Durability of the US Bull Market

 

“Having insurance doesn’t guarantee good health outcomes, but it is a critical factor.” ― Irwin Redlener

“Seeing the bigger picture opens your eyes to what is the truth.” ― Wadada Leo Smith

As the key indices in US equity market are once again approaching all-time highs, we look to assess the durability of the bull market in the face of a plethora of negative headlines and rising valuations. We also identify a few leaders in the retail sector as long ideas.

 

Technology Leadership

 

When a bull market is turning over, the tell tale signs can usually be found in the segment that has led the bull charge. And as we all know, technology has been the clear leader in the most recent incarnation of the US equity bull market.

 

The below monthly chart is a ratio of the NASDAQ 100 Index to S&P 500 Index. The ratio is now in territory witnessed during the tail-end of the tech bubble. The difference this time ― ominous last words ― being the steady, as opposed to parabolic, rise in the ratio.

 

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 09-39-55

 

The quarterly rate-of-change of the above ratio, shown in the chart below,  is another way to see the stark difference in the relative rise of the NASDAQ 100 over the last ten years as compared to the relative rise during the tech bubble.

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 10-22-11.png

 

What the rate-of-change, or momentum, chart does suggest is that the recent waxing-and-waning in technology stocks, be it due to slowing earnings or fears over antitrust action against the mega-capitalisation technology companies, is still within the normal bounds of volatility.

 

If the NASDAQ 100-to-S&P 500 ratio fails to make new highs in the coming weeks and months or there is a marked deterioration in the ratio’s momentum, we would become concerned about the durability of technology’s market leadership.

 

Growth and Value

 

Other ratios in tech bubble territory are those of the S&P Growth Index-to-S&P 500 Index and the S&P Growth Index-to-S&P Value Index.

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-17-07

 

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-16-27

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

Heavy Truck Sales

 

The below chart compares the S&P500 Index (magenta) to heavy truck sales in the US (orange). Heavy trucks sales are a barometer for economic activity in the US. Heavy truck sales rolled over in 2000 and in 2006 ahead of the cyclical peaks in the US equity market. Heavy trucks sales have thus far remained strong.

 

USASHVTK Index (United States He 2019-06-14 14-46-20.jpg

 

Cyclical to Defensive Stocks

 

The below chart is a ratio of the MSCI USA Cyclical Stocks Index to the MSCI USA Defensive Stocks. We see this ratio as a gauge of ‘animal spirits’. A rising line suggests a preference for profit over preservation.

 

The ratio has recently broken out to fifteen year highs. This is a but surprising given that Treasury yields have come in quite a bit in recent months, which should have benefited defensive sectors such as consumer staples and utilities.

 

MU704866 Index (MSCI USA Cyclica 2019-06-13 15-24-54.png

 

We would avoid or reduce allocations to bond-proxies such as utilities and REITs for now and search for alternative sources of diversification for portfolios with growth and technology heavy allocations.

 

The Smart Money Flow Index

 

The technology led rally from the lows recorded in February last year was not accompanied by a recovery in the Smart Money Flow Index. Rather, the index was hitting new lows just as the NASDAQ 100 was approaching new highs.

 

The rally in 2019, however, has coincided with a rebound in the Smart Money Flow Index. If the index starts retreating again we would be concerned.

 

SMART Index (Smart Money Flow In 2019-06-13 14-03-59.png

 

Corporate Yield Spreads

 

The below chart is the yield spread of Corporate BBB bonds to the US 10 Year Treasury.

 

Corporate yield spreads remain below the levels reached during the “volmageddon”on 2018 despite the sharp drop in oil prices in recent weeks. If yield spread breach the 1.65 per cent level in the below time series, we would think about scaling back equity exposures. Moreover, if we see exuberance take yield spreads below 2018 lows, we would worry that we are entering the “melt-up” phase in the bull market and also look to sell into strength.

 

CSI BBB Index (US Corp BBB_Baa - 2019-06-13 13-10-40.png

 

Consumer Leaders

 

If the Federal Reserve cuts interests rates, the US consumer will benefit from lower debt servicing costs on its mortgages and other debt. This should boost consumer spending, at least at the margin. We identify retail leaders that we add to our ideas on the long side.

 

ETSY  $ETSY

 

(The bottom panel is the relative strength to the SPDR Retail ETF $XRT.)

 

ETSY US Equity (Etsy Inc) Retail 2019-06-14 14-59-54

 

Five Below  $FIVE

 

FIVE US Equity (Five Below Inc) 2019-06-14 15-00-53

 

Under Armour $UAA

 

UAA US Equity (Under Armour Inc) 2019-06-14 15-00-22

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Two Ideas: Advanced Emissions Solutions & A Bitcoin Proxy

Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options. — Simon Sinek

Advanced Emissions Solutions $ADES

In Environmental Concerns: Ideas on Long Side we discussed the lack of progress in reducing global emissions since the Paris Climate Agreement was signed by 190-plus countries in December 2015. At a high level we suggested Advanced Emissions Solutions as a potential long idea that could benefit from increased regulatory pressure to control emissions.

$ADES owns a 42.5 per cent stake in a joint venture with Goldman Sachs and Nexgen Refined Coal called Tinuum Group. Tinuum is awarded tax credits when it produces refined coal — coal that has been processed to reduce emissions when burned.

In the American Jobs Act of 2004 there was a provision to encourage the use of chemically treated coal to reduce the emissions from US power plants. To qualify for the refined coal tax credit, producers “must have a qualified professional engineer demonstrate that burning the refined coal results in a 20 per cent emissions reduction of nitrogen oxide and a 40 percent emissions reduction of either sulfur dioxide or mercury compared with the emissions that would result from burning feedstock coal”. The tax credit was designed to increase with inflation and was valued at US dollars 6.91 per short tonne produced in 2017 and US dollars 7.10 per short tonne in 2018. As an added bonus, some operating expenses incurred in running a refined coal facility are also tax deductible, making the tax credit’s effective value in 2018 as much as  US dollars 9 a tonne.

The tax credit, as originally structured, was not easy for refined coal producers to take advantage of. The policy required producers to increase raw coal’s market value by 50 percent to qualify for the tax credit. This clause made cost-conscious utilities unwilling to buy refined coal.

A policy edit to the structure of the tax credit in 2008 by senators from Montana and Iowa, two coal producing states, however, removed the market value clause. The removal of this clause made it possible for refined coal producers to benefit from the tax credit even if they sold their product at a loss. This shift in policy incentivised  the creation of Tinuum and other refined coal producers like it.

Tinuum financed the construction of facilities to produce refined coal situated next to coal-fired power plants. The window to construct these facilities closed in 2011 and the tax credits expire in ten years from commencement of operations. Republican Senator John Hoeven from North Dakota, also a coal producing state, has, however, introduced legislation to extend the tax credits by another ten years.

On average, each facility cost between US dollars 4 and 6 million to construct.  Tinuum constructed 28 of them, making it the second largest operator in the refined coal space.

How does Tinuum benefit from the tax credit? 

1. Power plants lease refined coal facilities from Tinuum at say a rate of US dollar 4 per tonne of refined coal (plus, at times, additional royalty commissions) — 42.5 per cent of which goes to $ADES

2. The refined coal facility is used to process feedstock coal and generate a tax credit at the prevailing inflation adjusted rate. Operating the refined coal facility costs power plant owners a further US dollars 3 per tonne.

3.  Power plant owners receive the ~US dollars 7 per tonne in tax credits and at the same time the operating expenses  incurred in running the refined coal facility and the lease payment to Tinuum are tax deductible. At a marginal tax rate of 21 per cent, the power plants tax bill is reduced by approximately US dollars 1.47 per tonne.

Tinuum presently has 20 of 28 refined coal facilities (representing 55 to 65 million tonnes of refined coal capacity) contracted to the owners of coal-fired power plants.  In 2019, it has an opportunity to increase the utilisation of its idle facilities. A number of tax advantaged refined coal facilities that began operations in 2009 have seen or will see their tax advantaged status lapse during the year. One of the 20 operational facilities was contracted and brought online in January 2019. Management expects a further 12 millions tonnes of refined coal capacity to be contracted over the course of 2019.

Based on the 20 contracted facilities through 2021, when the tax credits expires, $ADES’s share of net refined coal related cash flows from Tinuum is estimated to be between US dollars 200 and 225 million. To put that into perspective the market capitalisation of $ADES is US dollars 248.8 million.

What other areas does Advanced Emissions Solutions operate in?

In December 2018, the company acquired ADA Carbon Solutions (ACS). ACS owns and operates an activated carbon manufacturing plant focused on “mitigating mercury emissions” from coal-fired power plants.

In its first full quarter since acquisition, ACS contributed US dollars 14.6 million in revenue to $ADES.

Management’s plan is to cross-sell ACS’s solutions to existing customers and also expand the mercury mitigation solutions services into other adjacent segments. One adjacent market they intend to target is the municipal water treatment market, a highly fragmented sector “comprised of many producers and re-sellers”.  Management does not expect the entry into adjacent markets to require incremental investments to be made by the company.

Investment Thesis

$ADES currently trades at trailing twelve months earnings of 6.9 times and a dividend yield of 7.50 per cent with return on equity of 46 per cent.

Given the majority of the company’s market value is covered by its share of Tinuum’s contracted cash flows, we see $ADES as a cheap call option on (1) the potential increase in tax credit by another 10 years, (2) contracting of Tinuum’s remaining 8 refined coal facilities through 2021 and (3) the activated carbon segment.

A Bitcoin Proxy

Famed short-seller Jim Chanos, using his Twitter alias Diogenes (handle: @WallStCynic) recently tweeted:

“How the F is this bitcoin nonsense being resurrected again? Are people really this stupid?”

We do not know if buyers of bitcoin are being clever or not so clever. We do not know what is driving the buying. Maybe it is the employees of Lyft, Uber, Zoom or Pinterest, newly minted as millionaires, using a portion of their winnings to buy bitcoin. Or Chinese capital fearful of an imminent devaluation of the renminbi finding a way around capital controls by buying bitcoin. Or [insert here whatever is the narrative du jour for crypto-aficionados or crypto-sceptics].

What we do know is that it has been going up and it may go higher still.

Our aim here is not to argue for or against bitcoin. There are far smarter and far more informed people on both sides of the argument for any contribution we may have to make the debate to be value accretive even at the margin. Rather, we have found the process of buying and selling bitcoin somewhat cumbersome and want to suggest a proxy for those that may want to trade bitcoin and not necessarily own it.

The below is a normalised chart of bitcoin and The Bitcoin Group ($ADE.GY) starting 31 December 2016. The Bitcoin Group is a holding company focused on investing in businesses and technologies in the fields of cryptocurrency and blockchain. Presently, the holding company owns one asset: 100 per cent of the shares of Bitcoin Deutschland AG, the only German authorised trading platform for bitcoin.

XBTUSD Curncy (XBT-USD Cross Rat 2019-05-16 10-53-39.png

So if you want to trade bitcoin but find the whole process a bit cumbersome, The Bitcoin Group might be worth a look. As the chart seems to suggest, it has been a pretty good proxy to buying bitcoin, at least since the beginning of 2017.

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.

European Growth Surprise

 

“Commerce flourishes by circumstances, precarious, transitory, contingent, almost as the winds and waves that bring it to our shores.” — Charles Caleb Colton

 

“Politicians know that structural reforms – to increase competition, foster innovation, and drive institutional change – are the way to tackle structural impediments to growth. But they know that while the pain from reform is immediate, gains are typically delayed and their beneficiaries uncertain.” — Raghuram Rajan

 

 

Following four quarters of negative growth surprises, the European economy positively surprised for the first quarter of 2019. Based on preliminary data, the Euro Area’s GDP grew 1.2 year-over-year and 0.4 per cent quarter-over-quarter. Quarter-over-growth was up from the 0.2 per cent recorded in fourth quarter last year and ahead of the 0.2 per cent growth anticipated by the ECB as recently as March. As an added boost, Italy emerged from its third recession in a decade.

 

In March, the ECB revised down its GDP growth projection for this year to 1.1 per cent from 1.7 per cent last December. If forthcoming data confirm the gradual improvement in the economy, the ECB may well need to revise its GDP growth projections in June. The performance of the European economy during the last quarter may yet prove to be fleeting given transitory effects.

 

Automotive sales declined month-over-month in each of last four months of 2018 — plunging 11.4 quarter-over-quarter, on a seasonally adjusted basing, during the fourth quarter — triggered by the introduction of tougher emission standards by  European regulatory authorities. The new standards have been drafted with the intent giving consumers a more realistic picture of fuel economy by compelling automakers to test vehicles in conditions more representative of real-world conditions. The transition to the new regulatory regime upset the apple cart, automakers struggled to complete testing and certification in a timely manner — impacting production and leading wide-scale inventory shortages.

 

More than half of automakers’ production losses were recouped in first quarter of this year.

 

Part of the slowdown in 2018 was also driven by the draw down of inventories, which led to weakness in intermediate goods production following a significant upcycle in 2017.  The downward inventory trend was partly reversed in the first of quarter of this year and the correction may still have a few more months to run.

 

Construction activity during the first quarter of this year may also have been exaggerated. A relatively mild winter, particularly in February and March,  boosted construction activity.  In February, construction output jumped by 3 per cent month-over-month. (March data is not yet available.)

 

The non-transitory positives were accelerating wages, healthy levels of job creation and robust consumer spending. Fixed investment by business also continued to expand at a healthy clip driven by high levels of capacity utilisation  — Italy is the exception of course, the economy continues to operate below levels recorded in 2008.

 

There were no signs of a pick-up in exports from Euro Area, based on January and February data. Global trade, however, is no longer declining and may not be headwind to growth in 2019, especially if the US and China reach some sort of agreement in their trade dispute in the near term and Europe avoids an escalation of trade tensions with the US.

 

The positive growth for the first quarter have been reflected in an uptick in European money supply M2 — defined as currency in circulation plus overnight deposits plus deposits with an agreed maturity up to 2 years plus deposits redeemable at a period of notice up to 3 months.

 

European M2 growing at an annual pace of 5 per cent, outside a recession, has in recent years translated into the economy expanding between 1 and 2 per cent. With M2 growth still range bound, we see limited capacity for the European economic growth to further surprise to the upside forth rest of 2019 barring a remarkable recovery in global trade or in global auto demand.

 

EHGDEUY Index (Eurozone Real GDP 2019-05-03 06-44-13

 

Turning to equity markets and with the MSCI Europe Total Return Index up almost 14 per cent year-to-date in US dollar terms, the question is whether a broad exposure to European equity markets warranted?

 

The chart below compares the MSCI Europe Index to the year-over-year growth in European money supply M1 advanced by 12 month. (M1 is the ECB’s narrow measure of money supply which comprises only currency in circulation plus overnight deposits i.e. highly liquid money that can be spent immediately.)

 

Based on the chart below the European equity markets may already priced in the good news.

 

MXEU Index (MSCI Europe Index) E 2019-05-03 06-25-31

 

Another time series we chart against the MSCI Europe Index is the ratio of the narrow measure of money supply M1 to the broader measure of money supply M2, once again advanced by twelve months. Based on the comparison of the two time series, the historical relationship suggests that there may yet be upside in Europe still.

 

The historical relationship makes sense, as M1 expanding at a faster rate than M2 — the composition of money supply shifting from a less liquid form to a more liquid one — was a leading indicator for increased capital expenditures. This relationship, in our opinion, is not as robust as it used to be as the ECB has eliminated the opportunity cost for individuals and businesses in holding cash in demand deposits, rather than placing it in higher yielding time deposits. Two-year deposits yield as little as 3 basis points today while businesses could earn as much 120 basis points prior to the Global Financial Crisis and as much as 300 basis points during the Eurozone crisis.

 

MXEU Index (MSCI Europe Index) E 2019-05-03 06-31-54

Exposure to Euro Area equities should be based on bottom stock selection to identify value opportunities, in our opinion. While we think broad based equity exposure to non-emerging Europe should be avoided at this stage.

 

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.

 

 

 

Where do we go from here? Credit vs. Duration

 

“Wealth does not pass three generations.” — Ancient Chinese proverb

 

“Most people do not have a problem with you thinking for yourself, as long as your conclusions are the same as or at least compatible with their beliefs.”  — Mokokoma Mokhonoana

 

Duration or Credit Risk?

 

“Real estate and mortgage credit got us in so much trouble in 2007,” he said. “Next it’s going to be corporate credit, and the breakdowns are something we have to pay attention to.”

 

The above passage comes from an article in the Institutional Investor and quotes famed hedge fund manager Paul Tudor Jones. The article goes on to detail Mr Jones’s concerns around, what he describes as, a probable “global debt bubble”.

 

Global corporate borrowing reached  US dollars 13 trillion at the end of last year — more than double the level prior to the Global Financial Crisis.  The Paris-based Organisation for Economic Co-operation and Development (OECD) estimates that global corporations will need to repay or re-finance as much as US dollars 4 trillion in debt over the next three years.

 

Given the amounts involved, it comes as no surprise that Mr Jones is not alone in warning about the high levels of corporate debt being a potential systemic risk. Stanley Druckenmiller has been outspoken about it. Bank of America Merrill Lynch expects “corporates, not consumers or banks,” to be source of the next recession. Mr Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, cautioned in December 2018 that “the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors”.

 

PIMCO, one of the world’s leading fixed-income investment managers, being a little more sanguine than the aforementioned, started advocating a more selective approve to US corporate debt allocations at the start of 2018.

 

From PIMCO’s research piece published in January 2018:

 

Crucially, the share of the U.S. investment grade (IG) nonfinancial bond market that is rated BBB (i.e., the lowest credit rating still considered IG) has increased to 48% in 2017 from around 25% in the 1990s. Drilling down into the riskiest part of the BBB market segment, the universe of low BBB rated bonds is now bigger than that of all BB rated bonds (i.e., the highest-rated speculative grade bonds) combined.

 

[…]

 

We think investors may want to consider taking a more cautious and selective approach to BBB nonfinancial corporate bonds, particularly those in the low BBB rated segment where the risk of downgrades is higher and the room for error is lower. Of note, we are not advocating a generic underweight to BBBs, but rather suggesting a more selective approach in this environment. We still see opportunities in select BBB nonfinancials, especially in sectors with high barriers to entry, above-trend growth and strong pricing power.

 

 

PIMCO’s timing, in hindsight, was prescient. US corporate bond spreads bottomed, on a cyclical basis at least, in January 2018, having tightened through most of 2016 and 2017 on the back of a recovery in oil prices and then the enactment of the Trump Tax Cuts. Spreads blew out in the second half of 2018 as global risk-off sentiment gathered steam.

 

US Corporate BAA spreads to 10 year US Treasuries bottomed at around 150 basis points, approximately the same level as the pre-Global Financial Crisis low. Today, spreads are below 230 basis points, having partially retraced the move to above 250 basis points from late last year.

BICLB10Y Index (US Corporate BAA 2019-03-19 12-11-52.png

 

US High Yield spreads to 10 year US Treasuries bottomed at around 295 basis points, failing, however, to break their 2014 low of  approximately 230 basis points. Incidentally, high yield spreads bottomed around 230 basis points prior to the Global Financial Crisis as well. Presently, spreads stand at approximately 390 basis points, having come in from over 530 basis points at the end of 2018.

 

CSI BARC Index (BarCap US Corp H 2019-03-19 12-13-00.png

 

A catastrophic event, widely experienced or one reported on extensively, can scar the collective imagination. The scarring can in turn heighten the sensitivity of individuals or the collective to signs pointing to the possible recurrence of said catastrophic event.

 

In the run up to the Global Financial Crisis, the investment community was long, very long, corporate credit —  investment grade and high yield spreads were at or near multi-decade lows between 2005 and 2008. Following the Lehman bankruptcy, credit spreads spiked to multi-decade highs, leaving many investors nursing significant mark-to-market losses.

 

We are therefore not surprised that corporate debt is widely cited as a major risk to global markets in the event of a recession or another financial crisis.

 

What is often overlooked, however, is that investors, particularly institutional investors, were not long duration in the run up to the Global Financial Crisis — rather, it could be argued, they were quite possibly short duration. Using the 10 year US Treasury term premium as an indicator — the higher the term premium, the shorter the market is duration and vice versa — we can see term premium, in the below chart, rising rapidly in the two years running up to the Lehman bankruptcy, i.e. the market punishing duration.

 

ACMTP10 Index (Adrian Crump & Mo 2019-03-19 12-06-34.png

 

As we all know, those who had the wherewithal to remain long duration were rewarded most handsomely soon after the collapse of Lehman.

 

Today, term premium for 10 year US Treasuries is negative —  more than 70 basis points negative versus over 150 basis positive in 2007. If the next crisis or recession is unlike the last one, and it usually is, could it be that long duration, not long credit risk, is the pain trade?

 

When duration is punished, the entire spectrum of fixed income instruments feels the pain. In the next crisis there may be few places for coupon clippers to hide.

 

 

The Hypothetical Family Office

 

The story is clichéd but bears repeating.

 

A patriarch from humble beginnings and limited employment opportunities establishes a small business, works hard, starts employing relatives into the business and later his villagers. Benefiting from macroeconomic tailwinds and nonexistent competition, the business expands at a rapid pace and starts spitting out cash the patriarch continues to put back into the business.

 

As the patriarch grows older, he encourages his children to join the business. In this instance, the patriarch has three sons. The first, having grown up when his family had little wealth, shows no interest and is far more concerned with spending his father’s newfound wealth than increasing it. The second, having had a comfortable, if not luxury laden, upbringing, wants to prove his worth and is eager to join his father in his entrepreneurial pursuits. The third, still young and having experienced little else except luxury, pursues formal education  at a school surrounded by the scions of other business magnates.

 

After decades of re-investing in the business and expanding it across the country, comes a point where the cash being generated by the business far overwhelms any of its investment needs. So the patriarch did, what any wealthy man in any developing economy has done over the last five decades, invests in real estate and then appoints his second son to manage and grow the real estate portfolio.

 

Real estate prices witness a parabolic rise over the next decade, driven by rapid population growth, urbanisation and lack of avenues to direct excess capital as local capital markets remain underdeveloped.  The income from the family’s real estate portfolio exceeds that of the patriarch’s original business.

 

Come the late-1990’s, the third son graduates from university and joins the family business with fresh ideas and aspirations. He tries to convince his father and elder brothers to establish a family office and diversify wealth across geographies and asset classes. The second son averse to change, urges his father to stick to what they know and not to pursue the third son’s ideas. The third son, being his father’s favourite, however, is able to get his way. A family office is established, the second son continues to manage real estate and the third son is given a small amount of capital to diversify the family’s wealth.

 

As the first order of business, the third son feels that his family must gain some exposure to the dot.com boom. He connects with private bankers to help him  allocate small amounts of capital to venture capital and technology funds.  Just as the family’s capital is deployed into these funds, the tech bubble bursts and the funds are quickly marked down to zero. Mistake number 1.

 

The second son gains the upper hand and continues expanding the family’s real estate portfolio. The ageing patriarch with little ambition to manage his original business decides to take a step back, handing over the business to his sons. The sons enamoured by the world of investing, show little appetite for day-to-day operations. Instead, with the local capital markets starting to take off and growing public interest in stocks, the family appoints an independent management team, lists the business on the local stock market and enjoys a cash windfall. They are no longer millionaires, but multi-billionaires. It is now the mid-2000’s.

 

The losses from the tech-bubble long forgotten, the third son is given purview over some of the windfall profits. Erring on the side of caution this time, he engages the services of strategy consultants and investment consultants. Their advice is to allocate capital to big-name private equity and real estate managers. Capital is allocated to the likes of Kohlberg, Kravis & Roberts, Carlyle Group, JP Morgan and Goldman Sachs, amongst others, albeit it through private wealth management structures loaded with upfront and hidden fees.

 

The timing of allocations was not great but not spotting the hidden fees was criminal. Eventually, the returns were respectable gross of fees but atrocious on a net basis. Mistake number 2.

 

With large amounts of dry powder still at his disposal, the third son starts directly and aggressively investing the family’s wealth into the financial services sector — “look at the return on equity financial institutions enjoy,” he said.

 

Come the back end of 2008, Lehman Brothers goes bankrupt and those high returns on equity are history.  Mistake number 3.

 

In 2011, the third sons starts investing small amounts of capital into biotechnology start-ups, directly not through funds — “we are investing alongside brand name venture capital funds without paying fees” he said. As it often happens, start-ups burn through cash and need to raise more capital. Not wanting to be diluted, the family participates in each subsequent round of financing. Come 2014 the handful of biotech start-ups are no longer small investments, rather the family is even the single largest shareholder in some instances.

 

In 2015, the biotech bubble pops and all of the start-ups invested in by the family prove to be duds. Mistake number 4.

 

In 2019, the family office allocated capital to venture capital funds for the first time since their late 1990’s debacle. 

 

Everything in the above tale is true, except for the family office being hypothetical.

 

 

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.

 

 

 

 

 

 

 

 

 

 

 

 

Environmental Concerns: Ideas on the Long Side

 

I met a traveller from an antique land,
Who said—“Two vast and trunkless legs of stone
Stand in the desert. . . . Near them, on the sand,
Half sunk a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal, these words appear:
My name is Ozymandias, King of Kings;
Look on my Works, ye Mighty, and despair!
Nothing beside remains. Round the decay
Of that colossal Wreck, boundless and bare
The lone and level sands stretch far away.”

— Ozymandias by Percy Bysshe Shelley

 

In this week’s piece we discuss the Paris Agreement — a global accord signed in 2015 with the aim of mitigating global warming —  and the progress made on curbing carbon emissions since the signing of the accord. We also identify two long ideas in the clean & renewable energy and waste management sectors. Finally, we briefly touch upon the surge in Chinese credit growth during January.

 

Environmental Concerns

 

On 12 December 2015, at COP 21 in Paris, the 190-plus parties to the United Nations Framework Convention on Climate Change (UNFCCC) signed onto the Paris Climate Agreement, which committed countries to do their best “to combat climate change and to accelerate and intensify the actions and investments needed for a sustainable low carbon future“.

The agreement was seen as  “a turning point in the history of common human endeavour, capturing the combined political, economic and social will of governments, cities, regions, citizens, business and investors to overcome the existential threat of unchecked climate change“.

Three years since the Paris accord was negotiated,  we were amazed to learn that there has been no reduction in global emissions. In fact, there has not even been a decline in the rate of increase in emissions. Much rather, the rate at which emissions are being added to the atmosphere has increased!

Coal-fired power generation is still increasing — coal powered plants continue to be built and existing plants are not being removed as fast as new ones are being added.

What has gone wrong?

The lack of progress since Paris is attributed, by some, to the opacity of pledges made in the agreement, and the parties to the agreement remaining vague on the specific policies they will adopt to meet them. Further, there is no official mechanism for measuring progress.

The governing body and framework for the agreement, we think, are both highly bureaucratic and politicised. As is their wont, politicised bureaucracies are as much about not offending their stakeholders as they are about effective governance, if not more. The implications of this, we think, are that the goals of the Paris Agreement are likely to prove far too ambitious and meaningful, if any, progress on curbing global emissions will have to be made through the participation of the private sector.

The private sector, however, is unlikely to participate of its own volition. Rather, the powers that be, as ever, will need to create incentives, if, of course, they want profit seeking enterprises to participate in the mission to curb global emissions. Incentives can come in the form of regulations —  a cost of doing business, per say — or rewards — profits or higher relative valuations.

Higher relative valuations would be a result of supranational, multi-lateral and public institutions limiting their investment allocations to securities of companies adhering to a set of predefined environmental, social and governance (ESG) standards. Thereby increasing the relative demand for ESG-compliant securities ipso facto a higher relative valuation to  that of non-compliant securities.

 

Ideas on the Long Side

 

Below we highlight two stocks we consider to be interesting  potential long-ideas in the clean & renewable energy and waste management sectors below.

Advanced Emissions Solutions $ADES

Advanced Emissions Solutions is an emissions solutions provider with a focus on mercury and gas control solutions for coal-fired power plants in the United States. The company supplies electric coal-fired generation facilities with systems that chemically pre-treat various types of coal prior to the burn process. It also up sells  existing customers by providing consulting services and chemicals used to remove mercury and other hazardous airborne pollutants from the emissions resulting from the burning of coal.

The company supports coal-fired electric generation facilities in complying with the United States Environmental Protection Agency’s Mercury and Air Toxics Standards (MATS) for Power Plants.

$ADES has a market capitalisation of US dollars 233 million, trades at estimated 2018 price-to-earnings of 6.5 times and dividend yield of 8.5 per cent.  Short interest in the company is high at more than 11 per cent of free float.

 

ADES US Equity (Advanced Emissio 2019-02-19 14-33-04.jpg

 

Heritage Crystal Clean $HCCI

Heritage-Crystal Clean is a US-centric company that helps businesses clean parts and dispose of highly regulated waste materials, such as cleaning solvents, used oil, and paint, that cannot be discarded through municipal trash systems or standard drains. Customers, primarily small to midsize companies, include car dealerships, auto repair shops, trucking firms, and manufacturers such as metal fabricators. $HCCI serves customers in 42 states in the central and eastern US.

$HCCI has a market capitalisation of US dollars 600 million, trades at a rich valuation of estimated 2018 price-to-earnings of 36 times. The company, however, has a strong growth profile with earnings estimated to increase by more than 70 per cent in 2019.

 

HCCI US Equity (Heritage-Crystal 2019-02-19 14-54-41.jpg

China: Soaring Credit Growth

 

From Bloomberg:

 

China’s credit growth exceeded expectations in January amid a seasonal lending surge at the start of the year.

  • Aggregate financing was 4.64 trillion yuan ($685 billion) in January, the People’s Bank of China said. That compares with an estimated 3.3 trillion yuan in a Bloomberg survey
  • Financial institutions made a record 3.23 trillion yuan of new loans, versus a projected 3 trillion yuan. That was the most in any month back to at least 1992, when the data began

 

The Chinese leadership’s efforts to reinvigorate credit growth and support economic activity in the latter half of 2018 may be beginning to bear fruit. Credit growth, in January reached 10.6 per cent  year-over-year — welcome relief given the less than stellar showing in the latter half of last year.

The data from January is the first sign that the Chinese credit cycle may have bottomed out.

Chinese banks originated new loans amounting to CNY 3.23 trillion, increasing by more than 13 per cent year-over-year and setting a new monthly record in the process. The reading was well above both the CNY 1.08 trillion distributed in December and market expectations of CNY 2.80 trillion.

Net corporate bond issuance came in at CNY 499 billion, the highest level in almost in three years. As impressive as this may seem, state-owned enterprises accounted for more than nine tenths of gross corporate bond issuance.  Suggesting that Beijing’s recent calls for banks to provide greater support to the private sector has not yet had the desired effect. Moreover, credit growth tends to be higher in January, and ahead of the Chinese New Year. We will not be surprised if February data is less encouraging and only expect greater clarity after March.

If, indeed, credit growth remains strong over the coming months, it will still take time to show up in economic data. Typically, a spike in Chinese credit growth has led a corresponding spike in domestic demand by nine months. We still expect first quarter data to be weak as exporters suffer a hangover from the fourth quarter rush to get US orders out ahead of the original tariff hike deadline.

Nonetheless, early indications from credit growth and the looser monetary policy stance of the People’s Bank of China are of Chinese economic activity, as we have posited previously, to get incrementally better, not worse, in 2019.

 

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Investment Themes and Considerations for 2019

 

“Every man is the smith of his own fortune.” – Iranian proverb

“Time is like a sword: if you don’t cut it, it cuts you.” – Arabic proverb

Contents

  • Global Liquidity
    • Enhancers
    • Depressants
  • Investment Themes
    • Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?
    • US Dollar: What Will the US Treasury Do?
    • China: Incrementally Better, Not Worse
    • Emerging Markets: Relief Not Reprieve
    • Semiconductors: Led On the Way Down, To Lead On the Way Up?
    • Saudi Arabia: Emerging Market Indices Inclusion
  • Outsiders for Outsized Returns
    • Triunfo Albicelestes
    • Data Driven Dystopia: “The monetization of every move you make”
  • Books
    • Five We Have Read and Recommend
    • Five from Our 2019 Reading List

Note: Our comparable piece from 2018 can be found here.

This post runs quite long, if you prefer you can click here to download the PDF.

 

Global Liquidity

 

As we reflect back on 2018, the year, in a capital markets context, was defined, in our view, by the charging and retarding forces acting upon global liquidity. On the one hand we had the tax reform driven liquidity enhancers, on the other a host of liquidity depressants, including monetary policy driven tightening, pseudo-capital controls under the guise of anti-graft measures, rising interest rates and high oil prices.

In the words of Thomas Joplin, the nineteenth century British banker and merchant,  “A demand for money in ordinary times, and demand for it in periods of panic, are diametrically different. The one demand is for money to put into circulation; the other for money to be taken out of it”.

Last January, with global stock markets off to their best start in more than three decades, the world was in the midst of demand for money to be put into circulation far outstripping demand for it to be taken out of circulation. From October through to the end of the year, as markets witnessed a sharp sell-off, demand to take money out far outweighed the demand to put it back. While in the intervening months between January and October, dominance waxed and waned between the two opposing forces.

 

Enhancers

One of the leading sources of liquidity in 2018 was US companies’ accelerated contributions to their respective defined-benefit pension schemes. The Republican Party’s tax reforms gave American corporations till mid-September of last year to benefit from the higher 35 per cent corporate tax rate when deducting their pension plan contributions from their tax bill. US Companies making contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference last year was that the value of the deduction fell to 21 per cent following the mid-September deadline.

Pension plan contributions by companies in the Russell 3000 Index are estimated to have topped US dollars 90 billion through mid-September last year – more than 10 times the contributions made the year before.

The other major source of liquidity was also motivated by US tax reforms. The reforms, by subjecting US corporations’ offshore profits to a one-time tax of 15.5 per cent on cash and 8 per cent on non-cash or illiquid assets, eliminated the incentive to keep money offshore. In response, US multinationals are estimated to have repatriated more than US dollars 500 billion last year, a significant portion of which went toward share buybacks. The flow of money was not evenly spread throughout the year, however. Corporations repatriated the vast majority of the funds in first half of the year with the amount of cash being brought back dropping off sharply in the second half of the year.

 

Depressants

There were many forces working to suck liquidity out of and impede the flow of capital through the global monetary system.

1. Oil and US Interest Rates

Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global monetary system and the other fuels everything else. Barring a toppling of the US dollar hegemony or till such time when the dominance of oil as the world’s primary energy resource diminishes meaningfully, the global economy is unlikely to enjoy prolonged and synchronised economic growth in an environment in which US interest rates are rising and oil prices are high.

In the more than 30 years between end of May 1988 through December 2018, the US 10-year treasury yield and the oil price have simultaneously been above their respective 48-month moving averages for less than a fifth of the time. And only on six occasions have the two prices remained above their respective 48-month moving averages for 5 or more consecutive months. (The periods when both prices are about their respective 48-month moving averages are highlighted in grey in the two charts below.)

US 10-year Treasury Yield 10YSource: Bloomberg

West Texas Intermediate Crude Price per BarrelOilSource: Bloomberg

2. Policy Driven Tightening

The two dominant liquidity centres of the world, the US and China, moved in 2018 to rein in animal spirits and tighten monetary conditions.

In China, the Communist Party’s, in a bid to bridle systemic risks, clamped down on shadow finance. The tightening of credit conditions, however, has thrown up an interesting twist: interest rates, as opposed to increasing as would be expected, have declined.

China Shadow Financing Growth Year-over-YearChina Shadow FinanceSource: Bloomberg

In the US, the Treasury upped issuance of short-term debt to replace maturing long-term bonds just as long-term issues were being worked off the Fed’s balance sheet through quantitative tightening.

The potential ramifications of quantitative tightening and increased Treasury bill issuance bubbling under the surface are difficult to assess. In a monetary system governed by the hitherto untested Basel III framework and the many policy tweaks enacted by the Fed, such as money market fund reform and setting the interest on excess reserves below the upper band of the feds fund rate, following the Global Financial Crisis, it is difficult to grasp what, if any, hiccups there will be in the transmission of monetary policy as the Fed continues to drain reserves from the banking sector.

Nonetheless, the tightening policies employed by the Fed and the People’s Bank of China, have squeezed global liquidity. Using year-over-year growth in money supply (M2) across the US, China and Europe, as a proxy, we can see global liquidity growth fell to multi-decade lows in 2018.

Global Money Supply Growth vs. MSCI ACWI and EM Indices Money SupplySources: Bloomberg, European Central Bank

3. Anti-Graft

A number of governments across the world have, in recent years, taken drastic measures to crackdown on corruption and the outflow of illicit funds from within their borders. We share a few examples below.

India

In 2016, in a bid to curtail corruption and weaken its shadow economy, the Indian government announced the demonetisation of all Indian rupees 500 and 1,000 banknotes. It also announced the issuance of new Indian rupees 500 and 2,000 banknotes in exchange for the demonetised banknotes. What transpired following the announcement was as, if not more, surprising than the government’s demonetisation scheme: an estimated 93 per cent of the old notes made into the banking system.

With most of the notes flowing into the banking system, they were now unsullied, legal tender. And little need for capital to flow out of India illegally through the hawala system to be held out of reach of the government remains.

Saudi Arabia

In November 2017, the Saudi government famously rounded up, amongst others, wealthy Saudi businessmen, government officials and members of the royal family in the glitzy Ritz Carlton hotel in Riyadh as part of its anti-corruption campaign. Little of what transpired within the boundaries of the five-star hotel has been confirmed by official reports. We do, however, know that billions of dollars of assets moved from private asset pools to the Saudi government’s coffers.

China

China, under the leadership of President Xi Jinping, has been pursuing a far-reaching campaign against corruption. Since the campaign started in 2012, Chinese authorities have investigated more than 2.7 million officials and punished more than 1.5 million people, including seven national-level leaders and two dozen high-ranking generals.

As governments across the world have cracked down on corruption and elicited the support of regulators across global financial centres, price insensitive bids for real estate across New York City, London, Sydney and Vancouver have started to dry up. The best gauge of the liquidity impact of the anti-graft measures described above, we think, is Dubai. Long a magnet for Russian, Chinese, Indian, Saudi and Iranian capital, amongst others, Dubai had one of worst performing equity markets globally in 2018.

Dubai Financial Market General Index DFMSource: Bloomberg

In summary, as the forces propelling global liquidity petered out over the course of last year, the squeezes on liquidity overwhelmed global financial markets taking down one market after the other, culminating with the dramatic end to the long-running US equity bull market in December.

 

Investment Themes

 

Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?

 One time series that has intrigued us over recent weeks and months is that of the ratio of MSCI All Cap World Ex-US Index (RoWI) to the S&P 500 Index (SPX). The chart below is a plot of the month-end ratio of the two indices from December 1987 through December 2018. (A rising line indicates the RoWI is outperforming the SPX while a falling line indicates the SPX is outperforming the RoWI.)

Superimposed on the chart are the Fibonacci projection levels based on the relative high of the RoWI, occurring in July 1988, and cyclical low of the ratio recorded in October 1992. (You can learn more about Fibonacci projections here.)

Ratio of the MSCI All Cap World Index Ex-US to the S&P 500 IndexROWUSSource: Bloomberg

From a long-term perspective, the drastic under performance of equity markets in the rest-of-the-world relative to the US equity market is obvious. Looking at the above chart, however, we cannot help but feel that a cyclical upturn for the rest-of-the-world is due.

The question then is: What would prompt a correction in the secular trend? We think the answer is a ramp up in global infrastructure investment led by infrastructure diplomacy programmes.

The most marketed, and some might say most notorious, infrastructure diplomacy programme is China’s Belt and Road Initiative. The initiative encompasses the construction of two broad networks spanning four continents:

  • The “Silk Road Economic Belt”: A land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and
  • The “Maritime Silk Road”: A network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

The Belt and Road Initiative, however, is not the only global infrastructure investment program in existence today. In 2015, worried by China’s growing influence in Asia, Japan first unveiled its “Partnership for Quality Infrastructure” initiative as a US dollar 110 billion investment programme targeting Asian infrastructure projects. In 2016, the initiative was expanded to US dollars 200 billion and to include Africa and the South Pacific.

In October 2018, the US Senate joined the US House of Representatives in passing the Better Utilization of Investment Leading to Development bill (or Build Act), a bipartisan bill creating a new US development agency –  the US International Development Finance Corporation (USIDFC). The passing of the Build Act is being hailed by many as the most important piece of US soft power legislation in more than a decade.

The USIDFC has been created with the goal of “crowding in” vitally needed private sector investment in low and lower-middle income countries. The agency, endowed with US dollars 60 billion in funding, is being positioned as an alternative to China’s Belt and Road Initiative, which has at times been described as nothing more than “debt trap diplomacy”.

We think if the three distinct initiatives propel infrastructure investment across the developing economies and help them integrate into the global economy, create jobs and gain access to much needed hard currency, the rest-of-the-world can once again enjoy a prolonged period of out performance.

Investors, particularly those with an investment horizon of at least three years, should gradually reduce exposure to the US and reallocate it to the rest-of-the-world.

  

US Dollar: What Will the US Treasury Do?

When the US Treasury issues bills and increases its cash balances in the Treasury General Account at the Federal Reserve Bank of New York, it inadvertently tightens monetary conditions in the global banking system.

For the period starting September 2017 through April 2018, the US Treasury did just that. It increased cash balances with the Fed from under US dollars 67 billion at the end of August 2017 to US dollars 403 billion by end of April 2018. (At the end of last year, cash balances with the Fed stood at US dollars 368 billion.)

The increase in the US Treasury’s cash balances was offset by the loss of an equivalent amount of reserves and / or deposits by the US banking system.  Thereby tightening monetary conditions and reducing the availability of US dollars.

The last time the US government faced the prospect of a shutdown, the US Treasury started drawing funds from its cash balances with the Fed to pay for entitlements and other government expenditures. The US Treasury’s Cash balances held with the Fed went from US dollars 422 billion at the end of the October 2016 down to US dollars 63 billion by the end of March 2017. The release of US dollars into the global banking system provided much needed relief, stimulated global risk appetite and weakened the greenback.

 

US Treasury General Account vs. US Dollar Index $DXY TGASources: Bloomberg, Federal Reserve

 

With the US government shutdown triggered by President Trump entering its third week and with little sign of progress in talks between the Democrats and the Republicans, the US Treasury may once again have to draw down on its cash balances with the Fed. If this does transpire and is similar in scale to the previous draw down, it could again stimulate risk appetite and weaken the US dollar.

We are bearish on the near-term (six to nine month) prospects of the US dollar.

 

China: Incrementally Better, Not Worse

 The year has barely started and the People’s Bank of China has already announced the first reserve ratio (RRR) cut of the year, a full percentage point reduction. Unlike previous RRR cuts in 2018, the latest move is a two-step reduction, effective on January 15 and January 25.

This RRR cut will release approximately Chinese yuan 1.5 trillion in liquidity, part of which will replace maturing medium-term lending facilities during the first quarter. On a net basis, the cut is equivalent to Chinese yuan 800 billion in easing.

On the fiscal stimulus side, the government has already approved new rail projects amounting to US dollars 125 billion over the course of the last month. Beijing refrained from stepping up fiscal spending in 2018. With a slowing economy and the on-going trade dispute with the US, however, the government appears to have greater willingness to loosen the purse strings in 2019.

Beijing, in a bid to shore up credit creation, is even allowing local governments to bring forward debt issuance.

Manufacturing data coming out of China is likely to get worse before it gets better – a hangover from US companies’ accelerated orders to build inventories ahead of the initial 1 January deadline for tariff increases. Nonetheless, given that the official policy stance has now tilted towards easing, we expect Chinese economic activity to improve, not worsen over the course of 2019.

Throw in the prospect of MSCI quadrupling the inclusion factor of Chinese A-shares in its emerging markets index and there is a strong possibility Chinese A-Shares break out of their bear market in 2019.

 

Emerging Markets: Relief Not Reprieve

A sharp drop in oil prices, a pause in the US dollar rally, signs of increasing fiscal stimulus in China and retreating long-term Treasury yields are providing emerging markets much needed relief. While the structural challenges, particularly on the funding side, faced by many of the emerging economies are unlikely to be resolved soon, the welcome liquidity relief can certainly provide tradable opportunities for investors.

Moreover, as we noted in December, emerging markets have been outperforming US markets since early October, which may well provide further impetus for asset allocators to re-consider exposures and potentially exchange some of their US exposure in favour of emerging markets.

Ratio of the MSCI Emerging Markets Index to the S&P 500 IndexEMSPXSources: Bloomberg

The simple play is to be long the iShares MSCI Emerging Markets ETF $EEM. And in times of either euphoria or despair, it can prove to be the right choice as there can often be little to distinguish between constituent level returns. Nonetheless, with the rise of China’s tech giant, we think $EEM has become both too tech and too top heavy.

For broad-based exposure we prefer being long dedicated emerging market asset manager Ashmore Group $ASHM.LN. In terms of country selection we prefer being long Russia $ERUS and Indonesia $EIDO. We would also like to be long Hungary, opportunities for direct exposure to the country are, however, limited and is instead better played with some exposure to Austria $EWO.

  

Semiconductors: Led On the Way Down, To Lead On the Way Up?

 We were bearish on the prospects of semiconductor stocks for the better part of 2018. With technology at the centre of China’s trade conflict with the US, and no technology more critical than semiconductors, our thinking was that production capacities, led by China, would rise faster than the market was pricing in.

While China has made headway in gaining market share in the more commoditised segments of the semiconductor market, it has failed to catch up with the leading chip companies in the world. The top-end of the semiconductors market remains tightly controlled by a handful of players.

The Trump Administration’s security hawks and a slowing China, however, have, we think, had a far greater impact on the sharp drop in chip prices than the increases in production capacities.

With valuations for the constituents of the Philadelphia Stock Exchange Semiconductor Index $SOX having corrected significantly and a lot of doom-and-gloom reflected after Apple’s guidance cut, we think semiconductors are well-placed to surprise to the upside in 2019.

  

Philadelphia Stock Exchange Semiconductor Index Trailing 12 Month P/E RatioSOXPESource: Bloomberg

Moreover, if there is to be a favourable outcome to the trade related negotiations between the US and China, we suspect China will pony up to reduce its trade surplus with the US by offering to buy more chips.

 

Saudi Arabia: Emerging Market Indices Inclusion

Ignoring the human rights grievances, the fallout from the murder of Washington Post columnist Jamal Khashoggi, and the sharp drop in the price of oil, we weigh the opportunity of investing in Saudi Arabia based purely on a technicality. That technicality being the inclusion of Saudi Arabia into the FTSE and MSCI emerging market indices in 2019.

Based on broker estimates, passively managed assets of greater than US dollars 15 billion are expected to flow into the Saudi equity market on the back of the inclusions. The vast majority of these passive flows are set to materialise during the first half of 2019. Given the size of flows relative to average daily traded values of less than US dollars 1 billion, the passive flows can move the needle in a market with few other positive catalysts.

We remain long the iShares MSCI Saudi Arabia ETF $KSA.

Outsiders for Outsized Returns

 

Here we discuss investment ideas that we think have an outside chance of generating outsized returns during 2019. We see these opportunities as cheaply priced out-of-the-money call options that may warrant a small allocation for those with a more opportunistic disposition.

Triunfo Albicelestes

Argentina, to put it mildly, has a chequered history when it comes to repaying its creditors. It has defaulted on its external debt at least seven times and domestic debt five times in the 202 years since its independence.

Argentina first defaulted on its sovereign debt in 1827, only eleven years after gaining independence from Spain. It took three decades to resume payments on the defaulted bonds.

The Baring Crisis, the most famous of the sovereign debt crises of the nineteenth century, originated in Argentina – at a time when Argentina was a rich nation and its credibility as a borrower had been restored. Argentina had borrowed heavily during the boom years of the 1880s and Britain was the dominant source of those funds. The flow of funds from Britain was so great that when Argentina defaulted on its obligations in 1890, the then world’s largest merchant bank, Baring Brothers & Co., almost went bankrupt. Had it not been for intervention by the Bank of England, the British lender would have been long gone before Nick Leeson came along a century later.

In 1982, Argentina once again failed to honour its external debt obligations and remained in default for almost a decade. Its emergence from default was made possible by the creation of Brady bonds – a solution proposed by then US Treasury Secretary Nicholas Brady as a means for debt-reduction by developing nations.

In the 1990’s Argentina kept piling on debt until it finally defaulted on around US dollars 80 billion of obligations in 2001, which at the time was the largest sovereign default ever. The government managed to restructure 93 per cent of the defaulted debt by 2010; however, Paul Singer’s Elliot Management famously held out and kept Argentina exiled from international debt markets for a further six years. Argentina returned to the bond market in 2016 after settling with the hedge fund and bringing to an end a long-running saga, which saw Paul Singer take extreme measures such as convincing Ghanaian courts to seize an Argentinian navy vessel so it could collects on its debt.

The lessons from Argentina’s history of defaults, however, were quickly unlearned by capital markets. In little more than a year after its return to the bond markets, Argentina successfully pulled-off the sale of a 100-year bond in 2017. The good times did not last very long, however. In August 2018, Argentina was heading to the IMF cap-in-hand requesting the early release of a US dollars 50 billion loan. By end of September the IMF had increased the debt-package to US dollars 57.1 billion – making it the biggest bailout package ever offered by the IMF.

After running through Argentina’s history of debt defaults and at a time when it may appear that its future is bleak, we are here to tell you that Argentina has the foundations in place to surprise to the upside.

The days of “Kirchnerismo”, the legacy of Cristina Fernández de Kirchner’s and her late husband Néstor’s  twelve years in power, defined by the concentration of power, unsustainable welfare programmes and fiscal profligacy shrouded under the guise of nationalism, are gone. President Mauricio Macri’s willingness to chart a new course, armed with a robust IMF bailout package, we think, can help revive the Argentinian economy.

What is transpiring in neighbouring Brazil, too, has potential spill over effects on Argentina. If newly elected president Mr Jair Bolsonaro remains true to his word, Brazil is likely to pursue a reformist economic agenda that liberalises the economy from the statist policies that were the mainstay of the Workers’ Party’s rule. If the economic reforms spur growth in Brazil, Argentina should benefit – Brazil is, after all, Argentina’s largest trading partner.

President Bolsonaro’s external agenda is also likely to diverge from that of his predecessors. He has openly criticised China – Brazil’s largest trading partner – and expressed a desire to forge closer ties with the US. If Brazil pivots towards the US, Argentina, as South America’s second largest economy, is likely to be wooed aggressively by China. China’s ambition to dilute the US’s influence in Latina America is an open secret. In China’s bid to acquire influence, Argentina is well placed to attract investments from Beijing.

There are many ways to play this theme be it through the bond market, the currency or the equity market. For the average equity market investor the easiest way to gain exposure is probably through the Global X MSCI Argentina ETF $ ARGT.

Data Driven Dystopia: “The monetization of every move you make

From The New Yorker’s article “How the Artificial-Intelligence Program AlphaZero Mastered Its Games”:

“David Silver, the head of research at DeepMind, has pointed out a seeming paradox at the heart of his company’s recent work with games: the simpler its programs got—from AlphaGo to AlphaGo Zero to AlphaZero—the better they performed. “Maybe one of the principles that we’re after,” he said, in a talk in December of 2017, “is this idea that by doing less, by removing complexity from the algorithm, it enables us to become more general.” By removing the Go knowledge from their Go engine, they made a better Go engine—and, at the same time, an engine that could play shogi and chess.”

As the leading tech companies have ramped up investments in developing their artificial intelligence – or machine learning, if you prefer – capabilities, what has started to become apparent is that data not algorithms hold the keys to success. The companies that collect the most and best data, not the ones that develop the most sophisticated algorithms, are likely to reap the greatest rewards from investing in artificial intelligence.

One, much maligned, ‘wearables’ company that has been tracking and collecting data on its users’ movements for many years, with little to show for it, is Fitbit Inc. $FIT. The company has fallen out of favour amongst investors ever since the launch of the Apple Watch – particularly after Apple’s health and fitness pivot following the launch of Series 2.

We think $FIT is a viable acquisition target for Amazon.

Amazon, through the Echo, is already collecting data at home and could close the data loop with an acquisition of $FIT. $FIT’s wrist bands and watches can be integrated with Alexa and with a little investment be upgraded to better compete with the Apple Watch. Moreover, Amazon could feature $FIT’s products front and centre on the most valuable retail real estate in the world – Amazon’s homepage.

 

Books

Five We Have Read and Recommend

  1. Monetary Regimes and Inflation: History, Economics and Political Relationships by Peter Bernholz
  2. Time to Start Thinking: America in the Age of Descent by Edward Luce
  3. Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts by Annie Duke
  4. The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor
  5. Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Five from Our 2019 Reading List

  1. Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze
  2. The Volatility Machine: Emerging Economies and the Threat of Financial Collapse by Michael Pettis
  3. Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
  4. The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox
  5. These Truths: A History of the United States by Jill Lepore

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Charts and Updates

 

Zé Pequeno: Can you read?

Gang Member: I can read only the pictures.”

City of God (2002) directed by Fernando Meirelles and Kátia Lund

 

“Yet in opinions look not always back,–
Your wake is nothing, mind the coming track;
Leave what you’ve done for what you have to do;
Don’t be “consistent,” but be simply true.”

Oliver Wendell Holmes Sr. 

 

This week’s piece is  lighter in words, heavier in charts. As we begin looking forward to 2019 we share some recent market developments that have caught our attention. For now there are more questions and observations than there are answers and actions.

 

Before getting to the charts, a few updates related to topics we have written about in the recent past.

 

Updates

 

1. President Trump has named US Trade Representative Robert E. Lighthizer to lead trade negotiations with China following the post-G20 meeting between President Trump and President Xi

 

From the Wall Street Journal:

 

President Trump named a China hard-liner to lead negotiations with Beijing, indicating the U.S. will pursue a tough stance in what is bound to be contentious talks over a trade dispute that has sent shivers through global markets.

 

Mr. Trump informed Chinese President Xi Jinping of his choice of Robert Lighthizer at their Saturday meeting in Buenos Aires, people familiar with the discussions said, pointing several times to the U.S. Trade Representative as the person who will face off with Beijing’s diplomats and using Mr. Lighthizer’s charts in presentations.

 

The remarks came as a surprise to a Chinese leadership that had maneuvered for months to deal with Treasury Secretary Steven Mnuchin, who had led initial rounds of talks, but failed to resolve the dispute over the past year.

 

The post-G20 niceties did not last very long and the positive developments of trade negotiations have unravelled rather quickly. The appointment of China hawk Robert E. Lighthizer to lead negotiations, we think, is a clear signal of intent by the Trump Administration – there is unlikely to be a breakthrough in US-Chinese trade talks any time soon.

 

Matters have deteriorated even further with arrest of Meng Wanzhou, Huawei Technologies’s chief financial officer and daughter of the company’s founder, by Canadian authorities in Vancouver at the request of the US. US authorities allege that Ms. Meng and Huawei violated economic sanctions placed on Iran and have submitted an extradition request for Ms. Meng.

 

The arrest aside, if the US government moves to sanction Huawei, it will be hurting US businesses such as Micron, Microsoft and Qualcomm, which count Huawei amongst their major customers. It will not be the first time the Trump Administration directly harms US corporate interests in its bid to punish China for the violation of sanctions or for intellectual property theft.

 

In October, the US Commerce Department placed export controls on American companies to restrict them from selling software and technology goods to Fujian Jinhua Integrated Circuit. Fujian Jinhua is a semiconductor startup supported by the Chinese government as part of the efforts to develop its own semiconductor industry.

 

Investors should avoid investing in American B2B technology, aerospace and defense companies with significant commercial interests in China. 

 

2. Intel: The next company to be “Amazoned”?

From Bloomberg (emphasis added):

 

Amazon.com Inc. has taken a big step toward reducing reliance on Intel Corp. for a critical component of its cloud-computing service.

 

The largest cloud company unveiled its own server processors late Monday and said the Graviton chips will support new versions of its main EC2 cloud-computing service. Until now, Amazon — and other big cloud operators — had almost exclusively used Intel Xeon chips.

[…]

 

Intel processors run more than 98 per cent of the world’s servers, and owners of massive data centers such as Amazon, Microsoft Corp. and Google have become some of its biggest customers. While these internet giants have driven down the price of most components by doing a lot of their own engineering, Intel’s Xeon chips have resisted that pressure. The average selling price of these processors has risen over time, something that almost never happens in the electronic industry.

 

As Jeff Bezo’s famously said: “Your margin is my opportunity.”

 

Charts

 

1.  Watch the 48 month moving average of gold

The logarithmic chart of the price of gold:

XAU 48M

 

Gold has been flirting with its 48-month moving average for more than 18 months. If it can get above the moving average and gather some momentum. We would be buyers of gold.

 

In the second panel in the chart below, we can see, using the 48-month rate of change in the price of gold, the barbarous relic has failed to gather momentum in recent months. A step up (down) in momentum would be quite bullish (bearish) given the relative narrowness of the trading range over the last three years.

 

XAU ROC.png

 

Gold has once again started out performing the broader commodity complex (the chart below is the price of gold divided by the CRB spot commodity index) after under performing during the first half of the year.

 

Over the longer-term, we can see the start of gold’s out performance over the commodity index dates back to late 2005 and the trend remains in favour of gold for now.

 

XAU CRB

 

2. The US dollar is losing momentum despite its strength

The dollar index $DXY is right above its 48-month moving average, having intermittently broken below it at the start of the year. The greenback, however, is losing momentum (second panel) with the 48-month rate of change making lower highs despite the continued strength in the dollar.

 

DXY ROC.png

 

3.  Emerging markets have been out performing the S&P 500 since early October

Emerging markets hit their recent lows at the end of October (top panel) but started outperforming the S&P 500 starting early October (bottom panel).

 

Coincidentally, emerging market out performance started soon after the deadline for tax-breaks for pension contributions by US corporations passed. Pension contributions made through mid-September of this year were deductible from income on tax returns being filed for 2017 — when the US corporate tax rate was still 35 per cent as compared to the 21 per cent in 2018. This one-time incentive encouraged US corporations to bring forward pension plan contributions and is likely to have had an out sized impact on US assets relative to non-US assets.

 

MXEF.png

 

Whilst not definitive by any means, the gold, US dollar and emerging markets charts, we think, appear to be sending the same message: weaker dollar, stronger commodities and non-US markets out performance relative to US markets.

 

4. Despite all the bad news, China too has stopped under performing the US

The signal from China is the weakest but follow through has the potential to be the strongest across emerging markets.

 

Chinese markets have remained above mid-October lows despite all the bad news in recent weeks. If the lows hold, we suspect China is likely to outperform the US in 2019.

 

SHCOMP.png

 

5. In the US, it is time to sell the rallies in growth to re-balance to value

The below chart shows the ratio of the S&P 500 Growth Index to the S&P 500 Value Index. Given the ratios distance from its 36-month moving average, portfolios should gradually be shifting away from growth to value over the course of 2019.

 

SPG.png

 

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 Hawks Have Not Left the Building

 

“Difficulties are meant to rouse, not discourage. The human spirit is to grow strong by conflict.” – William Ellery Channing

 

“Very few negotiations are begun and concluded in the same sitting. It’s really rare. In fact, if you sit down and actually complete your negotiation in one sitting, you left stuff on the table.” – Christopher Voss

 

The Hawks Have Not Left the Building

 

A “typical feature of conflicts is that […] the intergroup conflict tends to be exacerbated and perpetuated by intragroup conflicts: by internal conflicts within each of the two contending parties. Even when there is growing interest on both sides in finding a way out of the conflict, movement toward negotiations is hampered by conflicts between the “doves” and the “hawks” –or the “moderates” and “extremists” –within each community”.  So wrote Herbert C. Kelman, the Richard Clarke Professor of Social Ethics, Emeritus at Harvard University, in Coalitions Across Conflict Lines: The Interplay of Conflicts and Between the Israeli and Palestinian Communities.

 

Kelman – renowned for his work in the Middle East and efforts to bring Israel and Palestine closer towards the goal of achieving peace in the Middle East – identifies, in the paper he authored in 1993, the “relationship between intergroup and intragroup conflict” as a key hurdle towards building coalitions across conflict lines. According to Kelman, “doves on the two sides and hawks on the two sides have common interests”. The hawks, unlike the doves, can pursue their interests without the need to coordinate with their counterparts on the opposing side. The hawks simply “by engaging in provocative actions or making threatening statements” reaffirm the enemy’s worst fears and embolden the hawks on the opposing side. The doves, on the other hand, “tend to be preoccupied with how their words will sound, and how their actions will look, at home, and with the immediate political consequences of what they say and do.” Therefore, the doves tend to take a more measured approach in communicating their views and underplay their side’s willingness to negotiate – the kind of behaviour that plays right into the hands of the hawks and reduces the effectiveness of the doves

 

Kelman’s recommendation to increase the chances of resolving a conflict by means of negotiation is to facilitate greater coordination between the doves on the opposing sides and minimise the involvement of the hawks.

 

The lessons from Professor Kelman’s work, we think, are highly relevant today. His insights provide a framework for determining the possibility of success in each round of negotiations between the US and China in resolving the on-going trade dispute.

 

Subsequent to the working dinner between President Trump and President Xi in Buenos Aires following the G20 summit, the headlines have focused on the temporary ceasefire in the trade dispute. President Trump has pledged to suspend the increase in tariffs on US dollars 200 billion of Chinese imports that was to go into effect on 1 January 2019 for a period of up to 90 days. In return President Xi has pledged that China will buy more US goods, ban exports of the opioid drug, and offered to reconsider the Qualcomm-NXP merger that failed to receive regulatory approval in China earlier in the year.

 

The three-month period, before the suspension of the tariff increase lapses, provides the two-sides a window of opportunity to initiate a new round of talks to tackle some of the more sensitive issues surrounding the trade dispute, including ownership and access to technology and intellectual property.

 

Despite the announcements lacking details, capital markets have reacted positively to the news of the temporary ceasefire and the Chinese yuan, on Monday, posted its largest single day gain since February 2016.

 

We are not surprised by the bare bones nature of the agreement following the meeting between President Trump and President Xi. The last minute inclusion of Peter Navarro, White House trade policy adviser and prominent China hawk, to the list of guests attending the working dinner was, at least to us, a clear signal that meaningful progress on trade relations during the meeting was unlikely. After all, Mr Navarro’s role in the Trump Administration, as The Atlantic puts it, is “to shepherd Trump’s more extreme ideas into reality, ensuring that the president’s convictions are not weakened as officials translate them from bully-pulpit shouts to negotiated legalese. He is the madman behind Trump’s “madman theory” approach to trade policy, there to make enemies and allies alike believe that the president can and will do anything to make America great again.”

 

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

 

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

 

 

Liquidity Relief

 

In June in The Great Unwind and the Two Most Important Prices in the World we wrote:

 

“In the 362 months between end of May 1988 and today there have only been 81 months during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages – that is less than a quarter of the time.

 

Over the course of the last thirty years, the longest duration the two prices have concurrently been above their respective 48-month moving averages is the 25 month period between September 2005 and October 2007. Since May 1988, the two prices have only been above their respective 48-month moving averages for 5 or more consecutive months on only four other occasions: between (1) April and October 1996; (2) January and May 1995; (3) October 1999 and August 2000; and (4) July 2013 and August 2014.

 

Notably, annual global GDP growth has been negative on exactly five occasions since 1988 as well: 1997, 1998, 2001, 2009, and 2015. The squeeze due to sustainably high US interest rates and oil prices on the global economy is very real.”

 

We have updated the charts we presented alongside the above remarks and provide them below. (The periods during which both the US 10-year treasury yield and the oil price have been above their respective 48-month moving averages are shaded in grey in the two charts below.)

 

US 10-Year Treasury Yield10YSource: Bloomberg

 

West Texas Intermediate Crude (US dollars per barrel) WTISource: Bloomberg

 

The sharp drop in oil prices in recent weeks ended the 10 month streak of the 10-year Treasury yields and oil prices concurrently trading above their respective 48-month moving averages.

 

The recent drop in oil prices has coincided with the Fed weighing up the possibility of changing its policy guidance language. Several members of the Fed have suggested, according to the minutes of the FOMC’s November policy meeting, a “transition to statement language that [places] greater emphasis on the evaluation of incoming data in assessing the economic and policy outlook”. If the drop in oil prices sustains the data is likely soften and compel the Fed to dial back its hawkishness. With the base effects from the Trump Tax Cut also likely to recede in 2019, there is a distinct possibility that the Fed’s policy will be far less hawkish in 2019 than it has been over the course of 2018.

 

Lower (or range bound oil prices) and a more dovish Fed (even at the margin) are the conditions under which oil importing emerging markets tend to thrive. Although it is still too early to be sure, if oil prices fail to recover in the coming few months and the Fed is forced into a more dovish stance due to softer data, 2019 might just be the year to once again be long emerging markets.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

US vs. Europe: A Closer Look at US Outperformance

 “Europe was created by history. America was created by philosophy.” – Margaret Thatcher

“In America everything goes and nothing matters, while in Europe nothing goes and everything matters.” – Philip Roth, American novelist and modern literary great

MSCI Europe Index vs. S&P 500 Index – Total Return in USD Indices TRSource: Bloomberg

In the ten years since the global financial crisis, European stocks have underperformed US stocks by a considerable margin.

In the first three years following the global financial crisis, the performance of the two markets were not too dissimilar. For the period commencing end of November 2008 through October 2011, the MSCI Europe and S&P 500 indices generated total returns of 46 and 53 per cent in US dollar terms, respectively.

Since late 2011, however, investors in European stocks have been left frustrated all the while investors in US stocks have enjoyed a long-running bull market. From 29 October 2011 through 20 November 2018, the MSCI Europe Index has generated a total return of 35.8 per cent in US dollar terms – 102.8 per cent less than the total return of the S&P 500 Index for the same period.

Despite, the strong outperformance of US equity markets relative to European equity markets, European stocks have been more expensive, on a trailing 12 month price-to-earnings basis, for the majority of the time since late 2011. Only since late 2017 have European equities become cheaper than US equities on a trailing 12 month price-to-earnings basis.

MSCI Europe vs. S&P500: Trailing 12 Month Price-to-Earnings RatioIndices PESource: Bloomberg

At an index level and since the global financial crisis, US companies have grown revenues and earnings at a faster clip than their European companies.

MSCI Europe vs. S&P500: Revenue Growth RevenueSource: Bloomberg

MSCI Europe vs. S&P500: Earnings Growth EarningsSource: Bloomberg

In terms of annual performance, European markets have outperformed US markets in three out of the nine calendar years since the global financial crisis: 2009, 2012, and 2017. Notably, in 2009 and 2017, European companies’ year-over-year earnings growth rates were far superior to those of American companies. While outperformance in 2012, can be attributed to Signor Draghi uttering those famous words that brought Europe back from the brink: “Whatever it takes”.

European earnings also outpaced US earnings during the years 2010 and 2013, yet US stocks outperformed European stocks. The year 2010 was, of course, when the sovereign debt crisis engulfed the peripheral members – Portugal, Italy, Ireland, Greece and Spain – of the European Monetary Union. While in 2013, although European equities underperformed US equities , it was still a very good year for Europe with the MSCI Europe Index generating a total return of around 23 per cent in US dollar terms versus around 28 per cent for the S&P 500 Index.

Digging a little deeper we compare the performance between US and European markets on a sector-by-sector basis, using the Global Investment Classification Standards (GICS) level 1 classifications.

US vs. Europe: 5- and 10-Year Sector Level Total Returns (USD) Sectors TR

Source: Bloomberg

Note: Periods ending 31 Oct 2018, calculated using monthly data, and excludes real estate

For both the 5- and 10-year periods for every sector except energy, US performance has been superior to European performance – we have excluded real estate as we were unable to gather clean data for the sector.

The US energy sector has lagged the European energy sector largely due to the much higher number of listed shale oil companies in the US. Shale oil plays witnessed significantly larger drawdowns as compared to blue chip oil producers following the sharp drop in oil prices in late 2014.

For the 10-year period ended 31 October 2018, the greatest difference in performance between the two markets comes from the consumer discretionary and information technology sectors. The consumer discretionary sector includes Amazon and used to include Netflix – a significant portion of US consumer discretionary outperformance can be attributed to Amazon and Netflix. While the outperformance of the American information technology sector has been broader than that of the consumer discretionary sector, a handful of stocks still have had an outsized impact on US outperformance. These stocks are namely Apple, Google, Facebook, Salesforce.com, Microsoft and Nvidia. (Note: In January 2018 the industry classification of Google, Facebook, and Netflix was changed to communication services).

The most comparable performance between the two markets, for the 10-year period, comes from the energy, materials, consumer staples and industrial sectors.

US vs. Europe: 5-Year Sector Level Revenue and Earnings Growth Sectors Rev Earnings

Source: Bloomberg

The above table details the 5 year (4-years for communication services) revenue and earnings growth by sector for US and European stocks.

Notably, in the US, net margins expanded from 2012 through 2017 across all sectors except energy. While in Europe, margins expanded for six sectors and declined for three – margins declined for the consumer discretionary, utilities and communication services sectors.

Median sector level revenue growth in the US for the five-year period was 20.96 per cent versus -2.26 per cent in Europe. (Earnings level comparisons are not meaningful in our opinion due to the artificially high earnings growth in certain sectors in Europe due to write-downs / exceptional circumstances in 2012 that understate earnings at the beginning of the period.)

Investment Perspective

The underperformance of European equities relative to US equities over the last five- and ten-years can predominantly be explained by fundamental factors. The challenge at this juncture, however, becomes that of identifying scenarios under which European stocks would arrest this trend of underperformance and begin outperforming the US stocks on a prolonged basis. We outline three such scenarios below.

  1. If the next ten years are not like the last ten years

If we assume, simplistically and without trying to predict how, that the next ten years will be unlike the last ten years then there should be a preference for non-US stocks over US stocks in general.

In capital markets dominated by passive allocations to market capitalisation weighted indices, the main drawback is that the allocation to ‘go-go’ stocks is at its highest when they are at their peak relative to other stocks in the indices.

With respect to the S&P 500 Index, the information technology, healthcare, financials, communication services and consumer discretionary sectors have gone from representing 58 per cent of the index at the start of 2009 to almost 70 per cent today. And within these sectors the increase in allocation to technology and technology related stocks has been even more pronounced.

S&P 500 Index Allocation by GICS Level 1SPXSource: Bloomberg

The change in sector allocation for US indices has been far more prominent than it has been for European indices – simply because the dispersion in performance between sectors has been much greater in the US. Over the last ten-years the top performing sector in the S&P 500 Index has outperformed the median sector by almost 260 per cent. In comparison, the total return differential between the best performing and median sectors is 63 per cent for the MSCI Europe Index.

MSCI Europe Index Allocation by GICS Level 1 MSCIESource: Bloomberg

  1. Labour not capital is rewarded

“The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor.

Average wages doubled from 1940 to 1948, then doubled again by 1963.

And those gains focused on those who had been left behind for decades before. The gap between rich and poor narrowed by an extraordinary amount.”

– Excerpt from Morgan Housel’s piece How This All Happened:

In the aftermath of the global financial crisis, unemployment levels shot up across the world. The global economy has spent the last ten-years healing from the damage wrought by the financial crisis. Slack in the labour market has been slow to dissipate and wages have remained stubbornly stagnant.

The corollary of the abundance of labour has been capital owners benefiting at the expense of labour.

As the global economy has healed, unemployment levels have gradually declined and wage pressures have slowly emerged. The European labour market, however, has much more slack than the US labour market – where unemployment levels are reaching twenty year lows and wage pressures are much more significant.

If demand for labour picks up globally, Europe has much more room to reduce unemployment levels before wages have to pick up meaningfully. Whereas the US has limited, if any, room for unemployment levels to drop lower without a meaningful increase in wage inflation. Therefore, Europe has greater flexibility to facilitate an improvement in household earnings without it impacting profit margins.

  1. Capital investment / infrastructure spending pick ups

US corporations have been far savvier capital allocators than their transatlantic counterparts – they have reduced equity, through share buy backs, and increased leverage during a time when servicing debt has never been easier. The behaviour of US corporations has been facilitated not only by record low interest rates but also by a limited need for capital investment – a deflationary environment incentivises the postponement of capital investment.

If capital investment picks up globally – motivated by inflation, infrastructure development led diplomacy, such as China’s Belt and Road Initiative, or a need to reconfigure global supply chains due to trade wars – European indices, with their much greater weighting to the industrial and materials sectors, are better placed to outperform the more technology leaning US indices in such a scenario.

Moreover, increasing capital investment may spur demand for credit in Europe and support the much maligned European financial services sector, which also happens to be the sector with the highest allocation in the MSCI Europe Index.

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.

Late Cycle Signals and Yield Curve Dynamics

 

“Everything turns in circles and spirals with the cosmic heart until infinity. Everything has a vibration that spirals inward or outward — and everything turns together in the same direction at the same time. This vibration keeps going: it becomes born and expands or closes and destructs — only to repeat the cycle again in opposite current. Like a lotus, it opens or closes, dies and is born again. Such is also the story of the sun and moon, of me and you. Nothing truly dies. All energy simply transforms.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

“We say that flowers return every spring, but that is a lie. It is true that the world is renewed. It is also true that that renewal comes at a price, for even if the flower grows from an ancient vine, the flowers of spring are themselves new to the world, untried and untested.

 

The flower that wilted last year is gone. Petals once fallen are fallen forever. Flowers do not return in the spring, rather they are replaced. It is in this difference between returned and replaced that the price of renewal is paid.

 

And as it is for spring flowers, so it is for us.” – The Price of Spring by Daniel Abraham

 

“There are constant cycles in history. There is loss, but it is always followed by regeneration. The tales of our elders who remember such cycles are very important to us now.” – Carmen Agra Deedy

 

Late Cycle Signals

 

Each business cycle is unique. Certain patterns, however, have tended to repeat across business cycles with the ebbs and flows in the level of economic activity.

The late stage of the business cycle is often characterised by an overheated economy, restrictive monetary policy, tight credit markets, low unemployment rates and peaking corporate profit margins.  These are not the types of signals that form part of our discussion on the late cycle this week. Instead we focus on behavioural clues from the financial services and investment management sector that signal that we may have potentially entered the late stage of the business cycle – often the most rewarding, but also the most precarious, phase of bull market for investors.

 

1. Liquidity events for investors in ride hailing services companies

 

Few opportunities have captured the imagination of venture capital investors over the last decade as the one represented by ride hailing services companies such as Uber, Lyft, Didi Chuxing and Grab.

 

 

 

  • Didi Chuxing, China’s equivalent to Uber and valued at US dollars 56 billion during its last fundraising, is the most valuable start-up on the Mainland and counts Apple, Softbank and Uber amongst its shareholders. The start-up is estimated to have raised US dollars 20.6 billion in funding over 17 rounds of financing.

 

  • Southeast Asia’s leading ride hailing services company, Grab, was valued at over US dollars 10 billion in a fundraising round in June this year and has received US dollars 1 billion in funding from Toyota.

 

With such eye-popping valuations it should come as no surprise that most, if not all, of the leading ride hailing companies the world over are weighing up potential liquidity events, be it an initial public offering or a trade sale to larger competitors or strategic investors. The investors in these companies are undoubtedly eager to convert their paper profits into realised gains in the form of cold hard cash.

 

  • Lyft has hired JP Morgan to lead its IPO and is aiming to beat its much larger rival, Uber, in becoming the first ride hailing services company to be publicly listed

 

  • Uber has reportedly received proposals from Wall Street valuing the company as high as US dollars 120 billion – almost 67 per cent higher than the valuation at its last round of fundraising

 

  • Didi Chuxing is reportedly weighing up the possibility of a public offering in 2019

 

  • Careem Networks, the Middle East’s leading ride hailing services company, and Uber are rumoured to be in talks for a possible merger or an outright acquisition of the Middle Eastern business by Uber. Careem was valued at US dollars 1 billion during a fundraising round in December 2016. Bloomberg reported in September that the acquisition of Careem by Uber would value it between US dollars 2 to 2.5 billion – a 100 to 150 per cent increase in less than 24 months.

 

In 2007, The Blackstone Group, the leading alternative asset management firm, successfully listed on the New York Stock Exchange, selling a 12.3 per cent stake in return for  US dollars 4.13 billion. Blackstone’s listing was, at the time, the largest US IPO since 2002.

Although Blackstone was able to successfully list, many of its rivals – including Apollo Global Management, Kohlberg Kravis & Roberts and the Carlyle Group – missed the opportunity to float ahead of the global financial crisis and had to shelve their plans and wait for a more conducive environment.

We worry that a similar fate awaits the riding hailing services industry, where it becomes a case of one IPO and done and the remaining companies’ plans are delayed by an abrupt end to the current iteration of the US equity bull market.

 

 

2. INVESCO to buy OppenheimerFunds

 

INVESCO, the independent investment company headquartered in Atlanta, Georgia, this week agreed to buy rival Massachusetts Mutual Life Insurance’s OppenheimerFunds unit for US dollars 5.7 billion. According to the Wall Street Journal:

“Invesco will pay for the deal with 81.9 million common shares and another $4 billion in preferred shares, making MassMutual the firm’s largest stockholder. Including OppenheimerFunds, Invesco will manage more than $1.2 trillion in assets.”

In the summer of 2009, BlackRock acquired Barclays Global Investors, including its highly coveted iShares franchise, for US dollars 13.5 billion and created a combined entity with, at the time, approximately US dollars 2.7 trillion of assets under management.

BlackRock’s timing was impeccable: a near decade long equity bull market ensued and, even more importantly for BlackRock, the company put itself in the prime position to reap the rewards of the rise of passive investing.

The rationale for the OppenheimerFunds acquisition according to the Wall Street Journal paraphrasing INVESCO CEO Martin Flanagan is to: “strengthen Invesco’s position in some businesses that have been proven resilient to the move toward passive investing, including international and emerging-markets stock funds.”

We are curious to see if INVESCO’s decision today turns out to be as flawed as BlackRock’s decision in 2009 was impeccable.

 

3. Middle market alternative asset managers selling stakes

 

In recent years, seemingly successful, mid-sized alternative asset management firms have started selling equity stakes to their much larger, more established competitors such as Neuberger Berman, The Blackstone Group and the Carlyle Group.

Dyal Capital, a unit of Neuberger Berman, has closed 30 or more transactions acquiring stakes in alternative asset managers over the last 2 to 3 years, including a strategic investment into Silver Lake Partners. Dyal presently manages three funds with US dollars 9 billion in assets under management and is set to complete fundraising over 5 billion for a fourth fund.

The most recent of such sales comes from New Mountain Capital, which manages private equity, public equity and credit funds with more than US dollars 20 billion in assets under management. The company has reportedly sold a 9 per cent stake to Blackstone Strategic Capital Holdings.

We wonder: what are the chances that highly successful private equity and alternative investment firms would sell their stakes at anything but close to peak valuations?

 

Yield Curve Dynamics

 

Given that we have discussed late cycle signals above, we wanted to touch upon the historical dynamics of the Treasury yield curve when it has either gone (i) from inverted to flat or (ii) from flat to positively slopping.

Prior to sharing our findings, we wanted to share some analysis for the period starting 1959 and ending 1984 from Interest Rates, the Markets, and the New Financial World (1985) by Henry Kaufman:

 

“If the risk in investing in the long market is still great immediately following the point of maximum inversion, when does the long market offer the best opportunity? To answer this question, it is necessary to examine the swings in the U.S. Government securities yield curve during the past quarter century.

These swings are:

 

  1. from extreme negative (short rates above long) to flat
  2. from flat to extreme positive (long rates above short)
  3. from extreme positive to flat
  4. from flat to extreme negative

 

The results are as follows:

 

1. When the yield curve for government securities swung from extreme negative to flat, long yields actually increased with one exception – the 1980 cycle. In one of these cycles, there was greater rise in long yields than in short rates. In all other instances, however, short rates fell while long yields rose.

 

2. When the yield curve moved from flat to extreme positive, with long yields going above short, in all cycles long yields fell in conjunction with a more sizable drop in short rates.

 

3. The swing from extreme positive to flat can be quite dangerous in the long bond sector. In the four complete cycles… yield increases average 104 basis points for long-term issues, ranging from 40 to 220 basis points.

 

4. The most dangerous period of all for investors in long bonds, however, occurs when the yield curve moves from flat to extremely negative, with short rates moving up above long.”

 

Interestingly, the period around the time of publishing of Mr Kaufman’s book was the exception for how the long end of the curve reacted when the yield curve went from extreme negative to flat. And Mr Kaufman speculated in his book if the long-running bond bear market was over or not. With the benefit of hindsight we know that the bond bear market had indeed ended during the early 1980s.

For the period from 1980 till date and with respect to cycles where the yield curve went either (i) from inverted to flat or (ii) from flat to positively slopping, we make the following observations (based on the yield differential between 2 and 10 year Treasury securities):

 

  1. 1980 – 1982: the yield curve went from extreme negative to flat with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 1988 – 1992: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 2000 – 2003: from inverted to flat and then to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

  1. 2005 – 2010: from flat to extreme positive with both short and long rates declining. Short rates declined faster than long rates.

 

In recent weeks we have witnessed the yield curve correct its flattening trend due to a sell-off at the long-end. The yield curve has steepened due to higher long-term yields – a phenomena last witnessed in the 1970s. These are still early days and the recent sell-off at the long-end may be nothing more than a blip. If, however, the yield curve continues to steepen due to increasing long-term yields it would be an ominous sign for bond bulls.

Much like Mr Kaufman speculated that the bond bear market may have ended in the early 1980s, the recent shifts in the Treasury yield curve and the forthcoming supply of US Treasury securities have us wondering if the multi-decade bond bull market is over.

 

 

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.