernholz (2003)

Most of the commonly followed leading indicators for inflation and wage growth are signalling that the Fed’s two per cent inflation target is likely to be met by the end of 2018 and barring a recession exceeded in 2019. The Fed, however, prefers to remain data dependent, choosing to be reactive as opposed to pre-emptive in its policy making. This approach is unlikely to upset the apple cart. If, however, the Fed decides to get ahead of the curve this would in all likelihood be negative for risk assets, while being positive for long-dated bonds.

The last great secular bond bear market in the US started in 1946 and lasted up until 1981. We have been in a secular bond bull market since. One of the more fascinating aspects of the last bond bear market is the fact that short-term rates bottomed in 1941 and started rising. While long-term rates continued to decline all the way until 1946. Making 1941 to 1946 a rare period of history where short- and long-term rates moved in opposite directions for a prolonged period of time. To us this curious period is symptomatic of how long it can take for a deflationary mind-set to be overcome.

Psychological inertia at mass or institutional level is a powerful force against change. Although the behaviour of the Fed under new leadership is likely to be different, we struggle to imagine a scenario under which the Fed frees itself from the shackles of the deflationary mind-set that prevails today without sufficient data confirming that deflationary forces have given way to inflationary pressures.

Chinese reform goes too far

At the 19^th Party Congress in October last year, Xi Jinping made it clear that economic growth alone would not be the determinant of success. Softer facets relating to the social well-being of its citizens such as the level of pollution, reduction in wealth inequality, and increased access to quality education and healthcare would carry much greater weight in measuring China’s development.

While the probabilities are low, we worry that this shift in policy may incentivise government officials across China to pursue policies akin to the “battle for skies” with great fervour causing a sharp slowdown in Chinese economic activity.

Investment Perspective

Invoking Occam’s razor we try to search for the simplest solution to any problem. So if your problem is that you are worried about this market, our proposed solution to you is neither to short this market nor is it to buy protective puts. Instead, if you want portfolio protection, buy two-year Treasuries. Why? Well as they say a picture is worth a thousand words:

US Two Year Treasury Yield vs. S&P 500 IndexSource: Bloomberg

Europe: A Domestic Recovery Story

“By hamstringing the ability of French governments to act in the interests of the French people – or, to put it more realistically, by giving them an excuse for not so acting – that embrace has destroyed political legitimacy in France. It has contributed to a contempt for democratic politics so profound, among both rulers and ruled, that the survival of the Fifth Republic may be brought into doubt in the next few years, ‘Europe’ or no ‘Europe’.”

– Excerpt from The Rotten Heart of Europe: Dirty War for Europe’s Money by Bernard Connolly

“How can you govern a country which has 246 varieties of cheese?” – Charles de Gaulle

In medieval France, there was a legislative and consultative institution, known as the Estates-General (French: États généraux), which gathered representatives from different classes of people across the land to advise on matters of national importance. When the representatives congregated in 1614 in Paris at the occasion of the uprising being organised by Louis II de Bourbon, the prince of Condé, they complained about corruption and high levels of taxation while still maintaining allegiance to the crown. The Estates-General did not reconvene again till 1789 when it was summoned by King Louis XVI. This time, however, the representatives did not merely complain but rather provoked the French Revolution.

Political change takes times. Yet Emmanuel Macron, in only 8 months since taking office and on the back of a large parliamentary majority, has been successful in effecting meaningful change in France. Most notable of all of Macron’s achievements to date is the signing of five decrees in September last year to reform France’s labour law. The implications of these decrees include:

Streamlining social dialogue

When a company hires its fiftieth employee in France, it must comply with a long list of requirements, notably the nomination of workers’ representatives and the setting up of a works council and a health and safety committee. Under the reforms, the three employee representation bodies – the staff delegates (“délégués du personnel”), the Works Council (“Comité d’entreprise”) and the Health and Safety Committee (“CHSCT”) – will be merged into one single entity, called the Social and Economic Committee (“SEC”). Companies must set the SEC up by no later than 1^st January, 2020.

The merger of the three bodies will reduce administrative costs and cut through significant amounts of red tape faced by large companies.

Decentralisation of collective bargaining

Collective bargaining was generalised by law in France in 1950. This law established collective bargaining at the industry level as it was seen as the only way in which small companies could benefit from collective agreements. The introduction of the “Auroux laws” in 1982 imposed an added obligation on companies that have a trade union delegate amongst their staff – loosely companies with 50 or more employees – to negotiate pay and working hours annually – failure to do so could result in penalties.

Under Macron’s reforms, employers, in companies of less than 11 employees, will have the freedom to negotiate directly with their employees, on all topics open to collective bargaining, at company-level instead of industry-level. Agreement of terms between the employer and employees is subject to ratification by a majority of two-thirds of the employees. This new ratification method is also applicable to companies of 11 to 20 employees that do not have a trade union delegate.

The reforms also increase flexibility for businesses with 21 to 49 employees and no trade union delegate by allowing them to negotiate agreements with elected, but not unionised, employees.

Given that over 90 per cent of French companies have fewer than 50 employees and no trade union delegates, the decentralisation of collective bargaining is a major win for business. Companies are now less susceptible to being held hostage by powerful labour unions such as the General Confederation of Labour (CGT).

Settlements for unfair dismissal

Firing employees in France has always been both challenging and costly. Up until the recent reforms, employees in France could obtain huge settlements for unfair dismissal and could make claims against their dismissal up to two years after the fact. Now, however, damages will fall within a set floor and ceiling and workers will now have twelve months to lodge their application with the tribunal for compensation for wrongful dismissal.

Damages for employees with two years of services are capped at three months’ salary with compensation increasing by a month’s salary for each year of additional service up to ten years. After ten years’ service, the annual increments are reduced to half a month’s salary. The maximum compensation is set at 20 months’ salary.

Local not global profitability to assess case for lay off

In France, any plan to layoff multiple workers must be approved by a chamber of commerce. Judges have been known to block lay off plans or penalise companies by referencing the profitability of their global operations. This oddity, too, has been removed. Judges will now only be able to base their decisions on a lay off plan on the profitability of a company’s local operations. This is a major shift as global profitability has been the central issue over company shutdowns and restructurings in France over the years, most notably in ArcelorMittal’s attempt to lay off workers at Florange steelworks in 2013.

These labour reforms are certainly good for business. Administrative costs will be lower, transparency on potential damages arising from layoffs is higher, and multinationals will not be unduly penalised for the performance of their international operations. Employees, however, should also benefit. Companies will now be more willing to hire in good times as they know they will be able to shed staff, without onerous levels of red tape, in bad times. While wage gains will be limited as the combination of employers now having more flexibility in negotiating terms and the high unemployment levels in France give businesses a stronger hand, unemployment should decline.

France’s first budget under Macron, while not without its critics, is also another early success. The budget reduced the scope of the wealth tax to real estate assets and put in place a flat 30 per cent levy on capital gains, replacing the previous progressive tax on capital gains that went as high as 45 per cent. The corporate tax rate has been cut to 30 per cent starting 2018 and will be reduced to 28 per cent on 1 January 2020, 26.5 per cent on 1 January 2021 and 25 per cent on 1 January 2022. Until 1 January 2020, the corporate tax rate will remain 30 per cent.

The early reforms achieved by the Macron government should boost the domestic profitability of French companies over the coming 2 to 3 years; while at the same time strengthening the case for capital investment into France. Moreover, the reforms come at a time when Europe, collectively, is in a cyclical upturn. Thus enabling the French economy to both contribute to and benefit from this upturn.

Europe’s cyclical upturn is real and it is broad based. Industrial production, excluding construction, is picking up across the Eurozone.

Eurozone Industrial Production Ex-Construction YoYSource: Bloomberg

If we look across some of the major European economies, the industrial production trends are similar.

Industrial Production Ex-Construction YoY for Major EU Economies Europe Industrial Production Major Economies Source: Bloomberg

Construction activity too is starting to pick up. Using the number of residential construction permits issued as a proxy; we can see that construction activity is witnessing a strong pick up in France and Spain.

OECD Construction Orders Permits – Residential Buildings IndicesSource: Bloomberg

Unemployment is declining as a result of the higher levels of economic activity.

Eurozone Unemployment Rate (%)Source: Bloomberg

This is translating into improving consumer confidence.

European Commission Consumer Confidence Indicator Source: Bloomberg

Business appetite for borrowing has also picked up with a strengthening economy.

European Central Bank Money Supply M2 YoYSource: European Central Bank

Given the still high levels of unemployment in the Eurozone and relatively frictionless labour mobility, nominal wage growth remains subdued and is likely to remain so until the labour market tightens significantly. And this, we think, will keep the ECB from tightening too quickly and instead allow monetary policy to remain accommodative for at least another 18 to 24 months, which should be supportive of profitability of Eurozone companies.

Investment Perspective

A strengthening Euro has thus far not derailed the recovery in the Eurozone. This is because the recovery is domestically driven and not by exports or as a consequence of an undervalued currency. The ECB’s accommodative policies have kept the cost of capital low, allowing companies to repair their balance sheets and increase profitability.

Comparing the price performance of the STOXX Europe Mid 200 Index – a representative index for mid-cap companies in Europe – to the trailing twelve months price-to-earnings ratio of the index, we find that over the last two years earnings growth, not multiple expansion, has driven the price performance of mid-cap European companies. In fact, the price-to-earnings ratio has contracted over the last two years by over 25 per cent while the index is up over 16 per cent.

STOXX Europe Mid 200 Price Index – Price vs. Price-to-Earnings RatioSource: Bloomberg

We prefer small- and mid-cap exposure in Europe over broad based equities exposure. We think a stronger Euro will be a headwind for many large-companies as most of them have a significant portion of their earnings coming from exports.

At a sector level in the mid-cap space, we like automobiles and components producers, consumer services companies, mid-sized Spanish banks, and insurance companies. Areas that we would avoid include food & beverage producers and distributors, media companies and mid-sized energy related plays.

* Note if you would like to discuss specific names please email us

Agriculture Commodities and Chemicals: Catalyst Needed

“The ever more sophisticated weapons piling up in the arsenals of the wealthiest and the mightiest can kill the illiterate, the ill, the poor and the hungry, but they cannot kill ignorance, illness, poverty or hunger.” – Fidel Castro

“Feel what it’s like to truly starve, and I guarantee that you’ll forever think twice before wasting food.” – Killosophy by Criss Jami

“Agriculture is not crop production as popular belief holds – it’s the production of food and fiber from the world’s land and waters. Without agriculture it is not possible to have a city, stock market, banks, university, church or army. Agriculture is the foundation of civilization and any stable economy.” – Allan Savory, Zimbabwean ecologist, livestock farmer, environmentalist, and president and co-founder of the Savory Institute

‘Qu’ils mangent de la brioche’, that is, ‘Let them eat cake’, are allegedly the famous words uttered in the 18^th century by Marie-Antoinette, the last queen of France, upon being informed that the French peasants have no bread. While these words may or may not have been spoken at the time, food shortages and the high cost of bread were most certainly the precursors to the rioting that led to the French Revolution.

With over 1.3 billion mouths to feed, members of the Communist Party of China (CCP) will be all too aware of the dire consequences food shortages or rapidly rising food prices could have on their political careers. This in turn is likely to make them sensitive to any sharp rise in agriculture commodity prices. And it is no wonder that the CCP has over recent years taken steps to influence supply-demand imbalances in key agricultural commodities.

In 2016, for example, the Chinese government announced that it was scrapping its price support policy and stockpiling program for corn, a policy that had been put in place in 2007 to encourage local production of corn. The price support policy worked well, too well some might argue, in boosting local production especially as the government kept raising the support price until the end of 2011. The support price meant that corn prices in China were higher than prices in international markets. Unsurprisingly, given the incentives, the level of corn imports into China increased and the Chinese government was left to buy ever increasing amounts of locally produced corn. Analysts have speculated, that by 2016, the Chinese government’s corn reserves amounted to around half of all global stockpiles.

Chinese Quarterly Corn Imports

Source: United States Department of Agriculture

Chinese corn imports dropped in response to the abandoning of the price support policy. The premium between Chinese and international corn prices also shrank – the premium started dwindling in 2015 when the support price was reduced for the very first time.

In May 2017, the government decided to heap further pressure on commodity markets by auctioning off parts of its corn reserves, causing an initial sell-off in futures markets. International prices have stabilised since and remain largely range bound; however, Chinese prices bottomed in January 2017 and have been gradually rising since.

Chinese Corn Price vs. International Corn PriceSource: Bloomberg

The divergence in Chinese and international corn prices witnessed since January 2017 has been witnessed in other agricultural commodities, such as wheat and soybean, as well. China’s “battle for blue skies” and reduced air pollution forced many producers, both industrial and agricultural, to suspend operations last year. These suspensions rocked Chinese commodity markets and pushed prices higher. The situation was exacerbated in the winter when government officials – in a bid to meet year-end air pollution targets and to free up natural gas supply for households forced to switch from coal-fired to gas-based heating – forced natural gas-powered fertiliser plants to shut in areas like Sichuan and Yunnan, forcing prices of nitrogen-based fertilisers, such as urea, higher.

China Urea Prill Spot Price Source: Bloomberg

With year-end government targets met and the campaign set to end in March 2018, we suspect that the pressure will ease off and some of the suspended agricultural and industrial capacity will resume operations. The government has already reversed its ban on coal for heating as gas shortages left people freezing during the winter. As some of the shuttered capacity comes back online, we expect the premium in Chinese commodity prices to decrease. Nonetheless, with Xi Jinping highlighting environmental concerns in his speech at the CPC’s 19^th National Congress, we think that campaigns, such as the recent crackdown on smog, will continue in fits and spurts over the coming years and add to the volatility in Chinese industrial and agricultural production.

Although China has built up significant agricultural production capacity over the last decade, most of this capacity is inefficient as the price support policy incentivised capacity not efficiency. With the price support policy removed and our expectations of increasing volatility due to government policies, we suspect a significant portion of the existing capacity is already or will soon be at risk of closure due to mounting losses. Despite the level of Chinese stock piles, China cannot afford to lose productive capacity as stock-to-usage levels for some of the key agricultural crops in China are at very low-levels – levels last witnessed prior to the launch of the prior support policies for critical agricultural commodities.

China Corn Percentage Stocks-to-UseSource: United States Department of Agriculture

China Barley Stocks-to-Use DaysSource: United States Department of Agriculture

The global stocks-to-use level excluding China is even more precarious.

Global ex-China Corn Percentage Stocks-to-Use Source: United States Department of Agriculture

Global ex-China Wheat Percentage Stocks-to-UseSource: United States Department of Agriculture

Global ex-China Barley Percentage Stocks-to-UseSource: United States Department of Agriculture

With global stocks-to-use levels ex-China at or near multi-decade lows – and our belief that China is unlikely to become an exporter of agriculture commodities anytime soon – agriculture commodities remain susceptible to supply side shocks. These shocks could be caused by an adverse weather event, like La Niña, that disrupts production across key regions and causes food prices to spike, trade sanctions or tariffs being placed by the US on imports from key agriculture exporters, or rising freight and input costs for farmers.

Investment Perspective

As it generally tends to be the case with commodity related investments ideas, there are a number of ways to construct trades around the agriculture commodities theme. Our preferred approach, in this instance, is to combine direct commodity exposure with feedstock producer equities.

Historically, sharp rallies in key agriculture commodities have either coincided with or been preceded by global stock-to-use levels of the commodities being low, much as they are today. Low stock-to-use levels, in our opinion, are a necessary but not sufficient condition for a sharp increase in the prices of agriculture commodities. Demand or supply side shocks are usually the catalysts that cause prices to rally. We think key agriculture commodities are primed for a rally should a catalyst materialise.

Global ex-China Corn Percentage Stocks-to-Use vs. Corn Futures PricesSources: United States Department of Agriculture, Bloomberg

Global ex-China Wheat Percentage Stocks-to-Use vs. Wheat Futures PricesSources: United States Department of Agriculture, Bloomberg

Managed money positioning in futures markets are also extremely bearish. Money managers, on a net basis, shorts in corn and wheat are at or near a record number of contracts. Unwinding of these positions, too, can add fuel to any rally in prices should a catalyst materialise.

CFTC CBT Corn Managed Money Net Total / Disaggregated CombinedSource: Bloomberg

CFTC CBT Wheat Managed Money Net Total / Disaggregated CombinedSource: Bloomberg

On the feedstock side, our preference is to allocate to the equities of nitrogen-based fertiliser producers as our analysis suggests that supply and demand dynamics are gradually shifting in favour of producers. Taking urea for instance, production capacity growth is expected to plateau in 2019 while at the same time exports from China have been dropping sharply despite the removal of export tariffs in 2017.

China 12-Month Rolling Average Urea ExportsSource: Bloomberg

At the same time, Indian imports of urea appear to have bottomed. India is one of the largest consumers of urea globally and its market went through significant disruptions over the last two years, which dampened demand for urea. Farmer subsidy payments were delayed by the government, the introduction of the general sales tax of 18% in July 2017 increased the financial burden on farmers, and the reduction of urea bag sizes from 50 kilograms to 45 kilograms reduced demand as farmers in India tend to base their usage on bags as opposed to weight.

India 12-Month Rolling Average Urea ImportsSource: Government of India Department of Fertilisers

In terms of nitrogen-based fertiliser producers, we like Yara International (Yara) – the world’s largest nitrogen fertiliser producer. Yara has boosted efficiency as the global fertiliser slump has pressured margins and has increasingly shifted its focus toward higher margin products and high-growth regions. With fertiliser prices having picked up in the fourth quarter of 2017, Yara is well positioned to benefit from improved margins and increasing volumes should fertiliser markets remain resilient over the course of 2018.

We are long ETFS Corn ($CORN.LN), ETFS WHEAT ($WEAT.LN) and Yara International (Norwary).

Note: Yara International’s ADR is available is US OTC markets with ticker $YARIY.