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Trade Wars Revisited – Part II

 

“The secret to gaining the upper hand in a negotiation is to give the other side the illusion of control.” — Christopher Voss, former FBI hostage negotiator

Idea Updates

 

In our 2019 outlook piece issued on 7 January, we highlighted a number of emerging market ideas, the following are the idea we recommend closing out now:

 

1. Global X MSCI Argentina ETF $ARGT, which is up 11.61 per cent from market close on 7 January till yesterday’s close.

2. Ashmore Group $ASHM.LN, which is up 26.02 per cent from market close on 7 January till yesterday’s close in US dollar terms.

3. iShares MSCI Indonesia ETF $EIDO, which is down 9.66 per cent from market close on 7 January till yesterday’s close.

 

During the same period as the above ideas were open, the S&P 500 and MSCI ACWI indices have generated total returns of 11.56 and 9.07 per cent, respectively.

 

Trade Wars Revisited

 

More Bad News for Huawei

 

From the Financial Times:

 

Arm, which provides the underlying chip designs for the world’s smartphones as well as for many other types of semiconductors, has suspended business with the Chinese telecoms company due to the US clampdown on supplying it.

 

From the Nikkei Asian Review:

 

German chipmaker Infineon Technologies has suspended certain shipments to Huawei Technologies, three people familiar with the matter told the Nikkei Asian Review, in the first sign that Washington’s crackdown on the Chinese tech giant is beginning to choke off vital chip supplies from non-U. S. companies.

 

Huawei is going to need a lifeline sooner rather than later and the only person capable of providing it is President Trump. The Chinese company is likely to be central to an trade negotiations henceforth.

 

Is Oil Also Hostage to the Trade Dispute?

 

China’s three weaknesses just so happen to be three of the US’s strengths. One being semiconductors, which we have discussed previously, and the other two being oil and the US dollar.

 

China imports a lot of oil and produces very little of it. The US, propelled by the near miracle that is the Permian Basin, has become a net exporter of oil. A rising oil price hurts China, while it benefits the US and vice versa.

 

Given these dynamics, one is left considering the possibility that the US imposing economic sanctions on Iran and Venezuela, two oil exporting nations, and strong hints of warmongering in the Middle East by the Secretary of State Michael Pompeo  is as much about Iran and Venezuela as it is about weaponizing oil against China.

 

If the US is indeed weaponizing oil then it is only a matter time before a controversy or conflict involving the Strait of Malacca hits the newswires. More than 90 percent of crude oil volumes flowing through the South China Sea transit through the Strait of Malacca, the shortest sea route between suppliers in Africa and the Persian Gulf and markets in Asia, making it one of the world’s primary oil transit chokepoints according to the US Energy Information Administration.

 

On the other hand, much like Huawei was stockpiling semiconductor inventories in case of an escalation in the US-China trade dispute, China, too, may have been stockpiling oil ahead of a possible escalation in the trade war. If indeed this has been the case, then some of the strength in the price of oil, particularly relative to other commodities, can be explained by the aggressive buying by China.

 

The top panel in the below chart are the monthly volumes of oil imported by China. The bottom panel is the year-over-year change in oil imports.

 

CCCIIQTL Index (China Customs Cr 2019-05-24 14-46-13.jpg

 

In the second panel in the chart above, we can see that the year-over-year increase in Chinese oil imports was the highest in December since May 2016. What explanation could there be for the aggressive Chinese buying other than stockpiling ahead of a potential escalation in the trade dispute? The price was certainly was not as attractive as it was in 2016 and the Chinese economy was not as strong as it was then either.

 

The Chinese response to a weaponizing of oil, we think, can come in three forms:

 

1. Scaling back of monthly imports in response to the tighter oil markets and higher price.

2. Finding a work around the sanctions on Venezuela and Iran and buying oil from them in return for renminbi or gold.

3. Urging Russia, its supposed ally and victim of US imposed sanctions, to break rank from OPEC and bring to an end the self-imposed production quotas in a bid to capture higher share of Chinese demand.

 

We think we have entered a volatile phase for the price of oil driven by the waxing and waning of push and pull forces in the trade dispute.

 

A More Coherent Trade Strategy by the Trump Administration

 

In May of last year in AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote (emphasis added):

 

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

 

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

 

China is clearly becoming the administrations’ singular focus when it comes to trade.  Other trade disputes are being diffused just as hostilities towards China are escalating.

 

Last Friday it was announced that an agreement had been reached to lift the tariffs imposed by the US against Canadian and Mexican steel and aluminium imports in no later than two days.  The tariffs, implemented last year by the Trump Administration had been a key impediment to Congressional ratification of the US-Mexico-Canada Agreement (USMCA), and made chances of passage of the agreement this year difficult.

 

In addition to lifting the import tariffs against Canada and Mexico, President Trump also has delayed for six months a decision on imposing tariffs on automobile and auto parts imports.

 

While the amendments to the USMCA and the postponements to the auto tariffs are positives within a sea of negativity (at least as it relates to capital markets), we do not consider the risk of auto tariffs being imposed to have diminished. Rather we see the postponement as a sign that President Trump will return to the matter with renewed intensity.

 

President Trump, since taking office, has barely wavered is his commitment to protectionism. In 2016 he campaigned on a protectionist agenda that he will want to claim he has  delivered upon in his 2020 re-election bid. Moreover, with think he will feel is odds for success will be further strengthened by taking a hard line approach on trade rather than by negotiating agreements that would leave him open to criticism by both the trade hawks in his administration and by Democrats in Congress. Therefore we do not expect the President to pass up on the opportunity to be seen as being tough not only on China but also Japan and Germany, the nations most vulnerable to auto tariffs.

 

 

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 Revisited – Part I

 

“Uncertainty always creates doubt, and doubt creates fear.” — Oscar Munoz, Chief Executive Officer of United Airlines

“When the uncertain future becomes the past, the past in turn becomes uncertain.” — from Moth Smoke by Mohsin Hamid

 

We revisit the trade dispute between the US and China this week. We apologise in advance for the lengthy quotes from pieces we wrote last year but felt it necessary to provide context.

 

Note: We have split this week’s commentary in two parts as it runs quite long, the first part is below and the second will follow by Friday this week.

 

 

In December of last year in The Hawks Have Not Left the Building we wrote (emphasis added):

 

[W]e do not expect a breakthrough in negotiations to materialise during the next round of talks between Washington and Beijing before the suspension of the increase in tariffs lapses. As long as hawks such as Peter Navarro and Robert E. Lighthizer continue to have President Trump’s ear our view is unlikely to change. If, however, the dovish members of the Trump Administration, such as Treasury Secretary Steve Mnuchin and Director of the National Economic Council Lawrence Kudlow, begin to take control of proceedings we would become much more hopeful of a positive resolution to the trade dispute.

 

For now, we see the temporary agreement between the two sides as providing much needed short-term respite for China. More importantly, we see President Trump’s offer of a temporary ceasefire without President Xi offering any concessions on sensitive issues, such as industrial policy, state funded subsidies and intellectual property rights, to be a symptom of the short-termism that seemingly besets democratically elected leaders without exception. Had the US equity capital markets not faltered recently and / or the Republicans not lost control of the House of Representatives, it is unlikely, we think, that President Trump would have been as acquiescent.

 

The above quote provides the frame of reference from which the remainder of the analysis in this piece stems from.

 

Semiconductors: From Bad to Worse

 

The below chart compares the performance of the S&P 500 Index to that of the Philadelphia Semiconductor Index $SOX and the ADR of Taiwan Semiconductor Manufacturing Company $TSM over the course of the last month.

 

SPX Index (S&P 500 Index) Multi 2019-05-21 12-36-54.png

 

President Trump first tweeted about the trade negotiations with China falling apart on 5 May. Markets sold off a little in response to the tweet, semiconductor stocks sold off more. Then things got worse for semiconductor stocks, the US government issued an edict banning American suppliers from doing business with one of their biggest customers, Huawei Technologies Company, without the explicit approval of the US government. And then got even worse, the South China Morning reported that Huawei allegedly has been stockpiling a year’s worth of inventory out of fear of export ban being placed on US manufacturers. If true, US chipmakers’ earnings last year were much inflated.

 

Following the negative news, and striking a fear into markets that the Trump Administration was willing and able to inflict direct harm on US corporations in its bids to rein in China, government officials have come out suggesting that a handful of temporary exemptions may be granted. This would give some suppliers and customers of China’s telecom giant a 90-day reprieve from tough trade penalties.

 

From Fragile to “Antifragile”…

 

On 6 June 1967, Arab oil producing nations, to deter nations from supporting Israel in the six-day war, placed an embargo on oil exports to the US, UK and a number of other western nations. At the time the embargo was imposed, the UK was wholly dependent on foreign on oil resources and was, unsurprisingly, severely impacted by the embargo.

 

Between 1969 and 1970, vast oil reserves were discovered by the UK under the North Sea.

 

Then again in 1973, Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo targeting the US, Canada, the UK, Netherlands, Japan and South Africa. The embargo was targeted at nations perceived as supporting Israel during the Yom Kippur War. The price of oil shot up from US dollars 3 per barrel to nearly US dollars 12 globally.

 

In 1973, the UK was still a net importer of oil and felt the sting from the Arab oil boycott. By 1979, on the back of the strength of the North Sea discovery,  UK had propelled itself to become a net exporter of oil.

 

Just as the Arab oil embargoes spurred the UK’s discovery of North Sea Oil and eventual energy independence, the actions of the Trump Administration are almost certainly going to harden China’s resolve in developing a captive semiconductor industry.

 

President Xi Jinping has during his reign recounted the long and painful history of China surrendering to British imperialists in the nineteenth century, often referred to as the “century of humiliation”. Neither he nor his comrades at the Chinese Communist Party will want China’s dependence on US chipmakers to become a source of humiliation or an impediment to its growth ambitions. China has no choice but to invest in developing a captive semiconductor industry capable of competing with the best and brightest.

 

…But Achieving Antafragility Takes Time

 

From the original Arabian oil embargo, it took the UK a further eleven years to build up its oil production capabilities and to free itself from any future oil exporter hostilities.

 

China, too, will need time to develop its captive semiconductor industry. Huawei’s alleged hoarding of a year’s worth of supply of American manufactured inventory proves as much.

 

China’s semiconductor industry remains far behind its American and Korean counterparts in the manufacture of advanced processing chips. The challenges is further compounded with non-existent local production of the equipment that is required to design and fabricate advanced processing chips.

 

Semiconductor companies are now hostage to the vagaries of the American and Chinese trade dispute. Should some semblance of a trade agreement be miraculously salvaged semiconductor stocks will most likely rally and rally hard. If not, they might be in a long, painful ride.

 

The Huawei Question

 

Huawei, not for first time, is suffering at the hands of the US political establishment.

 

In January 2018, AT&T, pressured by Washington, walked away from a deal to sell the Huawei smartphone, the Mate 10, to customers in the United States just before the partnership was set to be unveiled. Verizon shortly followed suit.

 

Meng Wanzhou, CFO of Huawei and daughter of the company’s founder, was arrested on 1 December 2018 in Canada at the request of the US government for allegedly defrauding multiple financial institutions in breach of US-imposed bans on dealing with Iran.

 

In February 2019, US officials lobbied European authorities in banning Huawei from 5G network builds in Europe and called the Chinese company “duplicitous and deceitful”.

 

By forbidding US companies from trading with Huawei, one of China’s most prominent technology companies, without the government’s explicit permission, the Trump Administration is clearly sending a message. And the ban is not just limited to US companies, export controls also extend to non-US companies that sell any product in which US-origin technology comprises 25 per cent or more of the value. Given in the intertwined nature of semiconductor production, implying that Huawei is likely unable to replace US products it loses access to.

 

The question now is whether the Trump Administration goes for the kill or not. ZTE had to cease operations after being hit with US export controls, Huawei is likely to suffer same fate unless US officials make a u-turn. Given the heavy criticism President Trump received for rolling back sanctions on ZTE, it is unlikely that he would be as forgiving this time around with US elections next year unless he wants to revive the trade deal.

 

The fate of Huawei is now likely to signal the outcome of the trade deal:

 

1. Huawei survives and retains most of its pre-export glory and we get a “beautiful” trade deal.

2. Huawei survives but in a scaled back form and we get a patched up trade deal with both sides saving face.

3. Huawei fails and the trade deal is dead, or at least takes a very long-time to revive.

 

 

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.

 

 

 

 

 

 

Turkish Lira | HKD Peg

 

“We walked to the brink and we looked it in the face.” — John Foster Dulles, United States Secretary of State under President Dwight D. Eisenhower from 1953 to 1959

 

“People like me who were engaging in brinkmanship with the party economic bosses and the open dissidents who were being arrested were pursuing a common goal in different ways.”  — Vaclav Klaus, Czech economist and politician who served as the second President of the Czech Republic from 2003 to 2013

 

Turkish Lira and Non-Resident Holdings

 

After a sharp decline between January and August last year and crossing the 7 handle, the Turkish lira rebounded by 15 per cent from September through December, following a massive interest rate hike by the Turkish central bank. The currency, following a period of relative calm for during the first two months of 2019, has once again started dropping like a stone, although not as precipitously as last year.

 

The recent decline in the lira has been triggered by an economy stuck in stagflation and heightened political instability, which, of course, has been par for the course under President Recep Tayyip Erdoğan. The currency came under pressure this week after fresh elections were announced for the city of Istanbul on the demands of the AK Party, Turkey’s ruling party, which narrowly lost control of the city in municipal elections last March.

 

Nonresident investors in Turkish capital markets have responded to the economic and political uncertainties by dumping their holdings of domestic bonds and equities. Net outflows of nonresident portfolio investment in local currency assets amounted to US dollars 1.4 billion in March and April as foreign investors pulled capital out of both the domestic bond and equity markets. Nonresidents now hold only 12 per cent of domestic public debt, down from over 20 per cent in 2018.

 

The chart below compares the Turkish lira-US dollar currency pair (inverted) to the sum of the nonresident holdings of the domestic bond and equity markets. As can be seen from the chart, the currency pair has been tightly correlated with the level of nonresident holdings of domestic assets.

 

TRY / USD (Inverted) vs. Non-Resident Domestic Bond and Equity Holdings

TRY NonResidential Portfolio Investments.pngSource: Bloomberg

 

With limited room for the nonresident holdings to fall much further  — assuming that Turkey is not dropped from global equity and bond indices, events that would force passive investors to also sell down Turkish assets — we would be tempted to go long the lira at current levels, were it not for the unpredictability of Turkey’s leadership.

 

Hong Kong Dollar Peg

 

From The Wall Street Journal on 25 April 2019:

 

Kyle Bass, the often-bearish hedge-fund manager who won big during the global financial crisis, has trained his sights anew on the Hong Kong dollar.

Mr. Bass’s Dallas-based Hayman Capital Management LP published its first investor letter in three years this week, titled “The Quiet Panic in Hong Kong.” Mr. Bass gained publicity a decade ago for his bearish bets against securities tied to the U.S. housing market.

The investor letter, which was viewed by The Wall Street Journal, argues that a combination of rapid growth in floating-rate mortgages, the gap between local and U.S. short-term interest rates, and mounting geopolitical tensions between the U.S. and China put Hong Kong’s currency arrangement at risk of breaking.

“Hong Kong currently sits atop one of the largest financial time bombs in history,” Mr. Bass said in the letter. He said the size and leverage of the city’s banking system made it similar to Iceland, Cyprus and Ireland before their financial crises.

 

The Asian Financial Crisis originated on 2 July 1997, the day after the sovereignty of Hong Kong was transferred from the United Kingdom to China, with the devaluation of the Thai baht.

 

The crisis came to be defined by the speculative bets by western hedge fund managers against the many dollar-pegged currencies of South East Asia and precipitating the near collapse of famed US hedge fund Long Term Capital Management.

 

Hong Kong, too, was embroiled in the crisis; however, unlike Thailand, South Korea and Indonesia, the authorities in Hong Kong chose asset price deflation and economic pain over letting go of their currency peg. The Hong Kong Monetary Authority (HKMA) at one point in 1997 raised overnight interest rates to over 200 per cent, testing speculators’ wherewithal in holding on to their shorts against the currency and in the local stock market. As a corollary of the HKMA’s actions to deter speculators, GDP declined by 5 per cent in 1998 compared to growth of 5.3 per cent in 1997, unemployment reached 6.4 per cent and real estate prices in city-state more than halved.

 

The spillover effects of a collapsing real estate market were particularly damaging for Hong Kong’s economy. As property values fell, banks curtailed lending and land sales, a significant source of government revenues, fell off a cliff, sending the government’s fiscal revenues plunging. The government, accustomed to running a fiscal surplus, experienced a fiscal deficit of approximately US dollars 3 billion in 1998/99.

 

The HKMA ended up spending around US dollars 15 billion to fight off short sellers, including buying up stocks and borrowing all the stocks available in the market.

Hong Kong’s experience and the measures taken by its authorities in defending the currency peg is a testament to the pain the city-state is willing to endure to defend the Hong Kong dollar’s peg to the US dollar.  Anyone seeking to duke it out with the HKMA should expect a long and arduous battle with little hope of victory in the near term.

 

The political will to hold on to the dollar-peg is strong. What about the economic reality? One could fairly argue that the political will to defend the peg was also there in Thailand, South Korea and Indonesia but they failed where Hong Kong succeeded. We are of the opinion that the economic reality in favour of the peg remaining are just as strong as the political will.

 

We quote from the speech given by Mr Norman T. L. Chan, the then Chief Executive Officer of the HKMA, at the Oxford University in 1999 on the lessons from the Asian Financial Crisis (emphasis added):

 

The banking systems were inadequately supervised and were prone to incurring excessive risks by borrowing short-term funds to finance long-term lending to projects the viability of which was doubtful. Moreover, the corporate sectors of many Asian economies were over-stretching themselves by engaging in risky or unproductive investments. To a varying degree, both the banks and corporates were taking excessive currency risks by borrowing in foreign currencies, which had a much lower interest costs than domestic currencies, to fund projects which could only generate income, if any at all, in domestic currencies. The implicit guarantee of exchange rate stability provided by the governments weakened the alertness to the risks arising from currency and maturity mismatches. As the amounts of international capital flows increased phenomenally in the last few years, disaster struck when the bubble burst.

 

Excessive currency risk, to paraphrase the words of Mr Chan, were being taken by banks and corporations by borrowing in foreign currencies due to interest rates being lower offshore than onshore. Today, the interest rates in Hong Kong are lower than interest rates in the US. There is no structural reason for banks and corporations to borrow in hard currency and take on excessive currency risks. Implying that one of the conditions that made shorting South East Asian currencies such an asymmetric bet during the Asian Financial Crisis absent for the Hong Kong dollar today.

 

Short sellers may argue that what makes shorting the Hong Kong dollar particularly attractive is the positive carry i.e. they earn the interest differential between overnight rates in Hong Kong and LIBOR when they short the Hong Kong dollar.  Meaning that there is little downside to putting on the trade. This is true till it ceases to be true. If speculators begin to the pile into the trade, overnight rates in Hong Kong will ultimately converge with LIBOR and said free lunch will cease to exist. Should the size of the trade get sufficiently large, the positive carry could even turn into negative carry.

 

Next, we compare Hong Kong’s monetary base — as defined by the HKMA as consisting as the sum of the certificates of indebtedness outstanding, government notes and coins in circulation, closing aggregate balance, and outstanding exchange fund bills and notes  — to the office level of foreign currency reserves held by the HKMA.

 

Hong Kong Official Foreign Currency Reserves vs. Monetary Base

HKD Monetary Base.png

Source: Hong Kong Monetary Authority

 

As can be seen in the above chart, the level of foreign reserves held by the HKMA is more than double the city-state’s entire monetary base i.e. the HKMA has sufficient reserves for the entire monetary base to head for the exits twice over. During the Asian Financial Crisis, the HKMA used US dollars 15 billion to fight short-sellers. Today it has more than US dollars 200 billion to fight them with.

 

We do not have the wherewithal or the appetite for a fight with the HKMA and neither should you!

 

Definitions

Certificate of Indebtedness

 

When note-issuing banks in Hong Kong issue banknotes, they are required by law to purchase Certificates of Indebtedness, which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund. 

 

The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are withdrawn from circulation, Certificates of Indebtedness are redeemed and the note-issuing banks receive an equivalent amount of US dollars from the Exchange Fund.

 

Closing Aggregate Balance

 

Aggregate balance is the sum of balances in the clearing accounts and reserve accounts maintained by commercial banks with the central bank. In Hong Kong, this refers to the sum of the balances in the clearing accounts maintained by the banks with the HKMA for settling interbank payments and payments between banks and the HKMA. The aggregate balance represents the level of interbank liquidity.

 

Exchange Fund Bills and Notes

 

Exchange Fund Bills and Notes are Hong Kong dollar debt securities issued by the HKMA. They constitute direct, unsecured, unconditional and general obligations of the Hong Kong Special Administrative Region Government for the account of the Exchange Fund and have the same status as all other unsecured debt of the Government. The Bills and Notes are for the account of and payable from the Exchange Fund.

 

The Exchange Fund Bills and Notes Issuance Programme ensures the supply of a significant amount of high-quality Hong Kong dollar debt paper, which can be employed as trading, investment and hedging instruments. Authorized Institutions that maintain Hong Kong dollar clearing accounts with the HKMA may use their holdings of Exchange Fund papers to borrow Hong Kong dollars overnight from the Discount Window. Active primary and secondary markets for Exchange Fund Bills and Notes has facilitated the development of a sophisticated Hong Kong dollar debt market.

 

Source: Hong Kong Monetary Authority

Notes: To read more about the Hong Kong currency board click here

 

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 Infrastructure

 

“We need to build roads, bridges, airports, locks, dams, and rail that work for this century — not the last one. And let’s not forget about updating our energy grid, repairing and replacing our water infrastructure and sewers, and making sure all Americans have access to broadband.” — Amy Klobuchar

 

“We can only create good jobs if we make smarter investments in infrastructure and do more to support small businesses, not stiff them.”  — Michael Bloomberg

 

The condition of roads, bridges, schools, water treatment plants, and other physical assets greatly influences an economy’s ability to function and grow. For an economy to realise its full potential it requires well-maintained roads, railroads, airports, and ports to facilitate commerce.

 

Infrastructure in the United States, unfortunately, is crumbling — unsurprising when  non-defense gross government investment (federal, state, and local) has largely been in decline since the 1960’s, falling from above 4 per cent of GDP to about 2.3 per cent in 2017.

 

In its most recent report card on the condition of America’s infrastructure, the American Society of Civil Engineers (ASCE) gave U.S. infrastructure a D+ or “poor” rating. The ASCE argues that the US can no longer afford to delay investing in its critical infrastructure systems. Henry Petroski in his book The Road Taken: The History and Future of America’s Infrastructure explains that the delays caused by traffic congestion alone cost the economy over US dollar 120 billion per year.

 

According to the ASCE’s estimates, the cost of bringing America’s infrastructure to a state of good repair (a grade of B) by 2025 is US dollars 4.6 trillion, of which only little more than half has been committed. Improving roads and bridges alone requires more than US dollars one trillion more than the amount allocated.

 

Infrastructure investment has received renewed interest in Washington following the mid-term elections last year, we have seen President Trump, Senators and some Members of Congress all discussing the benefits of upgrading the US’s infrastructure in the recent past.

 

Amy Klobuchar, the Senator from Minnesota, one of the Democrats from the crowded field of Democrats angling to take on President Donald Trump in 2020, has proposed a US dollars 1 trillion infrastructure investment package.  President Trump in his 2020 budget request to Congress has renewed call for a US dollars 1 trillion infrastructure plan.

 

The consistency of the message on infrastructure spending from both the Democrats and Republicans is unsurprising.

 

There is a general consensus amongst economists and analysts that spending on infrastructure has a fiscal multiplier effect much larger than the typical government spending multiplier. A study conducted by economists at the Federal Reserve Bank of San Francisco in 2012 on the impact of unexpected infrastructure grants on state GDPs (GSPs) since 1990 found that, on average, each dollar of infrastructure spending increases the GSP by at least two dollars. While a University of Maryland study conducted in 2014 found that infrastructure investments added as much as US dollars 3 to GDP growth for every dollar spent.

 

Investment Perspective

 

The unmet infrastructure investment needs of the US and the growing political consensus around upgrading the nation’s infrastructure, we think, will be a tailwind for companies that can cater to the demand created by such spending.

 

The most obvious way to play the US infrastructure investment theme is through the Global X US Infrastructure Development ETF $PAVE.  

 

PAVE US Equity (Global X US Infr 2019-04-26 11-19-26.jpg

 

While we think a generalised exposure through an ETF may work well over a prolonged period. There a number of direct plays that we think may be superior in the nearer term — once there is more clarity or momentum in pushing through infrastructure spending programs in Washington.

 

On the telecommunications and technology upgrade front we think Clearfield Inc. and A10 Networks Inc. are potential long ideas.

 

The next generation of cell phone and wireless service will need  large scale investments in “small cell” wireless nodes, which are expected to replace traditional cell towers. Moreover, more than 19 million people living in rural America do not have access to broadband and investment needs to go into eliminating this so called “broadband gap”.

 

Clearfield Inc. $CLFD manufactures telecommunication equipment. The company designs accessories, cassettes, connectors, assemblies, panels, and other related products for various applications.

 

 

CLFD US Equity (Clearfield Inc) 2019-04-26 11-25-21

 

A10 Networks Inc. $ATEN provides computer networking products and security solutions. The Company offers controller, firewall, hardware appliances, protection systems, and other networking products.

 

 

ATEN US Equity (A10 Networks Inc 2019-04-26 11-30-19.jpg

 

On the construction and construction materials side we Vulcan Materials Co., Construction Partners Inc. and Quanta Services Inc.

 

Vulcan Materials Co.$VMC produces construction aggregates. The Company’s principal product lines are aggregates, asphalt mix and concrete, and cement.

 

VMC US Equity (Vulcan Materials 2019-04-26 11-39-16.jpg

 

Quanta Services, Inc. $PWR provides specialized contracting services to electric utilities, telecommunication, cable television operators, and governmental entities. The Company also installs transportation control and lighting systems and provides specialty electric power and communication services for industrial and commercial customers.

 

PWR US Equity (Quanta Services I 2019-04-26 11-42-45.jpg

 

Construction Partners, Inc. $ROAD provides infrastructure construction services. The Company offers services to public and private infrastructure projects includes highways, roads, bridges, airports, and commercial and residential sites. Construction Partners serves customers in the United States.

 

ROAD US Equity (Construction Par 2019-04-26 11-42-12

 

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.

 

 

 

 

 

 

Lighten Up On Semiconductors

 

“The good times of today, are the sad thoughts of tomorrow.” — Bob Marley

 

Chinese Economic Data

 

The Chinese economy grew at 6.4 per cent year-over-year during the first quarter of 2019, matching the economy’s growth during the fourth quarter of last year but below the 6.6 per cent growth achieved for the full year during 2018. Growth came in slightly higher than consensus expectations and appears to have been buoyed by strong credit growth — system-wide financing was up 10.7 per cent year-over during March, led by an acceleration in lending by Chinese financial institutions. Total loans extended by financial institutions increased by 13.7 per cent year-over-year in March to reach its highest rate since June 2016.

 

CNLNTTLY Index (China Total Loan 2019-04-18 13-38-21.png

 

There was a sharp recovery in the Chinese industrial sector during March, industrial value added surged to 8.5 per cent year-over-year, up from 5.7 per cent in February. Part of this growth can probably be attributed to the Chinese New Year falling in early February this year versus being in late February last year — factories are likely to have only reached stable production into March in 2018. We will look to April data upon its release for further clarity.

 

CHVAIOY Index (China Value Added 2019-04-18 13-54-41.png

 

Despite the above caveat, some of the notable metrics on the industrial side include:

 

 

  • Smartphone, automotive and semiconductor production dropped by 7, 3 and 2 per cent, respectively.

 

The bad news for semiconductors was not limited to production. Chinese imports of diodes and semiconductors during March declined by 11.8 and 12.7 percent year-over-year in value and volume terms, respectively. For the first quarter imports are down 9.6 and 14.7 per cent year-over-year in value and volume terms, respectively.

 

The decline in semiconductors may prove to be a red herring. It is altogether possible that Chinese authorities are eager to limit semiconductor imports up until a trade deal has been struck with the United States. Unleashing a flurry of semiconductors orders from to help close the bilateral trade deficit, upon signing of a trade pact. If this indeed is the case, it would go someway towards explaining the discrepancy between the strength in China’s Purchasing Manager’s Index and the weakness in Korean and Taiwanese exports to China.

 

Given the softness in Chinese semiconductor imports, our conviction in our earlier call of shorting Taiwanese semiconductor companies as a hedge for portfolios positioned for an amicable resolution to the US-China trade dispute is strengthened. Further, we think shorting Taiwanese semiconductor is one of those rare situations of “heads I win and tails I do not lose” — under an amicable trade resolution, marginal Chinese demand shifts from Taiwan to the US, while under a deterioration of trade relations the risk of Taiwan being annexed increases markedly.

 

Away from semiconductors, given the pick up in Chinese industrial activity and credit impulse and the robustness of the property market, we reiterate our call for fixed-income investors to close out long positions in long-dated Chinese government bonds.

 

Lighten Up On Semiconductors

 

Despite the slowdown in Chinese semiconductor imports, the market has bid up semiconductor stocks to record highs. The Philadelphia Stock Exchange Semiconductors Index is up 35.4 per cent year-to-date versus 16.4 per cent for the S&P 500 Index.

 

The index has been buoyed by recent announcements from Intel, Apple and Qualcomm.

 

Apple and Qualcomm announced that the two parties agreed to dismiss all litigation between them world-wide and signed a new licensing agreement, which brings to an end the long-running legal battle over how royalties are collected on innovations in smartphone technology. Qualcomm said the agreement will add about US dollars 2 in annual earnings per share. Qualcomm’s stock jumped 23 per cent on the news.

 

Following the announcement from Apple and Qualcomm, Intel announced that is was withdrawing plans to make modem chips for 5G smartphones. Investor’s cheered the decision, pushing Intel’s stock to 19-year highs.

 

Such positive news from two of the five largest constituents of the Philadelphia Stock Exchange Semiconductors Index is a pretty high bar to set for good news to clear in the near term. And the market’s reaction function to news about the on going US-China trade negotiations exhibiting more than a tinge of buying the rumour, we are concerned that an eventual agreement will close the loop by being a sell the news event.

 

We think it is as a good time as any to lighten allocations in the semiconductor space. 

 

Inflationary Pressures

 

From The Beige Book issued 17 April 2019 (emphasis added):

 

Employment continued to increase nationwide, with nine Districts reporting modest or moderate growth and the other three reporting slight growth. While contacts reported gains across a variety of industries, employment increases were most highly concentrated in high-skilled jobs. However, labor markets remained tight, restraining the rate of growth. A majority of Districts cited shortages of skilled laborers, most commonly in manufacturing and construction. Contacts also reported some difficulties finding qualified workers for technical and professional positions. Many Districts reported that firms have offered perks such as bonuses and expanded benefits packages in order to attract and retain employees. This tight labor market also led to continued wage pressures, as most Districts reported moderate wage growth. Wages for both skilled and unskilled positions generally grew at about the same pace as earlier this year.

 

The below chart compares the National Federation of Independent Business (NFIB) time series on businesses reporting on job openings hard-to-fill to the growth in US nonfarm unit labour costs on a year-over-year basis. (The unit labour costs time series is lagged by a year, as it takes time from businesses realising that jobs are hard-to-fill to be willing to pay higher.)

 

COSYNFRM Index (US Unit Labor Co 2019-04-18 16-35-16.png

 

As can be seen from the chart above, the disconnect between the two time series today is quite large. If we take the commentary in The Beige Book at face value, there should be some convergence between the two series, with unit labour costs rising. If that transpires, we may finally see a sustainable pick up in inflationary pressures in the US, which may also mark the cyclical top in corporate profit margins.

 

The acceptance for and popularity of socialism driven in part by a decade of returns flowing to asset owners at the expense of labour providers, may just be coming at very moment the structural forces are set to move in favour of labour.

 

 

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.

 

Market Puzzles

 

“People who work crossword puzzles know that if they stop making progress, they should put the puzzle down for a while.” — Marilyn vos Savant, listed in the Guinness Book of World Records under “Highest IQ” from 1986 to 1989 and entered the Guinness Book of World Records Hall of Fame in 1988.

 

English engraver and cartographer John Spilsbury is said to have invented jigsaw puzzles during the second half of the eighteenth century. He was concerned, allegedly, with promoting a new way of teaching geography. We suspect, he is unlikely to have envisioned how his invention would evolve to become a form of entertainment for the masses.

 

Jigsaw puzzles as a form of entertainment for adults emerged around the start of the twentieth century and by 1908 a full-blown jigsaw craze had started in the United States which quickly spread across the Atlantic to Britain, and then around the world. The trend is said to have started in Newport, before spreading to New York, Boston and abroad. Adults across all rungs, except the very lowest, of society were sucked into the craze and puzzles became a primary form of entertainment in high society house parties in Newport and other country retreats. Although the fever eventually subsided, puzzles remained a regular source of adult amusement for the next two decades.

 

The onset of the Great Depression in 1929 coincided with a resurgence in the popularity of jigsaw puzzles. Sales are estimated to have peaked in early 1933 at a remarkable 10 million units per week. Puzzles, it seems, offered an escape from the financial woes of the times, as well as providing a sense of accomplishment during a time when jobs were hard to come by.

 

For us, price charts and evolving relationships between macroeconomic variables are  the pieces of a puzzle we are continuously striving to put together in order to have a clearer picture of the market.

 

In this week’s piece we run through some charts and macroeconomic relationships that dominate our thinking at the moment.

 

US Credit Flows and the US Dollar

 

 

Prior to the Global Financial Crisis, the year-over-year change in the broad measure of US  money supply, M2, was a very good proxy for trading the US dollar. Essentially, if the expectations were of credit to flow at a faster clip in the US economy, it paid to be long the dollar. If one the other hand, if the expectations were of credit conditions to tighten, it was better to be short the dollar.

 

The chart below plots an adjusted measure of year-of-year growth in broad US money supply, with the US dollar index, $DXY. The relationship worked swimmingly till the run up to the financial crisis. Following the crisis, there has been a disconnect that has largely remained.

 

DXYM2 wo ER

 

What we think changed following the crisis is broad money supply no longer being a suitable proxy for the flow of credit in the US economy. And the source of that change was the Fed’s large scale asset purchases in response to the financial crisis. The purchases were funded through the increase in reserve balances in excess of regulatory reserve minimum requirements. Essentially, the growth in the broad money supply following the crisis was not translating into increases in the flow of credit because banks were parking money with the Fed.

 

The below chart further adjusts the money supply time series for increases and decreases in the supply of excess reserves — the year-over-year growth (decline) in excess reserves is deducted (added) from (to) M2 to obtain a better estimate of the flow of credit in the US economy.

 

DXYM2 w ER

We think this chart captures the recent resilience of the US dollar. Although credit in its traditional forms, as depicted in the first chart, has remained tight, the draw down of excess reserves due to quantitative tightening has supported broad money supply growth. This in turn has been, we think, supportive of the greenback.

 

Given this adjusted metric, we can now hypothesise on the ways forward for the dollar.

 

For now, given the Fed’s intention to stop shrinking its balance sheet from September onward, the dollar’s continued resilience will hinge upon other sources of growth in credit. The reemergence of President Trump’s infrastructure bill could be one such source — should it materialise, it is likely to draw capital to the US from the rest of the world and push the dollar to new highs. Till it transpires, however, the risk-to-reward ratio is not in favour of dollar bulls.

 

Large scale infrastructure spending in the US may also be the scenario under which commodities and the dollar strengthen in sync while US Treasuries do poorly.

 

 

Emerging Markets

 

Given the crackdown on shadow banking in China, the waxing and waning of Chinese shadow financing is no longer a primary driver of emerging markets.

 

MXEF Index (MSCI Emerging Market 2019-04-11 15-37-39.png

 

Standalone and relative to the S&P 500, emerging markets do not look bearish at an aggregate level.

 

MXEF Index (MSCI Emerging Market 2019-04-11 15-38-38

 

Russia is increasingly looking like the market to own in emerging markets. (The bottom panel is the MSCI Russia Index relative to the MSCI Emerging Markets Index.)

 

MXRU Index (MSCI Russia Index) R 2019-04-11 15-55-30.png

 

The gains in oil this year, however, have not fully been reflected in the Russian equity market’s performance. (The bottom panel is the MSCI Russia Index relative to WTI crude.)

 

MXRU Index (MSCI Russia Index) R 2019-04-11 16-54-28.png

 

While those long $ARGT should be looking to sell into Argentina’s inclusion into the MSCI Emerging Markets Index at the end of May.

 

ARGT US Equity (Global X MSCI Ar 2019-04-11 15-56-57.png

 

London-based emerging markets asset manager, Ashmore Group $ASHM.LN, has had a great run even relative to the emerging markets index. It is up 30.3% year-to-date in US dollar terms.

 

ASHM LN Equity (Ashmore Group PL 2019-04-11 16-02-52.png

 

Long Term Yields in China and the US

 

The below chart compares China’s purchasing managers’s index (advanced by three months) to the yield on 10 year Chinese government bonds.

 

Despite China’s inclusion into global bond benchmarks and record foreign inflows, yields are no longer moving lower suggesting that long-term yields in China may have bottomed — the recent pickup in PMI indicates as much as well. If yields have bottomed, or close to it, it is also likely that economic activity in China, too, is set to pick up.

 

GCNY10YR Index (China Govt Bond 2019-04-11 16-17-13

 

Long-term yields in China have over the last decade largely mirrored movements of long term yields in the US. If Chinese yields have bottomed and economic activity is picking up, we would not be surprised to see US long-term yields move higher from here as well.

GCNY10YR Index (China Govt Bond 2019-04-11 16-13-38

 

 

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

 

The Spectre of Capital Destruction

“As the financial experts all over the world use machines to unwind Gordian knots of financial arrangements so complex that only machines can make – ‘derive’ – and trade them, we have to wonder: Are we living in a bad sci-fi movie? Is the Matrix made of credit default swaps?” — Richard Dooling

Legend has it that Alexander the Great, travelling through the Persian Empire during the fourth century before Christ, learned of an ox-cart in the city of Gordium belonging to its former king, Gordias. The ox-cart was tightly secured to a pillar in the centre of the acropolis using an intricate knot — in what is known today as a Gordian knot.

An oracle from Gordium had declared that any man who could unravel the elaborate knot securing the ox-cart was destined to become ruler of all of Asia. Many men of skill had attempted to untie the knot, but none succeeded. 

Alexander the Great too failed in his initial attempts to unravel the knot. After reflecting on how tight the knot was, he drew his sword and sliced it in half with one stroke. Then it is said that he declared, “Destiny is not something brought about by legend, but by clearing away with one’s sword.”

The Spectre of Capital Destruction

The three major central banks in the developed world — namely the US Federal Reserve, Bank of Japan and European Central Bank — have failed thus far to unravel the knot of deflation that has inhibited the global economy from achieving escape velocity. Their attempts to unshackle the global economy from deflationary forces have primarily entailed lower, and in some cases negative, interest rates.

Low (real) interest rates for an extended period, however, lead to the emergence of a different type of risk:  the permanent loss of capital.

The US has suffered from destruction of capital following a prolonged period of suppressed interest rates on three occasions over the last 100 years: 1929, 1966 and 2000. On a total return basis, it took on average 15 years for US markets to recover from these major draw downs.

Japan has had one episode of capital destruction, starting in 1989, and has hitherto been unable to recover the entirety of the lost capital.  In Europe, Italy started experience permanent loss of capital in 2008 and still remains a long way from regaining the highs.

The common theme across all these episodes of capital destruction has been the banking sector, in the respective economies, becoming insolvent, if not suffering from outright bankruptcy.

Maintaining low interest rates over a prolonged period may propel risk appetite and reduce volatility for a while but eventually such a policy increases the risk of a permanent loss of capital. Central banks’s repeated experiments with low rates have demonstrated that low rates lead to higher asset prices, higher indebtedness, lower capital investment and lower productivity. Asset owners get richer. The asset poor get poorer, and that leads to the emergence of populism and the problems that come with it.

The question then arises, after more than a decade of low interest rates, where does the greatest risk of a permanent loss of capital lie today? We think it is not in the US, not in China, not in Latin America, and not even in Italy but rather in Germany. For Germany has not only enjoyed an extended period of low interest rates but also of an artificially undervalued currency. The scale of malinvestment in Germany, particularly in the automotive sector, is likely to be staggering.

If and when the tide goes out, we suspect the level of capital destruction in Germany will prove to be unprecedented. 

The Inverted Yield Curve

The recent inversion of the US yield curve has sent alarm bells ringing for an impending recession in the US, and by extension, of a global recession. We are, however, not yet worried about an imminent recession in the US for the following reasons:

1. Bond yields remain low everywhere. In the US, real yields are now back at 0.7 per cent and should not be a drag on the economy.

2. While corporate debt is at record levels, corporate spreads remain within their historical range, after a brief rip higher at the back end of last year.

3. Oil, on a year-over-year basis, is lower and is soaking up less liquidity on the margin.

4.  The US dollar has been range bound, neither adding to nor detracting from global liquidity.

Given the above, we think the recent economic softness in the US is likely to prove to be nothing more than a pause. The US economy is already stabilising. The Atlanta Fed has revised up its estimate for first quarter GDP growth to 2.1 per cent and indicators such as mortgage applications, PMI readings and durable goods orders also indicate the same. We expect economic activity to continue picking up through the second and third quarters of 2019 underpinned by the Fed’s dovish stance, the release of dollar liquidity by the US Treasury and less tight, if not outright easy, monetary and fiscal policy in China.

And if growth does pick up, why should around  US dollars 10 trillion of global sovereign debt trade at negative yields?

Our core view is that just as global yield curves have witnessed a rapid flattening in recent months, the realisation that US, and by extension global, growth is picking up again is likely to trigger a sudden sharp steepening of yield curves. We see global equity markets, after their near record performance during the first quarter of the year, confirming as much. And there are more supporting signs such as rising copper prices and the inability of non-cyclical stocks to outperform cyclical stocks.

We expect those long duration to be nursing significant losses in second half of 2019.

What Could Push Bonds Yields Lower?

Given our repeated calls for a cyclical bottoming in long-terms yields, it is only prudent for us to consider a scenario, or scenarios, under which yields could yet go lower.

One such scenario that worries us that of a deflationary bust led by China.

Over the course of the last three decades, China has gone through the biggest capital spending boom in recorded history. All through this period, the driver of the Chinese economy has been capital spending more so than consumption. And China has not fueled this capital spending boom alone rather economies such as Australia, Brazil, Germany and South Korea have directly benefited from and contributed to the China led capital spending boom of the last thirty plus years.

If there is a deeper than anticipated slowdown in China that brings about an end to the structural ascent in global capital spending, then obviously investors should be positioning portfolios to be long duration and other yielding assets.

A China led deflationary bust, at least in the next 24 to 36 months, is not our base case view. Rather, we believe, that the steps taken by the Chinese leadership in the last 5 years have led to a curtailment of significant amounts of excess production capacities  — the evidence of which can be found in, for example, the resilience of steel prices. Moreover, with China’s belt and road ambitions and the developed world’s seeming desire to wean itself off Chinese supplies, we are more concerned with the prospect of global capacities being insufficient to satisfy future demand than that of a deflationary bust.

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.

Sugar Rush

 

 

“It’s not only moving that creates new starting points. Sometimes all it takes is a subtle shift in perspective, an opening of the mind, an intentional pause and reset, or a new route to start to see new options and new possibilities.” — Kristin Armstrong, former professional road bicycle racer, three-time Olympic gold medalist and unrelated to Lance Armstrong

 

“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.” — Vladimir Lennon 

 

 

Tech IPO Rush

 

In October last year, we wrote (emphasis added):

 

Over the last twelve months there has been little to no incentive for venture capital backed companies to go public. They have had a much better alternative that does not come with the scrutiny faced by a publicly listed company: sell to SoftBank’s Vision Fund.

 

[…]

 

Given the recent events surrounding Saudi Arabia and deceased Washington Post columnist Jamal Khashoggi, there is likely to be little appetite in Silicon Valley to accept  Saudi Arabian money henceforth.

 

[…]

 

Given recent developments and Silicon Valley likely to shy away from engaging the Vision Fund any further, we suspect many venture capital backed “unicorns” are actively soliciting proposals from investment banks to help them go public.

 

We expect a flurry of tech-led IPO activity in the first half of 2019.

 

After a delay caused by the US government shutdown, the markets are starting to see a flurry of tech IPO activity materialise.

 

  • The other ride hailing company, Lyft, has already filed for its IPO, which is said to be oversubscribed and set to surpass the US dollars 23 billion valuation the company was seeking.

 

  • Social content sharing platform Pinterest has filed its S-1 and is expected to go public in April.

 

  • Postmates, the food delivery app, announced in February that it had filed with SEC to go public. The company was last valued at US dollars 1.85 billion.

 

  • Zoom Video Communications, the video conferencing startup and one of the few profitable unicorns, recently filed to raise US dollars 100 million through an initial public offering.

 

  • Messaging platform Slack is taking a slightly approach, similar to the one taken by Spotify previously, and will be directly listing on to the markets without a public offer. A direct listing allows current investors to offer their stakes directly to new shareholders priced purely on demand. The company was valued at $7.1 billion in a $427 million funding round in August.

 

  • The biggest and the most awaited of  them all, the riding hailing company Uber is on track to publicly list at an estimated valuation of US dollars 120 billion.

 

There are, however, some startups that have indicated that they may delay their plans to go public. Notably:

 

  • Airbnb, the company recently valued at US dollars 35 billion, is also amongst the select group of profitable unicorns and recently acquired HotelTonight to expands its product offering. The company has previously expressed its intention to go public in 2019 but has recently cast some doubt on those plans.

 

  • Software and internet security services startup Cloudflare, which was rumoured to have filed for an IPO in October last year, recently raised US dollars 150 million in a financing round led by Franklin Templeton.

 

The recent flurry of tech-led IPO activity is reminiscent of the tech bubble at the turn of the millennium.

 

The S&P 500 peaked on 24 March, 2000.  Some of the notable public listings in and around the time of the market peak included:

 

  • Finnish national telecom operation Sonera Corporation’s listing in the US during October 1999

 

  • The listings of Charter Communications and United Parcel Service during November 1999

 

  • Chip manufacturer Infineon Technologies listingin March 2000

 

The biggest of the tech bubble IPOs came a little over a month after the S&P 500 peaked. AT&T Wireless Group listed on 27 April 2000.

 

Similarly, The Blackstone Group went public on 21 June 2007 and the S&P 500 peaked in October 2007 at less than 3 per cent above the level it was on the day the alternative investment manager listed. The largest pre-Global Financial Crisis IPO was of Visa, which listed in March 2008, a few months after the market peaked.

 

Will Uber’s mega-IPO mark the peak in S&P 500 this time round? We are not sure but when CNBC runs the below headline, it feels ominous!

 

From Lyft to Airbnb, investors shouldn’t worry the newest tech IPO rush signals a market top

 

 

Where Should Investors Hide?

 

Three and five years on from the S&P 500’s peak in March 2000, gold was up 14.7 per cent and 48.6 per cent, respectively. Respectable not spectacular.

 

Three and five years on from the S&P 500’s peak in October 2007, gold was up 58.1 per cent and 139.1 per cent, respectively. Spectacular.

 

You could always own some fixed income, of course. From recently published research on the the Federal Reserve Bank of New York’s Liberty Street Economics blog (emphasis added):

 

Long-term government bond yields are at their lowest levels of the past 150 years in advanced economies.

 

[…]

 

[L]ow interest rates in advanced economies are a secular phenomenon driven by global forces that emerged well before the Great Recession and that are unlikely to be connected to country-specific factors, such as national policies or other domestic developments. Therefore, whatever forces might lift real interest rates in the future must be global, such as a sustained pickup in world economic growth, or a better alignment of global supply and demand with respect to safe and liquid assets.

 

Given the above, we think it will be difficult for bonds to go much higher from here. And even if they do, whatever takes them higher is likely to take gold much higher.

 

Don’t be fully invested in gold, but have some for a rainy day.

 

 

 

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.

 

 

Notes on Russia and Oil & Gas

“My problem is that my imagination won’t turn off. I wake up so excited I can’t eat breakfast. I’ve never run out of energy. It’s not like OPEC oil; I don’t worry about a premium going on my energy. It’s just always been there. I got it from my mom.” — Steven Spielberg

“Russia is tough. The history, the land, the people — brutal.” — Henry Rollins

We recently met with the management team at Rosneft — the third largest company in Russia and one of the top 25 oil & gas exploration companies in the world by revenue —  for a wide ranging discussion on oil & gas, Russian macro, the deal with Saudi Arabia and OPEC, shale oil and geopolitics. In this week’s piece we share our notes from the meeting.

On Russian macro:

  • Russian budget balances at an oil price of around US dollar 47 per barrel.
  • Government and corporate external debt has declined from around US dollars 730 billion in 2014 to approximately US dollars 450 billion by the end of 2018.
  • 50 per cent of crude oil production is exported unrefined, 50 per cent of production is utilised for refined products of which 50 per cent are exported. Directly and indirectly, approximately 75 per cent of oil produced is exported.
  • The government is actively running a weak ruble policy, which is benefiting exporters at the cost of lower domestic economic growth and lower purchasing power for the Russian consumer. This is translating into Russian economic growth being investment-led as opposed to consumption-led.
  • Moreover, the policy is resulting in weaker than potential economic growth. Real GDP growth is around 2 per cent while the economy has the potential to grow between 3 to 5 per cent annually.
  • To counter the below potential growth, the government is trying to attract foreign direct investment into the economy — Russia moved up to 31st in the World’ Bank’s ‘Doing Business’ rankings in 2018, up from 120th in 2011. The spectre of further economic sanctions, however, has thus far deterred foreign capital.
  • To implement the weak ruble policy, the Central Bank of Russia sterilises all oil revenues above US dollars 40 per barrel. At current oil prices, the central bank purchases between US dollars 200 to 300 million from the open market on a daily basis
  • Russia is able to implement its weak ruble policy as the majority of costs, even for oil & gas exploration companies, are priced in rubles. For example, Schlumberger and Haliburton price onshore oil rigs lease rates in rubles, not US dollars. Oil & gas companies are only impacted if they are engaged in offshore drilling as offshore drills are not available in Russia. At present none of the Russian oil & gas majors are engaged in offshore drilling.
  • Pension reforms implemented in 2018 raised the retirement age from 60 to 65 years for men and 55 to 60 years for women.  The reforms were deeply unpopular  amongst the populace and instigated protests across the former Soviet Union. Eventually only a watered down version of the originally proposed reforms were implemented.

On the deal with OPEC / Saudi Arabia:

  • The production quotas / deal between Russia and OPEC holds far greater significance for Saudi Arabia than for Russia given Russia’s lower budget break even price, free floating currency and ruble based cost structure.
  • Russian oil production peaked in October 2018 at 11.4 million barrels per day. It has been cutting daily production levels by 65,000 barrels each month starting January 2019 and will reach the agreed upon production level in May 2019, which should be between 220,000 to 230,000 barrels per day lower than levels recorded in October.
  • Saudi Arabia has already cut production by more than the levels they had committed to as part of the deal with Russia and they expect the Kingdom to enact further cuts in the coming months.
  • Subsequent to our meeting, Bloomberg reported that “Saudi Arabia will supply its clients with significantly less oil than they requested in April, extending deeper-than-agreed production cuts into a second month”.
  • Although Rosneft is opposed to the production quotas, they expect the deal between Russia and OPEC to be extended beyond June 2019.
  • Rosneft, which accounts for 41 per cent of Russian oil production, could have increased its output by 5 per cent in 2019 but will limit growth to 2 per cent. In return, they have submitted a request for tax breaks to the Russian Ministry of Finance to compensate for the lost revenue.
  • One of the unintended consequences of the production cuts has been heavy, high-sulphur (or “sour”) crude trading at a premium to Brent crude in parts of North West Europe and the United States despite its lower grade. This has occurred as the majority of OPEC producers, predominantly Saudi Arabia, have focused their production cuts on high-sulphur crude and at the same time sanctions have been enacted on Venezuela, a major producer of high-sulphur crude. Demand from US refiners, which are configured to operate only with high-sulphur crude, and China’s preference for it as well — a byproduct of refining heavy crude is bitumen, which is used in the construction of roads  — has caused the squeeze.

On demand:

  • Demand erosion from electric vehicles has not been evident and it will take a much higher adoption rate for it to have a meaningful impact. Whatever adoption that is taking place is being more than compensated for by first time automobile buyers in emerging markets, particularly India and China.
  • Global demand is robust and should remain so as long as the US can avoid a recession in 2019.

On shale oil:

  • Full cycle, operating and capital expenditures cash break even for the Permian basin is between US dollar 40 to 50 per barrel versus the widely touted US dollars 35 to 40 dollars. This excludes the cost of land, which can push break even levels to as high as US dollars 55 to 60 per barrel.
  • There are signs of high cost inflation in the shale patch, particularly in the Permian, which may push up break even levels.
  • Listed shale oil companies returning capital to shareholders are being rewarded and those increasing capital expenditures have been punished. This suggests that the capital expenditure cycle for US shale may have peaked and that an increasing number of companies will choose to return capital as opposed to increasing production. If this happens, US production growth is likely to disappoint to the downside.

On natural gas and geopolitics:

  • Nord Stream is an offshore natural gas pipeline between Russia and Germany that is owned and operated by Nord Stream AG, whose majority shareholder is the Russian state company Gazprom. It has an annual capacity of 55 billion cubic metres.
  • Gazprom has a monopoly on all Russian natural gas exports.
  • Nord Stream 2 is a project to lay two additional lines and double annual capacity to 110 billion cubic metres and due for completion in 2019 . The project was backed by Chancellor Angela Merkel and the German government despite objections from some EU and NATO member states and from the European Commission
  • Since November 25, 2015, Ukraine has no longer imported Russian gas; instead, all supplies that enter Ukraine’s gas network from Russia are transferred to Europe. The gas transit agreement with Ukraine expires in December 2019. Nord Stream 2 is incidentally due for completion in December 2019. The completion of the project would allow all Russian gas to flow directly into Germany without transiting through Ukraine.
  • The cost of liquefaction, transportation and gasification of natural gas from alternate sources means that Russian gas remains the most economically viable source for Europe. Given Germany’s reliance on natural gas, especially after Chancellor Merkel outlawed nuclear power in Germany, it is difficult to see Europe turning away from Russian gas. German dependence on Russian gas has, however, caused a rift between France and Germany in the recent past.
  • Russia is confident that it can find alternative buyers for its supplies should Europe decide to stop buying from them.
  • In 2017, Rosneft sold a 20 per cent stake in Verkhnechonskneftegaz — one of the largest-producing fields in eastern Siberia that connects Russia with China, Japan and South Korea — to Beijing Gas. This is a sign of growing collaboration between the two states and a possible step towards de-dollarization.  With the added benefit for Rosneft and Beijing Gas of undermining the domestic monopolies of Gazprom and China National Petroleum Corporation.

Some data points:

  • Organic reserve replacement costs in Russia are approximately US dollar 0.20 per barrel of oil equivalent vs. US dollars 1.10 for BP, 1.00 for Chevron, 2.90 for Royal Dutch Shell and 5.70 for PetroChina
  • Lifting costs (the cost of producing oil and gas after drilling is complete) is US dollar 2.50 in Saudi Arabia and US dollars 3.10 in Russia vs. US dollars 5.60 for Total, 7.30 for BP, 10.60 for Royal Dutch Shell, 11.40 for Chevron, 11.50 for PetroChina and 12.30 for ExxonMobil.

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.

China Aplenty | Another Cloud Long Idea

 

“Plans are nothing; planning is everything” — Dwight Eisenhower

 

“Ultimately, the cloud is the latest example of Schumpeterian creative destruction: creating wealth for those who exploit it; and leading to the demise of those that don’t.” — Joe Weinman

 

 

This week we discuss China A-Shares, China’s 2019 budget announcements and share another cloud-based solutions providers as a potential long-idea.

 

China A-Shares Update

 

Global equity and fixed income indices provider, MSCI, has decided to quadruple the inclusion factor of China A-Shares in its Emerging Markets Index from 5 to 20 per cent over three phases. The result is the weight of China A-Shares in the index will increase to approximately 3.3 per cent from the current 0.7 per cent, leading to an estimated US dollars 13 billion of passive inflows into the market. While flows from actively managed funds could be as high as US dollars 50 billion dollars according to sell-side estimates.
MSCI, originally intending to increase the weighting of China A-shares in its Emerging Markets Index by May next year, is fast-tracking the increased weighting to be in effect by November this year.

 

The X-trackers Harvest CSI 300 China A-Shares ETF $ASHR has returned 28.6 per cent year-to-date (as at market close on 1 March 2019) as compared to the S&P 500 Index returning 12.3 per cent during the same period.

 

The strong performance of the broader Chinese market, particularly following the Chinese New Year, have coincided with a significant increase in daily trading volumes.

 

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A thawing of US and China trade tensions and the rebound in credit growth witnessed in January have provided welcome relief for the Chinese equity markets. Although negative economic surprises may lead to pullbacks in the nearer term,  with the increase in the weighting of China A-Shares in the MSCI Emerging Markets Index, we think Chinese equities remain good value for the remainder of 2019.

 

 

China: Notable Announcements from the Annual Legislative Session

 

At the Annual Legislative Session, which kicked-off in Beijing on Tuesday, Premier Li Keqiang announced that the government is targeting GDP growth in the range of 6.0 to 6.5 per cent for 2019, down from the 6.5 per cent guidance maintained over the last two years. Signalling the Chinese leadership’s preference for stability and all but ruling out the possibility of another credit binge of the likes witnessed following the global financial crisis and in 2015/16.

 

Announced value-added tax cuts came in higher than expectations. The highest VAT bracket, which applies to the manufacturing sector, was cut by 3 percentage points to 13 per cent, providing some welcome relief for industrial business. The VAT bracket applicable to the construction and transportation sectors was cut by 1 per cent to 9 per cent. The lowest bracket remained unchanged at 6 per cent.

 

To manage its fiscal deficit and balance the reduction in revenues from VAT, total government spending is budgeted to increase 6.5 per cent in 2019, down from the 8.7 per cent increase in 2018. The targeted fiscal deficit is 2.8 per cent, up from 2.6 per cent last year. Premier Li emphasised that China would not resort to a “flood of strong stimulus policies” to drive economic growth. The quota for local government bond issuance, however, is budgeted to  increase by Chinese yuan 800 billion, or almost 60 percent, to Chinese yuan 2.15 trillion in 2019, which should support spending on new infrastructure projects and  credit growth.

 

Overall, the announcements seem to reaffirm our view that following a marked slowdown in the first quarter, the economic environment in China should get incrementally better, not worse, over the course of 2019. Fiscal spending, however, is likely to prove more conservative than we had anticipated at the start of year — the Chinese leadership appear unwilling to undo the effort put in to reduce systemic risks in 2018 by meaningfully increasing the flow of credit in the economy. Nonetheless, we believe credit growth, which has been slowing since the first half 2016, has bottomed and should pickup.

 

A flaw in reading too  much into budgetary announcements, however, is that Beijing can always use state-owned enterprises (SOEs) to implement policies through unofficial means. If SOEs are directed to markedly increase capital expenditures and investments, this should have the same result as a significant increase in fiscal spending done by the government. We think the risk to state led capital spending, direct or indirect, is to the upside.

 

We have been bullish on long-dated Chinese government bonds for some time but now think it time for fixed income investors to tactically close out any long positions they may have. 

 

 

One More Cloud-Based Solutions Play

 

At the tail end of last year, Conlin Matthew, Founder and President, bought shares worth more than US dollar 450,000 representing 2.6 per cent of the company, in Fluent Inc. $FLNT.

 

Fluent is a cloud-based mobile user and data acquisition services providers that creates marketing programs to deliver superior digital advertising experiences for consumers with measurable results for advertisers. The company claims to interact with over 1 million consumers on a daily basis from its “proprietary first-party data asset” consisting of over 190 million opted-in consumer profiles to gather “self-declared” data. This data is used to create targeted advertising solutions on the company’s proprietary digital properties for brands to connect and interact with consumers.

 

The company in its present form was created through the business combination of the international digital media assets of BlueFocus International Limited, a wholly-owned Hong Kong subsidiary of BlueFocus Communications Group (a publicly traded Chinese Company), and the performance marketing platform of Cogint Inc. $COGT.

 

The company has a market capitalisation of US dollars 405 million with a free float of 43 per cent of outstanding shares and short interest of 3 per cent of free float.

 

We are long Fluent Inc. $FLNT with a stop-loss at US dollars 4.50.

 

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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.