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Will Europe be the Fall Guy in the Trade Deal?

 

“Capable, generous men do not create victims, they nurture victims.”  — Julian Assange

 

“Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.”  — Stone Gossard, lead guitarist for Pearl Jam and member of the Rock and Roll Hall of Fame

 

A slightly shorter piece than usual this week as we recover from  jet lag following a ten day trip to the US. This week we discuss, the potential fallout from a US-China trade deal.

 

 

In 1978 China accounted for less than one hundredth of global trade. By the turn of the millennium, its share had increased threefold. In a decade’s time, by 2010, its share of global trade had tripled again and in 2013 China surpassed the United States, becoming the world’s largest overall trading nation.

 

As China’s share of global trade has increased so too has the number of trade disputes it has been involved in. Between 2006 and 2015, China was party to, as either complainant or respondent, in more than a quarter of the trade dispute cases lodged with the World Trade Organisation (WTO).

 

Notably, according to Harvard Law Professor Mark Wu, there has been a notable shift in the “pattern of WTO cases among the major trading economies — the United States, European Union, Japan, and China”. Up until the global financial crisis, the US, Japan and the European Union would regularly file complaints against one another. Following the crisis, however, only three cases have been brought by the three major developed economies against one another. Instead, the cases brought by the major powers have almost exclusively been focused on China — 90 per cent of the cases they brought to the WTO between 2009 and 2015 were China-related.

 

The meteoric rise of the Chinese economy and its growing influence on global trade has challenged the pretext under which the WTO was formed. The WTO has struggled to adapt and to develop an equitable dispute settlement system to counter China’s, at times, egregious trade practices. The WTO cannot, given China’s importance to global trade, make rulings or draft new rules that China sees as discriminatory or unfair but at the same time it cannot seen to be a lame duck and see other member countries turn away from it. The inability to effectively settle this dilemma has weakened the institution’s credibility.  So much so that the WTO Appellate Body no longer has enough members to hear all possible cases — the US has vetoed all appointments to the body. Many see the US vetoes as a death knell for the WTO — signalling a return to  a world where trade disputes are settled through bilateral negotiations and the WTO’s dispute settlement system is defunct.

 

The United States Trade Representative, Robert E. Lighthizer, has, since taking office in May 2017, pursued a campaign against China based on the statutes of Section 301 of the 1974 Trade Act, which allows unilateral action by the US President against trade policies deemed unfair. In effect, the US Trade Representative’s strategy sidelines the WTO.

 

The Trump Administration’s approach of using Section 301 has been seen, by many, as both aggressive and likely to lead to negative consequences for the Chinese economy.  What if, however, President Trump has come to the realisation, that also afflicted his predecessors, that the American and Chinese economies are too closely intertwined for either side to be a victor in a trade war? If so, we wonder, is Europe going to be the fall guy in the trade deal?

 

Europe’s Trade Surplus with the US

 

From the Wall Street Journal:

 

The European Union reported a record trade surplus with the U.S. last year, a development that could weigh on slow-moving U.S.-EU trade talks and comes as the Trump administration prepares to deliberate hefty tariffs on European car imports.

Meanwhile, slowing exports from Europe to other trading partners, most notably China, in 2018 suggest the flagging EU economy could cool further this year. Failure of the U.S.-EU trade talks and fresh duties from the U.S. could compound Europe’s economic pain in 2019.

 

President Trump, we suspect, is going to look for an alternative win should the trade dispute with China be resolved amicably. We suspect, Europe, with its record bilateral trade surplus, is likely to find itself in the line of fire. For it was only days before Trump’s visit to Europe last year that President Macron called for the creation of a “true European army” and agitating the US President in the process.  Moreover, Europe is in a mess —  with the small matter of Britain’s exit from Europe imminent and a leadership vacuum with Angela Merkel a lame duck in office, Emmanuel Macron too occupied trying to contain the yellow vest movement, Italy moving from one crisis to another — meaning there is little hope for a coordinated response from the trade bloc, should President Trump throw down the gauntlet.

 

With any resolution of the US-China trade dispute likely to come with conditions for China to increase purchases of US goods and services, China is likely to reduce purchases of European goods and services in response. This is will only compound Europe’s problem further.

 

We think there is little reason to be overweight, or even equal weight, European equities at present.

 

Extending the same line of thinking, we think China is likely to increase its purchases of agricultural commodities from the US by reducing purchases from Brazil. For emerging markets exposure, we would underweight Brazil.

 

Semiconductor Leadership

 

 

Were the above tweets a wink to the national security hawks in the Trump Administration to end the pursuit of Huawei and stop placing export controls on US semiconductors producers?

 

If so, we think $SOXX should continue to be amongst the leaders in the US market. If, however, if there is sudden weakness in the semiconductor space we would be concerned about the prospects of an amicable trade resolution.

 

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: Portfolio Hedges | 3-D Printing

“It’s easier to hold your principles 100 percent of the time than it is to hold them 98 percent of the time.”  — Clayton M. Christensen

“Character, like a photograph, develops in darkness.”  — Yousuf Karsh

In this week’s piece we discuss hedges to provide some portfolio protection under the different potential outcomes to the US-China trade dispute as the 1 March deadline to  reach an agreement approaches. Also this week, we discuss 3-D printing — the one time darling and now much maligned corner of the technology sector — and consider potential long ideas within the segment.

Trade Wars: Portfolio Hedges

US trade representative, Robert E. Lighthizer, and US Treasury Secretary, Steven Mnuchin,  are heading to Beijing this week, ahead of the 1 March deadline to reach an agreement and prevent a further hike in tariffs.  As part of the on going negotiations, the Trump Administration is demanding China to (1) reduce its trade surplus with the US, (2) stop enabling the theft or forced transfer of intellectual property and trade secrets from US businesses operating in China, (3) ease restrictions on foreign investment and foreign ownership of Chinese companies, and (4) put an end to industrial subsidies and the preferential treatment given by the Chinese government to state-owned enterprises.

In broad terms, we think there are four possible outcomes to the on-going trade related negotiations between the US and China. These outcomes are:

  1. A compromise much akin to kicking the can down the road whereby China agrees to reduce its trade surplus with the US and increases its purchases of US products and services. Nothing else of material consequence is agreed upon and both parties make assurances of negotiating over unresolved matters in the near future.
  2. Both parties make some concessions and meaningful progress is made on trade, giving Corporate America greater access to the Chinese market and intellectual property theft by China.
  3. One of the two parties capitulates. In the case of China capitulating means agreeing to an overwhelming majority of the Trump Administration’s demands. While the US capitulating means most demands unrelated to the China’s bilateral trade surplus are dropped.
  4. There is no agreement and a hike in tariffs goes ahead as planned.

The type of hedge a portfolio may need depends on how said portfolio is positioned.

A portfolio positioned for an amicable resolution to the trade dispute needs hedges for the first and fourth scenarios briefly outlined above. While a portfolio positioned for a prolonged trade war requires hedges under the second and third scenarios.

Positioned for an Amicable Resolution

Given China’s ambitions on the technology front and the Trump Administrations to rein Chinese technological through use of national security measures and export controls, the semiconductor industry is likely to be a key battleground in the dispute.

Investors positioned for an amicable resolution to the trade dispute can hedge themselves, we think, by going long South Korean semiconductor companies — China will need to turn to them in the event export controls are imposed on US semiconductor companies. Investors can further hedge themselves by shorting Taiwanese semiconductor companies because, if China’s thirst for semiconductor supplies is as strong as we think it is, the risk of annexation of Taiwan by China to secure supply rises significantly in the event of a less-than-amicable end to the negotiations.

Positioned for a Prolonged Trade War

Investors positioned for a prolonged trade war can hedge themselves, we think, by going long US agriculture commodity producers — one of the simplest ways for China to shrink its bilateral trade surplus is to increase purchases of agricultural commodities from the US.

3-D Printing: Inflection Point?

At the beginning of 2018, Bugatti revealed it had developed the first series-production 3-D printed brake caliper for use in its vehicles. In December last year, the Volkswagen Group released a video of the finished product in action.

In October last year, Dutch robotics company MX3D completed the 3-D printing of a steel bridge and announced that it will be installing the bridge across a canal in Amsterdam during 2019. Two months later, the Marines from the 1st Marine Logistics Group at Camp Pendleton, California –  with the help of the Marine Corps Systems Command Advanced Manufacturing Operations Cell and the Army Corps of Engineers —  successfully 3-D printed a concrete bridge on site as opposed to in a factory setting.

NOWlab, the innovation arm of German additive manufacturing company BigRep, unveiled NERA — a fully 3D-printed motorcycle – in November 2018.  All parts of the motorcycle — excluding the electrical components that power the bike — have been 3-D printed, including the tyres, rims, frame and seat.

In January, Relativity Space — a rocket-building company founded by former SpaceX and Blue Origin employees — revealed that it has been granted permission by the US Air Force to launch its, almost entirely 3-D printed, rockets from Launch Complex 16 at Cape Canaveral in Florida. And just last week, UK-based space startup Orbex publicly unveiled its Prime rocket — the world’s largest 3-D printed rocket engine — at the opening of its new headquarters and rocket design facility in Forres in the Scottish Highlands.

The Innovation S-Curve

Many investors have turned their backs on 3-D printing after exhibiting irrational exuberance towards the technology over years past. After a failed promise of endless growth, and a bursting of the stock price bubble that sent shares of publicly traded 3-D printing companies tumbling, we wonder if interest in 3-D printing stocks may be rekindled as the potential benefits of the technology begin to be realised?

Everett Rogers, previously professor of communication studies at the University of New Mexico, popularised the theory of diffusion of innovations in his book Diffusion of Innovations. The theory is amongst the oldest theories in social science.

The theory postulates that the adoption of an innovation within a social system is determined by four factors, namely:

  1. The innovation itself;
  2. Communication channels;
  3. Time; and
  4. The characteristics of the social system.

Over the years,  the innovation S-curve has been popularised a means of measuring the adoption of existing technologies.  The innovation S-curve is an application of Professor Rogers’ theory.

S-Curves-New-Products.pngSource: ideagenius.com

3-D printing has gone through its early adoption phase. The recent delivery of a number of innovative solutions based on 3-D printing makes us wonder if 3-D printing technology is now at an inflection point within its innovation S-curve and ready to enter a phase of rapid growth? If indeed it is, many of the publicly listed 3-D printing stocks could, in a few years time, trade at many multiples of the prices they trade at today. 

3-D Printing Stocks

Below we highlight two 3-D printing related stocks that caught our attention upon initial screening,

The ExOne Company $XONE

$XONE is a micro-cap stock with market capitalisation of US dollars 172 million. Short interest in the stock is high at more than 27 per cent of free float.

The company  was spun-off from Extrude Hone Corporation, a global supplier of precision nontraditional machining processes, 2005.

$XONE is a global provider of 3-D printing machines, 3-D printed products and related services to industrial businesses operating across the aerospace, automotive, pumps, heavy equipment and energy industries. The company’s product and services offering revolves around industrial strength sand castings and moulds and directly printed metal parts.

Following a transition year in 2018, during which the company took measures to improve operating efficiencies and reel in costs,  the company’s management expects net income and operating cash flows to be positive in 2019. Further, the company will be introducing larger format 3-D printing machines during the year to increase the size of its addressable market and to up sell existing clients.

Stratasys Limited $SSYS

$SSYS has a market capitalisation of US dollars 1.4 billion. Short interest in the stock stands at almost 12 per cent of free float.

The company manufactures 3-D printers used by designers, engineers, and manufacturers for office-based prototyping and direct digital manufacturing to visualise, verify, and communicate product designs. Engineers, for example, use Stratasys systems to model complex geometries in a wide range of thermoplastic materials such as polycarbonate.

$SSYS’s CEO,  Ilan Levin, resigned in May 2018 and its Chairman has been serving as its interim CEO since. Levin’s exit came after the company posted losses of of almost US dollars 40 million in 2017 and US dollars 13 million during last year’s first quarter.

The company has been witnessing growth in 3-D printing system orders since the second quarter of last year and management expected this trend continue into 2019. They are also see their customers moving from experimenting with 3-D printing to deploying and expanding the capacity of these systems in true production environments.

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.

Pick-and-Mix

“The whole world is simply nothing more than a flow chart for capital.” – Paul Tudor Jones

“It’s still true that the big players in the public markets are not good at taking short-term pain for long-term gain.” – Jeffrey W. Uben, ValueAct Capital

In this week’s piece we (i) revisit our call on cloud-based software stocks, (ii) touch upon Dollar Tree Inc. $DLTR, which we think is poised to outperform in the near term, and (iii) consider the possible ramifications of the recent policy statements by the US Treasury and the Fed.

Cloud-Based Enterprise Software Update

We highlighted cloud-based enterprise plays as a potential long idea in Two Investment Ideas on 14 January, 2019. Two out of our three preferred names, Veeva Systems $VEEV and Workday Inc. $WDAY, are up 16.46 and 13.92, respectively, from market close on 14 January through 2 February. In comparison, the S&P 500 Index is up 4.88 per cent during the same period.

We think it is a good time to tactically take profits in both names and to continue playing the theme through Benefitfocus $BNFT and the two additional names we highlighted in our weekly piece on 21 January. We will look to re-enter long positions in $VEEV and $WDAY at lower levels, should they correct.

Dollar Tree Inc.

We have been long $DLTR for more than a year now. Initially the stock did really well,  outperforming the S&P 500 Index. Alas, it did not last and performance was lacklustre between February and December last year.

DLTR US Equity (Dollar Tree Inc) 2019-02-04 14-06-14.png

The underwhelming performance of the stock stems from the declining sales and earnings at its Family Dollar franchise. The company acquired Family Dollar for US dollars 9 billion in a fiercely contested battle with Dollar General $DG during the second half of 2017.

The Family Dollar acquisition was motivated by management’s desire to scale up to better compete with larger players such as $DG and Target $TGT. What transpired, however, is the company ended up buying an under performing business that it has, to date, been unable to turnaround.

What has made the failure to turnaround Family Dollar even more vexing, for shareholders and management alike, is that following $DLTR’s ill-fated acquisition, its direct competitor, $DG, has managed to grow strongly, open up new locations and increase its market share.

$DLTR’s troubles with Family Dollar have attracted the attention of activist investors and in January of this year Starboard Value – the New York Based activist hedge fund – announced that it owned 1.7 per cent of the company and had nominated seven directors to its board.

Starboard wants $DLTR to consider a sale of Family Dollar, even if it means selling it for significantly less than it paid for it. It has also suggested that the company should make changes to its current business model including selling some items at price points above US dollar 1, such as US dollar 1.50 or 2 – something that $DLTR’s competitors already do.

Whether a sale of Family Dollar transpires or not, having an activist hedge fund as a vocal shareholder, we think, is likely to place pressure on $DLTR’s management to make meaningful improvements in the company’s operational performance and create shareholder value.

We have waited on commenting on the stock following Starboard’s announcement as we wanted the initial euphoria to die down and for long frustrated shareholders to take the opportunity to sell following the news.

We think $DLTR is well placed to out perform in the near term and we will be adding to our existing position.

US Treasury Refunding Statement

From the US Department of the Treasury’s press release issued on 28 January:

  • During the January – March 2019 quarter, Treasury expects to borrow $365 billion in privately held net marketable debt, assuming an end-of-March cash balance of $320 billion. The borrowing estimate is $8 billion higher than announced in October 2018. The increase in borrowing is driven primarily by a lower than previously assumed opening cash balance.
  • During the April – June 2019 quarter, Treasury expects to borrow $83 billion in privately-held net marketable debt, assuming an end-of-June cash balance of $300 billion.

The US Treasury’s deposits held in its general account with the Fed stand at US dollars 411.4 billion as of 30 January 2019.

Based on the US Treasury’s press release, around US dollars 110 billion of deposits held with the Fed will be injected into the global banking system between now and 30 June.

This announcement is important because deposits held by the Treasury with the Fed are unlike deposits held with banks. Outside periods of extreme economic instability, the Fed is not engaged in the business of lending money, it only takes money in as deposits. Cash taken in by the Fed does not percolate through the global banking system, rather it sits idly in Fed’s accounts in New York.

Consequently, the build up of cash in the Treasury’s general account, to park funds generated through the issuance of Treasury bills, tightens monetary conditions while withdrawals from the account tend to ease monetary conditions. With the US Treasury contributing to tightening financial conditions for the better part of 18 months, it will for the next five months, at least, reverse course and become a source of monetary easing.

The Fed’s U-Turn

From the Wall Street Journal:

In what arguably was Mr. Powell’s most significant statement on Wednesday, he struck a dovish tone on this process of “balance-sheet normalization.” The signal was that so-called quantitative tightening would continue for now but end sooner than expected. Moreover, he also raised the possibility that the balance sheet could be “an active tool” in the future if warranted—in other words, more bond purchases if markets or the economy cry out for help. Until recently, Fed officials had been insisting the balance-sheet shrinkage was on autopilot.

As discussed last week, the Fed has little choice but to maintain a large balance sheet if it wants the US banking sector to continue being governed under the stringent Basel III framework. Chairman Jay Powell confirmed as much during his press conference on Wednesday last week.

The combination of:

(i) the US Treasury releasing dollars into the banking system;

(ii) the Fed putting interest rate increases on and introducing language that opened up the possibility that the next move in interest rate could either be down or up; and

(iii) increased clarity on the Fed’s plans for shrinking its balance sheet

we think, should be conducive for risk-assets during the first half of the year.

After a strong showing by global markets in January and the little matter of the US-China trade resolution deadline fast approaching, we think caution is warranted in February. Nonetheless our highest conviction ideas for the first half of the year are: long selective emerging markets, long precious metals, short US dollar and long selective US technology companies. 

With respect to precious metals, the Chinese New Year holidays have more often than not proven to be periods of weakness. Those with a bullish disposition should take advantage of this seasonal weakness.

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 Fed’s Permanently Big Balance Sheet & More

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“I’m not in this world to live up to your expectations and you’re not in this world to live up to mine.”  – Bruce Lee

 

“The Federal Reserve has a responsibility to ensure the safety and soundness of financial institutions and to contain systemic risks in financial markets.” – Bernie Sanders

 

In this week’s piece we discuss the possibility of the Federal Reserve ending quantitative tightening sooner than the markets expect. We also briefly touch upon precious metals, Amazon’s growing advertising business and potential short candidates in the advertising space.

 

The Fed’s Permanently Big Balance Sheet

 

From the Wall Street Journal:

Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.

Officials are still resolving details of their strategy and how to communicate it to the public, according to their recent public comments and interviews. With interest rate increases on hold for now, planning for the bond portfolio could take center stage at a two-day policy meeting of the central bank’s Federal Open Market Committee next week.

 

From the Financial Times:

Some cracks have emerged in short-term lending markets that lubricate the supply of dollars through the financial system, said analysts. After the crisis, the Fed bought assets by crediting banks’ reserve accounts, increasing the cash available for short-dated lending activity. As the Fed’s assets decline, so do bank reserves, reducing the money available for things such as overnight repo trades, where cash is lent in return for Treasuries, or commercial paper issuance, where corporates can borrow cash for short periods.

 

The fed funds market used to be US dollars 250 billion in size prior to the Global Financial Crisis. US banks were active participants in the market on a daily basis to secure funds to meet on-going regulatory reserve requirements.

Since the crisis the market has shrunk to about US dollars 50 to 60 billion today. Following the introduction of quantitative easing and as US banks built up excess reserves held with the Fed, there was no incentive left for US banks to borrow as there were no reserve requirements to meet. On top of that, the introduction of Basel III and its stringent liquidity coverage requirements means that banks are now penalised for lending in the unsecured inter-bank market.

The fed funds market is now primarily limited to transactions between Federal Home Loan Banks (FHLBs), as lenders, and a handful of US and foreign banks, as borrowers.

Before the Fed started shrinking its balance sheet, the US and foreign banks were borrowing from FHLBs, amongst other reasons, to arbitrage the difference between the fed funds rate and the interest rate on excess reserves (IOER) paid by the Fed.

Since the Fed started shrinking its balance sheet – swapping banks’ reserve accounts with Treasury and mortgage backed securities – it has become apparent that the majority of the excess reserves held with the Fed were not truly ‘excess’. The implementation of the Basel III framework has made high levels of reserves a permanent fixture within banks’ balance sheets. And by extension, the big Fed balance sheet is here to stay.

In the chart below the yellow and magenta lines are the fed funds rate and the IOER, respectively. In the years when reserves were in excess, there is a gap between the feds fund rate and the IOER. This gap was exploited by the banks borrowing from FHLBS and depositing with the Fed.  In 2018, the fed funds rate converged with the IOER – indicating that a need for reserves not arbitrage were now driving the fed funds market.

 

US Federal Funds Rate, Target Rate and Interest Rate on Excess Reserves

Fed Funds Rate.png

Source: Bloomberg

 

In response to the convergence between the two rates, the Fed placed the IOER below the upper bound of it the fed funds target rate – the IOER had always been at the upper end of the target range prior the move in the summer of last year. The issue with this move, however, is that if banks are no longer active in the fed funds market for arbitrage purposes but rather to meet reserve requirements then the IOER is unlikely to act as a cap on rates. Rather, a deficiency of  reserves, which banks cannot afford to have at any cost, could well push the fed funds rate beyond the upper bound, not only IOER.

The fed funds rate pushing through the upper bound is likely to send a signal that the Fed is losing control of short-term interest rates. Something we are certain none of the member of FOMC want. For this reason, and not due to the sharp drop in S&P 500, do we think that Chairman Jay Powell may hint at, as the Wall Street Journal suggests, ending  quantitative  tightening sooner than the market expects when the Fed meets this week.

If the Fed does indeed hint as much, we think it is likely to spur risk-appetite and be one more reason to be long emerging markets.

 

Precious Metals Update

 

Following up on a discussion from late last year, gold having briefly dipped below its 48-month moving average has moved back above it and started to created some distance.

XAU Curncy (Gold Spot $_Oz) 48 2019-01-28 13-26-59.png

 

We see little reason not to own precious metals, or miners if you have the stomach for it, especially if silver manages to move above its 48-month moving average – something it has failed to do since it dropped below it during the first quarter of 2013.

 

XAG Curncy (Silver Spot $_Oz) 4 2019-01-28 13-26-20.png

 

Amazon’s Advertising Flex

 

From the New York Times:

Ads sold by Amazon, once a limited offering at the company, can now be considered a third major pillar of its business, along with e-commerce and cloud computing. Amazon’s advertising business is worth about $125 billion, more than Nike or IBM, Morgan Stanley estimates.

 

Eyeballs combined with targeting capabilities based on actual spending patterns – ask any data-centric advertising professional and they are likely to tell you that that is the ‘holy grail’ of advertising. And Amazon has it.

While there are bound to be repercussions for Google and Facebook from the outgrowth of Amazon’s advertising business, we think it is likely to prove much worse for the more conventional advertising businesses. Many of these businesses are probably zeros in the long-run.

We think the following advertising companies are potential short-candidates:

  1. Clear Channel Outdoor Holdings $CCO – outdoor advertising company.
  2. JCDecaux SA $DEC.FP – Paris-listed outdoor advertising company with a stronghold on advertising across public transport networks including airports, business, and train stations.
  3. The Intepublic Group of Companies  $IPG – a consortium of advertising agencies and marketing services companies.
  4. Omnicom Group $OMC – a group of advertising and market agencies.
  5. Telaria Inc $TLRA – digital video advertising services provider.

 

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.

 

 

Emerging Market Stock Picks

 

“I think that if you shake the tree, you ought to be around when the fruit falls to pick it up.” – Mary Stevenson Cassatt, American painter and print maker

 

“Humans have a knack for choosing precisely the things that are worst for them.” – J. K. Rowling

 

In this week’s piece we focus on emerging markets, identifying individual stock picks to complement broad-based exposure to emerging markets. Also this week, we briefly  follow-up on the cloud-based software investment ideas discussed last week.

 

Emerging Markets Stock Picks

 

Generally speaking, when it comes to emerging markets we prefer broad-based exposures – country, asset class or sector specific ETFs – as opposed to picking individual stocks. Nonetheless, to add more nuance to a portfolio the broader exposures can form the core and individual stock picks can play the role of satellites. These satellites can be a valuable source of alpha, particularly during upward trending markets.

Below we identify six stock across emerging markets that we think warrant taking single stock exposure for.

 

China Mobile

China Mobile $941.HK (US listed depositary receipt $CHL) is the telecommunication company with the largest mobile customer base in the world.  From January through October last year, the company’s mobile user base grew by over 32 million to almost 920 million with 4G penetration of 76 per cent of the user base.

Chinese consumers, as voracious internet users, are driving a dramatic shift in China Mobile’s business model from voice to data. The launch of 5G, with its super fast transfer speeds, is likely to further accelerate the consumption of video content and the development of ‘Internet of Things’ technologies. In turn, data’s share of telecommunications companies’s revenues is only likely to increase further.

Huawei Technologies is leading the charge in the global 5G race. With anti-China rhetoric increasing across a number western states, however, Huawei is being blocked from participating in the roll out of 5G networks in those markets. Unless Huawei’s western competitors catch up on the technological front, China is likely to be the first major economy to roll out 5G.

China Mobile is well placed to benefit from the deployment of 5G in China.

The stock trades at 12.4 times 2018 earnings and a dividend yield of 4.2 per cent.

China Mobile

 

Pou Chen

Pou Chen $9904.TT is a leading footwear manufacturer in Taiwan, and the largest branded athletic and casual footwear manufacturer in the world. It manufactures  footwear for major global brands such as Nike, Adidas, Asics, Clarks, Reebok, Puma, New Balance, Crocs, Merrell. Timberland, Converse and Salomon.

The company also has a vast retail network in China with over 5,400 owned stores and directly operated stores and over  3,300 sub-distributors. It is levered to the growth in sportswear consumption in China.

Given the tax cuts recently implemented by the Chinese government and decent prospects for further easing of the tax burden, we think Chinese consumption could pick-up in 2019 and in turn drive Pou Chen’s growth.

Trading at 8.7 times 2018 earnings and a dividend yield of 5.6 per cent, we think the Pou Chen offers good value at current levels.

 

Pou Chen

 

Russian Retail: Magnit and X5 Retail Group

In Russia we like two food retail plays: Magnit (London depositary receipt $MGNT.LI) and X5 Retail Group (London depositary receipt $FIVE.LI). Both companies operate supermarkets, convenience stores and discount stores across Russia.

 

MGNT

 

The food retail sector in Russia, exacerbated by intense competition, was amongst the worst performing sectors in the Russian market last year. Valuations for a number of the food retailers are now amongst the lowest in emerging markets across the industry group – more than pricing in  the downside we think. Moreover, retail plays should benefit if there is a pick-up in consumer spending driven by a strengthening ruble (weakening dollar) or rising oil prices.

 

FIVE

 

Magnit trades at 14.3 times 2018 earnings and a dividend yield of 7.9 per cent while X5 Retail Group trades at 14.8 times 2018 earnings and 4.7 per cent dividend yield.

 

Indofood

Indofood $INDF.IJ (US listed depositary receipt $PIFMY) is an Indonesian food company engaged in manufacturing instant noodles, wheat flour, baby food, food seasonings, coffee, cooking oil, and snacks. The company is the de facto leader in the Indonesian instant noodles market with pricing power to pass on rising costs but also hold prices steady during periods costs decline.

 

INDOFOOD

 

Hypera SA

Hypera Pharma $HYPE3.BZ (US listed depositary receipt $HYPMY), previously known as Hypermarcas, is Brazil’s largest pharmaceutical company by market capitalisation.

Hypera leading position in the market is driven by its low-cost positioning with the market combined continued investment in research & development. Over the coming 4 years the company is expected to significantly expand its portfolio of “power” drugs – products with the potential to reach at least Brazillian rials 100 million is sales.

With the Brazilian pharmaceutical market expected to grow between 10 and 15 per cent per year over the coming 5 years, Hypera is well placed to significantly increase its revenues and earnings in the years to come.

Moreover, with the right leaning Jair Bolsonaro coming into power, there is a distinct possibility that they new government will look to push through pro-business regulatory and tax reform. This can be a near term catalyst for the highly regulated pharmaceutical companies in Brazil.

 

Hype3

 

 

Cloud-Based Software Follow-Up

 

Last week we shared an investment idea around cloud-based software providers and identified a number of enterprise focused stocks that we think attractive potential longs. This week, we identify a cloud infrastructure play and a SME focused cloud-based software provider as potential longs.

 

Nutanix

Nutanix $NTNX is a hyper-converged infrastructure pioneer that markets its technology as a building block for private clouds.

$NTNX is a difficult company to understand and its technologies are not easy to parse for the layman. At its simplest, $NTNX provides the basic building block for companies looking to (i) build private clouds to in-source data warehousing, (ii) to manage a hybrid structure consisting of data managed with outsourced cloud-service providers, the likes of Amazon and Microsoft’s Azure, and more sensitive data managed in a captive private cloud, or (iii) build an interface to seamlessly manage data stored with multiple cloud-service providers. Essentially, $NTNX is aiming to do cloud-service providers what cloud-service providers did to servers, commodotise them.

In addition to the infrastructure building blocks for the cloud, $NTNX provides complementary services such a processing, networking and multi-cloud optimisation that it can use to up sell clients after the initial sale.

NTNX

 

 

HubSpot

HubSpot $HUBS is a developer and marketer of software products for inbound marketing and sales. The company provides tools for social media marketing, content management, web analytics, landing pages and search engine optimisation. It has integration features for salesforce.com, SugarCRM, NetSuite, Microsoft Dynamics CRM and others.

With the growth in e-commerce and explosion of data monitoring consumers’s behaviour online, companies are increasingly looking to use the data they have gathered to both attract customers and get existing customers to spend more. $HUBS has developed a leading platform that enables small and medium enterprises to do just that.

We think small and medium businesses, particularly in the US, are going to be investing in increasing their online presence and establishing e-commerce platforms, as they do they are likely to require inbound marketing support to generate a meaningful return on their investments. $HUBS is a play on the anticipated increase in penetration of inbound marketing services.

hubs

 

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. 

 

Two Investment Ideas

 

“Since the earliest days of our youth, we have been conditioned to accept that the direction of the herd, and authority anywhere — is always right.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

“My life seemed to be a series of events and accidents. Yet when I look back, I see a pattern.” – Benoît B. Mandelbrot

 

 

In this week’s piece we identify two investment ideas: cloud-based enterprise software companies and European banks. The former has caught our attention through its recent show of strength and the latter for its recurring weakness.

 

Cloud-Based Enterprise Software

 

A number of cloud-based, software-as-a-service (SaaS) companies have been out performing markets since the US equity market started to sell-off in October last year.

 

Volatile Period: 4 Oct, 2018 – 11 Jan, 2019

  Total Return
S&P 500 Index -10.74%
Veeva Systems -5.49%
Workday Inc. +14.97%
Salesforce.com -7.26%
Benefitfocus Inc. +32.01%
Intuit Inc. -10.48%

 

Sell-Off: 4 Oct – 24 Dec, 2018

Despite being higher beta tech-stocks, some of the SaaS names have fared far better than the S&P 500 Index during the sell-off between October and Xmas, whiles others largely matched the market’s performance.

  Total Return
S&P 500 Index -19.25%
Veeva Systems -23.36%
Workday Inc. -2.23%
Salesforce.com -23.74%
Benefitfocus Inc. +13.18%
Intuit Inc. -20.83%

 

Rally Off-the-Lows: 26 Dec 2018 – 11 Jan, 2019

On the other had, in the rally off-the-lows all of the SaaS stocks we identify have significantly outpaced the market.

  Total Return
S&P 500 Index +10.54%
Veeva Systems +23.32%
Workday Inc. +17.59%
Salesforce.com +21.61%
Benefitfocus Inc. +16.63%
Intuit Inc. +13.07%

 

In each of the charts presented below, there are two panels – the top one showing the price performance of each stock and the bottom one showing the performance of the stock relative to the S&P 500 Index. A number of the stocks are witnessing their respective relative performance break to new highs.

 

Veeva Systems   $VEEV

(This is not the first time we are discussing $VEEV, our previous comments on the stock can be found here.)

$VEEV, founded in 2007, is the leading customer relationship management (CRM) solutions provider to the life sciences industry. The company was founded by and is managed by a highly experienced management team with both software and life sciences experience.

The company delivers its services through cloud-based architecture and its core CRM products, representing close to nine-tenths of revenue, are built upon Salesforce.com’s force.com platform.

 

Veev

 

$VEEV counts over two-thirds of the 50 leading global pharmaceutical companies amongst its clients. Its products enable pharmaceutical and life sciences companies to manage customer databases, track drug developments, and organise clinical trials with industry-specific functionality and maintaining regulatory compliance.

Multinational companies’ growing preference for cloud-based solutions has been and continues to be a secular tailwind for $VEEV. Specialised cloud-based solution providers, we think, are well-placed to continue grabbing market share from on-premise incumbents, such as SAP and Oracle, that have been slow in adapting to their clients’ shifting preferences.

$VEEV having established a beachhead with its core CRM products has over the years launched complimentary products that are supporting sales growth.

  • 2011: Introduced Vault, a document management product, which quickly gained traction with existing clients including at least six out of the top 20 global pharma companies.
  • 2013: Launched Network, product that provides critical customer information that can easily be integrated with its other solutions.
  • 2018: Unveiled Nitro, a  ready-to-use commercial data warehouse in the cloud tailored  for the needs of the life sciences industry that comes with a packaged software solution. The company has already signed up four customers for the product since its launch.

The newer solutions, unlike the core CRM products, are based on the company’s proprietary platform and not force.com.

 

Workday Inc.   $WDAY

$WDAY is a cloud-based financial and human capital management software solutions provider. Amongst the enterprise software companies, $WDAY has one of the largest established and addressable markets. It already counts 35 per cent of the Fortune 500 companies as clients for its human capital management solutions and its financial management solutions are also gaining traction.

WDAY

$WDAY has been extending its international presence and product offering, in a bid to  grab market share from incumbents SAP and Oracle.

The company’s products, ranking at the highest levels in independent customer satisfaction surveys, are regarded by many industry experts to have the potential sustain strong sales growth at scale for many years to come.

 

Benefitfocus Inc.  $BNFT

We added to $BNFT to our trade ideas on 3 December, 2018.

BNFT

 

Salesforce.com   $CRM

$CRM, with its iconic 1,070-foot tower in the South of Market district of downtown San Francisco, is of course one of the pioneers of cloud-computing and amongst the very elite tech companies in the world.

CRM

 

Intuit Inc.   $INTU

$INTU develops and markets business and financial management software solutions for small and medium sized businesses, financial institutions, consumers, and accounting professionals. It is one the highest quality enterprise software franchises in the US market.

 

Intu

 

Our preferred picks amongst the above names are $VEEV, $WDAY and $BNFT.  We are neutral to positive on $CRM and neutral on $INTU. We would look to buy our preferred names on any pullbacks. Moreover, for the brave amongst you,  SAP $SAP.GY and Oracle $ORCL can be shorted on rallies.

 

European Banks

From the Financial Times:

“Representation has splintered in almost every sizeable political system in Europe, making it harder to form governing coalitions, creating political instability and giving a voice to new formations on the radical left and right and in the political centre.”

Add “splintered representation” to the growing list of crises, existential or otherwise, European Union has had to deal with since the Global Financial Crisis.

Greece.

Cyprus.

Other periphery states’ debt crises.

Brexit.

Mouvement des gilets jaunes.

Italy’s populist coalition.

Spain’s Banco Popular.

Italy’s Banca Monte dei Paschi di Siena.

Deutsche Bank.

 

Given the long-list of challenges faced by Europe, it may seem strange that we are identifying European banks as an investment opportunity. However, one look at the chart of the European banking index below should explain why.

 

Euro Banks

 

Ever since the Global Financial Crisis, whenever European banks have fallen to the levels they are currently trading at, the ECB has come out with a statement or a policy to shore up investor confidence.

Given the ECB’s track record, we think being long European banks at current levels has an attractive risk-reward profile. Nonetheless, given the uncertainty surrounding Europe, we think a pair trade involving long European banks and short the STOXX Europe 600 Index might be a prudent way to express the view.

  • If the ECB comes out with a favourable policy announcement and all European stocks rally, European banks, we think, will out perform the broader European stock indices.
  • Alternatively, if the ECB does nothing and things continue to deteriorate, even though banks would probably go down, they are likely to out perform the broader equity market given that they are already at 10-year lows and the average European stock is not.

An alternative expression of the trade could be to be long EURUSD.

Euro Banks EURUSD

 

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 Shadow Banking | US Foreign Funding

“[H]ope is by nature an expensive commodity, and those who are risking their all on one cast find out what it means only when they are already ruined.” – Thucydides, The History of the Peloponnesian War

“Narrative is linear, but action has breadth and depth as well as height and is solid.” – Thomas Carlyle

Continuing on from last week,  we share more market observations that have caught our attention as we think about investment ideas and themes for 2019. This piece, too, will be chart heavy.

Please note this will be this year’s last weekly update, we will be back with our next piece during the first week of January.

China Shadow Banking

China’s leadership, at the end of last year, made it abundantly clear that ­reining in financial risk was an economic priority for the next three years. With the centenary of the founding of the Communist Party of China (CCP) in 2021, Chinese leadership would be loathe to witness the run up to the milestone be marred by an economic collapse precipitated by spiralling debt.

About the CCP it is sometimes said “to watch what they do and not what they say”. At least in this instance, they have done exactly as they said they would.

Chinese shadow finance has collapsed and there are no signs of reprieve – the drop in shadow finance has not been cushioned by stimulative fiscal policies undertaken by the central government. Monetary policy, too, has remained neutral for much of the year. It is only in recent months that we have seen some loosening of monetary policy at the margin with the reduction in reserve requirements for banks.

According to Reuters, by the end of September, 25 Chinese issuers had defaulted on
payments for 52 bonds worth a total of 60.6 billion yuan.  Compared with 20 issuers defaulting on 44 bonds worth 38.5 billion yuan during 2017, and 35 issuers defaulting on 79 bonds worth 39.9 billion yuan in 2016.

China Shadow Banking

The Chinese leadership’s resolve in sticking to its financial de-risking policy is being tested by both the Trump Administration’s hawkish trade policies and, what we suspect is, a much sharper slow down in credit growth and economic activity than anticipated.  Despite the economic challenges, we do not think the CCP will relent – at least not when it comes to shadow banking. Too much effort has already gone into scaling back shadow finance and slowly ridding the system of bad actors.

Emerging Markets

The fortunes of emerging markets are closely intertwined with those of China – the Mainland is, of course, the leading trade partner of the majority of emerging markets. With the collapse of shadow financing  and economic slowdown in China, we have seen emerging markets fall quickly out of favour amongst investors.  At the end of November, the MSCI Emerging Market Index was down 12.2 per cent for the year.

MXEF Index (MSCI Emerging Market 2018-12-14 14-08-40.jpg

In last week’s piece we highlighted that we are seeing initial signs that emerging markets may well have formed an interim bottom in October and are well placed to outperform US markets in 2019.

How do we then reconcile our expectation of emerging market out performance in 2019 with the continuation of financial de-risking in China?

Consider the following chart, which plots the 12 month moving average of year-over-year Chinese social financing growth with the Commodity Research Bureau (CRB) Spot Raw Industrial Commodities Index.  The three instances since 2007 when Chinese social financing growth has bottomed and accelerated have each been preceded by a bottoming of the CRB Index.

China Social Financing Industrial Commodities

The CRB Index peaked in January and witnessed a sharp drop from May on-wards. Recently, however, the index has started to rise again. While it is early days still, the rising CRB Index may be indicative of China once again beginning to stimulate its economy.

Instead of social financing picking up, however, we may have to look for confirmation elsewhere.

In August, China’s Ministry of Finance said local governments should complete no less than 80 percent of their special bond issuance quota by end of September.  Local governments in China issue special bonds for such purposes as highway projects and shanty town redevelopment.  Local governments were set a quota of 1.35 trillion yuan of special bonds issuance this year. During the first half of the year, however, local governments had utilised less than 25 per cent of their quotas.

We will be monitoring infrastructure investment growth and local government bond issuance closely to anticipate a recovery in Chinese economic activity and by extension to time an entry into emerging markets.

China Infrastructure Investment YoY

Infrastructure investment and local bond issuance aside, the Chinese economy has received some much needed relief from the recent drops in oil and semiconductor prices. In 2017, China spent US dollars 260 billion semiconductors imports, according to the China Semiconductor Industry Association. In comparison, China spent US dollars 162 billion on importing oil.

ISPPDR37 Index (inSpectrum Tech 2018-12-14 18-59-38.jpg

US Foreign Funding and US Dollar Implications

In “Is the United States Relying on Foreign Investors to Fund Its Larger Budget Deficit?“, a piece issued on the Federal Reserve Bank of New York’s Liberty Street Economics blog, the authors write (emphasis added):

“Data for the first half of 2018 are available and, so far, the country has not had to increase the pace of borrowing from abroad. The current account balance, which measures how much the United States borrows from the rest of the world, has been essentially unchanged. Instead, the tax cut has boosted private saving, allowing the United States to finance the higher federal government deficit without increasing the amount borrowed from foreign investors.”

Just because the US has been able to rely on higher private savings to fund its deficit this year does not mean it will be able to continue to fund deficits without increased foreign participation. The authors speculate:

Of course, these are early days and it will be interesting to see how the increase in business saving will play out. For example, the increase in that saving component may diminish over time, perhaps because firms pass on some of their profit boost from lower taxes to their customers via a drop in markups. Firms could also use their higher after-tax income for salary increases in the current tight labor market. A third possibility is for firms use the jump in saving to increase their capital stock through higher investment spending. Indeed, this perspective suggests that a deterioration in the trade balance is a sign that firms are passing on the gains from the tax cut to their employees and consumers.

Finally, the additional downward pressure on government saving going forward will be from higher spending. It may turn out that future drops in government saving from higher spending translate more directly into higher borrowing from abroad.

As we have argued in the past, a rising US dollar environment and add to it a shortage of US dollar funding for non-US borrowers, which increases borrowing and hedging costs, are not the conditions under which foreign institutional investors increase their participation in US Treasury instruments. We  are already witnessing Japanese institutional investors scaling back their exposure to US Treasury instruments.

The below chart shows the cumulative Japanese portfolio flows into the US:

Japan Cumulative Portfolio Flows US.jpg

The US’s current account balance has been unchanged despite Japanese outflows because of higher oil prices. Middle Eastern oil exporters have recycled their petrodollars back into US Treasury instruments as oil prices have exceeded their fiscal break-even levels this year. With oil prices having corrected recently, however, Middle Eastern participation is likely to diminish.

If, indeed, the US ends up requiring foreign participation to increase to fund its deficits we expect one or both of the following to happens:

1. The US Treasury will start spending from its General Account – much like it did in late 2016 / early 2017 in anticipation of a potential government shutdown – and this will release much needed US dollar liquidity into the global banking system.

2. The Fed starts offering foreign central banks unlimited (or very high) quantities for US dollar swap lines much like it did in the aftermath of the global financial crisis. The Fed has the ability to fix the quantity of US dollars available, this results in the price of US dollars rising when demand for US dollars rises, or fix the price of US dollars, this results in unlimited availability of US dollars. Today the Fed fixes the quantity of US dollars available not the price.

Both of the above would be US dollar negative and would provide a signal to short $DXY / go long emerging market currencies.

TGA DXY

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.

Humble Pie, US Credit Standards, General Electric and More

 

“I don’t enjoy eating humble pie; it never tastes good. But I do appreciate it when it happens.” – Simon Sinek

“I have more respect for a man who lets me know where he stands, even if he’s wrong, than the one who comes up like an angel and is nothing but a devil.” – Malcolm X

 

Humble Pie

 

Last week we wrote about our bullish view on oil prices. A few days later oil prices dropped by more than 7 per cent in one trading session, leaving us to eat a large portion of humble pie. Capital markets are tough and, on occasion, very cruel.

Following the sharp drop in oil prices this week, we were left scratching our heads and have since tried to understand what transpired. One of the best explanations we have found comes from the Macro Tourist blog. Rather than commenting on the piece, we provide the link here and urge you to read the analysis.

There is also an article from Bloomberg that presents Goldman Sachs’s reasoning for the recent drop in oil prices. We quote from the article:

 

Goldman analysts blamed the rout on a combination of momentum trading strategies, and selling from financial institutions which had helped arrange hedges on behalf of oil producers. Goldman is itself one of Wall Street’s top commodity banks.

“Increased selling of crude oil futures by swap dealers as they manage the risk incurred from existing producer hedging programs” was a key contributor to the rout, analysts including Jeff Currie said in a note.

Producers often lock in their price exposure by buying put options from banks. As prices fall toward the level where the options pay out, the banks are then forced to sell ever greater numbers of futures to hedge their own risk.”

 

Both articles point to technical as opposed to fundamental factors being behind the recent drop in oil prices. At the risk of becoming victims to confirmation bias, we tend to agree and continue to maintain our fundamental view.

As one of our former colleagues and dear friends often reminds us, market participants with an information advantage can only express themselves through the markets, ipso facto technicals, in such circumstances, front run fundamentals. If oil prices continue to drop from current levels we will have to accept that something that we do not know or understand is afoot in the oil market and close our long position in $XLE.

 

 

Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices

 

The Fed published the most recent edition of its quarterly “Senior Loan Officer Opinion Survey on Bank Lending Practices”. We quote from the Fed’s commentary on the key findings from the survey:

 

“Regarding loans to business borrowers, banks indicated that they eased their standards and terms for commercial and industrial (C&I) loans while experiencing weaker demand for such loans on balance. At the same time, banks reportedly left their standards unchanged on most categories of commercial real estate (CRE) loans, while demand reportedly weakened for most categories of such loans.

For loans to households, banks reported easing their standards on most categories of residential real estate (RRE) loans while experiencing weaker demand for such loans on balance. In contrast, banks reportedly left their standards on auto and credit card loans about unchanged, while demand for such loans also remained unchanged.”

 

The latest survey showed US banks continue to loosen lending standards for commercial and industrial loans as opposed to tightening them. Notably, the survey data suggests that banks are facing declining loan demand. Reasons for declining demand for credit include (i) increases in companies’ internally generated funds, (ii) reduced investment, and (iii) borrowers shifting their borrowing to new lenders.

One of the primary reasons we have remained bullish on the prospects of the US market, particularly since the ‘volmaggedon’ driven sell-off in February, is that we have seen little evidence of a meaningful tightening in either the availability of credit or credit standards in the US. The loan officer survey confirms as much.

Credit standards have been reliable leading indicators for commercial and industrial loan demand over the coming six to twelve months. It might well be that loosening credit standards stimulate demand for credit; or it may be that business prospects are bright enough to warrant a loosening of standards. With increases in companies’ internally generated funds being cited as one of the reasons for the softness in credit demand, it suggests strong business prospects are contributing to a loosening of standards.

 

General Electric Fears

 

Uneasiness around General Electric’s US dollars 114 billion in debt has been growing since October, when Standard & Poor’s downgraded the company’s credit rating to BBB+, just three notches above junk. In Novembers, Moody’s and Fitch Ratings followed suit, pushing the company’s bonds to new all-time lows. Making matters worse, newly appointed chief executive Larry Culp expressed in an interview that General Electric urgently needed to cut its debt and sell assets in order to do so – the company’s share price fell 10 per cent price drop in response.

With the Fed continuing to raise interest rates, we are not surprised to see a company with a weak balance sheet and poor business prospects suffering from the ills of excessive debt. General Electric is unlikely to be the last of such cases that we read about before the Fed is done raising rates.

For now, however, with credit standards remaining loose and corporate yields spreads remaining tight (despite the slight widening in recent weeks), we do not consider the fallout from the likes of General Electric to be systemic. Nonetheless, we would avoid allocating capital to high yield credit at this stage of the business cycle.

 

 

Paul Krugman on the Tax Cuts and Jobs Act and the Balance of Payments

 

In the Fed loan officer opinion survey one of the reasons highlighted for soft credit demand is reduced investment. This is somewhat perplexing when we consider the incentives provided by the Trump Tax Plan, or the Tax Cuts and Jobs Act (TCJA), for US corporations to repatriate capital back onshore and use it for capital investments.

Paul Krugman, the Nobel Prize winning economist, has an excellent piece titled “The Tax Cut and the Balance of Payments (Wonkish)” in the New York Times that provides some explanation and evidence for why the TCJA has not resulted in increased capital investment in the US. While urging you to go and read the piece yourself, we quote from the article to highlight some of the critical points Professor Krugman makes (emphasis added):

 

“What tax-cut advocates argued was that the rate of return in the U.S., net of taxes, is set by global forces. Suppose that there is a global rate of return r*; then the U.S. will have to offer r*/(1-t), where t is the corporate tax rate.

Now imagine cutting t; the figure shows a complete elimination of corporate taxes, but the logic is the same for simply reducing the rate. This should lead to inflows of capital from abroad, increasing the capital stock, which both raises GDP and reduces the rate of return. In the end the after-tax return on capital should be back where it started, with all of the tax cut passed through to wages instead.

The crucial point, however, is that for this to happen you have to have a large increase in the physical stock of capital – it’s not an immaculate financial transaction. This in turn means that those inflows of capital have to enable a massive wave of real investment in plant and equipment.”

 

…

 

“[P]romoting capital inflows was at the heart of the halfway reasonable argument for the tax cut. So far, that argument appears to be not totally stupid, but also, as it happens, quite wrong.”

 

…

 

“On its face, a corporate tax cut looks like a big giveaway to stockholders. Proponents of the TCJA claimed that this was misleading, because large capital inflows would ensure that the cut went to workers instead. But there’s no sign of those big inflows, so what looks like a big giveaway to stockholders is, in fact, a big giveaway to stockholders.

And about 35 percent of that giveaway is to foreigners, so the tax cut makes America as a whole poorer.”

 

What Professor Krugman presents invalidates one of the key strong US dollar / offshore US dollar shortage arguments out there: the repatriation of offshore US dollar holdings into the US by US corporations. As Professor Krugman puts it, repatriation by US corporations might just be an accounting gimmick that does not require cash to move between jurisdictions. If, in fact he is correct in his diagnosis, there are plenty of reasons to be optimistic about the prospects of non-US markets heading into 2019.

 

We have for several weeks been working on better understanding the offshore US dollar market, the monetary transmission mechanisms being utilised by the Fed in a post-QE world and what it means for the prospects of the US dollar and non-US markets. We hope to have our work completed to share with you in the coming few weeks.

 

 

 

 

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.

Oil Market Misery | Amazon Ups Its Advertising Game

 

“This is a frightening statistic. More people vote in ‘American Idol’ than in any US election.” – Rush Limbaugh, American radio talk show host

 

“When luck plays a part in determining the consequences of your actions, you don’t want to study success to learn what strategy was used but rather study strategy to see whether it consistently led to success.” – The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing by Michael J. Mauboussin

 

“Sometimes it is the people no one can imagine anything of who do the things no one can imagine.” – Alan Turing

Oil Market Misery

 

Since late September, when oil prices hit four year highs, Brent and WTI prices have slumped by more than 20 and 23 per cent, respectively. With economic sanctions fully re-imposed on Iran starting 5 November, the price action of oil market makes one wonder if it is yet another case of buying the rumour and selling news.

The drawdown in oil prices coming at a time when Chinese oil imports have surged to record levels makes it all the more glaring.

 

Brent.PNG

 

The sharp drop in oil prices over the last six weeks has attributed to a number of factors, including:

 

  • The growing conviction that the Trump Administration’s will take a soft-touch approach in policing adherence of the economic sanctions on Iran;

 

  • Rising US oil production;

 

  • Expected growth in production from OPEC member states after the easing of production quotas;

 

  • Global economic growth expectations for next year being revised downwards, in turn implying weaker oil demand growth next year; and

 

  • Higher than anticipated levels of crude inventory builds in the US.

 

On Monday, when the US administration announced granting waivers to eight of the largest importers of Iranian oil including China, India and Turkey, it was seen as confirmation that US’s enforcement of sanctions on Iran will be lukewarm at best. We do not agree with this view and see no reason for the Trump Administration to take anything except the most hard line approach towards Iran.

The waivers granted by the US have been on the cards ever since the Trump Administration first announced it would re-impose sanctions on Iran back in May. They are a means to avoid disruption in the oil market and to give importers ample time to shift away from Iranian oil.  The waivers have little to no impact on Iranian oil exports expectations for 2019 and beyond. Iranian oil exports are expected to drop from a peak of 2.5 million barrels per day in 2018 to less than 1 million barrels per day during the grace period afforded to the eight importers and drop off sharply once the waivers lapse.

We expect the Trump Administration to tighten the noose around the Iranian economy in 2019. We see no political or economic incentive for President Trump to act otherwise. Trump’s Middle Eastern allies – Saudi Arabia and Israel – are passionately in support of the sanctions and with mid-terms elections now out of the way Mr Trump is unlikely to agitate over a moderate rise in domestic gas prices at the cost of appearing to go easy on Iran.

Moreover, Mr Trump’s band of trade warriors and security hawks, with one eye on the on-going trade negotiations with China, are likely to be partial to higher oil prices and unlikely to want to see the Administration come across as being soft. Higher oil prices put a squeeze on the Chinese economy and increase its need for US dollars – factors that are likely to give the US an upper hand in trade related negotiations with China.

As it relates to rising US production capacity, nothing has changed since oil prices peaked in September to alleviate capacity constraints and infrastructure bottlenecks that would allow for an uninterrupted rise in US production. If anything, the recent drop in prices is bound to have a negative impact on future production growth.

We also think that worries about rising output from OPEC and Russia are misplaced. Although OPEC member states and Russia agreed in June to raise production by a combined 1 million barrels per day from May levels in order to offset expected losses from Iran and Venezuela, the Saudis and Russians are reportedly already contemplating production cuts for 2019 in response to the reason drop in prices. Our view is that oil exporting nations have little to no incentive to release their stronghold over the oil market.

High oil prices, a strong US dollar, rising interest rates and a slowing China certainly raise cause for concern for global economic prospects in 2019. Despite the concerns, OPEC still expects world oil demand to grow by 1.36 million barrels per day in 2019. Moreover, Chinese demand should continue to increase with at least two major refineries scheduled to start operations during the first half of 2019.

We consider the recent sell-off in oil to be largely sentiment driven and an unwinding of exceedingly bullish positioning by speculative accounts. Total net long exposure has declined by around 40 per cent in the last six weeks – representing almost 400 million barrels of crude.

Given that oil market supply-demand dynamics point to a probable supply deficit in 2019 and waivers for Iranian sanctions set to expire in six months, we expect oil prices to consolidate and move higher from current levels in the coming weeks and months – potentially even making a new cyclical high in the process.

Amazon Ups Its Advertising Game

 

Just a quick update on Amazon and another step the company has taken to increase its share of the advertising pie.

Amazon is shipping its first-ever printed holiday toy catalogue, titled “A Holiday of Play”, to millions of customers starting this month. Toys featured in the catalogue come with a QR code, allowing readers to instantly scan and shop for the products. Readers can also scan the product images in the catalogue with their Amazon App to get more information.

This is quite an interesting development in our view. We have a hunch that Amazon’s efforts have been heavily subsidised by advertising dollars from brands eager to feature their products and logos in the catalogue.

If Amazon’s efforts to blur the boundaries between offline and online prove successful in increasing consumer spending on its website, we can certainly envision a scenario where Amazon, the combination of the website and catalogues, becomes the go to destination for consumer brand advertising. Which half of the advertising pie Amazon gets its share from is likely to have far reaching implications for both digital incumbents (Google and Facebook) and traditional media.

 

 

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 US Consumer is Not Immune and More

 

“Progress is impossible without change, and those who cannot change their minds cannot change anything.” – George Bernard Shaw

 

“The first rule of business is: Do other men for they would do you.” – Charles Dickens

 

“Globalization and trade liberalization were supposed to make us all better off through the mechanism of trickle-down economics. What we seemed to be seeing instead was trickle-up economics, accompanied by a destruction of democratic politics, as we moved ever closer to a system of ‘one dollar, one vote’ as opposed to ‘one person, one vote.’” – Joseph Stiglitz

 

The US Consumer is Not Immune from the Trade War

 

On 6 July 2018 the first tranche of tariffs imposed by the Trump Administration on China went into effect. The first tranche amounts to a 25 per cent import duty on 818 Chinese goods, representing US dollars 34 billion of China’s exports to the US in 2017. The first set of tariffs primarily target industrial goods such as aircraft engines and engine parts, cranes, nuclear reactors, electricity transformers and industrial magnets.

 

On 24 September 2018 the second tranche of tariffs on Chinese imports went into effect. Import duties on goods targeted in the second tranche started at 10 per cent and will rise to 25 per cent from 1 January 2019. All manner of Chinese goods, constituting roughly US dollars 200 billion of China’s exports to the US in 2017, have been hit in the second wave of tariffs. Targeted products include consumer goods such as furniture and luggage, agriculture products such as fruit and seafood, and industrial products such as chemicals and printed circuit boards.

 

The imposition of tariffs on Chinese goods has coincided with the gradual depreciation of the Chinese yuan. From its peak in April, the Chinese yuan has dropped by approximately 11 per cent. The drop in the currency is seen by many as a means by which China aims to counter the 10 per cent import duty imposed on its exports.

 

In reaction to the steady depreciation of the Chinese yuan this year, a narrative has started to take hold amongst those with a pro-tariff / anti-China disposition. That narrative being that the US consumer will be sheltered from the negative effects of a trade war as China will simply continue depreciating its currency in response to the tariffs. And a further 15 per cent decline in the value of the Chinese yuan relative to the US dollar is being anticipated ahead of the increase in import duties to 25 per cent on goods targeted in the second tranche of tariffs.

 

Chinese Yuan to US Dollar Exchange RateCNY.png

Source: Bloomberg

 

While the currency devaluation argument has merit, we do not agree with the view that the US consumer is immune to the effects of the trade war. A cheaper currency does not solve everything. Raw materials prices for Chinese exporters have increased in local currency terms and pushed up their costs, especially for producers with inputs comprising of commodities or imported products priced in US dollars.

 

Contrary to the view that the US consumer will not be impacted by trade wars, the recent decline of the Chinese yuan against the US dollar does not mean exporters can cut prices, in US dollar terms, to entirely offset the impact of the imposed tariffs, especially as most exporters operate with very thin profit margins.

 

In our estimation, under an optimistic scenario, the depreciation of the currency will only support to offset about 50 per cent of the import duties. Implying that, in most cases, the cost of tariffs will have to be shared by Chinese exporters and US consumers.

 

Prices for US consumers, however, should not start rising immediately.  US companies are preparing for the increased tariffs by purchasing higher levels of inventories from Chinese exporters. This also means that Chinese exporters are still to feel the pinch from tariffs. Based on anecdotal evidence we have gathered, Chinese exporters are inundated with orders and are operating at full capacity to ensure US bound orders are fulfilled in time to reach US ports ahead of the 1 January 2019 deadline.

 

A necessary corollary of the accelerated demand from US importers this year is that the first quarter of 2019 is going to be very tough for Chinese exporters. And US consumer prices are likely to start increasing in the second or third quarter of next year.

 

US consumer discretionary stocks have had a pretty good run in 2018; the time to start rotating out of the sector is approaching fast.

 

China Doubles Down on the Consumer

 

At last year’s 19th Annual Communist Party Congress Xi Jinping highlighted the need to tackle financial risks as one of the priorities for the Chinese leadership. Following the event, the government took steps to clampdown on the shadow banking sector. New regulations were introduced to close loopholes that were being exploited both by banks and asset management companies to funnel loans under the guise of investment. Consequently, credit growth in China has stalled – possibly even more so than the Chinese leadership may have anticipated.

 

China Money Supply M2 Year-over-YearM2.png

Source: Bloomberg

 

Facing the escalating trade dispute with the US and the marked slowdown in credit growth, China has been under pressure to use fiscal policy more aggressively to support the economy. The government has so far resisted the urge to ramp up fiscal spending – possibly wanting to hold on to the option to combat further economic challenges in 2019.

 

Instead of increasing fiscal spending the Chinese government has focused on reducing reserve requirements for banks and providing inducements to Chinese consumers to increase spending.

 

In our view, reserve requirements cuts are unlikely to change the trajectory of either credit or economic growth in the near term. The government still remains committed to its financial de-risking campaign, and while there have been noises about scaling it back, there is little sign of it happening.

 

China needs increased spending to spur its economy forward and if it is not going to come from the government, it has to come from the consumer. And this is where it seems the Chinese government is focusing its near terms economic policy.

 

A sharp rise in consumer and household debt is what drove China’s economic growth in recent years. The build-up in household debt has been quite rapid, and in some coastal areas of China debt levels are now quite high. Consequently, compelling Chinese consumers to borrow more does not appear to be a viable policy option. For this reason the Chinese government has instead opted for tax cuts.

 

In September, China implemented its first income tax cut in seven years. Moreover, the implementation date of the tax cut was brought forward to 1 October from 1 January. The major change in the new tax regime is an increase in the threshold for paying tax to Chinese yuan 60,000 in annual compensation, from Chinese yuan 42,000 – individuals will not pay tax on their first Chinese yuan 60,000 of income. This change delivers a tax cut at all levels of income.

 

Further cuts apply for the first four of China’s seven income-tax brackets. The benefits of the tax cuts are highest for those with monthly incomes of Chinese yuan 10,000 to 50,000, with the cuts representing approximately 6 per cent of their income.

 

In total, these changes, according to the Ministry of Finance, will reduce revenue from the personal income tax by about Chinese yuan 320 billion – equivalent to roughly 1 per cent of annual household income. Also according to the Ministry of Finance, the share of the population paying income tax will fall 44 per cent to 15 per cent as a result of the changes to the income tax law.

 

More recently, the Chinese government has introduced plans to let households deduct major expenses such as housing and education from their income taxes. An estimated 80 per cent of households stand to benefit from the change and the tax burden on lower and middle class households is expected to be reduced by as much as 25 to 30 per cent

 

There has also has been news that China is considering a tax cut to revive its flagging automotive market.

 

There is little reason to doubt that the Chinese government will do more to support growth as and when it becomes necessary. For now, however, it may be time to go bottom fishing in beaten down Chinese consumer plays.

 

 

 

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.