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Investment Observations

 

“People’s minds are changed through observation and not through argument.” – Will Rogers

 

“If you make listening and observation your occupation you will gain much more than you can by talk.” – Robert Baden-Powell

 

“The important thing is not to stop questioning. Curiosity has its own reason for existing.” – Albert Einstein

 

Autumn months are more volatile; 2017 was an aberration

October is, on average, the most volatile month of the year for US equity markets. From 1993, the year the VIX index was launched, through 2017, the average level for the VIX for the month of October has been 21.8 per cent.

In October 2017, the VIX averaged 10.8 per cent, which at the time was the lowest monthly average for any month on record since the VIX index was launched. The complacency witnessed in capital markets last year was an aberration and should not be the yardstick by which investors manage their portfolios.

 

US mid-term elections: History is on the side of equity markets

Regardless of how midterm elections turn out, equity investors tend to be the big winner. At least that is what history suggests.

The S&P 500 index has climbed in the twelve months following each of the midterm elections going back to 1946, with an average return of 16.7 per cent. That is eighteen elections irrespective of who won and what changes were wrought on the balance of power.

Do not let the typical level of volatility witnessed in months starting with the letter ‘O’ put you on the wrong side of history. Stay long US stocks.

 

Treasuries: “The dog that didn’t bark”

If stocks go down, treasuries go up. Rinse and repeat. This is the axiom on which strategic asset allocations of institutional investors and quantitative investment strategies, such as ‘all-weather’ and ‘risk parity’, have been built.

Yet this past month we have seen treasuries fail to bounce even though global equity markets have sold off. This failure is even more surprising given that speculative short futures positions across the US Treasury bond curve are at or near record highs. The inability of bonds to rally in the face of an equity market sell-off gives credence to the argument that the short bond positions are not speculative but rather hedges to long positions held by institutional investors and / or hedge funds.

 

Gold: Risk-off rally?

Unlike treasuries, the recent sell-off in stocks has coincided with a strengthening of the price of gold. This is all the more surprising when we consider that the US dollar has not weakened but rather strengthened as well.

 

Is gold the new hedge to stock market volatility? We are not sure. The recent rally might just be a case of unwinding of oversold conditions or of speculative investors closing their short gold positions in response to redemptions or margin calls caused by their declining long positions.

Alternatively, we wonder if a new bull market in precious metals is getting underway. It is, we feel, too early to tell and with gold miners remaining weak despite the gold price holding strengthening, it should give anyone bullish on the prospects of precious metals some pause.

For example, Newmont Mining, one of the few ‘blue chip’ gold mining companies, reported solid third quarter earnings yesterday that handily surpassed consensus estimates but still saw its stock price decline by almost 7 per cent. (Admittedly, at the time of writing some of yesterday’s weakness has been reversed today.)

 

SoftBank’s Vision Fund and the race for venture capital exits

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.

The Vision Fund, the largest ever venture capital fund raised anchored by capital commitment of US dollars 45 billion from Saudi Arabia, has been deploying capital at record pace with, what appears to us at least, limited consideration for valuation and due diligence.

Take for instance Benchmark Capital’s partial exit in Uber. The venture capital fund was able to monetise one of its most successful investments without a trade sale or public listing. Benchmark sold 14.5 per cent of its holding in Uber for around US dollars 900 million to the Vision Fund. Considering that Benchmark originally invested US dollars 12 million in Uber, the partial exit is quite the coup and something, we feel, that would not have been possible without a public listing were it not for the 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. For example, Ari Emanuel’s media and entertainment group Endeavor is considering terminating a US dollars 400 million investment into the company by Saudi Arabia’s Public Investment Fund.

SoftBank’s Vision Fund is synonymous with Saudi Arabian money.

Masayoshi Son, SoftBank’s founder, was as recently as August talking up the prospects for a second Vision Fund with Saudi Arabia once again the cornerstone investor. Talks of the second fund have died down given recent events.

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.

 

Brazilian election: Fears of a Latin Rodrigo Duterte

Brazil held the first round of general elections on 7 October, 2018 to elect the President, Vice President and the National Congress.

Rio de Janeiro congressman Jair Bolsonaro came first in the first round of the election. The run-off will be between him and former São Paulo mayor Fernando Haddad.

Fernando Haddad represents the Workers’ Party – the leftist party that has won the last four elections held in Brazil.

Former army captain and seven-time congressman Jair Bolsonaro is the right-wing candidate representing the Social Liberal Party. Barring a late twist, Mr Bolsonaro is expected to be elected as Brazil’s next president on Sunday. Mr Bolsonaro has ridden a wave of populism and angst against the incumbent party to put himself in pole position.

Since Mr Bolsonaro’s victory in the first round of the elections, Brazilian assets have rallied even as other emerging markets struggled. Market participants do not want the Worker’s Party back in power – fearing that the leftists will undo the reforms that have stabilised the Brazilian economy in the aftermath of the 2014-16 recession. Moreover, there is hope that Mr Bolsonaro will continue on the path of reforming the Brazilian economy.

Mr Bolsonaro’s proposed economic team, should he come into power as expected, will be made up of technocrats under the leadership of University of Chicago-trained financier Paulo Guedes. Mr Guedes is an advocate of deep public spending cuts and deficit reduction with the seemingly incongruent goals of reigniting consumer and business confidence. He has advised Mr Bolsonaro to push ahead with painful reforms, should he be elected, from the very beginning of his term. In particular, Mr Guedes is pushing for social security and pension reform that would trim benefits and raise the state retirement age to 65 for men, and 62 for women to be at the top of Mr Bolsonaro’s agenda.

While right-wing candidate’s economic agenda appears to be encouraging, his social agenda is eerily reminiscent of the type of opinions expressed by Philippine President Rodrigo Duterte. Mr Bolsonaro, to quote the Financial Times, “is known as an apologist for the 1964-85 military dictatorship, for endorsing torture and for making disparaging remarks about homosexuals, women and black people.”

We are concerned that Mr Bolsonaro will try to prolong the wave of populism as much as possible by prioritising his social agenda over economic reforms. In particular, we would be surprised, if he makes the unpopular social security pension reforms his key priority early in his presidential term. In fact, during his campaign, Mr Bolsonaro went as far as criticising current president Michel Temer’s planned social security system reforms as well as the tax changes proposed by Mr Guedes.

Brazilian assets may continue to rally should the country elect Jair Bolsonaro as its 38th president on Sunday. We, however, prefer to tread carefully until there is more clarity on Mr Bolsonaro’s priorities once he is in office.

 

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.

Tightening Only in Name

 

“We cannot control the way people interpret our ideas or thoughts, but we can control the words and tones we choose to convey them. Peace is built on understanding, and wars are built on misunderstandings. Never underestimate the power of a single word, and never recklessly throw around words. One wrong word, or misinterpreted word, can change the meaning of an entire sentence and start a war. And one right word, or one kind word, can grant you the heavens and open doors.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

In November 2010, esteemed investors and academics including Cliff Asness (AQR Capital), Jim Chanos  (Kynikos Associates), Seth Klarman (Baupost Group),  Paul Singer (Elliot Associates) and Michael J. Boskin, the T. M. Friedman Professor of Economics and senior fellow at Stanford University’s Hoover Institution, sent, the then Federal Reserve Chairman, Ben Bernanke an open letter warning him of the consequences of undertaking a second round of quantitative easing:  “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

 

Monetary policy transmission mechanisms are amongst both the most confusing and most important concepts for financial market participants to come to grips with. Many of us misunderstood quantitative easing. We do not want to repeat the same mistake and misinterpret quantitative tightening.

 

For starters, quantitative tightening in not what is “rattling markets”.

 

One of the best explanations we could find on why quantitative tightening is not tightening in the normal sense comes from The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession written by Mr Richard Koo, Chief Economist at Nomura Research Institute. We quote (emphasis added):

 

“Under quantitative easing, the Bank of Japan supplied liquidity to the market. It did so by purchasing government bonds held by commercial banks, and crediting money to their current accounts. This process was repeated until the aggregate value of banks’ current accounts had risen to more than ‌¥30 trillion. To terminate the policy, this process had to be reversed. In theory, this would involve the bank selling government bonds to commercial banks to absorb the excess funds in their current accounts.

 

Selling government bonds should cause their price to fall, driving up interest rates. In practice, however, abandoning quantitative easing was not a “tightening” of monetary policy in the ordinary sense. In a standard tightening phase, the Bank of Japan responds to an overheated economy by selling bonds to commercial banks to mop up market liquidity and reduce the volume of money circulating. Commercial banks, on the other hand, normally try to maximise income on available funds by reducing liquidity on hand to the statutory minimum or thereabouts, and lend or invest the rest of their funds. Under these circumstances, commercial banks would not have the surplus funds needed to buy bonds from the Bank of Japan – their only option would be to sell other assets. In some cases, they might even consider calling in loans. So when the Bank of Japan starts selling bonds to commercial banks, banks are prompted to sell other financial instruments, driving down the price of financial assets in general (and thereby pushing up interest rates). This chain reaction of selling has a restrictive impact, and serves to cool economic activity.

 

But in terminating quantitative easing, the ¥25 trillion in surplus funds that the Bank of Japan sought to mop up was already sitting in commercial banks’ current accounts with the central bank, which pays no interest. Facing an absence of private-sector borrowers, the commercial banks could do nothing else with these funds. So when the Bank of Japan asked the banks to buy ¥25 trillion of government bonds, they paid for the purchases with money already on deposit with the Bank of Japan.

 

Because the banks did not need to raise funds elsewhere, the operation had none of the negative impact of a normal tightening operation, and interest rates did not rise significantly. Quantitative easing – the great non-event of the fifteen-year recession – vanished without a trace.”

 

 

For good measure, we also quote from Dr. Manmohan Singh’s article from FT Alphaville in April 2017, where he argues that the unwinding of the Fed’s balance sheet “may not be tantamount to tightening”:

 

“Deposits have taken too much balance-sheet space of the banking sector with excess reserves of the banks at the Fed are presently over $2tn. This inhibits financial intermediation and in turn, monetary policy transmission. As an analogy, oil is only needed for lubricating a car’s engine; similarly, excess reserves, are needed only to smoothen out the need for reserves in the financial system. They were close to zero before the Lehman crisis. Now instead of an “oil change” we are carrying the oil in the car trunk, in our homes, everywhere.

 

Markets currently can digest duration of good collateral. As seen in the past year, policy rate hikes may not percolate to the long end of the yield curve and vice versa, because the investor base is very different for the short and long end.

 

For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1. 8 per cent from 2.3 per cent, as markets digested duration despite sizeable sales of Treasuries by many emerging markets throughout 2016.

 

So the unwinding of a central bank’s balance sheet may not result in tightening. Collateral that will be released (from the asset side of the Fed balance sheet) to the market, with reuse, is a far better lubricant for the financial system than the reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). Although the Dodd Frank Act and Basel III make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system (due to the central bank unwind) may more than neutralize the regulatory cost. Thus, a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle than currently being anticipated.”

 

Investment Perspective

 

If quantitative tightening is not tightening in the normal sense, this begs the question of what has gotten into global stock markets this year.  The simple answer is: we do not know for sure. It could be any one of a number of reasons or a combination of them. Some of the commonly cited explanations we have come across for the recent selloff include the escalating trade dispute between the US and China, the Chinese yuan breaking 6.9 to the US dollar, contagion from the selloff in emerging markets, fallout from the bond market route and, our favourite, that “TINA” (there is no alternative) no longer applies to stocks as the short end of the yield curve is now viable investment opportunity.

 

We think it may simply be a case of temporary exhaustion after accelerated pension contributions and cash repatriation by US corporations bid up US asset prices. With the deadline for accelerated pension contributions having passed and the rate of cash repatriation by US corporations slowing, the presence of ‘price insensitive’ buyers is likely to have diminished.

 

Regardless of the drivers behind the recent selloff, we think there still are compelling reasons to remain long US stocks. To expand on our reasoning, we return to Mr Koo’s book and present his yin-yang cycle of bubbles and balance sheet recessions:

 

Yin yang.png

 

We think, with the capital spending incentives in the Trump tax cuts, low employment and strong consumer spending, the US economy is in stage six of Mr Koo’s framework. US corporations are finally showing signs of increasing capital investment and there is a growing chance that the borrowing needs of the US Treasury are going to start crowding out the private sector. This could exasperate the situation for the US private sector, which is already under pressure to invest in increasing productivity to counteract tightness in the labour market and the pressure on margins from rising wages.

 

We think that under present conditions, the US economy can quickly accelerate from stage six to stage nine – the US fiscal deficit is expected to accelerate in 2019, even excluding any potential boost in spending from a revival in President Trump’s infrastructure spending bill.

 

We remain long US equities and are increasingly looking for opportunities to allocate capital to the industrial sector. We also think the time to increase allocation to non-US equities is upon us – for now we defer that discussion to another update.

 

 

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.

 

 

 

 

 

 

Olson’s Paradox and the Successful Collusion Amongst Oil Exporters

 

“What most of these doomsday scenarios have gotten wrong is the fundamental idea of economics: people respond to incentives. If the price of a good goes up, people demand less of it, the companies that make it figure out how to make more of it, and everyone tries to figure out how to produce substitutes for it. Add to that the march of technological innovation (like the green revolution, birth control, etc.). The end result: markets figure out how to deal with problems of supply and demand.” – Steven D. Levitt

 

“The only thing about sanctions is that, like a lot of drone strikes, there are countless unintended victims.” – Henry Rollins, American musician

 

“The English language has 112 words for deception, according to one count, each with a different shade of meaning: collusion, fakery, malingering, self-deception, confabulation, prevarication, exaggeration, denial.” – Robin Marantz Henig, contributing author to the New York Times

 

 

 

Mancur Olson in his seminal book The Logic of Collective Action: Public Goods and the Theory of Groups challenged the prevailing wisdom during his time and developed a theory of collective action, commonly referred to as Olson’s Paradox, to explain why the existence of a common interest among a group of people is not sufficient to induce cooperative behaviour amongst the members of the group.

Olson argued that “unless the number of individuals in a group is quite small, or unless there is coercion or some other special device to make individuals act in their common interest, rational, self-interested individuals will not act to achieve their common or group interests.” In a scenario where a change is being proposed and there are two rival groups contesting said change, and the number of members in one group vastly outnumbers those in the other group, the theory poses that the smaller group will have an organising advantage over the larger group and is thus far more likely to achieve a winning outcome.

Oil importing nations greatly outnumber oil exporting nations. And it almost goes without saying that rising oil prices richly benefit oil exporting nations while the gains of declining oil prices are more modestly divided amongst the oil importing nations. Oil exporters then have both (i) a greater incentive to push up the price of oil than do oil importers to push it down and (ii) an organising advantage. It is this combination of incentive and advantage that enabled OPEC and Russia et alia (NOPEC) to implement and maintain joint production cuts that stabilised and eventually propelled oil prices higher.

Oil prices have ripped higher this week, the price of Brent Crude has pushed through the US dollars 80 per barrel mark – a level previously unreached since the collapse in oil prices in late 2014; the level may have remained unreachable had it not been for the Trump Administration’s reinstatement of economic sanctions on the Islamic Republic of Iran in May this year.

The catalyst for this week’s push higher is seen to be the lack of response coming from the OPEC-NOPEC alliance to President Trump’s protestations for an increase in production to cool prices. Mr Trump, it seems, is asking for his vig as the bully who ejected Iranian oil from global markets.

Even though OPEC did indicate that it has the necessary capacity to replace Iranian supplies markets remain concerned about a supply deficit next year, especially with infrastructure bottlenecks limiting supply from shale.

The International Energy Agency (IEA) estimates oil demand growth to average 1.5 million barrels per day in 2019. Assuming that the moderate pace of global economic growth anticipated for 2019 is not derailed by the on-going trade conflict between China and the US, realised demand levels should not differ significantly from the estimate.

The supply side is where the challenge, we think, lies.

In the absence of renewed sanctions on Iran, the supply-demand dynamics would have remained evenly balanced. Shale production has continued to exceed expectations; US production has reached 11 million barrels per day – increasing by 1.6 million barrels per day over the course of the last 12 months. With oil prices as high as they are, shale producers are likely to continue pushing for increased output and US production may well continue to surprise to the upside.

The Trump Administration is likely to prove far less tolerant of importers breaching sanctions than the Obama Administration, which allowed China and other nations to continue exploiting legal loopholes to access Iranian oil

The impact of the Iranian sanctions on the oil supply-demand dynamic will come down to China and whether it chooses to comply with the US-led sanctions or not. We think China, at least in the near term, is far more likely to reduce (or completely halt) oil imports from Iran. Our thinking is led by the fact that the major Chinese oil corporations, such as SINOPEC, are listed on the New York Stock Exchange and have sprawling global operations that can easily be targeted by the US. Given the ZTE experience, the Chinese leadership, we believe, is unlikely to want one more of its national champions to get caught in the Trump Administration’s cross hairs.

If we our correct in our thinking on China, oil markets will end up losing a large chunk of the 1.5 million barrels per day of Iranian output starting November. Add this to curtailed Venezuelan output and the world could find itself in an oil supply deficit anywhere in the range of 2 to 4 million barrels per day in 2019, depending on how shale and OPEC production ramps up following the sanctions.

 

Investment Perspective

 

The figure of US dollars 100 per barrel of oil has been bandied in headlines recently. We think the three-figure market is largely symbolic and not one that concerns us much. Nonetheless, given the high likelihood of a supply deficit occurring next year, we expect oil prices to remain high (if not move higher) until we see a meaningful supply response or an unexpected drop in demand.

We have been long the SPDR Energy Select Sector ETF $XLE since late October last year and remain long.

 

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. 

Thought Experiment: China Oil for Gold Contracts

 

“Too many people in the modern world view poetry as a luxury, not a necessity like petrol. But to me it’s the oil of life.” – Sir John Betjeman, English poet, writer, and broadcaster

 

“Oil is like a wild animal. Whoever captures it has it.” – J. Paul Getty

 

“Gold is a treasure, and he who possesses it does all he wishes to in this world, and succeeds in helping souls into paradise.” – Christopher Columbus

 

“We Spaniards know a sickness of the heart that only gold can cure.” – Hernan Cortes

 

China imports a lot of oil and produces very little of it. And for all its progress, the People’s Republic has been able to do very little in overcoming its dependence on the black stuff. In fact, even a cursory glance at a time series of Chinese import statistics shows that, China is becoming increasingly more dependent on oil imports.

This is the price China pays to be the ‘factory of the world’.

 

China Oil ImportsChina Imports.pngSource: BP Statistical Review

Oil is priced in US dollars. Oil importing nations have but no choice to hold US dollars.  This is ‘American Privilege’.

No wonder then when the price of oil goes up, especially when US dollars are becoming increasingly difficult to come by, oil importing nations suffer a liquidity squeeze and see their economic performance deteriorate in short order.

The price of Brent crude averaged US dollars 54 per barrel last year; year-to-date it has averaged almost US dollars 72 per barrel – close to a third higher. It follows then that the stock markets of many of the largest oil importers amongst the emerging economies have had a torrid time of it this year.

 

Emerging Market Indices Year-to-Date Total Return (US dollars)EMSource: Bloomberg, Note: MSCI Indices

 

China, if it is to realise its economic and geopolitical ambitions, must overcome this oil price and liquidity conundrum. Unless China discovers the equivalent of the Ghawar oilfield in Saudi Arabia or undergoes a Permian like shale revolution, the solution to this problem is likely to be found in a reconfiguration of Chinese capital markets.

In March this year, China launched renminbi-denominated oil futures, which coincidentally is also the first Chinese futures product that can be traded by overseas entities without a presence in China. Simply launching an oil futures contract, however, is not enough especially for an economy with a closed capital account.

While the prospect of a renminbi-denominated oil contract may appeal to oil exporters, such as Russia and Iran, that have suffered from the weaponised dollar, the contract on its own provides nothing more than a case of out of the frying pan and into the fire.  Most oil exporters, we suspect, are far more willing to trust the United States than China given the status quo. For this reason, China must do more to provide the necessary comfort to oil exporters to trade in renminbi and a means for them to swap their renminbi for other more freely tradable assets.

China has taken steps to provide two alternatives to anyone settling physical deliveries in renminbi. The first is the equivalent of the US petrodollar model whereby renminbi receipts can be recycled into Chinese bonds with the gradual opening up of the Chinese bond market. The second is the back-to-back conversion of renminbi-denominated oil contracts into renminbi-denominated gold contracts for physical delivery in gold.

The latter solution is particularly intriguing because it eliminates the need for trust and rewards exporters in the form of an unencumbered asset.

 

Thought Experiment

 

From Wikipedia:

A thought experiment considers some hypothesis, theory, or principle for the purpose of thinking through its consequences. Given the structure of the experiment, it may not be possible to perform it, and even if it could be performed, there need not be an intention to perform it.

With China completing the first physical delivery for crude futures yesterday, we think it a good time to think through the non-conspiratorial implications of the oil for gold structure that China is offering for oil settlement.

The relevant statistics to think this through are as follows:

 

  • Chinese oil imports have now reached 8.4 million barrels per day or 3.066 barrels per year

 

  • At US dollars 70 per barrel that translates into an annual oil import bill of US dollars 214.62 billion; growing at 3 per cent per annum this would take Chinese spending in oil imports to over US dollar 315 billion by 2030

 

  • Chinese gold mine output is estimated at around 450 tonnes per annum and expected to rise to 500 tonnes by 2020

 

  • At US dollars 1,200 per troy ounce, Chinese gold mine output of 500 tonnes translates to US dollars 19.29 billion; at US dollars 1,600 per troy ounce it translates to US dollars 25.72 billion

 

  • Global gold production is estimated 3,150 tonnes per annum

 

  • At US dollars 1,200 per troy ounce, global gold production is valued US dollars 121.53 billion; at US dollars 1,600 per troy ounce translates to US dollars 162.04 billion

 

At current oil and gold prices and assuming China only uses gold flow and not stock to fund its oil imports, the People’s Republic can only pay for about 12 per cent of its oil imports using its annual gold mine production. Moreover, even if China was to buy 100 per cent of the gold mined in the world (it cannot), it would still only be able to pay for approximately 57 per cent of its oil imports in gold.

Lest we ignore the obvious, buying the equivalent of annual global gold production neither solves China’s problem of having a large commodity related import bill nor does it end its reliance on US dollars.

China needs a 9x re-rating of the gold-to-oil ratio for the oil-for-gold structure to be a wholesale solution to its oil-liquidity conundrum. Unless the cost of mining gold relative to the cost of extracting oil increases nine fold, there is little to no economic basis for such a re-rating. For this reason we doubt that the oil-for-gold structure is the most feasible solution to the problem. Moreover, it does not seem, to us at least, a sound thesis for investing in gold.

For those who can, investing in Chinese government bonds, we think, is a better bet than investing in gold in expectation of the gold-to-oil ratio re-rating 9 times higher.

 

 

 

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 Challenge for Food & Beverage Retail Incumbents

 

“I was a pizza delivery boy at the Pizza Oven in Canton. I wanted to get fired so bad, I actually wrecked the delivery car, but they wouldn’t fire me because I was the only person they had working there.” – Marilyn Manson

 

“The secret of success in life is to eat what you like and let the food fight it out inside.” – Mark Twain

 

“Let’s face it: so much of what we consume is not driven by knowledge but by basic craving and impulse. The process of what we eat starts in our heads. And no one is more in our heads than a food industry that spends billions of dollars in marketing its message in every means possible.” – Chuck Norris, who, if you did not know already, can make onions cry

 

In this week’s piece the focus is on food & beverage retail and the challenge for incumbents with the rapidly changing dynamics within the industry. We start, however, with a quick update on uranium, which we touched upon at the start of the year and again recently.

The spot price of uranium increased to US dollars 26.60 per pound on Wednesday, exceeding the highs recorded in December last year following the back-to-back production suspension announcements by Cameco and Kazatomprom.

Uranium Participation Corporation, a pure play commodity exposure on uranium, also recorded new US dollar highs on Wednesday – mirroring the increase in the spot price of the commodity.

Share Price of Uranium Participation CorporationURPTF.pngSource: Bloomberg

With Cameco soliciting bids for 500,000 pounds of uranium for delivery between the end of this year and through 21 March 2019, and looking to purchase as much as a 15 million pounds from the spot market through the end of 2019, uranium prices may well have a lot further to run from here. How $URPTF performs from here on out is, in our opinion, worth monitoring.

 

Food & Beverage Retail

 

Domino’s Pizza: The “e-commerce company that happens to sell pizza”

Domino’s Pizza’s market capitalisation at the end of 2006 was US dollars 1.75 billion and the company had total debt of US dollars 742 million in debt.  By the end of 2007 the company’s market capitalisation had dropped by 55 per cent to US dollars 785 million while debt had ballooned to US dollars 1.72 billion – increasing by more than 130 per cent year-over-year. The following year things got even worse as market capitalisation dropped to US dollars 261 million – close to a seventh of what it was merely two years prior.

Today, the company’s market capitalisation stands at around US dollar 12.6 billion – a 48 fold increase since the end of 2008.

The turnaround in Domino’s Pizza’s stock price has quite simply been remarkable, to say the least.

The below chart shows the stock price performance of Google and Domino’s Pizza, respectively, starting from the time of Google’s public listing (Domino’s was listed a little over a month before Google).

Despite the sharp fall in Domino’s Pizza’s stock price between 2006 and 2008, its price performance compared to that of Google’s stock, starting from their respective public listings till date, is not too dissimilar

Price Performance: $GOOGL vs. $DPZDPZ GOOGL.pngSource: Bloomberg

In 2008, with sales flagging and the company under pressure, Domino’s revamped its menu and its ingredients.  In 2010, it became one of the first quick service restaurant chains to launch online ordering and did so by building an in-house technology team to lead the effort.

While these initiatives had a positive impact on the company’s bottom and share price, if we look at the chart comparing the price performance of Domino’s and the S&P500 Restaurants Sub-Industry Index, what is apparent is that something more drastic happened starting in 2012. That change according to company’s management was the realisation that Domino’s was no longer a pizza company but rather an “e-commerce company that happens to sell pizza”.

Price Performance: $DPZ vs. S&P500 Restaurants Sub-IndexDPZ Index.pngSource: Bloomberg

In 2012, Dennis Maloney, Chief Digital Officer, and Kelly Garcia, SVP of e-Commerce Development and Emerging Technologies, presented the idea to Domino’s Pizza’s board of directors and CEO that in order to endure and flourish in the cut-throat business of quick-service pizza, the company had to go further in its adoption of technology. The company had to undergo a digital transformation, they said. What the two executives pitched was nothing short of stripping down the company to its bare bones and rebuilding it with a new tech-first culture and an entirely different operational model.

Domino’s invested heavily in its online ordering system. The aim was to improve the overall consumer experience. It introduced the Domino’s Tracker – a bar that shows you the progress of your order, in real time. The tracker was an instant hit. It also enabled the creation of profiles as part of the ordering system. This was done so that returning customers could login and re-order items they had ordered in the past with only a few clicks.

In developing its online ordering system, the company recognised the growing importance of mobile and took a mobile-first approach by launching easy-to-use iOS and Android applications. These applications, too, were an instant success and their adoption accelerated the transformation of the company’s operating model.

Domino’s did not stop at mobile. It followed up the success of its mobile applications with the launch of Domino’s AnyWay, an innovative ordering platform that enables customers to place order through any one of their preferred devices, from anywhere. Customers can order using text messages, Apple TV, Amazon Echo, Google Home, Samsung Smart TVs, smart watches and via Tweets, Facebook messenger and Slack. In 2014, the company even launched its proprietary voice-ordering tool, nicknamed “Dom”, for its mobile applications.

On the two-way customer dialogue and engagement side, the company launched the ‘Think Oven’ campaign. Think Oven is a Facebook page, just not a typical one. It consists of two parts: ‘Projects’ and the ‘Idea Box’. In Projects the company asks for ideas on specific items such as the colours to use for their uniforms and chooses its favourite suggestions and rewards those who submitted them. Idea Box is an open suggestion box for any and all things to do with Domino’s. Suggestions submitted in the Idea Box have from time-to-time become the inspiration behind the launch of new projects.

To track the performance of and glean insights from all the digital initiatives, the company built an analytics team. This team introduced A/B testing – the process of comparing two versions of a web page to see which one performs better – and used it to help the company better understand what did and did not work in driving sales. This in turn fostered a cultural of innovation; the company started experimenting with different ideas and by introducing new products and adopting those that were successful in increasing sales and / or profitability.

With all the digital initiatives underway, the company did not stay quiet about them. Instead, it used them as part of its marketing campaigns and pushed forward the idea that Domino’s is an innovative, tech-driven food company. It launched Domino’s Live – a tool allowing customers to watch their order being prepared live. It also placed the its live Twitter feed on the front page of its website – the feed captures every conversation about Domino’s on Twitter, irrespective of whether it is positive or negative.

The result of all these efforts is that digital sales now make up the majority of the company’s sales with mobile representing half of all digital sales, technology is now the company largest department in terms of employee headcount, more than a half million orders have been placed using Dom since its launch, and Pizza Hut from being the forerunner, is now a very distant second quick service pizza chain in the US. And of course, the incredible price performance of its stock.

 

Not the Only One

Domino’s is not the only quick service chain to undergo a drastic transformation. McDonald’s is another. The world’s largest food chain has revamped its iconic quarter pounder in the US, which is now made using never-frozen beef patties in each and every one of its restaurants in the US. (Fast Company has a fantastic piece on McDonald’s’ transformation that is well worth the read.)

Dunkin’ Donuts too has taken steps toward a drastic digital transformation of its business and is starting to reap the rewards.

 

 UberEats and the Challenge for Incumbents

What the Domino’s, McDonald’s and Dunkin’ Donuts transformation experiences show is the drastic amounts of effort and patience that is needed by incumbent food & beverage retail businesses to overhaul their businesses in order to thrive in today’s hyper-connected world.

And it is not getting any easier.

With the growth of food delivery platforms, such as UberEats, Deliveroo and GrubHub, in recent years, the competitive landscape is gradually tilting in favour of niche and small scale food businesses and giving rise to new food businesses that are completely eschewing a physical presence and simply delivering through these platforms.

Prior to the launch of these platforms, restaurants had to invest in hiring a driver and a vehicle if they wanted to cater to delivery demand. This model of having a proprietary delivery service was neither the most efficient use of capital nor of time. For instance, when a food business is running its own delivery service, it has to wait for its drivers to return to do the next round of deliveries, which is a significant opportunity cost for all but the very biggest food chains. Drivers on food delivery platforms, on the other hand, do not have to return and restaurants have access to the drivers that are both free and nearest to them.

The entry of Uber into the food delivery business, in particular, has been a game changer in our minds. And Uber CEO, Dara Khosrowshahi, confirmed just as much at the Code Conference in March when he stated that UberEats already has a US dollars 6 billion bookings rate.

The reason UberEats is such a game changer is that Uber already has a very large number of drivers signed up for its ride-sharing business and it gives these drivers the option to drive for just Uber, just for UberEats or both, i.e. Uber already has a very large captive source of drivers that it can convert to driving for UberEats at little to no cost.

The upshot of the proliferation of food delivery platforms for customers is that they now have the choice of placing orders among dozens (if not hundreds) of restaurants and as well as the convenience of ordering from multiple restaurants to accommodate varying dietary preferences. This is turn is allowing niche and small food businesses to compete for delivery demand with the very largest food businesses.

 

Investment Perspective

 

The investment implications of the changing competitive dynamics are really quite simple: there are very few listed food & beverage retail businesses that are resilient to the changing industry dynamics and therefore worth investing.

For now the only quick service restaurant stock we like is Dunkin’ Donuts $DNKN and we are also looking at Yum! Brands $YUM as a potential long.

Disclaimer: No pizzas were consumed in preparation of this week’s piece

 

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. 

Trucking: High Freight Rates and Record Truck Orders

 

“I don’t think there’s any real motivation for somebody to be a truck driver. Mine was simple; dad was a truck driver, I wanted to own one.” – Lindsay Fox, Australian billionaire and founder of Australia’s largest privately held logistics company

 

“A man who has never gone to school may steal from a freight car; but if he has a university education, he may steal the whole railroad.” – Theodore Roosevelt

 

“Look for opportunities with pent-up demand.” – Sam Zell, American billionaire and real estate mogul

 

If you live in or have recently spent even a few days in any major city, chances are you have witnessed dozens of delivery vehicles whizzing throughout the city on any given day of the week. In the US, delivery trucks from the United States Postal Service, FedEx, and UPS spend all week weaving through cities across the country, retrieving and delivering parcels. The increasing number of delivery trucks on the road reflects the boom in online shopping.

According to the US Census Bureau, e-commerce now accounts for 8.9 per cent of total retail sales in the US, and grew by 16 per cent year-over-year in 2017. This growth in online retail is not only being directly driven by Amazon but also by traditional brick-and-mortar retailers complementing their physical presence with an online existence in a bid to keep pace with Amazon. Take for instance, Target and Williams Sonoma, both companies that recently reported earnings, citing robust growth in online sales as a reason for their expectations beating results.

For the three-month period ended 4 August, Target reported that comparable digital channel sales were up 41 per cent year-on-year and were responsible for more than a fifth of of the 6.5 per cent overall like-for-like sales growth during the quarter — the highest in 13 years.

Williams Sonoma this week reported year-over-year net revenue growth of 6.1 per cent for the last quarter. Online sales outpaced brick-and-mortar sales and now account for 53.9 per cent of the company’s overall sales, up from 53.7 per cent the previous quarter.

American retailers, particularly those with a strong online presence and / or differentiated brick-and-mortar offering, are benefitting from very strong consumer sentiment. Low unemployment levels and a windfall from tax cuts is increasing US consumers’ willingness to spend. And this is pushing US retailers and manufacturers to stock-up their inventories in expectations of consumer spending remaining robust all the way up to the end of the year,

Domestic freight demands are surging on the back of the strong re-stocking needs of retailers and manufacturers. This escalation in in turn is driving the demand for trucking services. Trucks are used to transport more than two-thirds of total US freight, taking imports from ports to distribution centres and raw materials to factories.

The trucking industry, after years of lacklustre demand, scaled back capital investments and today lacks the capacity to adequately cater for the rising demand. The supply-demand imbalance in the trucking market means that companies are unable to get their cargo moved in time and rising spot trucking rates are eating into their margins. In July rates for truckload services increased by more than 10 per cent year-over-year – the highest ever increase since records have been kept – continuing the streak of rising year-over-year prices for a seventeenth consecutive month – the longest such streak since the industry was deregulated in 1980.

As a corollary of the supply-demand imbalance, haulage companies are ordering a record amount of heavy-duty vehicles. In July this year, an all-time record 52,400 heavy-duty trucks were ordered as compared to the less than 19,000 heavy-duty trucks ordered during the same period last year. Month-over-month, heavy-duty truck orders were also up, increasing by 24 per cent. What makes the record orders even more astonishing is that trucking companies coming into the month had already been on a six-month long ordering spree and that July has typically been the slowest month for new orders.

The exceptional demand for heavy-duty vehicles has pushed the backlog at truck factories to nine months as compared to four to five months normally – meaning that any company ordering a heavy-duty truck today should only expect to receive it in the second quarter of 2019.

The availability of heavy-duty vehicles is not the only bottleneck faced by the trucking industry. A shortage of new drivers, an ageing pool of qualified drivers and the implementation of new regulations in December last year requiring truckers to electronically log their hours are compounding the problem further.

Long-haul driving is a tough sell – long working hours and extended periods away from home are not exactly the characteristics that pull in new recruits. Add to all of this a booming economy with jobs aplenty in other industries and it comes as no surprise that trucking companies are raising pay and are offering sign-on bonuses.

Given the inability of trucking companies to fully exploit the strong demand for their services due to the above described bottlenecks, we think industries vertically adjacent to trucking may provide a superior investment opportunity.

 

Investment Perspective

 

Allison Transmission $ALSN is the leading original equipment manufacturer of commercial-duty automatic transmissions and electric hybrid propulsion systems.

$ALSN has an impressive 60 per cent market share of the global on-highway fully-automatic transmission market. Specifically, the company has 68 and 71 per cent market shares in the Class 8 (i.e. heavy-duty) straight truck and Class 6 & 7 (i.e.) medium-duty truck transmissions, respectively. Sales of fully-automatic transmissions account for almost two-thirds of the company’s revenues; more than half of the automatic transmission segment’s sales come from the heavy- and medium-duty truck transmissions.

The company’s top customers are leading heavy-duty truck manufacturers Daimler, Paccar, Volvo, and Navistar. These customers made up 49 per cent of $ALSN’s sales in 2017.

With new long haul truck orders running at record levels, we do not expect $ALSN’s customers to experiment when it comes to critical components that go into assembling a heavy-duty vehicle. Moreover, it is unlikely that any other manufacturer has the capacity or expertise to deliver the sheer quantity of transmissions that will be needed to clear the order backlog. Therefore, we expect demand for $ALSN’s automatic transmissions to remain strong as long as the heavy-duty truck manufacturers’ order books remain full.

Lastly, the company trades at an undemanding valuation of 11.3x price to consensus 2018 earnings and has an industry leading return on invested capital of 27.0 per cent (based on trailing twelve month data).

ALSN.PNG

 

We are long $ALSN.

In addition to $ALSN, we are looking into Navistar International $NAV and Commercial Vehicle Group $CVGI as potential long trade ideas under the trucking theme. We will send trade alerts in due to course should we decide to add either or both of these stocks to our long trade ideas.

 

 

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. 

Too Much of a Good Thing

 

“Why then, can one desire too much of a good thing?” – William Shakespeare, As You Like It Act 4, scene 1

 

“Water is life’s matter and matrix, mother and medium. There is no life without water.” – Albert Szent-Gyorgyi (1893 – 1986), Hungarian biochemist who won the Nobel Prize in Physiology or Medicine in 1937

 

“Anyway, no drug, not even alcohol, causes the fundamental ills of society. If we’re looking for the source of our troubles, we shouldn’t test people for drugs, we should test them for stupidity, ignorance, greed and love of power.” – P. J. O’Rourke, American political satirist and journalist

 

According to the World Health Organisation (WHO), at least 2 billion people globally only have access to drinking water from sources contaminated with faeces. Contaminated water is known to transmit diseases such diarrhoea, cholera, dysentery, typhoid, and polio and is estimated to cause 502 000 diarrhoeal deaths each year.

The WHO estimates that by 2025 half of the world’s population will be living in water-stressed areas – that is, areas where the demand for water exceeds the available amount or when poor quality restricts its use.

Water is essential. There is no life on earth without water. All of us have known this from a very young age.

 

During our first year at university, we had a friend, let’s call him Zed. Zed was an odd fellow, eccentric even. Even his taste in music could be described as being unusual: Tom Waits and Chuck E. Weiss’ Do You Know What I Idi Amin could regularly be heard playing loudly from his room in the wee hours of the night. One evening, as a group of us gathered together for dinner at our dormitory’s dining hall, Zed joined us a little later and mentioned that he had not had anything to drink all day and that he was incredibly thirsty. Instead of a tray full food like the rest of us, Zed came to the dining table with a tray holding eight glasses of cold water. He needed to drink all the water to quench his thirst he claimed.

After quickly chugging down six of the eight glasses of water, Zed stood up, told us he was not feeling well and left. We did not see Zed for the next day and a half. When we did finally see him, he told us that he had been bed ridden ever since he downed all that water. Having so much water, so quickly had made him sick.

 

In 2007, David Rogers, a fitness instructor from Milton Keynes, died at the tender age of 22 died during the London Marathon. David did not die from exhaustion, nor did he die as a direct consequence of the sweltering temperatures – which reached their highest level in the event’s, at the time, 27-year history – during the race. No, he died from hyponatraemia, or water intoxication.

Water intoxication occurs when the amount of water in the body is so great that it dilutes vital minerals such as sodium down to dangerous levels. It can lead to confusion, headaches and a fatal swelling of the brain.

David Rogers drank too much water during the race without taking in the commensurate amount of minerals.

Do not let anyone ever tell you that “You can never have too much of a good thing”.

 

Investment Perspective

 

When AT&T announced its intention to buy Time Warner in late 2016, Netflix was valued at 18 per cent of the combined stock market value of AT&T and Time Warner.

By the time the courts cleared the way for AT&T to acquire Time Warner in June this year, Netflix’s value stood at a much heftier 60 per cent of the combined market capitalisation of AT&T and Time Warner.

The rationale for AT&T acquiring Time Warner was provided by CEO Stephan Randall at the time the intention to acquire the media company was revealed in late 2016:

 

Premium content always wins. It has been true on the big screen, the TV screen and now it’s proving true on the mobile screen. We’ll have the world’s best premium content with the networks to deliver it to every screen. A big customer pain point is paying for content once but not being able to access it on any device, anywhere. Our goal is to solve that.  We intend to give customers unmatched choice, quality, value and experiences that will define the future of media and communications.

 With great content, you can build truly differentiated video services, whether it’s traditional TV, OTT or mobile. Our TV, mobile and broadband distribution and direct customer relationships provide unique insights from which we can offer addressable advertising and better tailor content.

 …

 It’s an integrated approach and we believe it’s the model that wins over time.

Time Warner’s leadership, creative talent and content are second to none. Combine that with 100 million plus customers who subscribe to our TV, mobile and broadband services – and you have something really special.

…

It’s a great fit, and it creates immediate and long-term value for our shareholders.

 

What AT&T did not mention, however, is how they intend to treat Time-Warner content on their network post-acquisition. That is, will they give Time-Warner content consumer on AT&T’s network a zero-rating much the way they have done for DirecTV content or not?

According to Wikipedia, zero-rating is the practice of providing Internet access without financial cost under certain conditions, such as by only permitting access to certain websites or by subsidizing the service with advertising.

Simply put, if AT&T gives a zero-rating to all Time Warner content, any of this content consumed by AT&T customers will incur no charge (i.e. it will not count against their allotted data / download quotas).

Also in June this year, Disney received approval from the antitrust courts to acquire 21st Century Fox on the condition that Disney divest Fox’s regional sports networks, as they would create anti-competitive conflicts due to its ownership of ESPN.

Sporting rights aside, the combination of Disney and Fox will create a media behemoth. Disney and Fox’s combined domestic box office intake equalled US dollars 4.5 billion in 2017 – representing approximately 40 per cent market share, a figure no single major studio has ever hit. Even more staggering, however, is that with the acquisition of Fox, Disney will control the rights to two of the biggest back catalogues in entertainment, which includes full ownership of all Marvel Comic characters and the Star Wars, Simpsons, X-Files, Indiana Jones, Pixar, and Alien/Predator franchises.

To complement the huge catalogue of content, Disney plans to launch its proprietary streaming service during the second half of 2019. In preparation for the launch of streaming service, Disney has also announced that it will be pulling all of its content from Netflix in 2019.

 

Netflix is spending cash hand over fist to produce new content.

The US’s largest telecommunication network may well monetise the huge library of Time Warner content by zero rating it on their network. And just for good measure, it is also spending some of its cash pile on original content creation.

Disney, probably the largest media company in the world after it completes the acquisition of Fox,  is likely to put a chunk of its vast amount of content on its proprietary streaming service in 2019.

Let’s not forget that Amazon, Alibaba, and Apple, are all throwing money at original content too.

We may soon reach a stage, if we have not already, where there is just too much content.

The bull and bear cases for and against Netflix are well known and we will not regurgitate them here. We will, however, say that given the tectonic shifts taking place in the online video streaming space, holding Netflix at current valuations does not make sense, to us at least.

A Week of Plenty: Parsing the Big and the Small

 

“A lot happens in our everyday life, but it always happens within the same routine, and more than anything else it has changed my perspective of time. For, while previously I saw time as a stretch of terrain that had to be covered, with the future as a distant prospect, hopefully a bright one, and never boring at any rate, now it is interwoven with our life here and in a totally different way. Were I to portray this with a visual image it would have to be that of a boat in a lock: life is slowly and ineluctably raised by time seeping in from all sides. Apart from the details, everything is always the same. And with every passing day the desire grows for the moment when life will reach the top, for the moment when the sluice gates open and life finally moves on.” – Karl Ove Knausgård, Norwegian novelist

 

There are a lot of interesting and market moving developments that have either transpired or come to light over the course of the last week or so. This week we take a break from taking a deep(ish)-dive into a given theme and instead parse through some of these developments.

 

US Market Breadth

 As US markets have recovered and moved within a whisker of the year-to-date highs recorded in January, we have witnessed a growing chorus of criticism on the robustness of the recent rally. One of the more common criticisms is how only a handful of stocks – namely Facebook, Amazon, Netflix, Google, Microsoft and Salesforce.com – are responsible for the positive returns of the S&P500 Index year to date and were it not for these stocks, the market would be in the red.

To that we counter with two pieces of evidence.

The equally weighted index of the constituents of the S&P500 Index, as of Wednesday’s close, is 2.3 per cent from its January highs.

SPW Index (S&P 500 Equal Weighte 2018-07-26 13-45-34.jpg

 

The equally weighted index of the constituents of the Nasdaq 100 Index, as of Wednesday’s close, is above its January highs.

NDXE Index (NASDAQ 100 Equal Wei 2018-07-26 13-47-07

 

There have been and continue to be plenty of opportunities to outperform the broad market indices without the need to invest in the FAANG or other large cap tech stocks. You just need to do the work.

There are of course other criticisms including valuations, such as price-to-sales and price-to-earnings multiples, and the near record high net profit margins being achieved by companies, which critics argue should all mean revert over time and said reversion should lead to a sharp drop stock prices.

With respect to valuations, we counter with two arguments: (1) valuations can mean revert by either prices dropping or sales / earnings increasing, as the quarterly results of the current reporting season have demonstrated, valuations in many instances are adjusting on higher sales and / or earnings; and (2) rich valuations are not in and of themselves a precursor for market corrections, rich valuations are a necessary condition for equity market corrections but not a concurrent one.

Turning to record high profit margins as a bearish argument against owning US stocks, we counter that such arguments do not adjust for the change in the composition of major US equity market indices. Once the S&P500 Index, for example, is adjusted for the changes in sector weights, profit margins do not appear to be anywhere near as high as they appear to be without adjusting the index for changes in sector allocations. This is because the current heavyweights of the index, namely tech and healthcare stocks, tend to generate much higher margins than businesses in other sectors that dominated index historically.

The changes in the composition of the index also go some way to explaining the high level of the price-to-sales ratio the market is trading at – at risk of stating the obvious, higher margin businesses capture much more of their sales as profits than do lower margin businesses, and thus high margin businesses are bound to trade at higher multiples of sales than do low margin businesses.

 

 Is Amazon the biggest threat to Google’s dominance in search-driven advertising?

Quoting Brian Olsavsky, Amazon’s chief financial officer, from the company’s quarterly earnings update:

 “A big contributor to the quarter and the last few quarters obviously has been strong growth in our highest profitability businesses and also advertising.”

The CFO further added that Amazon is working to automate tasks for advertisers and to help media buyers measure the results.

Last quarter, Amazon’s revenue from the advertising sales category and some other items grew 132 per cent year-over-year to US dollars 2.2 billion. Quarterly revenue of over US dollars 2 billion is not to be scoffed at. More importantly, this revenue is coming straight out of Google’s share of the advertising market.

The appeal of advertising on Amazon for advertisers is obvious: customers searching on Amazon are already there with the intent of buying something. With Amazon controlling close to 45 per cent of total online sales in the US and perpetually increasing its product offering, it becomes progressively more convenient for online shoppers to begin their product searches with Amazon and not Google. If the propensity of consumers to being their product searches with Amazon over Google continues to increase, the proclivity of advertisers to spend their dollars on Amazon over Google is also likely to follow suit.

How Google responds to this challenge is something we await with much intrigue.

We expect Amazon to be the first company to achieve a trillion dollar market capitalisation.

 

Japanese Government Bonds

Global bond markets have been roiled by speculation that the Bank of Japan (BoJ) is considering tweaking its policy stance and could scale back its stimulus programme. Yields on 10-year Japanese government hit a fresh twelve-month high on Thursday, forcing the BoJ’s in making a rare intervention in the bond market to push yields on the 10-year government bonds back below 10 basis points.

In practical terms, the BoJ currently guides the yields on 10 year government bonds to be within the range of 0 to 11 basis points. The official directive, however, only states that “The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain at around zero percent.”

We are of the opinion that the BoJ will take steps to widen the tight range of 0 to 11 basis points on 10-year government bonds associated with the ‘around zero’ directive. The objective of said widening being to allow Japanese banks to have more influence on 10-year rates and to steepen the curve ever so slightly to enable them to make their lending activities profitable.

 

 Qualcomm / NXP Semiconductor

The two-year saga of Qualcomm’s attempted acquisition of Dutch chipmaker NXP Semiconductors came to an abrupt end after the deal failed to receive final approval from Chinese regulators ahead of the expiration of the companies’ agreement on Wednesday night. Had the transaction gone through, it would have been the semiconductor industry’s largest ever acquisition.

Unquestionably, the Qualcomm-NXP deal is collateral damage in the political game between Beijing and Washington and can be seen as retaliation for President Donald Trump’s tariffs on Chinese imports.

After Congress, earlier this month, decided against re-imposing a seven-year ban on ZTE, the Chinese telecommunications equipment and systems company, from buying equipment in the US market — a move that would have effectively put the Chinese firm out of business, it was widely expected that China would have cleared the Qualcomm-NXP deal quid pro quo. By effectively ending the Qualcomm-NXP deal, however, the Chinese leadership is essentially adopting an extremely hawkish strategy toward the US.

We believe the Chinese move to end the Qualcomm-NXP deal is a significant escalation of trade-related tensions with the US, and see it is as weakening the position of dovish officials on both sides: in this case, Steve Mnuchin for the US and Liu He for the Chinese. This should only further complicate US-China trade related negotiations.

 

Trump-Juncker Meeting and the Prospect of Improved US-EU Trade Relations

In a joint announcement after meetings in Washington on Wednesday, President Donald Trump and the EU’s Jean-Claude Juncker declared a truce on trade-related tensions with the aim of eliminating all tariffs, trade barriers and subsidies related to non-auto industrial goods.

The rosiest outcome, from the perspective of the global economy, following this joint declaration is that President Trump seeks to settle the US trade-related tensions with the EU, Canada and Mexico, and instead focuses his energy on China – something Peter Navarro, Robert Lighthizer and other security and trade hawks in the administration have probably wanted all along.

If the rosy scenario does indeed materialise then the EU is likely to join in on US efforts to back against China’s efforts to move up the industrial value, discriminatory tariffs and abuse of intellectual property rights. The US-China trade-related tensions would escalate and Qualcomm’s failed acquisition of NXP would not be the last casualty in this spat. Every major US and Chinese company and asset would become fair game and everyone loses – China more than the US we suspect.

Earlier this year, President Trump announced broad based tariffs on steel and aluminium imports. Following the announcement, however, there were clear signals given by his administration that many of the US’s allies would be granted exemptions. Given that this not only did  not happen but that the tariffs were fully imposed on US allies, we assign a very low probability to the rosy scenario materialising.

Instead, we expect Mr Trump to keep upping the ante on trade, irrespective of the counterparty, right up until the mid-term elections. And only expect a coherent strategy on trade to materialise after the elections.

 

 Uranium: Extension of Cameco’s Facility Shutdowns

In November last year, Cameco Corporation, the world’s largest publicly traded uranium mining company, announced that it was temporarily suspending production at two of its northern Saskatchewan facilities – Key Lake and McArthur River – for a period of ten months. The decision was driven by the oversupply of uranium and low market prices that have persisted ever since Japan shut down its nuclear reactors following the radiation leaks at Tokyo Electric Power’s Fukushima Daiichi nuclear plant in 2011.

Taking Cameco’s lead, Kazatomprom – Kazakhstan’s state-owned uranium mining company and the world’s largest natural uranium producer – announced in December last year that it would cut production by 20 per cent, representing 7.5 per cent of total global supply, over the next three years.

The impact of these two announcements was to send both uranium spot prices and share prices of listed uranium miners sharply higher. The euphoria did not last long, however. Spot prices gradually drifted lower, falling from just under US dollars 25 per pound at the start of the year to under US dollars 21 per pound by late April.  And the stock prices of many of the uranium miners fell below where they traded prior to Cameco’s announcement in November.

As spot prices fell, expectations that Cameco would extend the shutdown of its two Saskatchewan facilities started to grow. And Cameco has not disappointed, announcing on Wednesday after market, along with its quarterly results, that it would be suspending production at the two mines ‘indefinitely’ and does not plan to resume production at the site until the company can commit its ‘production under long-term contracts that provide an acceptable rate of return’.

The corollary of the extended suspension is that Cameco will be a buyer of up to 14 million pounds of uranium from the spot market (or otherwise) over the next 18 months to fulfil its commitments under on-going contracts.

Prior to their quarterly earnings call on Thursday morning, Cameco’s shares in pre-market trading were marked at 7 plus per cent below their closing price on Wednesday evening. Cameco shares closed up 3.4 per cent by end of trading on Thursday and spot uranium prices jumped 6.2 per cent to year-to-date highs at US dollars 25.65 per pound.

The malaise in the uranium sector may turn out to be much worse than Cameco’s management anticipating and the rally in the spot could well prove to be fleeting once again. If, however, uranium spot prices can push above US dollar 26.25 per pound, the highs recorded in 2017, they have significant room to run much higher.

For now we remain long select uranium miners as well as commodity pure play Uranium Participation Corporation $URPTF.

 

 

 

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 Crisis Everyone Knows About

 

“There are decades where nothing happens; and there are weeks where decades happen.” – Vladimir Lenin

 

“There cannot be a crisis next week. My schedule is already full.” – Henry Kissinger

 

“When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents opportunity.” – John F. Kennedy

 

“The crisis of today is the joke of tomorrow.” – H. G. Wells

 

On Tuesday President Donald Trump met with North Korean leader Kim Jong-un in Singapore and offered a significant concession: to halt the “tremendously expensive” joint US-South Korean military exercises. The North Korean leader in turn committed to the “complete denuclearisation of the Korean Peninsula”. While we think the meeting is a positive step towards reducing tensions in the Korean Peninsula, we remain sceptical – after all the US just recently did an about turn on the Iran nuclear deal and announced fresh sanctions on the Persian state. We suspect, with the possibility of US military action against North Korea diminished, that China and South Korea are the only parties truly satisfied with the outcome of the Trump-Kim summit.

 

On Wednesday the Federal Reserve raised the Fed funds target rate by 25 basis points to a range between 1.75 per cent and 2 per cent. At the same time it also increased the interest rate on excess reserves (IOER) – the interest the Fed pays on money placed by commercial banks with the central bank – by 20 basis points to 1.95 per cent. Finally, the Federal Open Market Committee (FOMC) raised its median 2018 policy rate projection from 3 hikes to 4.

 

The change in the policy rate projection from 3 to 4 hikes is not as significant as the headlines may suggest – the increase is due to one policymaker moving their dot from 3 or below to 4 or above. In fact, the mean 2018 rate increase is only 5 basis points. The median number of 2019 rate hikes remains at 3, while for 2020 one rate hike was removed and the median projection is now at 2 hikes.

 

On Thursday the European Central Bank (ECB) after holding a two-day Governing Council session in Riga announced its decision to halve the size of monthly asset purchases to €15 billion after September and end its asset purchase program by the end of the year. As a reminder, the ECB had already started implementing a step-by-step exit from its bond buying as follows:

 

  • First, in December 2016, the ECB announced that its monthly purchases would decline from €80 billion to €60 billion as of April 2017 until yearend.

 

  • Second, in October 2017, the ECB announced that the monthly purchases would fall to €30 billion as of April 2018 until at least September of this year.

 

  • Third, in March 2018, removed its easing bias by omitting in its statement a reference to the possibility of bigger bond purchases.

 

The ECB did not tighten monetary policy, however, and is committing to keeping interest rates at record lows for another year by adding that it expected rates to “remain at their present levels at least through the summer of 2019.”

 

Lastly ahead of the small matter of the FIFA World Cup kicking off in Russia on Thursday with the host nation playing against Saudi Arabia, Messrs Vladimir Putin of Russia and Mohammed bin Salman of Saudi Arabia had a meeting. The state of the oil market was unsurprisingly a key talking point during the meeting, what with the OPEC meeting in Vienna next week and Trump demanding concessions on OPEC-NOPEC supply constraints.

 

The events of this week may have brought about much for market participants to digest and could well shape the way markets play out over the remainder of the year. For now and  in terms of prospects of global equity markets and the US dollar we, however, think that the events of this week only matter at the margin and that the prevailing trends remain intact.

 

Investment Perspective

 

As is the financial media’s wont, Fed and ECB pronouncements are followed by a flurry of commentary and analysis on the ramifications of the central bankers’ statements. In the flood of digital ink commentaries warning of either (1) a stock market crash that is surely to follow due to the major central banks shrinking their balance sheets, or (2) a US dollar shortage that will undoubtedly squeeze emerging markets, have become almost customary.

 

We address the concerns of tightening monetary policy leading to a stock market crash with some historical context. In 1928, the Fed started raising interest rates, taking them from 3.5 per cent in January to 5 per cent by July. Concurrently, the FOMC proceeded to drain excess reserves from the US banking system.

 

Instead of the stock market crashing, the Dow Jones Industrial Stock Price Index proceeded to increase by 82 per cent between 1 January 1928 and 1 September 1929. To further contextualise the performance of the stock market, the index had already increased by 160 per cent between 1 January 1918 and 1 January 1 1928, excluding dividends.

 

Dow Jones Industrial Stock Price IndexDJI 1928.pngSource: Federal Reserve Bank of St. Louis

 

Reiterating our message from The Bull Market is Not Dead from earlier this year, we consider the equity market sell-off in the first quarter of this year to be a correction and not the end the of the bull market. Adding to that, we think it is not the recent actions of the Federal Reserve or the ECB that will bring this bull market to an end, instead it will be a speculative over extension of the market driven by excessive optimism and greed that will lead to the eventual market crash. For now we maintain our expectation that the US equity markets will record significantly higher new highs before the party is over.

 

Stay long US equities.

 

The issue of a US dollar shortage is a little more complex. It is something both the IMF and the Bank for International Settlements (BIS) have repeatedly warned about. The warnings have been prompted by the Fed undertaking quantitative tightening and the Trump Tax Plan, which removes the tax loophole corporations exploited by keeping US dollar abroad.  The argument goes that these two US-centric developments will result in US dollars fleeing from international markets and into the US. This analysis is not wrong, data from the Institute of International Finance shows that investors pulled out more than US dollar 12 billion out of emerging debt and equity markets in May this year.

 

While we acknowledge that short-term risks can arise due to US dollar shortages, we consider the risk of a broad based US dollar funding shortage to be technical not endemic in nature. And technical risks by design can be fixed by a few strokes of the pen. Again, we turn to history for some context. In October 2008, at the height of the global financial crisis, the Fed authorised temporary arrangements extending US dollar 45 billion in liquidity to New Zealand, Brazil, Mexico, South Korea and Singapore. Around the same time, the IMF launched a short-term financing fund to help emerging market economies weather the global credit crisis.

 

If there truly is a US dollar funding crisis, the Fed will find a technical solution to a technical problem. For now, we agree with the Fed in that there are no major concerns around US dollar funding in international markets. We quote from the minutes of FOMC’s meeting in May this year (emphasis added):

 

“While term LIBOR (London interbank offered rates) had widened relative to comparable maturity OIS (overnight index swap) rates in recent months, the cost of dollar funding through the foreign exchange swap market had not risen to the same degree. Recent usage of standing U.S. dollar liquidity swap lines had been low, consistent with a view that the recent widening in LIBOR–OIS spreads did not reflect increased funding pressures or rising concerns about the condition of financial institutions.”

 

Do not short emerging market currencies. Short the US dollar instead.

 

If you have questions about this post or generally on our views, feel free to email us or message us on Twitter at any time.

 

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 Vollgeld Initiative

 

“Money is a public good; as such, it lends itself to private exploitation.”  ― Manias, Panics, and Crashes: A History of Financial Crises by Charles P. Kindleberger

 

 

This weekend the people of Switzerland vote on the Swiss sovereign-money referendum – a radical bank reform plan otherwise known as the Vollgeld proposal. The proposal for the referendum was initiated by Hansruedi Weber, a former schoolteacher turned financial reformer who founded the Monetary Modernisation Association (MMA) – a Swiss, not-for-profit, non-governmental, non-politically affiliated organization. Mr Weber and other proponents of the reforms argue that the reforms within the Vollgeld proposal will make the financial system safer while the Swiss National Bank dismisses them as a “dangerous experiment”.

 

So which is it? The short answer, it is a bit of both.

 

Taking a step back, the Vollgeld proposal consists of two key elements:

 

  1. Imposing a 100 per cent reserve requirement on demand deposits i.e. putting an end to the long-standing system of fractional reserve banking; and

 

  1. Transferring the right to “create” money to the central bank (without the need to finance debt).

 

By requiring banks to back demand deposits fully with reserves, the Vollgeld proposal effectively necessitates the conversion of Swiss banks from lenders to depository institutions. In simple terms, under the terms of the Vollgeld proposal, Swiss banks will not be permitted to use demand deposits to extend financing. Thus making hundred per cent of demand deposits available on demand and in turn fully mitigating the risk of a bank run.

 

Since money is created by commercial banks by extending financing, commercial banks would, as a consequence, no longer be able to create money. Banks wishing to continue their lending activities would instead have to obtain funds through alternative sources and in all likelihood offer higher interest rates to attract time deposits. From this perspective, if the reforms were to pass it would be a victory for savers. And given that capital is fungible, capital would flow from the negative and zero interest rate regimes across the developed world into Switzerland.

 

The losers from the reforms passing, we think, would be Swiss banks and banks across the Eurozone. While we suspect the Swiss banks shares would be the first to be hit, the forward earnings expectations of European banks operating under zero and negative interest regimes would be most severely impacted. European banks we think would suffer from marginal capital fleeing from the environment interest repression in Europe to benefit from interest rate liberalisation in Switzerland.

 

For the Swiss economy at large, a hundred per cent reserve requirement may well turn out to be positive. There would no longer be the waxing and waning in the demand for, or supply of, credit that could cause wild swings in money supply. A stable money supply in turn would reduce both the risk of credit led excesses building up in the economy and the volatility in business cycles.

 

Unfortunately the Vollgeld proposal is not limited to simply ending fractional reserve banking.

 

For all its soundness with respect to putting an end to fractional reserve banking, the proposal is equally flawed as the current system by allowing the central bank to continue to lend directly to the banking system. The provisions within the proposal allow the Swiss National Bank: (1) to support any banks suffering from declining net interest margins or shrinking loans and (2) to control interest rates by offering funds to banks at low interest rates.

 

Moreover, the Vollgeld proposal enables the central bank to create money and inject it into the system simply by giving it away. In contrast, today, the Swiss National Bank is only able to create money either by lending to commercial banks or by selling Swiss francs in exchange for other assets such as euros or US equities. In either case, the central bank can only create money today by financing debt .

 

The reforms would free the Swiss National Bank to undertake Milton Friedman’s famous ‘helicopter drop’ of money at any time should they wish to do so as money creation will be unhinged from the requirement to buy debt. The only limitation on the central bank would be that money can only be given out either to the government or to the Swiss population.

 

The MMA insists this loophole will be used prudently. There are no checks and balances on the central bank to ensure conservatism, however. And history has taught as us that when push comes to shove central banks when placed under political pressure can abandon conservatism without hesitation.

 

For this reason, in the unlikely event the Vollgeld plan does get approved this weekend, it is not clear that in the short term it should be either bullish or bearish for the Swiss franc. The Swiss National would still have all the tools to manipulate the Swiss franc in any way it wishes.

 

While would be somewhat surprised if the reforms pass, we think the Vollgeld proposal is the start of trend that will result in many such banking reforms being put to vote across the developed world. For this reason and until the dust settles, we would avoid investing in Swiss and European banks.

 

 

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