Tribalism and Consistency in a Volatile Market

A somewhat lengthy piece discussing some of the psychological hindrances all of us face from time-to-time in investing and trading pursuits.

We share one chart right at the end of the piece with little comment, which is the basis of our expectation that the US equity market is to see new highs still.

The Science of Tribalism

 “Everybody wants to protect their own tribe, whether they are right or wrong.”Charles Barkley

While watching television, have you ever looked away or squealed in response to a gruesome scene, the kind that became a regular occurrence on HBO’s Game of Thrones?  Turns out, this is because the imagery activates our brain’s empathy network, which then stimulates brain areas involved in the sensation of our own pain.

Neuroimaging studies have revealed that watching another person in pain triggers brain areas that are active when we feel pain. The neural response to seeing others in pain, however, is not constant; rather it is modulated by context and by allegiances.

Neuroscientist David Eagleman used functional magnetic resonance imaging (fMRI) to measure the response in the brain’s empathy network. He examined the brains of people watching videos of other people’s hand getting pricked by a needle or touched by a Q-tip. When the hand being pricked by the needle was labelled with the participant’s own religion, the participant’s empathy network showed a larger spike of activity than when the hand was labelled with a different religion.

More surprisingly, when participants were assigned to an arbitrary group immediately before the subject entered the MRI machine, and the hand being pricked was labelled as belonging to the same arbitrary group as the participant, the participant’s brain still showed a larger spike ― even though the grouping did not exist just moments earlier!

Participants also exhibited a diminished response in their empathy networks if they believed the pain-recipient has acted unfairly in a simple economic exchange or were told that the victim is receiving a large monetary compensation for undergoing the pain.

Commitment and Consistency

“Consistency is the hallmark of the unimaginative.”Oscar Wilde

Last week we were forwarded a quarterly commentary and portfolio review for a fund managed by a self-proclaimed “old-school value investor”. The commentary was standard fare really, espousing the well-known values of Graham and Dodd and Buffet and Munger schools of investing as would be expected from a value-oriented manager. The fund manager was particularly insistent that they only buy “companies at a big discount to the present value of their future cash flows”.

As we turned to the section listing the fund’s top holdings, that too read like a standard portfolio that we had seen from countless other value managers. There was a lot of Google in the portfolio, a little Apple, a few big-name financial stocks and a not-so-insignificant allocation to General Motors. Except there was one holding which we did not expect, Netflix. And seeing it in the list of holdings, one of top-five in terms of allocation, irked us. Reading the commentary already felt like it was not the best use of our time but after seeing Netflix in the portfolio, the feeling changed to that of being cheated somehow.

Feeling cheated after reading the commentary and seeing the holdings for a fund we are not invested in, strange right?

The following passage is excerpted from Influence: The Psychology of Persuasion by Robert B. Caldini (emphasis added):

Psychologists have long understood the power of the consistency principle to direct human action. Prominent early theorists such as Leon Festinger (1957), Fritz Heider (1946), and Theodore Newcomb (1953) viewed the desire for consistency as a central motivator of behavior. Is this tendency to be consistent really strong enough to compel us to do what we ordinarily would not want to do? There is no question about it. The drive to be (and look) consistent constitutes a highly potent weapon of social influence, often causing us to act in ways that are clearly contrary to our own best interest.

Consider what happened when researchers staged thefts on a New York City beach to see if onlookers would risk personal harm to halt the crime. In the study, an accomplice of the researchers would put a beach blanket down five feet from the blanket of a randomly chosen individual—the experimental subject. After several minutes of relaxing on the blanket and listening to music from a portable radio, the accomplice would stand up and leave the blanket to stroll down the beach. Soon thereafter, a researcher, pretending to be a thief, would approach, grab the radio, and try to hurry away with it. As you might guess, under normal conditions, subjects were very reluctant to put themselves in harm’s way by challenging the thief—only four people did so in the 20 times that the theft was staged. But when the same procedure was tried another 20 times with a slight twist, the results were drastically different. In these incidents, before leaving the blanket, the accomplice would simply ask the subject to please “watch my things,” something everyone agreed to do. Now, propelled by the rule for consistency, 19 of the 20 subjects became virtual vigilantes, running after and stopping the thief, demanding an explanation, often restraining the thief physically or snatching the radio away (Moriarty, 1975).

To understand why consistency is so powerful a motive, we should recognize that, in most circumstances, consistency is valued and adaptive. Inconsistency is commonly thought to be an undesirable personality trait (Allgeier, Byrne, Brooks, & Revnes, 1979; Asch, 1946). The person whose beliefs, words, and deeds don’t match is seen as confused, two-faced, even mentally ill. On the other side, a high degree of consistency is normally associated with personal and intellectual strength. It is the heart of logic, rationality, stability, and honesty.

The fund manager was inconsistent. He championed investing in “companies at a big discount to the present value of their future cash flows” and then went ahead and owned Netflix. The gall of it!

The Incompatibility of Tribalism and Consistency in a Volatile Market

Our vocation is such that we are often engaged in debate. On the merits of buying one security over another. On the signals from one asset class for the prospects of another asset class. On the reaction function of the Federal Reserve to the latest release of economic data. And on many other topics much like these.

Over the last eighteen or so months, markets have been extraordinarily challenging.

US stocks have rallied, sold off, rallied sharply, sold off sharply, rallied sharply and now started to chop. G-7 governments have sold-off with the US ten-year reaching yields of 3 per cent and then rallied to record low yields. The trade-dispute between the US and China has escalated, de-escalated and escalated again on more occasions than we care to recall. Bitcoin lost more than two-thirds of its value, then tripled and then halved. Repo rates spiked for reasons no-one can fully comprehend. Oil witnessed the re-emergence of a geopolitical premium only for it to subside almost instantly.

In our discussions and debates, we have found that a fair share of traders, active managers and asset allocators are, more than ever, struggling to keep up, let alone outperform, broader market indices. Markets are never easy, in these challenging climes even less so. Nonetheless, two of the recurring hindrances to better performance we have increasingly noticed are tribalism and consistency.

Tribalism in Social Media and Investment Decision Making

Tribalism can be easy to spot. Just go on to Twitter and you will find bond bulls re-tweeting bond bulls, goldbugs sharing articles of Paul Tudor Jones stating that gold is his best idea for the next two years, equity market bears praising the analysis of other bearish analysts, Tesla bulls and bears slinging mud at each other, the examples are countless. Worse still, try debating with someone you do not know but disagree with and present factual data that invalidates their view and you are likely to be blocked more often than you would expect.

Tribalism in a social media context leads to filter bubbles and to the consumption of news, views and research that confirms that which we already know or believe. The utility of a social media platform, such as Twitter, to a user is significantly reduced by tribal behaviour. It has never been easier, faster and cheaper to seek out and obtain a variant perception. Investment professionals and traders would be better served and probably see improving performance if they used social media platforms more to seek out non-conforming views rather than searching for the false sense of security that belonging to arbitrary Twitter tribe would bring.

In professional settings tribalism is less of a problem but at the same time harder to spot. At investment firms, it usually manifests in team members with non-consensus views or opinions being cast aside in the investment decision making process.

Tribalism can lead to poor investment decision making when good ideas are rejected because they are put forth by those long belonging to the ‘other tribe’ and bad ideas presented by those belong to ‘our tribe’ are accepted.

Worse still, is the case of tribal behaviour on social media that creeps into professional settings. If you are wondering if it really happens, we recently attended a meeting with a prospective client where one of the analysts quoted recent tweets by three, to remain unnamed, permabears to make a case against an allocation to US equities.

Consistency is the Real Enemy

“Laziness isn’t merely a physical phenomenon,about being a couch potato,stuffing your face with fries and watching cricket all day. It’s a mental thing, too, and that’s the part I have never aspired for.”Shah Rukh Khan, Indian actor, film producer, and television personality

While tribalism can be toxic, it is consistency that can be the real enemy in the investment decision making process.

Since a “high degree of consistency is normally associated with personal and intellectual strength” it usually serves one’s interests to remain consistent. The downside, however, is that this fosters almost blind consistency which is detrimental, and at times outright disastrous, in the process of investment decision making.

Blind consistency, outside of investment decision making, has its attractions. For starters, it frees up our mental resources by giving us a relatively effortless means for dealing with the complexities of daily life that make severe demands on our mental energies and capacities. Having made up our mind about an issue, blind consistency allows us to stop thinking about the issue and when confronted with the issue we only react in a manner consistent with our earlier decision.

Another attraction of mechanically reacting to an issue is that it protects us from the uncomfortable truth that we may be wrong. If we never expend the energy to understand the counter-argument, and reject it off the bat, we never have to confront the possibility that we may wrong.

Consider the following (real life) examples and if any resonate with you.

Bond bulls who will exit their bonds positions to lock in profits but will never go long stocks because a recession is always just around the corner.

– Gold bears that short at the lows because it’s a ‘barbarous relic’ and fail to cover or go long even as real rates are collapsing.

– Federal Reserve critics that see every market jitter as further confirmation of central banker incompetence but have not taken the time to understand the intricacies of the financial system.

– US dollar bulls that never go long another currency against the greenback even as it becomes painfully obvious that a rally has become over stretched.

– Permabears that told you that Apple was done after the ‘failed’ iPhone 5 and now poo-poo over the company’s services narrative.

– The bearish fund manager that identifies the flaw in his framework that led them to catastrophically underperform over the last decade somehow finds that the updated framework indicates that is time to short US stocks.

– The technical analyst that shows you analogs of today’s US market performance versus sometime leading up to the crash in 1929, 1987, 2008 or any other market crash that can be found or compressed to fit the narrative but never one that shows the market going higher.

All of the above examples are of blindly consistent people. In any other context you would respect them. In an investment context, they would have at times cost you money, a lot of it. In many instances it is acceptable to underperform. It is, however, unacceptable to underperform because you were unwilling to do the work or to appear inconsistent.

Improving Liquidity Indicators Suggest New Highs Still to Come

Combine the below with the three charts we shared last week and the prospect of the S&P 500 reaching levels 10 to 15 per cent higher from here is not altogether unreasonable.

Thanks for reading and please share!

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

Three Macro Charts

 

“We can chart our future clearly and wisely only when we know the path which has led to the present.” ― Adlai Stevenson I, 23rd Vice President of the United States of America

A short piece with three macro charts and limited commentary.

1. Global Risk

Data validating recessionary fears have been the flavour du jour recently. The below is a chart of the MSCI All Cap World Index and the twelve-month moving average of the Citi Macro Risk Index, which suggests that a cyclical upturn in global equities is probable.

It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.

A similar sell-off to that witnessed in the fourth quarter of 2018 is not inevitable in the fourth quarter of 2019.

2. Cyclical USD

A custom leading index of global financial conditions suggests the cyclical trend for the USD is lower, even as the secular trend of the greenback remains intact.

 

3. Secular Trend in Real Yields

Quoting the National Bureau of Economic Research:

“The large and growing US current account deficits resulted from the large volume of foreign savings pushing in, as indicated by the declining US real interest rates, and not from US ‘profligacy’.”

The below chart is of the sum of foreign reserves held by China and Japan (inverted) and the real US 10 year treasury yield, for the period starting right after the Asian Financial Crisis.

The Asian Financial Crisis set in motion the trend of rising current account surpluses in Asia that were funneled back into the US. One major leg that furthered the trend, Chinese savings being recycled into US assets, has been broken by the protectionist policies of the US and economic challenges China is facing up to domestically.

The recycling of Asian current account surpluses into US assets is coming to end at the same time the US is entering a demographic driven inflationary phase, as argued by the Bank for International Settlements.

The secular tailwinds that drove down real yields in developed economies are weakening.

Thanks for reading and please share!

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. 

Clustered Volatility and the “Momentum Massacre”

 

“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

 

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework”  ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

 

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

 

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to  front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

 

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003,  formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process.  (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

 

Momentum Massacre

 

From the Financial Times on 12 September 2019 (emphasis added):

 

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.

 

The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.

 

The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”

 

This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”

 

The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

 

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

 

SGX Index (S&P 500 Growth Index) 2019-09-18 16-41-52.jpg

 

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

 

Our prescription from June remains valid:

 

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.

 

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

 

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 energy plays on the other.

 

Do Not Drop Momentum ― Not Completely Anyway

 

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

 

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

 

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

 

Why Energy Over Precious Metals?

 

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

 

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

 

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

 

 

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.

 

Shifts in US Capital Flows and Positioning for a Steepening Yield Curve

 

A chart heavy piece this week in which we dig into the underlying shifts in the capital flows into the United States.

 

We had aimed to issue this piece last week but it took more work and longer to draw out coherent conclusions than we had anticipated.

 

The key takeaways we draw out from the analysis in this week’s piece are (1) the structural shifts in capital flows into the US since the Global Financial Crisis and (2) a flows based framework for charting the path of the US dollar.

 

“Total return has three elements: the interest rate differential, the exchange rate differential, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.

 

Of the two, exchange rates are by far the more important. It does not take much of a decline in the currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events.

 

That is not to say that interest rate differentials are unimportant; but much of their importance lies in their effect on exchange rates and that depends on the participants’ perceptions. There are times when relative interest rates seem to be a major influence; at other times they are totally disregarded. For instance, from 1982 to 1986 capital was attracted to the currency with the highest interest rate, namely, the dollar, but in the late 1970s Switzerland could not arrest the influx of capital even by imposing negative interest rates. Moreover, perceptions about the importance of interest rates are often wrong.

 

The Alchemy of Finance, George Soros (emphasis added)

 

For those of you not wanting to run through the lengthy discussion, jump to the ‘Putting It Altogether’ section at the end of the piece.

 

One Quick Detour

 

Before going on to this week’s piece, a brief comment on bitcoin (or cryptocurrencies, in general).

 

We do not discuss cryptocurrencies or blockchain often and write about them even less. Even so, in our occasional discussions about cryptocurrencies we regularly come across statements along the lines of: “I am bullish on blockchain, not bitcoin,” or “The use case for blockchain technology far exceeds that of cryptocurrencies.” You too might have heard similar such statements from investors, venture capitalists, or other “authoritative sources” in discussions or interviews.

 

This line of thinking, we suspect, has driven capital and resources into developing private blockchains or proprietary databases that are based on blockchain technology. For example, banking behemoths of the likes of JP Morgan and UBS are spearheading efforts to use blockchain technology for settling cross-border trades worldwide with their own “Bitcoin-like” tokens.

 

The arguments in favour of private blockchains over public cryptocurrencies may yet prove prescient and the development of private database-like structures turns out to be the optimal use case for blockchain technology. The below passage from The Hard Thing About Hard Things written by Ben Horowitz, of Andreesen Horowitz fame, about the Internet and competing proprietary networks, is a reminder, however, that the public versus private implementation debate is not new. And a technology that appears to be inferior, insecure or volatile can evolve and supersede a seemingly superior competing solution.

 

“In retrospect, it’s easy to think both the Web browser and the Internet were inevitable, but without Marc’s work, it is likely that we would be living in a very different world. At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community-least of all the most important technology industry leaders, who were busy building proprietary alternatives. The overwhelming favorites to dominate the race to become the so-called Information Superhighway were competing proprietary technologies from industry powerhouses such as Oracle and Microsoft. Their stories captures the imagination of the business press. This was not illogical, since most companies didn’t even run TCP/IP (the software foundation for the Internet)they ran proprietary networking protocols such as AppleTalk, NetBIOS, and SNA. As late as November 1995, Bill Gates write a book titled The Road Ahead, in which he predicted that the Information Superhighwaya network connecting all businesses and consumers in a world of frictionless commercewould be the logical successor to the Internet and would rule the future. Gates later went back and changed references from the Information Superhighway to the Internet, but that was not his original vision.

 

The implications of this proprietary vision were not good for business or for consumers. In the minds of visionaries like Bill Gates and Larry Ellison, the corporations that owned the Information Superhighway would tax every transaction by charging a “vigorish”, as Microsoft’s thenchief technology officer, Nathan Myhrvold, referred to it.

 

It’s difficult to overstate the momentum that the proprietary Information Superhighway carried. After Mosaic, even Marc and his cofounder, Jim Clark, originally planned a business for video distribution to run on top of the proprietary Information Superhighway, not the Internet. It wasn’t until deep into the planning process that they decided that by improving the browser to make it secure, more functional, and easier to use, they could make the Internet the network of the future. And that became the mission of Netscapea mission that they would gloriously accomplish.”

 

A parting thought, consider the oft-cited explanation for the superiority of open-source solutions: “Given enough eyeballs, all bugs are shallow.”

 

US Trade Balance and Foreign Portfolio Investment

 

The below chart consists of the de-trended US trade balance (magenta bars), presented in reverse order and defined as the quarterly trade balance minus the three-year moving average of the trade balance,  and the quarterly foreign portfolio investments into the US on a net basis (orange line).

 

US Trade Balance De-Trended vs Net Foreign Portfolio InvestmentNPI vs TB.pngSources: US Census Bureau, US Department of the Treasury

 

The US, over the last twenty-five years, has, more often than not, run a trade deficit with the rest of the world. That is, Americans have consumed more than they have produced. During the 1990’s and the first five years of the current millennium, a growing trade deficit coincided with increasing foreign portfolio flows into the US.

 

Ahead of the financial crisis, the US trade deficit shrank and was duly followed by a sharp drop in foreign portfolio inflows. During and a few quarters following the Global Financial Crisis, the trade balance and foreign portfolio flows relation was flipped on its head. The US started to run a trade surplus, more on that anon, yet foreign portfolio flows increased rather than retrenching. The safe-haven bid for US assets, specifically US Treasury securities, was sufficiently large to overrun the impulse for foreign capital to retreat as the US went from running a trade deficit to running a trade surplus.

 

In the chart below, international flows into US Treasury securities are plotted against the US trade balance.  The international bid for Treasury securities was strong during the Global Financial Crisis and, following a brief pause, remained strong all the way through 2011.

 

US Trade Balance De-Trended vs US Treasury International Capital FlowsTrade Balance vs Treasury InflowsSources: US Census Bureau, US Department of the Treasury

 

Following the Global Financial Crisis and up until the election of President Trump, the US no longer ran consistent trade deficits and even when it did, they were not as large as they were prior to the crisis. As a corollary, foreign portfolio investments, too, waxed and waned between positive and negative during the time period.

 

The Diminished Role of Oil in Dictating Foreign Flows

 

Prior to the crisis, US oil imports were on a steady uptrend, going from below 5 million barrels per day at the end of 1990 to a peak of more than 10 million barrels in 2006/07. Imports dropped sharply to below 8.5 million barrels per day during the crisis, spiked in 2010, then continued declining through 2015, picked up in 2016 and 2017, and once again started falling from the second quarter of 2018. In February 2019, US oil imports averaged less than 7 million barrels per day for an entire month for the first time since February 1996.

 

US Trade Balance De-Trended vs Price of Brent Crude Oil De-TrendedTrade Balance vs BrentSources: US Census Bureau, Bloomberg

 

The rise of shale and the sharp drop in oil prices in the second half of 2014 has shifted the source and structure of net foreign portfolio investments into the US. The US trade balance, particularly during the commodity super-cycle witnessed during the first decade of the new millennium, was strongly correlated with the fluctuations in the price of oil. Since 2012, however, the correlation has broken down.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedPPI vs BrentSources: US Census Bureau, Bloomberg

 

The US trade balance being less correlated with the fluctuations in the price of oil also coincided with the correlation between foreign portfolio flows and the price of oil declining.

 

The breakdown in the correlation can be understood through the shifting structure of foreign portfolio flows. From the 1990’s  through 2006, the growth in portfolio flows was predominantly driven by increasing international flows into US Treasury securities. Oil exporting nations, particularly those operating US dollar pegged currency regimes, and China, were recycling their US dollar windfalls back into Treasury securities.

 

The rise of shale and subsequent drop in the price of oil has meant oil exporting nations no longer have the kind of excess capital to re-direct into Treasury securities as they once used to. China’s dollar-shortage challenges are, of course, well documented. Consequently, foreign flows into US government bonds have become more sporadic and the relative share of foreign flows into other securities has increased. The relative share of US foreign portfolio flows from other pools of capital, specifically pension funds and insurance companies in Europe and Japan, has also increased.

 

Structure of US Net Foreign Portfolio InvestmentNPISource: US Department of the Treasury

 

The shift, however, in the correlation between the fluctuations in the price of oil and foreign flows into US Treasury securities has not been as dramatic. Suggesting that oil exporters continue to prefer parking excess capital into US government bonds and are not going out on the risk curve.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedTreasury Inflows vs BrentSources: US Department of the Treasury, Bloomberg

 

Putting It Altogether

 

We have gone through some of the high level dynamics of the US trade balance and foreign portfolio flows. To round off the discussion, we outline a framework that can be helpful in thinking about the US dollar and demand for US dollar assets in general.

 

US Trade Balance + Net Foreign Portfolio Investment De-Trended vs YoY Change in US Dollar IndexTB NPI vs DXY (1).pngSources: US Census Bureau, US Department of the Treasury, Bloomberg

 

The magenta line in the above is the sum of the de-trended trade balance and the de-trended net foreign portfolio investment. The line being above zero implies foreign demand for US dollars exceeding the supply of US dollars. For example, the demand for US dollars emanating from portfolio flows exceeds the supply of US dollars being created by the US running a trade deficit.

 

Demand outstripping supply, to state the obvious, places upward pressure on the US dollar.

 

Outside of periods of insatiable demand for safe-haven assets, this flows based framework works well as a tool to chart out a path for the US dollar.

 

Based on this framework, let us consider the scenario of the US undertaking a large fiscal spending programme following the presidential election. If such a fiscal spending programme greatly increases the US trade deficit, supply of US dollars should also increase substantially. This increase in the supply of US dollars will place tremendous downward pressure on the greenback unless accompanied by a commensurate increase in foreign portfolio flows into American financial assets.

 

An increase in foreign demand for American financial assets, in all likelihood, requires higher long-term interest rates. The optimal way for investors to position for it in the current environment, in our opinion, is to be long yield curve steepeners.

 

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. 

 

 

Cheap vs. Expensive | The Threat to Incumbents

 

“Business is the systematic playing of games.” ― Reid Hoffman

 

We gathered some data on the changes in the make up of S&P 500 Index over time and did some good old fashioned number crunching in MS Excel. In this week’s piece we share some of the analysis and insights from this number crunching, which covers the following:

 

  • Price-to-earnings spread between ‘expensive’ and ‘cheap’ constituents of the S&P 500 Index;
  • Return profile of stocks added to the S&P 500 Index between 31 August 2017 and 30 April 2019; and
  • How the largest US companies, in a rush to return cash to shareholders, may be unwittingly setting themselves up to be disrupted.

 

As a disclaimer, the analysis presented below is neither meant to paint a bullish nor bearish picture. We have, however, on a number of occasions in the last year expressed our constructive view on the market, most recently here and prior to that here.

 

Price-to-Earnings Differential

 

The below chart presents the trailing price-to-earnings ratio spread between the 25th and 75th percentiles for the constituents of the S&P 500 Index ranked by their trailing twelve month price-to-earnings ratio.

 

A rising line implies that the spread between the upper and lower quartiles is expanding or simply put expensive stocks, in terms of trailing price-to-earnings, are getting even more expensive relative to cheaper stocks.

 

Differential Between 25th & 75th Percentiles TTM P/E Ratio of S&P 500 Constituents

PE Differential.png

Source: Bloomberg, S&P Global

 

The dashed lines in the above chart are the levels marking +/- 1 and +/- 2 standard deviations from the average TTM P/E ratio differential between the 25th and 75th percentiles.

 

As can be seen in the above, this is yet another market metric reaching levels last seen during the tech bubble.

 

S&P 500 Index Inclusion: Return Metrics

 

For a stock to be added to the S&P 500 Index is quite a big deal. The sheer amount of passive and non-discretionary assets tracking the S&P 500 Index means that any stock included into the index should see an uptick in its trading volumes and a near perpetual bid from S&P 500 trackers and ETFs.

 

What, however, does inclusion mean in terms of returns for investors holding stocks included in the S&P 500 Index? We try to answer that question by looking at a relatively small sample: stocks included into the index between 31 August 2017 and 30 April 2019. We are aiming, in the next two weeks, to extend the sample set to as far back as 1 January 1990 and also to include the impact on stocks dropped from the index.

 

Post Inclusion Alpha
1 Month 3 Months 6 months 1 Year
Average 0.73% -3.46% -3.12% -7.32%
Median 2.54% -1.42% -5.91% -6.39%

 

Based on the analysis of the limited sample, it suggests that one would be better off, one average, selling a stock that has been included into the S&P 500 Index immediately after its inclusion and buying the S&P 500 Index instead.

 

The data set used for the above calculations can be found here.

 

Research & Development

 

According to alternative assets data provider Preqin, at the end of 2018 the amount of dry powder committed to private capital funds and investment programmes stood at US dollars 2 trillion, of which approximately US dollars 400 to 450 billion was committed to angel investing and venture capital funds. To put that in context, the amount dry powder available to angel and venture capital investors as recently as 2014 was estimated to be in the range of US dollars 100 to 150 billion dollars.

 

An estimated three-fold increase in the amount of capital gives venture capitals a lot of money to throw at a lot of problems.

 

We recently listened to a podcast featuring famed venture capitalist Bill Gurley in which he passingly mentioned something along the lines of incumbents being more at risk of being disrupted today than ever before.

 

This got us to thinking that what if US corporations were prioritising returning capital, through buybacks and dividends, to investors to such a degree that it was coming the expense of the future profitability of the respective businesses?

 

While we do not have an answer to our question, we do have some interesting data to shares.

 

R&D Expense as a Percentage of Net Sales (Average) for S&P 500 Constituents 

RD Exp Sales.png

Source: Bloomberg

 

There appears to have been a structural step down in the amount of money, as a percentage of net sales, that has been invested in research and development following the Global Financial Crisis. There was a spike up recently, we suspect that is due to US tax reform and the repatriation of non-US profits.

 

Year-over-Year Growth in R&D Expenses (Average) of S&P 500 Constituents 

RD Exp Growth.png

Source: Bloomberg

 

Similarly, even in terms of absolute dollar amounts, there has been a slowdown in growth of absolute dollars being invested in research and development by the constituents of the S&P 500 Index. This is all the more surprising given the makeup of the S&P 500 has shifted in favour of healthcare and technology companies over the last decade. Healthcare and technology companies are generally known to be heavy investors in research and development. Businesses operating in the more “old economy” sectors are, it seems, investing even less in research and development.

 

Average Cash and Marketable Securities Balances for S&P 500 Constituents

Cash.png

Lastly, the above chart is of the average cash and marketable securities balances of S&P 500 constituents, excluding major financial services businesses.

 

The largest corporations in the United States are draining their cash in financialisation at a record pace just as their predators in the venture capital industry have been building up their war chests. The picture gets even worse once you exclude the major technology companies with large piles of cash ready to be invested in acquiring and developing up and coming technologies.

 

Low interest rates did not encourage large US corporations to invest, rather they encouraged financialisation. The unintended consequence of which may be the death of the incumbents.

 

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. 

 

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.