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Consumer Staples: Niches and Acquisition Targets

“You can say Pizza Hut is terrible pizza, but they also sell more pizzas than anybody else.” – Jimmy Kemmel

“Mergers are like marriages. They are the bringing together of two individuals. If you wouldn’t marry someone for the ‘operational efficiencies’ they offer in the running of a household, then why would you combine two companies with unique cultures and identities for that reason?” – Simon Sinek

“One thing I love about customers is that they are divinely discontent. Their expectations are never static — they go up. It’s human nature. We didn’t ascend from our hunter-gatherer days by being satisfied. People have a voracious appetite for a better way, and yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’. I see that cycle of improvement happening at a faster rate than ever before. It may be because customers have such easy access to more information than ever before — in only a few seconds and with a couple taps on their phones, customers can read reviews, compare prices from multiple retailers, see whether something’s in stock, find out how fast it will ship or be available for pick-up, and more. These examples are from retail, but I sense that the same customer empowerment phenomenon is happening broadly across everything we do at Amazon and most other industries as well. You cannot rest on your laurels in this world. Customers won’t have it.” Jeff Bezos in this year’s letter to Amazon shareholders

“If you don’t like what’s being said, change the conversation.” – Don Draper, Mad Men Season 3, Episode 2

June 2017: Amazon announces it is acquiring Whole Foods. The market cap of twenty companies in the food and retail sectors declines by almost US dollars 40 billion.

August 2017: Amazon announces that it will be cutting prices at Whole Foods. The market cap of Kroger, Wal-Mart, Target, Costco, Supervalu and Sprouts Farmers Markets drops by nearly US dollars 12 billion.

May 2018: Walmart announces acquiring a controlling stake in India’s largest online retailer. Walmart shares decline by 4 per cent in response.

May 2018: Kroger announces that British online supermarket Ocado’s technology will be used in the US exclusively by Kroger and that it will also take a 5 per cent stake in Ocado. Ocado’s share price surged by 44 per cent subsequent to the announcement.

Are Walmart and Kroger trying to change the conversation or do they want to be seen to be doing something?

One year, while we were working at a boutique asset management firm, our flagship fund was underperforming both its benchmark and peers by a significant margin. We had suffered two straight quarters of underperformance and were on track to record our third consecutive quarter of underperformance – a humiliation hitherto avoided by the organisation in its 10-year history.

The CIO’s response to our continued underperformance was to get the team to work harder: longer hours, more meetings with management teams of our various holdings, more research, more analysis, more detailed financial models, more team discussions, more, more, and more. The end result: more underperformance.

Given the underperformance, each team member knew bonuses were going to be bad, everyone expected a significant cut. Despite this knowledge, not one single team member took time-off in the two months leading up to date bonuses are distributed. Each and every one of us worked even longer hours, sent out more emails, and upped our contribution during team discussions. We were all guilty of wanting to be seen as contributing positively to the investment process.

Working harder does not always lead to better results, especially when it comes to investing.

To be seen as contributing is not the same as actually contributing.

S&P 500 GICS Level 1 Consumer Staples Index

Staples Source: Bloomberg

We have written about the challenges faced by consumer staples and consumer packaged goods companies on a number of occasions (see Unbranded: The Risk in Household Consumer Names, The Incumbent’s Challenge, and Containers and Packaging Companies: Challenges Aplentyhttps://lxvresearch.com/2018/03/01/containers-and-packaging/). The narrative of the decline in consumer staples, we think, has gradual come into acceptance and this acceptance is being reflected both in the share prices of many of the leading consumer staples companies as well in the types of articles appearing in broadsheets such as the Wall Street Journal and the Financial Times. Take for instance the following excerpt from ‘Amazon Effect’ Stings Consumer-Staples Stocks as Pricing Woes Mount published on 25 April, 2018 by the Wall Street Journal:

The industry’s pricing issues have many money managers wondering whether the biggest makers of household staples have already seen their best days.

“What’s happening is that these firms are struggling to pass on rising costs to consumers,” said Shawn Cruz, manager of trader strategy at TD Ameritrade. “Big brands have counted on their brand name drawing customers in, and that’s not necessarily happening anymore.”

To date, as it relates to the consumer staples sector, our focus has primarily been on avoiding losers and identifying potential shorting opportunities. All is not doom-and-gloom in the consumer staples sector, however. As the cliché goes, where there are challenges, there are also opportunities. And we are starting to see opportunities.

Investment Perspective

Management teams at the leading consumer staples companies have responded to the challenges they face and to declining share prices by looking inwards. Management teams can be inward looking in many ways.

One way is to hire strategy consultants like McKinsey & Co. to help identify areas of inefficiency and procedural optimisation, or to devise cost cutting initiatives that can rid the businesses of unnecessary costs. Another way to double-down on what has worked in the past: to increase investments into their brands i.e. to advertise more, to increase awareness of their brands. Yet another way is to increase research & development budgets to develop new, better, and more “on-trend” products.

Eventually, we suspect, a number of the large consumer product companies will come to realise that (1) cost-cutting only goes so far and that it does not really excite would be shareholders, (2) doubling-down no longer works in the internet-era, and (3) they lack the creativity to deliver “on-trend” products. As companies come to these realisations they will become increasingly outward looking i.e. they will look to acquire that which they do not have and that which consumers desire.

Unilever has already done this by acquiring Dollar Shave Club. Coca-Cola and Procter & Gamble too by acquiring kombucha tea brand Honest Tea and all natural deodorant brand Native, respectively.

While a number of the acquisitions will be made in private markets, we believe owning a basket of small- and mid-cap food and retail companies that have carved out successful niches can provide investors with exposure to potential acquisition targets and the promise of outsized returns.

With this perspective, we think a basket of names such as Natural Grocers by Vitamin C $NGVC, Village Supermarket $VLGEA, Weis Markets, Alico Inc $ALCO, Cal-Main Goods Inc $CALM, Primo Water $PRMW, and Natural Health Trends Corp $NHTC can provide just that kind of exposure.

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

The Old Man and the Election

It was considered a virtue not to talk unnecessarily at sea and the old man had always considered it so and respected it. But now he said his thoughts aloud many times since there was no one that they could annoy.

“If the others heard me talking out loud they would think I am crazy,” he said aloud. “But since I am not crazy, I do not care. And the rich have radios to talk to them in their boats and to bring them the baseball.” ― Excerpt from The Old Man and the Sea by Ernest Hemingway

The ability to create and imagined reality out of words enabled large numbers of strangers to cooperate effectively. But it also did something more. Since large-scale human cooperation is based on myths, the way people cooperate can be altered by changing the myths – by telling different stories. Under the right circumstances myths can change rapidly. In 1789 the French population switched almost overnight from believing the myth of the divine right of kings to believing in the myth of sovereignty of the people. Consequently, ever since the Cognitive Revolution Homo sapiens has been able to revise its behaviour rapidly in accordance with changing needs. This opened a fast lane of cultural evolution, bypassing the traffic jams of genetic evolution. Speeding down this fast lane, Homo sapiens soon far outstripped all other human and animal species in its ability to cooperate. – Excerpt from Sapiens: A Brief History of Humankind by Yuval Noah Harari

David William Goodall, the 104 year old British-born Australian botanist and ecologist, voluntarily ended his life at a clinic in Basel, Switzerland yesterday. Mr Goodall enjoyed fish & chips and cheesecake for his final meal. He passed away surrounded by family and listening to Beethoven’s Ninth Symphony.

Reportedly, Mr Goodall was not terminally ill but rather had become fed up with his life after having had to stop most of his activities – including conducting research at the Centre for Ecosystem Management at Edith Cowan University – due to his eyesight and mobility deteriorating.

Physician assisted dying, where a patient’s decision to end their lives is aided by a physician, is legal in Canada, the Netherlands, Luxembourg, Switzerland and parts of the US.

On the very day Mr Goodall made his final decision to end his life, Malaysia swore in 92-year old Mahathir Mohamad – the man famously called a ‘moron’ and the ‘Marcos of Malaysia’ by George Soros at the depths of the Asian Financial Crisis – as their prime minister, making him the world’s oldest elected leader.

Mahathir Mohamad, Malaysia’s premier from 1981 to 2003, has pulled off what can only be described as an astonishing upset in the parliamentary elections. His Pakatan Harapan (Alliance of Hope) coalition’s victory brings to an end the governing coalition’s six-decade rule.

The initial international reaction to Dr Mohamad’s victory was negative with both offshore Malaysian ETFs and offshore ringgit non-deliverable forwards selling off sharply. International investors are understandably spooked: Dr Mahathir campaigned on a populist platform. The nonagenarian promised wide-ranging tax cuts, rolling back the previous administration’s subsidy cuts, and to return to state coffers the billions plundered from 1MDB, one of Malaysia’s prominent sovereign wealth funds, as part of his election campaign.

The newly elected prime minister reiterated his populist promises straight after taking the oath of office at the state palace in Kuala Lumpur on Thursday.

Ahead of the election, Dr Mahathir also promised that should he once again become Malaysia’s prime minister, he would hand over power to Anwar Ibrahim – leader of the opposition from 2008 and 2015.

Mr Ibrahim served as Malaysia’s finance minister from 1991 to 1998 and deputy prime minister from 1993 to 1999. He was removed from his post in 1999 and jailed on sodomy charges by Prime Minister Mahathir Mohamad. The charges were overturned and he was released from prison in 2004. After his release Mr Anwar helped form the coalition of three opposition parties, which contested the 2008 and 2013 general elections.

Anwar Ibrahim was arrested a second time on sodomy charges in 2015 and sentenced to five-years in prison. This time the charges were brought against him by Prime Minister Najib Razak just as Mr Anwar was preparing to contest a state by-election he was expected to win and become the chief minister of Selangor, Malaysia’s main economic hub surrounding Kuala Lumpur.

Anwar Ibrahim today received a royal pardon for his five-year prison sentence that he has been serving since 2015. This pardon clears the way for Mr Anwar to replace Dr Mohamad as the prime minister of Malaysia.

The Malaysian economy’s growth surged to 5.9 per cent last year and is forecast by the central bank to reach 5.5 to 6 per cent in 2018. The economic recovery has come on the back of a pick-up in global trade and rising domestic demand. Despite the recovery, the economy remains fragile. Public debt stands at 50 per cent of GDP – much higher than that for other comparable economies – and approximately two fifths of its local currency debt is held by international investors.

Prime Minister Mahathir Mohamad has promised to remove the 6 per cent goods and services tax (GST), introduced by the Najib government in 2015, and reinstate the more lenient sales and services tax (SST) that was in place prior to the GST. This change, if enacted, will put severe pressure on government finances. The GST was estimated to contribute eighteen per cent of total government revenues this year. In contrast, the SST contributed only eight per cent to government revenues in 2014.

Another shift in policy promised by Dr Mohamad is a re-assessment of Chinese investments in to Malaysia. In recent years China has been the primary source of foreign direct investment into Malaysia. Despite the campaign trail promise, we do not expect any meaningful change resulting from the re-assessment. We believe calling out China was the low-hanging fruit for the populist platform as the rhetoric resonates well among ethnic Malay voters.

Investment Perspective

Malaysia Real Effective Exchange Rate (REER)Source: Bank for International Settlements

The Malaysian ringgit is presently one standard deviation below its fair value. If an election-led sell-off in the currency or a sustained rally in the dollar brings the currency close to two standard deviations below fairly value, we would become eager buyers of Malaysian assets.

Since the end of 2009, the monthly correlation between the Malaysian equity index and the real effective exchange rate is 73.4 per cent with an r-squared of 0.54, i.e. the stock market goes up with a rising real effective exchange rate. If the Malaysian currency were to weaken such that it becomes close to two standard deviations below fair value, we would consider that an attractive entry point into the Malaysian stock market.

Malaysia Real Effective Exchange Rate vs. Malaysian Stock Market Performance REER Stocks Sources: Bank for International Settlements, Bloomberg

The Convergence of US and Chinese Bond Markets

“The emergence of China is the most dramatic event in economic history. We are living in an age of convergence no less dramatic than the age of divergence brought about by European colonialism and the Industrial Revolution. The downward pressure on the incomes of the West’s middle classes in the coming years will be relentless.” – The Retreat of Western Liberalism by Edward Luce

“Demographics show that we are entering a battle between young and old. I call it the ‘Age War.’ The young want to hang onto their money to grow their families, businesses, and wealth. The old want the tax and investment dollars of the young to sustain their old age.” – Robert Kiyosaki, famed author of Rich Dad, Poor Dad

“Today, the attention of government policymakers has turned to the notion of a glut of global saving. Such a shift of emphasis seems particularly surprising from a U.S. perspective where the public discussion has focused on an ongoing decline of private saving and the re-emergence of large budget deficits. Certainly, the United States is not plagued by an oversupply of saving. The absence of saving in the United States, in conjunction with strong domestic investment opportunities, has created an unprecedented large current account deficit — $800 billion in 2005, and still growing. The U.S. has emerged as the world’s largest debtor nation by a wide margin.” – Saving and Demographic Change: The Global Dimension by Barry Bosworth and Gabriel Chodorow-Reich, The Brookings Institution

Analysing data covering 85 countries for the period between 1960 and 2005, researchers at the Brookings Institution found that (1) the highest saving rates are associated with the population aged 40 to 50 years old and (2) a population’s savings rate is likely to exceed its rate of investment when the relative population of 35 to 64 years is growing at a faster rate than the total population outside the 35 to 64 years old age bracket.

The findings of The Brookings Institution research make sense. Children earn little yet consume much and require significant investment into their education and well being. Thus children tend to have a negative impact on the gross level of savings. As children grow up, turning into young adults, and enter the workforce they will, in most cases, not earn enough to save much.

As the population ages and the relative share of the older working population (35 to 64 year olds) increases, the situation reverses. A greater portion of the population is in their peak earning years and so savings increase on an aggregate basis.

The situation once again reverses at the stage when the population of retirees starts to increase relative to that of the older working population. Retirees on aggregate have a much lower propensity to save than the older working age population. Thus retirees too have a negative impact on savings.

Investment Perspective

The chart below presents the share of US population represented by 35 to 64 year olds versus the share of US population represented by all age groups outside the 35 to 64 year olds age bracket. Even a cursory analysis of the chart is quite revealing.

US Population Demographic Profile US Population Demographic.png Source: United Nations Data Retrieval System

The end of the last great US bond bear market – which commenced in 1946 and ended in September 1981 – ended around the time the share of the US population made up by 35 to 64 year olds began to increase relative to the share of the US population of all other age groups. This trend of the increasing relative population of 35 to 64 year olds in the US continued from 1981 to all the way through 2005. From 2006 to 2014 the share of population made up by 35 to 64 year olds in the US remained relatively stable; in 2015, however, the share of 35 to 64 year olds started to decline.

If the conclusions of the study conducted by The Brookings Institution continue to hold, the on-going shift in the US demographic profile is bound to have far reaching consequences for the US bond market. We are quite possibly at the early stages of what in many years from now may appear to be the obvious point at which another great US bond bear market started.

The shifting secular trend does not, however, warrant shorting US treasuries. The last secular US bond bear market lasted thirty-five years and can be sub-divided into thirteen parts: seven major price declines and six bear market rallies. Moreover, even though short-term interest rates bottomed around 1941, long-term bond yields continued to decline till 1946. We would not be overly surprised if a similar dynamic played out once again, with short-term rates bottoming in 2015 and long-term bond yields bottoming several years after.

There may well be a superior alternative to shorting US bonds: being long Chinese bonds. China’s middle class population is forecast to expand from the estimated 430 million today to 780 million by the mid-2020s. Combine this with the fact that Chinese households have a much higher savings rate – estimated to be around 30 per cent – as compared to households in the US, where savings rate are estimated to be around 5 per cent, and you have conditions ripe for a secular bond bull market in China.

Chinese Easing and the Case for China A Shares

“A complex system that works is invariably found to have evolved from a simple system that worked. A complex system designed from scratch never works and cannot be patched up to make it work. You have to start over, beginning with a working simple system.” – John Gall, American author and retired paediatrician

The People’s Bank of China (PBoC) announced its first permanent and general reserve requirement ratio (RRR) cut since February 2016. The RRR cut is one percentage point for most commercial banks and is effective on April 25. The direct implication of this move is that the proportion of deposits that large Chinese banks will have to hold as reserves with the PBoC will decline from 17 to 16 per cent.

The headline number suggests an increase in system-wide liquidity of RMB 1.3 trillion, the easing effect, however, is actually much lower at RMB 400 billion as RMB 900 billion of the released reserves will be used to replace the existing medium-term liquidity facility (MLF).

The PBoC has used three main tools to impact monetary policy on the Mainland:

Open-market operations;
Reserve rate requirements; and
The medium-term liquidity facility.

In January 2016, the PBoC in a bid to be more responsive to market demands increased the frequency of its open-market operations from twice a week to daily. The seven-day reverse repo is the primary instrument used by the PBoC to conduct its open market operations and to guide short-term market interest rates.

The reserve requirement ratio is the PBoC’s main instrument for managing longer-term liquidity – it provides a means to respond to capital inflows and outflows. For example, When China experienced huge capital inflows starting in the early 2000s, and foreign-exchange reserves increased to US dollars four trillion, the PBOC started increasing the RRR when it was at 6 per cent taking it all the way up to 21.5 per cent in 2011. More recently, the PBoC has made RRR cuts to offset liquidity withdrawn by the decline of foreign reserves.

The MLF, introduced by the PBoC in September 2014, offers three- to six-month loans to commercial lenders. The PBOC uses the MLF on a monthly basis to inject three- to six-month liquidity into the banking system, and the rate on the MLF guide medium-term market interest rates. Part of the liquidity from the RRR cut will be to repay the MLF loans from the PBoC – in effect creating some uncertainty with respect to the MLF being utilised by the PBoC in the future.

Following the recent RRR cut announcement, the PBoC commented that the cut does not represent easing but is rather a reflection of their “prudent and neutral” monetary policy stance. Nonetheless, we see the move as a signal from the PBoC that it is moving away from its more recent tightening bias towards easing, especially given that the easing is the first major decision made by central bank under its new leadership team. Moreover, if the PBoC did not want to signal the shift in bias, it could have continued using the MLF as a means of injecting liquidity into the system, instead it choose to make a 1 percentage point cut in the RRR. The only other times the PBoC cut the RRR so drastically in the last ten years was (1) following the Lehman Brothers bankruptcy in 2008 and in April 2015 when capital outflows were at or near their peak and were placing a real strain on system-wide liquidity.

In all likelihood, the announcement to cut the RRR by the PBoC is motivated by the slowing level of credit growth in the economy. March M2 money supply growth slowed to 8.2 per cent year-over-year – close to the lowest ever recorded level of 8.1 per cent. Additionally, outstanding total social financing (TSF) – regarded by many China watchers as the most important indicator for aggregate credit – slowed to 10.5 per cent year-over-year, down from 11.2 per cent in February. Since both M2 and TSF are key leading indicators for GDP growth, the central bank, it seems, is trying to counter the headwinds of toughening financial regulation through the RRR cut.

China Monthly Money Supply M2 Growth Year-over-YearSource: Bloomberg

In Our Thoughts and Investments Ideas for 2018, we wrote:

“We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot.”

We see the RRR cut has the carrot to the stick that is much tougher financial regulation and higher interest rates. We believe that this combination of RRR cuts, increasingly tougher financial regulation and higher interest rates is likely to continue for the rest of 2018, and the PBoC is unlikely to revise it official stance on monetary policy as being anything other than “neutral and prudent”.

Investment Perspective

The PBoC’s move to cut the RRR by 1 percentage point is positive for Chinese equities as any marginal improvement in liquidity would be considered to be. The signalling of a switch from a tightening to an easing bias, however, can be a sustained tailwind for the equity market, especially if, as we suspect, this recent RRR cut is not the last of the cuts for 2018.

Easing monetary policy is not the only tailwind for Chinese equities. We recently met with MSCI – the indices provider for global capital markets – to discuss the potential weight of China A Shares in MSCI’s emerging market index. China A Shares will be included in the MSCI Emerging Markets Index from June this year with an index weight of around 75 basis points – the weight is essentially negligible relative to the size of the Chinese market. The interesting point, however, is that were China to be included in the index at its full weight – this requires foreign investment restrictions in China to be greatly relaxed – the weight of China A Shares in the index would rise to 50 per cent.

Based on MSCI’s estimates, approximately US dollar 1.5 trillion in passive assets track the MSCI Emerging Market Index, at full weight that entails USD 750 billion of passive funds flowing into China A Shares – a significant amount by any measure. While we do not expect the 50 per cent index weight to be reached any time soon, China has started to significantly ease foreign ownership restrictions through various means:

The Shanghai-Hong Kong Stock Connect scheme launched in November 2014 is the first and the only market that Western investors can be connected to Chinese stock market but with limitations. Starting 1 May, the daily quotas of the stock connect schemes linking mainland and Hong Kong markets will be increased to facilitate higher level on trading by non-Mainland investors.

The potential launch of a second connect scheme in 2018. The second scheme will be with London and will enable allow the flow of capital between London and Shanghai.

Removing the cap on foreign ownership of banks and asset management companies, and lift the cap on foreign ownership of securities companies, fund managers, futures companies and life insurers from 49 to 51 per cent, with a view to removing it entirely in the next three years.

Removal of foreign-ownership limits for ship and aircraft manufacturing and other key industries this year.

As these measures are enacted, MSCI will gradually continue to increase the weight of China A Shares in its emerging markets index leading to a constant stream of inflows into the China A Shares market.

With the PBoC now signalling a shift towards an easing bias and the potential of growing MSCI flows, we see no valid reason to not have an allocation to China A Shares.

We are long Xtrackers Harvest CSI 300 China A Shares ETF $ASHR.

Consumer: Long Stuff / Short the Experience Economy

“I think if you give in and accept society’s stereotypes, then you start thinking, ‘I cannot dance till late at night because I’m 70.’” – Yoko Ono

“Through most of human history, our ancestors had children shortly after puberty, just as the members of all nonhuman species do to this day. Whether we like the idea or not, our young ancestors must have been capable of providing for their offspring, defending their families from predators, cooperating with others, and in most other respects functioning fully as adults. If they couldn’t function as adults, their young could not have survived, which would have meant the swift demise of the human race. The fact that we’re still here suggests that most young people are probably far more capable than we think they are. Somewhere along the line, we lost sight of – and buried – the potential of our teens.” – Robert Epstein, American psychologist, professor, author, and journalist

“The theory of Economics must begin with a correct theory of consumption.” – The Theory of Political Economy (1871) by William Stanley Jevons

The human brain is predisposed to stereotyping. Stereotyping serves as a social heuristic that reduces the amount of thinking we have to do as it allows the brain to cluster people into groups with a whole range of expected characteristics and abilities. Scientific studies have gone as far as to show that that the brain responds more strongly to negative stereotypes – something the mainstream media has long understood with programming and messaging tilted towards negativity to exploit the human predisposition.

One population group that has become much maligned by negative stereotyping are the millennials – the generational cohort typically recognised as having birth years between the early eighties and the early 2000s. Stereotypes depict millennials as a generation of entitled, fame obsessed, narcissistic and lazy young adults that continue to live off of their parents with the aim of postponing the rites of passage to adulthood as long as possible.

Millennials also have a reputation for being over-indulgent spenders that do not save for retirement. A recent report issued by Bank of America Merrill Lynch in partnership with Khan Academy, however, discredits some of the widely held stereotypes about millennials, particularly those relating to financial matters. For starters, the report shows that almost half of millennials in the United States have managed to save at least US dollars 15,000, while one out of every six of them have US dollars 100,000 stashed away in a savings account, investments, individual retirement accounts, or pension plans. Millennials’ financially savvy – it appears from the report at least – is on par with or exceeds that of the baby boomers and Gen Xers.

Millenials are even driving home ownership higher in the United States – the cohort make up the largest segment of American home buyers today. Economic recovery is the simplest explanation for why more millennials are buying homes. Millennials started entering the workforce just as the Global Financial Crisis hit. A significant portion of the generation found itself unemployed, underemployed, or underpaid. And only now that the economic and psychological overhang of unemployment and underemployment has worn off meaningfully, has it become possible for the generation to step into home ownership at large.

A second reason is that marriage rates amongst millennials have also risen slightly as they have gotten older and achieved a degree of financially stability. Irrespective of the generation, marriage is widely accepted as being the number one indicator of whether people buy homes or not.

Beyond these obvious reasons we also believe that there is growing disillusionment amongst young adults today when it comes to the gig economy, big tech, and the echo bubbles that exist within Silicon Valley and popular social networks. This change can be seen with Peter Thiel ditching Silicon Valley for Los Angeles, increasing hostility towards Mark Zuckerberg and Facebook, and the gradual exodus of residents from San Francisco.

One cure to disillusionment is to lay down roots. And nothing establishes roots quite like buying a home.

Investment Perspective

Capital markets are not averse from stereotyping either. Markets in recent years have bought into at least one of the millennial stereotypes and put capital to work behind it. One such stereotype being that young adults today prefer experiences over goods. While this may indeed hold true, we believe that a larger change is afoot and that millennials are reaching a stage in their development where priorities will shift away from spending on experiences to accumulating assets and goods.

The rise of social media gave rise to the increasing trend toward experiential consumption. Conspicuous consumption amongst millennials as compared to Baby Boomers and Gen Xers was less about “stuff” and more about experiences. Social media both explicitly and implicitly rewarded the sharing of experiences – users receive positive feedback and increased network engagement from sharing photos, videos, and comments. The positive feedback incentivised users to share more and sharing more required engaging in more experiences – attending more concerts, going to more trips to far off places and trying out more restaurants. While we do not see a wholesale change is this behaviour to take place anytime soon, we do think that the marginal user is decreasing social media engagement, reversing the trend of the last decade of increasing marginal engagement.

Increasing social media disengagement – however small it may be – also means that the marginal dollar of conspicuous consumption will no longer be going toward experiences, it will be going elsewhere.

Millennials are stepping into homeownership and the wave of home buying is only getting started. With increasing homeownership comes increasing consumption, new homeowners have to fill up their houses with everything from furniture to lawnmowers. The marginal dollar of conspicuous consumption will be spent on stuff. For the homeowners this will be household goods. For the non-homeowners this will be on clothes, shoes, sports equipment, and health and beauty products.

In our recent trade ideas we added a long in Lululemon Athletica ($LULU). The idea was based on our thesis of increasing consumption of stuff. We consider the likes of Nike ($NKE), Ralph Lauren ($RL) and Under Armour ($UAA) as names that we see as beneficiaries of increasing conspicuous consumption by millennials both in the United States and overseas.

On the other hand, we consider restaurants and other experiential economy companies to be prime candidates to short. We certainly would avoid stocks of companies such as McDonald’s ($MCD), Starbucks ($SBUX), Darden Restaurants ($DRI) and cruise ship operators such as Carnival Corp ($CCL) and Royal Caribbean Cruises ($RCL).

We are getting long $UAA and $RL and short $CCL.

Oil: Fighting the Myth

“This one will really take you back,” said the Great Winfield. “Sheldon’s Western Oil Shale has gone from three to thirty.”

“Sir!” said Sheldon the Kid. “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It’s selling at twenty-four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”

“Shale oil! Shale oil!” said the Great Winfield. “Takes you way back, doesn’t it? I bet you can barely remember it.”

“The shale oil play,” I said dreaming. “My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…”

“See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvellous! It’s like having a son! My boys! My kids!”

The Great Winfield had made his point. Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before.”

– Excerpt from The Money Game (1976) by Adam Smith (aka George Goodman)

Muscle Memory: Misnomer

Complicated skills that humans can overtime perform without much thought, almost automatically, such as riding a bike, playing the guitar, or knitting a sweater, are often thought of as being held in muscle memory. Think back to Karate Kid and Mr Miyagi’s ‘wax on, wax off’ training regime – popular culture fed us the idea of muscle memory and we gobbled it up.

While it is true that certain skills may require the strengthening of various muscle groups, the reality is that learning and retention of new skills occurs in the brain, not in muscles. The process of acquiring new skills causes changes to the structure of the brain. Magnetic resonance imaging (MRI) scans reveal that there is a visible increase in the number of the connections between the different areas of the brain that are required for the skill being acquired. This structural change alters the information the brain transmits to the muscles, thereby altering the movements produced by the muscles.

Ideas: Power

The ability to imagine a reality that neither exists today nor has existed in the past, to give birth to an idea, is one of the truly remarkable gifts endowed to humanity.

Ideas are the seeds of progress. It is ideas that enable large scale human cooperation that transcends self-interest, race, and borders.

Simple ideas: Highly contagious

Ideas are powerful. Simple ideas that are fully formed and easily understood are also highly contagious. Once a simple idea has taken hold, it is difficult, almost impossible, to eradicate.

Peak oil was a simple idea and it was easy to understand, making it both powerful and contagious. It was so contagious in fact that it bordered on belief; it was hardly ever questioned. And the parabolic rise in the price of oil during the last decade was taken by many as confirmation of that belief.

So when the price of oil crashed during the second half of 2014, the immediate reaction of the global investment community was not that peak oil was a myth but rather that OPEC (read: Saudi Arabia) had been greedy. That the cartel had artificially kept supply constrained to maximise its earnings and that the greed had comeback in the form of shale to bite the cartel in their proverbial behind.

The resilience of the peak oil concept is the very reason we think that oil prices recovered sharply during the first half of 2015 and that dedicated energy focused private equity funds were able to raise so much capital in a relatively short amount of time. As market participants witnessed the sharp drop-off in rigs across shale oilfields, it reminded them that cheap oil would eventually run out and higher prices would be needed to satisfy global oil demand – muscle memory or not, investors proceeded to bid up the price of oil.

Ideas that have taken hold in people’s minds are difficult to eradicate. And this is precisely the reason why an even sharper drop in the price of oil was needed to debunk peak oil as a myth. As oil prices tanked during the fourth quarter of 2015 and January 2016, a new idea took hold: the existence of shale placing a cap on the price of oil, i.e. if oil prices were to move above an arbitrary price, usually quoted to be between US dollar 65 to 80 per barrel, for a prolonged period of time, shale producers would ramp up production and flood the market with excess oil.

As oil prices recovered during 2017 so too did US oil production – US output has climbed by approximately 1.2 million barrels per day since January 2017. This surge in production is being seen by many as confirmation of both the responsiveness of shale oil producers and the existence of a cap on the price of oil. We beg to differ.

Investment Perspective

While the surge in US shale production has been impressive and may well continue for the remainder of 2018, we consider the supply and demand dynamics of oil to be decidedly in favour of steady or higher oil prices over the medium term:

The cyclical upturn in the global economy has supported oil demand, which grew by around 1.6 million barrels per day in 2017 and based on OPEC estimates is going to grow by a similar amount in 2018 and reach almost 100 million barrels per day.

Even though US shale oil production is increasing, it is not overwhelming the market. Suggesting that shale production is not exactly like a tap and that there may even be infrastructure related bottlenecks that constrain supply growth.

The anticipated phasing out of the combustion engine by electric powered vehicles, we think, will take far longer than oil bears expect. Beyond the intangible benefit – at least at an individual consumer level – of doing what is good for the environment, consumers receive very few, if any, tangible benefits in switching to electric vehicles. (We accept that there are some notable exceptions in countries where governments have incentivised electrical vehicle adoption through tax breaks, subsidies, etc.)

There simply are not enough electric vehicle charging stations across any automotive market of meaningful size. Any large scale roll out of electric vehicle charging stations would, in our opinion, have to be subsidised, directly or indirectly, by governments as any such roll out does not, at this stage, make commercial sense, even as an industry-wide joint effort.

China has been a strong proponent of electric vehicle adoption over the years.

China’s recent pollution crackdown, at face value, also appears to be a continuation of its policy of promoting electric vehicle adoption. The reality, however, is that the crackdown has placed immense pressure on China’s already limited natural gas supplies, fuelled discontent amongst its citizen and driven China to import record amounts of LNG.China simply cannot afford for the adoption rate of electrical vehicles to accelerate. We, therefore, think that China is likely to gradually phase out any remaining incentives for electric vehicle adoption as opposed introducing further incentives promoting adoption.

In addition to the above we do not think the market is fully pricing in the potential disruptions to supply from:

A collapse in Venezuelan crude production;

The increasing probability of the Trump Administration pushing through reinstatement of economic sanctions on Iran;

Sustained cooperation between Saudi Arabia and Russian in managing supply; and

Slashed exploration and production budgets across the non-state owned oil majors.

Positioning in futures markets remains stretched, making the price of oil susceptible to a sharp correction, especially if trade war rhetoric continues to ramp-up between the US and China. We would see any such correction as an opportunity to build a position in our most favoured oil plays.

Russia: Tailwinds, Not Geopolitics

“Russia is a riddle wrapped in a mystery inside an enigma.” – Winston Churchill

“The secret of politics? Make a good treaty with Russia.” – Otto von Bismarck, founder and first chancellor (1871–90) of the German Empire

“Sometimes it is necessary to be lonely in order to prove that you are right.” – Vladimir Putin

In 1985, members of Hezbollah, the Sh’ia political party and military group based in Lebanon, kidnapped four Russian diplomats in West Beirut. The terrorists “warned that the four Soviet captives would be executed, one by one, unless Moscow pressured pro-Syrian militiamen to cease shelling positions held by the pro-Iranian fundamentalist militia in Lebanon’s northern port city of Tripoli.” The militants ended up killing Arkady Katkov, a consular attaché and one of the four kidnapped diplomats.

Moscow, upon hearing the news of Mr Latkov’s death, dispatched Spetsgruppa “A” – also known as the Alpha Group.

The Alpha Group was formed in 1974 by Yuri Andropov, the chairman of the KGB at the time, in response to the Black September attacks at the Munich Olympics in 1972. Although founded under the KGB, the unit survived the collapse of the Soviet Union and operates today as a stand-alone counter-terrorism and counterintelligence unit under the auspices of Russia’s Special Forces.

The Alpha Group successfully rescued the three remaining diplomats after being dispatched to Lebanon. How they achieved this feat though is a chilling tale of brutality and effectiveness.

According to one version of how events transpired, the Alpha Group kidnapped twelve Shi’a, one of whom was the relative of a Hezbollah leader. The kidnapped relative was castrated and shot in the head, his testicles stuffed in his mouth, and his body shipped to Hezbollah with a letter promising a similar fate for the eleven other captives if the Russian diplomats were not released. In an alternate retelling of events, the unit is said to have abducted one of the kidnapper’s brothers, and sent two of his fingers home to his family in separate envelopes.

Russia allegedly has a longstanding policy of targeting family members of terrorists. The reports of Alpha Group’s rumoured operation in Lebanon are in keeping with this tradition.

Hezbollah has long since heeded Otto von Bismarck’s advice and made a ‘good treaty’ with Russia. Today, Russia and Hezbollah operate closely as allies in the Syrian civil war and in their support for Bashar Al Assad in the conflict

The recent poisoning of former Russian spy Sergei Skripal in the UK has set-off a wave of diplomatic expulsions. The United Kingdom, accusing Russia as being behind the poisoning, made the first move by expelling twenty three Russian diplomats. In a show of solidarity, twenty six other nations, including the US, followed Britain’s lead and expelled Russian diplomats. Moscow, rejecting the accusations, has announced the closure of the British Council and US consulate in St. Petersburg and the expulsion of British and American diplomats.

While the saga continues to make the headlines, we believe neither the British nor the Americans have the wherewithal to sustain a diplomatic dogfight with the Russians. Britain still has the not-so-small matter of Brexit negotiations to deal with and its economy cannot afford to close itself off from Russian capital or Russian consumers. The Trump Administration, on the other hand, is fighting too many battles on too many fronts and a diplomatic standoff with Russia, as it appears at least, is way down the list of priorities.

While geopolitics will always be a concern when one invests in Russia, we think the political risks are no greater today than they have been in the past. We think both the US and the UK will either make good with Russia over time or there will be little development in solving the murder and the issue will be demoted to background noise. We certainly do not see Russia backing down – Putin after all remains ready to exploit the ‘us against them’ siege mentality to the benefit of his popularity amongst Russians.

For now, we prefer to focus on cyclical tailwinds that Russia is enjoying today and not the geopolitics.

Investment Perspective

The sharp drop in the oil price in late 2014 forced Russia to move the ruble to a floating exchange rate. The move led to a sharp drop in the ruble as the artificially overvalued currency adjusted to the new regime. The inflation that followed was painful and the Central Bank of the Russian Federation responded by hiking interest rates. The combination crippled economic activity.

No sector suffered more in the economic slump than the consumer sector. As inflation ravaged the Russian consumer in 2015 and 2016, consumer spending dropped off a cliff – leading to high levels of consolidation across consumer facing companies. Only the largest were able to withstand the challenging environment. And even then, they too had to adapt and become leaner and more efficient.

The rebound in oil prices last year has lifted the economy out of recession, supported the ruble and allowed the central bank to aggressively cut interest rates – cumulatively the central bank has cut the policy rate by 9.75 per cent since January 2015. The policy rate now stands at 7.25 per cent, well above the central bank’s target inflation rate of 4 per cent.

In response to the economic upturn, we expect Russian consumer demand to recover as increased economic activity translates into higher employment rates and higher wages. This recovery in consumer spending in turn should fuel further improvements in economic activity. The combination of increasing economic activity and significantly lower interest rates will encourage, we think, Russian corporates to increase capital investment.

Based on the Levy-Kalecki profit formula:

Profits – Tax = Gross Investment + Government Deficit + Net Exports – Workers’ Saving

Increasing capital investment and higher consumer spending (lower workers’ savings) both contribute to higher profitability. If Russian consumer spending and capital investment do increase as we suspect they will in 2018, the profitability of Russian companies, too, should be much higher. Specifically, consumer companies that have come out of the slump much leaner and with much larger market shares are well placed to benefit from the cyclical upturn in the Russian economy.

For those of you that have frequented Bond Street in London or Dubai Mall in the United Arab Emirates will be all too aware that Russian consumers have a taste for the finer things in life. Demand for luxury handbags, expensive automobiles, and beachfront properties all goes up when the Russian consumer is spending. For this reason we think that some of the leading European fashion houses will also be amongst the primary beneficiaries of the improvements in the Russian economy.

We have been long Russia since the start of the year and remain long. Next week, we will be adding a number of European fashion houses as long trade ideas as means to play the Russia theme, especially for those of you that cannot directly invest in Russian assets.

Trade Wars: Two Can Play That Game

“One day, she’ll start sending you mixed signals, and you’ll get mad because she finally learned how to play your game.” – Unknown

“Hold out baits to entice the enemy. Feign disorder, and crush him.” – The Art of War by Sun Tzu

“A slander is like a hornet; if you cannot kill it dead at the first blow, better not to strike at it.” – Henry Wheeler Shaw, 19^th century American humourist who used the penname Josh Billings

The United States is the only western country that continues to apply the death penalty to this day. Capital punishment is used as legal penalty across 31 American states and by the US federal government and the US military. The Bill of Rights – the first ten amendments to the US Constitution that were adopted in 1789 – included as part of the Eighth Amendment the prohibition of cruel and unusual punishment. Following the Bill of Rights, punishments such as drawing and quartering, public dissection, burning alive, and disembowelment were recognised as cruel and unusual punishments and consequently outlawed by the Supreme Court.

Capital punishment also survives in the People’s Republic of China till this day. Cruel and brutal practices in serving the death penalty were also abolished in China but much later than they were in the US. One practice used by the Chinese was particularly barbaric. Far more barbaric than any practice that may have been used in the US even prior to the passing of the Bill of Rights.

The ancient Chinese practice known as lingchi – more commonly referred to as death by a thousand cuts – was not officially outlawed in China until 1905. Lingchi was a long, drawn out punishment, intended to test how many cuts a person could withstand before dying.

President Donald Trump has this week announced plans to impose tariffs on Chinese imports amounting up to US dollar 60 billion. The plan is based on applying a 25 per cent import duty on a yet to be determined list of Chinese products. Mr Trump has unleashed the firing squad with the intent, according to US officials, of derailing Chinese high-tech ambitions. General Secretary Xi Jinping has identified ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, agricultural machinery and biomedicine – as part of his “Made in China 2025” initiative. These are the sectors that the Trump Administration aims to attack through the planned tariffs. Mr Trump and his band of trade warriors, not content with import tariffs alone, are also looking to introduce legislation placing new restrictions on Chinese investment into the US in the aforementioned industries.

In hope of rattling the hornet’s nest some more, the Trump Administration granted temporary exemptions – until 1^st May – on steel and aluminium tariffs announced earlier this month to a number of US allies, including the European Union, Australia, South Korea, Argentina, and Brazil.

To top it all off, President Trump replaced national security adviser Herbert Raymond McMaster with super-hawk John Bolton.

In response to the US’s plans to introduce tariffs on Chinese imports, China’s Ministry of Commerce said it is planning to place import tariffs on 128 US products representing US dollar 3 billion in imports. Tariffs will be placed on products such as US steel pipes, recycled aluminium, pork, fresh fruit, and wine. To some Beijing’s reaction appears measured, to others it seems meek. In our opinion, Beijing has just made its first cut; it has a thousand more lined up. How many cuts they make depends on Washington.

Ever since Mr Trump abandoned the Trans Pacific Partnership, Mr Xi has taken it upon himself to become the primary advocate of global trade and in turn positioning China to play a greater global role. The measured response is sound politics. Beijing will not want to come off looking aggressive or to take steps that could derail global trade. For seemingly undue aggression from China would push Europe and other American allies to align with the US – something they have thus far resisted in doing.

Investment Perspective

Mr Trump, in our opinion, is not the crazed madman with too much power to wield as some segments of the mass media would have us believe. Instead, we think he has two immediate goals in mind when it comes to China: to shore up his voter base; and to send China the signal that the rules of engagement have changed. The latter goal is something a number of commentators and analysts have pointed to while citing Mr Trump’s interview with Oprah Winfrey in 1988. While we have no reason to doubt that Mr Trump indeed is approaching the situation in the way he described he would to Ms Winfrey three decades ago, we must also accept that the world we live in today is drastically different to the one that existed at the time of that interview. The rise of China is amongst the most far-reaching changes over the last three decades.

Before the rise of China, the US was already running trade deficits – in effect borrowing US dollars – and supporting the internationalisation of leading US companies. These companies invested all over the world and became what today are commonly referred to as multinational corporations. These multinationals used, in effect, US debt to fuel international expansion and generated returns that far exceeded the interest cost the US incurred on its debt. The end result being that the US was able to collect the spread between the return on investment on the multinationals’ international operations and the cost of its debt.

The rise of China has had a profound impact on the above described dynamic. First, it has led to US multinationals earning much higher returns on their international investments. Second, China has as a matter of policy helped reduce the cost of US debt. The end result: the US earned an even juicier spread on its international investments.

As any corporate financier worth their salt will attest to, when such a spread is available to exploit you should continue to add leverage till the point the marginal benefit of additional leverage is zero. And this is exactly what the US did. Wall Street won at the cost of Main Street.

Donald Trump by unleashing a trade war is attempting to reverse this trend. The consequence of which is that the US’s net investment income that has been positive for so long will turn negative. Leverage after all cuts both ways. For his protectionist policies to yield long-term results tariffs may not be enough, however. Mr Trump will need both a much higher interest rate and a stronger US dollar. Given where US debt levels stand and the US Treasury’s borrowing needs for the coming years can the US withstand this policy? We think not.

We do not want to be long the US dollar. Tactical positioning aside of course.

China’s Governmental Revamp and the World’s Shift Toward an Inflationary Regime

“It is necessary sometimes to take one step backward to take two steps forward.” – Vladimir Lenin

“I don’t mind going back to daylight saving time. With inflation, the hour will be the only thing I’ve saved all year.” – Victor Borge, Danish-American Comedian

A Chinese parliamentary document released this week unveiled a major revamp of China’s central government. As part of the overhaul China will merge its banking and insurance regulators to create the Banking and Insurance Regulatory and Management Commission. Two new ministries to oversee the protection of natural resources – the Ministry of Natural Resources – and ecology and environment – the Ministry of Ecology and Environment – will also be set up.

The merger of the banking and insurance regulators will be accompanied by the transfer of authority to draft and issue banking and insurance regulations to the People’s Bank of China (PBoC). The overhaul of the financial regulatory infrastructure comes at a time when Mr Zhou Xiaochuan, governor of the PBoC, is expected to retire after 15 years at the helm of the Chinese central bank. The Chinese banking system has grown by an order of magnitude since Mr Xiaochuan’s appointment as governor in 2002. At the end of 2017, Chinese banking assets amounted to RMB 252 trillion and China’s total debt reached 257 per cent of GDP.

During the Communist Party of China’s 19^th National Congress last year, Mr Xi Jinping identified containing financial risks as one of the government’s priorities for the next three years. In November last year, not long after the National Congress, Chinese financial authorities took the first step towards a more unified approach to regulating the financial sector by unveiling new draft regulatory standards for the issuance of asset management products by all types of financial institutions.

The new guidelines will bring the Chinese asset management industry under a single regulatory regime for the very first time and are aimed at closing the many regulatory loopholes that exist in the current setting. Under the new rules, any financial institution issuing asset management products will face a number of new regulatory constraints. Most notably, financial institutions will be unable to pool assets raised through “wealth management products” or roll over these products indefinitely. The ability to pool assets and roll over products indefinitely provided a loophole that allowed investment losses in legacy wealth management products to be covered through the issuance of new products – resulting in a pyramiding of financial risk within the system. The new rules will now expose investors in wealth management products to a greater possibility of incurring losses. While the rules do increase the risk of suffering losses on investors, they are a much needed step toward reducing the systemic risk wealth management products pose to the Chinese financial system.

The authorities, in recognition of the potential disruption a wholesale change in regulations can cause, have proposed a transition period till 30 June, 2019, for existing asset management products to become compliant with the rules under the new regulatory regime.

The plans announced in this week’s parliamentary release are one more step towards bringing the Chinese financial sector under a unified regulatory regime. The transfer of authority to draft and issue banking and insurance regulations to the PBoC, in particular, is a bold move. Under the proposed set up the Banking and Insurance Regulatory and Management Commission will effectively become the PBoC’s oversight and enforcement agency.

In the current setting the PBoC is one of four financial regulators in China. Given the unprecedented growth of the Chinese financial system, a disjointed approach to managing the financial sector is no longer feasible and should have been done away with many years ago. The increased authority of the PBoC and the existence of only one oversight and enforcement agency, we believe, should lead to a more proactive approach to controlling the risks within the financial system. The days of unlicensed peer-to-peer lending – the Chinese equivalent of US wildcat banking in the nineteenth century – are, in our opinion, over. And the toughening of financial regulation that started in 2017 is a theme that, we think, will continue over the course of 2018 and quite possibly 2019.

Mr Xiaochuan’s, during his reign as governor of the PBoC, went to great lengths at reforming and liberalising the Chinese financial system. His contributions, albeit very gradual, were instrumental in the transition of the renminbi from a fixed to a managed float exchange rate, the growth of private sector banks, and the liberalisation of interest rates. The reforms, however, have come at a cost: a banking system that is unparalleled both in terms of scale and complexity. We therefore think that the Chinese government, and by extension the PBoC, will put any plans to further liberalise the system on hold in favour of defusing financial risks.

The Chinese government’s geopolitical ambitions and the success of the Belt and Road Initiative will at a point greatly depend on the PBoC’s ability to transition to a liberalised capital account, which in turn will require the renminbi to be switched from a managed to a floating exchange rate. The opening up of the capital account, and by extension the ambitions of the Chinese leadership, cannot be achieved with an unstable financial system. The Chinese have no choice but to increase control over the financial system in order to diffuse systemic risks.

Mr Zhou’s successor is more likely to be a conservator as opposed to a reformer.

Investment Perspective

The Chinese leadership under Mr Xi’s reign has increasingly come to emphasise the importance of social wellness. So much so that social wellness now sits near the top of the Chinese government’s priorities – the creation of an “ecological civilisation” has been added to the government’s goals as part of the most recent round of amendments to the Chinese constitution.

With the focus on the environment it might seem that the Chinese leadership is attaching less importance to economic growth. With the government announcing target economic growth of “around 6.5%” at the start of this year’s National People’s Congress, however, such an assertion would be far from the truth. In addition to a continued commitment to strong economic growth, the government also highlighted cutting production capacities as one of the goals for 2018.

If we take the Chinese government’s stated goals at face value then we think the world may be entering a profoundly different economic environment to the disinflationary one we have lived through over the last three decades. Consider the scenario that the Chinese government is proposing:

Chinese credit growth will be regulated to the extent that certain types of corporate borrowers may no longer have access to any form of additional credit;

Production capacities of industrial commodities, such as steel and coal, will be reduced and there will be negligible amounts of new capacity additions;

Industries and households will be weaned off coal and other polluting fuels and shifted to more environmentally friendly yet more expensive alternatives such as natural gas;

Government officials will not only be judged on the absolute level of economic growth achieved but also on the environmental cost of that growth; and

Chinese growth will continue to be above economic potential despite environmental and financial constraints.

At the same time the world is at the cusp of an infrastructure spending boom. China is moving full steam ahead with the Belt and Road Initiative and the US government is concurrently pushing for congressional approval for a USD 1.5 trillion infrastructure investment plan.

A world with growing demand for industrial commodities combined with lower Chinese capacities is bullish for industrial commodities. Once we throw the fact that the developed world has all but lost its industrial manufacturing capabilities and is unlikely to be able to make up for lost Chinese capacities into the mix, we find ourselves considering the possibility of a wildly bullish outlook for industrial commodities over the medium-term.

Coupling this outlook with the fact that US financial institutions hold over USD 2 trillion in excess reserves, and that US companies’ attitudes toward capital spending are more positive than they have been in a decade, we find ourselves considering the possibility that commodities may well serve as a better hedge for equity market risk than US Treasuries at this stage.

Trade Wars: Hedging for Tariffs

“You realise that all the lines on the maps really do not exist. You can’t even tell where one country starts and the other one stops. All those things that create conflict just melt away, and you can see our planet as one home for all of us.” – Anousheh Ansari, Iranian-American astronaut’s reflection upon seeing the earth in its entirety

“No nation was ever ruined by trade.” – Benjamin Franklin

“The whole is more than the sum of its parts” – Aristotle

“We can only see a situation with true clarity when we take the time to carefully consider the interests at hand. And we understand it even better when we consider how the situation might be different if the underlying interests were different.” – Excerpt from Pebbles of Perception: How a Few Good Choices Make All the Difference by Laurence Endersen

The government of Israel has for many years placed a complete ban on trade with Iran. In fact, Israeli law stipulates the penalty for violating the ban on Iranian imports can be as high as imprisonment of up to two years. Despite this, Iranian marble, it turns out, is a notable feature of some of the most prominent buildings in Israel.

A complex adaptive system is a system in which a complete understanding of the individual components does not directly translate into a comprehensive understanding of the system’s behaviour as a whole. The global trade system that enables the cross-border exchange of goods and services is a type of complex adaptive system. It is the adaptive nature of this system that enables the availability of Iranian marble in Israel.

President Trump and his posse of international trade warriors is, by unveiling their first wave of import tariffs, attempting to change the dynamics of the global trade system. How the individual and collective components of the system mutate in response to the Trump Administration’s policies is anyone’s guess. What is an almost foregone conclusion, however, is that system’s response will include second and third order effects – the so called unintended consequences – that US policymakers will not have anticipated.

Our rudimentary attempt at diagnosing some of the potential unintended consequences of the Trump Administration’s protectionist theatrics is based on identifying how the prominent players within the global trade system are incentivised. The European Union is one of the major players within the system we consider to be trapped by a complex web of incentives. The predicament faced by the bureaucrats in Brussels is of an existential nature. Existential threats activate the most basic of human instincts – the instinct of survival. And the thing about basic human instincts is that they can cause the most rational of agents to behave irrationally.

The bureaucrats in Brussels are unelected officials. Their only claim to legitimacy comes from the existence of the European Union. These bureaucrats it leads are incentivised to ensure the survival of the European project. This survival depends on the union members maintaining their memberships. It is therefore in this context only rational for the bureaucrats to heavily punish any wantaway member even if said wantaway member happens to be running a huge trade deficit with Europe. The bureaucrats in Brussels, we believe, want to severely punish the UK for the British populous’ decision to exit the European Union.

We fully expect the leaders of the European project to continue to drive a hard bargain in the negotiations on the terms of UK’s exit from Europe – at least in the short-term. The bureaucrats may or may not realise it but the protectionist turn in President Trump’s policymaking has tilted the balance in the UK’s favour and the British government now has the upper hand when it comes to the Brexit negotiations.

The Trump Administration placing tariffs on steel and aluminium imports will increase cost pressures faced by US auto manufacturers – making their vehicles, in all likelihood, uncompetitive in relation to imported vehicles. German automakers exported more than half a million vehicles to the US in 2016 and Germany runs, what we suspect to Mr Trump’s international trade warriors is, an unpalatable level of trade surplus with the US. Should the metal import tariffs be successfully enacted by the Trump Administration, we suspect that German automakers will find themselves at the centre of the next round of Mr Trumps’ protectionist theatrics.

In 2016 the UK ran a GBP 82 billion trade deficit with imports from EU representing 54 per cent of the UK’s imports during the year. German automobiles represented a not so insignificant share of those imports.

Now consider the incentives for the German government. After months of uncertainty Germany has a new government with the Social Democratic Party of Germany (SPD) finally agreeing to a coalition with Chancellor Angela Merkel’s Christian Democratic Union of Germany (CDU). Chancellor Merkel in a bid to secure a fourth-term had to relinquish control of the finance ministry to the SPD. For the SPD the coalition offers an opportunity to position itself as a viable alternative to the CDU for the next election. The CDU on other hand does not want to lose any further ground to the SPD. Collectively the parties want to stop the rise of the nationalist Alternative Party of Germany party. The closure of factories operated by German automakers serves neither party’s objectives. The rational course of action for the German leadership in this context is to reach an amenable trade agreement with the British.

What the bureaucrats want and what Germany needs may test the cordial relationship that may exist between Brussels and Berlin today. The fact, however, remains that there is no European project without Germany and the Germans will eventually get their way. For this reason, we expect Brexit negotiations between the UK and Brussels to turn decidedly in the favour of the British.

Investment Perspective

The time, we think, to buy UK stocks is coming. Exporters benefited at the cost of domestically focused companies as the British pound fell sharply following the Brexit referendum. The tide, in our opinion, is turning and we favour more domestically focused British companies over exporters. We also think the sterling should strengthen relative to the Euro.

Domestically focused British companies may, in our opinion, be amongst the best available hedges to the rising level of protectionist rhetoric coming out of the US.

On the European front, we favour domestically focused automakers in France and Italy over the more export oriented German auto manufacturers. The domestically focused automakers, we think, should benefit from lower steel and aluminium prices as non-US based steel and aluminium producers redirect their supply toward Europe and Asia.