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 name 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 reported:

 

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.

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.

 

 

 

 

 

 

Trade Wars: Clearing the Way for a War of Attrition

 

“The two most powerful warriors are patience and time.” – Leo Tolstoy

 

“The primary thing when you take a sword in your hands is your intention to cut the enemy, whatever the means. Whenever you parry, hit, spring, strike or touch the enemy’s cutting sword, you must cut the enemy in the same movement. It is essential to attain this. If you think only of hitting, springing, striking or touching the enemy, you will not be able actually to cut him.” – Miyamoto Musashi, The Book of Five Rings

 

“Only an idiot tries to fight a war on two fronts, and only a madman tries to fight one on three.” – David Eddings, American novelist

 

A few updates relating to themes and topics we have written about in the recent past before we get to this week’s piece.

1. Two out of three companies we highlighted as potential value plays in Searching for Value in Retail in June have now announced that they are evaluating opportunities to go private.

The most recent of the announcements comes from Barnes & Noble $BKS which said on Wednesday that it is reviewing several offers to take the bookstore chain private. We are not surprised by this development and had expected as much when we wrote the following in June:

“Trading at a price to consensus forward earnings of around 10x and with a market capitalisation of under US dollars 500 million, $BKS remains a potential target for even the smallest of activist investors or private equity funds.”

The other company we discussed in the same piece was GameStop $GME, which at the start of September announced that it is engaged in discussions with third parties regarding a possible transaction to take the company private.

 

2. Following-up on Trucking: High Freight Rates and Record Truck Orders, orders for Class 8 semi-trucks increased 92 per cent year-over-year in September. Last month capped the highest ever recorded quarterly sales of big rigs in North America.

American trucking companies continue to struggle with tight capacity at the same time demand from the freight market remains strong.

We continue to play this theme through a long position in Allison Transmission $ALSN.

 

3. When the tech bubble popped at the start of the millennium, between 2001 and 2003, the S&P 500 and the NASDAQ 100 indices declined by 31.3 and 57.9 per cent on a total return basis, respectively. During the same period, Cameco Corporation $CCJ, the world’s largest uranium miner by market capitalisation, went up by more than 40 per cent.

Yesterday, as we witnessed global equity markets sell-off in response to (depending on who you ask) (i) tightening central bank policies and rising yields raising concerns about economic growth prospects, (ii) the accelerating sell-off in bond markets, or (iii) news that China secretly hacked the world’s leading tech companies, including Amazon and Apple, $CCJ closed up 5 per cent on the day.

Maybe history as Mark Twain said rhymes, maybe it is nothing, or just maybe it is one more sign of the increasing awareness of the nascent bull market underway in uranium.

CCJ.PNG

 

4. With the recent sell-off in the bond market, long-term Treasury yields have surged. Yields on the ten-year treasuries rose as high as 3.23 per cent on Wednesday, recording their highest level since 2011.

Does this level in yields make the long-end of the curve attractive for investors to start to re-allocate some equity exposure to long-term Treasury bonds? We think not.

Our thinking is driven by the following passage from Henry Kaufman’s book Interest Rates, the Markets, and the New Financial World in which he considers, in 1985, the possibility that the secular bond bear market may have come to an end:

“[T]wo credit market developments force me to be somewhat uncertain about the secular trend of long-term rates. One is the near-term performance of institutional investors, who in the restructured markets of recent decades generally will not commit funds when long when short rates are rising. The other development is the continued large supply of intermediate and long-term Governments that is likely to be forthcoming during the next period of monetary restraint. There is a fair chance that long yields will stay below their secular peaks, but the certainty of such an event would be greatly advanced with a sharp slowing of U.S. Government bond issuance and with the emergence of intermediate and long-term investment decisions by portfolio managers.”

 

In August this year, the US Treasury announced increases to its issuance of bonds in response to the US government’s rising deficit. This is the very opposite of what Mr Kaufman saw as a catalyst for declining long-term yields in 1985. Moreover, this increased issuance is baked in without the passing of President Trump’s infrastructure spending plan, which has been temporarily shelved. We suspect that Mr Trump’s infrastructure spending ambitions are likely to return to the fore following the upcoming mid-term elections. If an infrastructure spending bill of the scale Mr Trump has alluded to in the past come to pass, US Treasury bond issuance is only likely to further accelerate.

With the window for US companies to benefit from an added tax break this year by maximising their pension contributions now having passed, it will be interesting to see if institutional investors now become reluctant to allocate additional capital to long-dated Treasury bonds due to rising short rates.

The relative flatness of the yield curve, in our opinion, certainly does not warrant taking on the duration risk. At the same time, we do not recommend a short position in long-dated treasuries either – the negative carry is simply too costly at current yields.

 

On to this week’s piece where we discuss the United States-Mexico-Canada Agreement, or USMCA, the new trade deal between the US, Canada and Mexico that replaces the North American Free Trade Agreement, or NAFTA, and its implications on the on-going trade dispute between the US and China.

The many months of the will-they-won’t-they circle of negotiations between the US, Canada and Mexico have culminated in the USMCA, which will replace NAFTA. The new deal may not be as transformative as the Trump Administration would have us believe but nonetheless has some important changes. Some of the salient features of the new agreement include:

 

1. Automobiles produced in the trade bloc will only qualify for zero tariffs if at least 75 per cent of their components are manufactured in Mexico, the US, or Canada versus 62.5 per cent under NAFTA.

The increased local component requirement is, we feel, far more to do with limiting indirect, tariff-free imports of Chinese products into the US than it is to do with promoting auto parts production in North America. The latter, we think, is an added benefit as opposed to the Trump Administration’s end goal.

 

2. Also relating to automobiles, the new agreement calls for 40 to 45 per cent of content to be produced by workers earning wages of at least US dollars 16 an hour by the year 2023.

This provision specifically targets the relative cost competitiveness of Mexico and is likely to appease Trump faithfuls hoping for policies aimed at stemming the flow of manufacturing jobs from the US to Mexico.

How this provision will be monitored remains anyone’s guess. Nonetheless, the USMCA, unlike NAFTA, does allow each country to sanction the others for labour violations that impact trade and therefore it may well become that the threat is used to coerce Mexico into complying with the minimum wage requirements.

 

3. Canada will improve the level of access to its dairy market afforded to the US. It will start with a six-month phase-in that allows US producers up to a 3.6 per cent share of the Canadian dairy market, which translates into approximately US dollars 70 million in increased exports for US farmers.

Canada also agreed to eliminate Class 7 – a Canada-wide domestic policy, creating a lower-priced class of industrial milk. The policy made certain categories of locally produced high-protein milk products cheaper than standard milk products from the US.

 

4. The term of a copyright will be increased from 50 years beyond the life of the author to 70 years beyond the life of the author. This amendment particularly benefits pharmaceutical and technology companies in the US. American companies’ investment in research and development far outstrips that made by their Canadian and Mexican peers

Another notable victory for pharmaceuticals is the increased protection for biologics patents from eight years to ten years.

 

5. NAFTA had an indefinite life; the USMCA will expire in 16 years.

The US, Canada and Mexico will formally review the agreement in six years to determine whether an extension beyond 16 years is warranted or not.

 

The successful conclusion of negotiations between the three countries, subject of course to Congressional approval, combined with the trade related truce declared with the European Union in the summer, should be seen as a victory for US Trade Representative Robert E. Lighthizer.

Earlier this year, in AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote (emphasis added):

 

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

 

Mr Trump and his band of trade warriors and security hawks are now in the clear to focus their attention on China and deal with the threat it poses to the US’s global economic, military and technological leadership.

 

The Big Hack

On Thursday, Bloomberg Businessweek ran a ground breaking story confirming the Trump Administration’s fears relating to Chinese espionage and intellectual property theft. The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies details how Chinese spies hacked some of the leading American technology companies, including the likes of Apple and Amazon, and compromised their supply chains.

Bloomberg’s revelations were swiftly followed by strongly worded denials by Apple and Amazon.

The timing of Bloomberg’s report – coming so soon after the USMCA negotiations were completed successfully – regardless of whether the allegations are true or not is notable.

Coincidentally, also on Thursday, Vice President Pence, in a speech at the Hudson Institute, criticised China on a broad range of issues, from Beijing’s supposed meddling in US elections, unfair trade practices, espionage, and the Belt and Road Initiative.

 

American Corporate Interests

The main hurdle for the Trump Administration in its dispute with China is the US dollars 250 billion invested in China by Corporate America.

We see the recent moves by the Administration in upping the ante on China, by disseminating the theft and espionage narrative through the media and new rounds of tariffs, as a means to provoke Corporate America to begin reengineering its supply chains away from China. Whether this happens, and at what the cost will be, remains to be seen.

 

War of Attrition

We expect US-China tensions to continue to escalate especially as we draw closer to mid-term election. And the Trump Administration to (threaten to) impose higher tariffs and use other economic and non-economic measures to pressurise the Chinese. The only near term reprieves we see from the US side are (i) a resounding defeat for the Republicans in the mid-term elections (not our base case) or (ii) a re-assessment of priorities by the Trump Administration following the elections.

From the Chinese perspective, the short-term impact of tariffs has partially been offset by the ~10 per cent fall in the renminbi’s value against the US dollar since April. A continued depreciation of the renminbi can further offset the impact of tariffs in the short run – for now this is not our base case.

The other alternative for Beijing is to stimulate its economy through infrastructure and housing investment to offset the external shock à la 2009 and 2015. However, given that Xi Jinping highlighted deleveraging as a key policy objective at the 19th National Congress, we expect fiscal stimulus to remain constrained until is absolutely necessary.

For now our base case is for China to continue to buy time with the President Trump and at the same time for it to work on deepening its economic and political ties in Asia, with its allies and the victims of a weaponised dollar.

 

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.

Consumer Stocks: The Long and Short of it

 

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, American publisher and author

 

“When thinking about the future, it is fashionable to be pessimistic. Yet the evidence unequivocally belies such pessimism. Over the past centuries, humanity’s lot has improved dramatically – in the developed world, where it is rather obvious, but also in the developing world, where life expectancy has more than doubled in the past 100 years.” – Bjørn Lomborg, Danish author and President of Copenhagen Consensus Center

 

“What day is it?” asked Pooh.

“It’s today,” squeaked Piglet.

“My favourite day,” said Pooh.

Alexander Alan Milne

 

American consumers are the driving engine of the US economy – consumer spending is estimated to represent about two-thirds of US economic output. If sentiment surveys and retail sales are anything to go by then the American consumer, and by extension the US economy, is in rude health.

Consumer sentiment, as tracked by the University of Michigan, in September jumped to its second-highest level since 2004.

According to the Commerce Department, US retail sales increased by 6.6 per cent year-over-year in August – running well ahead of inflation. Month-on-month growth, however, was disappointing with August sales only increasing 0.1 per cent over July – whilst somewhat unsatisfactory, monthly comparisons tend to have a very low signal-to-noise ratio and are therefore misleading to read into, in our opinion.

Given the robust retail sales and soaring consumer sentiment, one would expect investors to be all bulled up on consumer stocks. Yet, as we compare the level of short interest across the constituents of the S&P500 Index we find that the greatest concentration of shorts (relative to free float) is in consumer related stocks. Investors remain circumspect about the prospects of consumer focused companies due to the potential impact of (i) rising interests on the disposable income of US consumers, and (ii) escalating trade tensions between the US and China on the companies’ supply chains, which in turn could meaningfully increase their cost of goods.

The below chart shows the average level of short interest (as a percentage of free float) by industry group. (Consumer related industry groups are highlighted in yellow.)

 

Average Short Interest across S&P500 Index by Industry Group 1Source: Bloomberg

The above chart shows that all but one of the consumer related industry groups has a higher level of short interest than the average level of short interest for a stock in the S&P500 Index. Moreover, the top three most shorted industry groups are all consumer related.

To further dissect the level of short interest across consumer related stocks, we focus in on the constituents of the SPDR S&P Retail $XRT and iShares US Consumer Goods $IYK exchange traded funds.

 

Retail

The average level of short interest for $XRT constituents is 7.5 per cent of free float. The most shorted sub-industry groups are food retail (something we have written about recently in The Challenge for Food & Beverage Retail Incumbents), automotive retail, and drug retail.

Average Short Interest across $XRT by Sub-Industry Group 2Source: Bloomberg

American department store chain Dillard’s is the most shorted stock amongst the constituents of $XRT with short interest making up a whopping 66.2 per cent of free float. The high level of short interest in the stock has not been rewarded by a declining price this year – the stock has generated a total return of 31.5 per cent year-to-date (as at market close on 19 September, 2018).

A further seven constituents have short interests that exceed 30 per cent of their free float, namely: Overstock.com (45.7 per cent), JC Penney (45.7 per cent), GameStop (39.6 per cent), Camping World Holdings (39.3 per cent), Hibbett Sports (36.4 per cent), The Buckle (36.0 per cent) and Carvana (31.3 per cent). The performance of these stocks has been more mixed with online retail company Overstock.com down 58.8 per cent year-to-date while online car dealer Carvana has generated an astonishing 208.3 per cent return year-to-date.

Many of the heavily shorted retail stocks appear to us to be the companies investors view as the mostly likely to be “Amazoned” in the near term.

 

Top 30 Most Shorted $XRT Constituents 3Source: Bloomberg

 

Total Return Year-to-Date of the Top 30 Most Shorted $XRT Constituents 4Source: Bloomberg

 

Generally, being short retail stocks has not been rewarding this year. The price return of $XRT is 14.2 per cent year-to-date versus 9.6 per cent year-to-date for the S&P500 Index.

 

Scatter Plot of Short Interest versus Year-to-Date Total Return for $XRT Constituents 5Source: Bloomberg

Note: Chart excludes Dillard’s and Caravan

 

Consumer Goods

The average level of short interest for $IYK constituents at 6.2 per cent of free float is lower than for $XRT constituents but still significantly higher than the average for the S&P500 Index. The most shorted sub-industry groups are tires & rubber, home furnishings and housewares & specialties.

Rising mortgage rates and the home buyer affordability index at ten-year lows are the likely reasons for the high levels of short interest in the home furnishings and housewares & specialties segments.

Average Short Interest across $IYK by Sub-Industry Group 6Source: Bloomberg

 

Only two stocks amongst the $IYK constituents have a short interest to free float ratio exceeding 30 per cent: B&G Foods (32.7 per cent) and Under Armour (31.8 per cent).

Generally, being short consumer goods stocks has been more rewarding than being short retail stocks. $IYK is down 3.5 per cent year-to-date. (We wrote about our concerns relating to the consumer goods sector last year in Unbranded: The Risk in Household Consumer Names.)

 

Top 30 Most Shorted $IYK Constituents 7Source: Bloomberg

 

Total Return Year-to-Date of the Top 30 Most Shorted $IYK Constituents 8Source: Bloomberg

 

Scatter Plot of Short Interest versus Year-to-Date Total Return for $IYK Constituents 9Source: Bloomberg

 

 

Investment Perspective

 

There is, we think, no clear playbook when it comes to heavily shorted stocks. Some portfolio managers we have interacted with in the past have occasionally gone long ‘consensus shorts’. Their track record is middling; they have done very well at times but also been burnt badly at other times.

Our approach is to identify heavily shorted stocks where we have a differentiated view on the prospects of near term earnings, valuation or the potential for the company to be acquired and to go long those stocks. (These lessons have been hard learned over time as in the past we have found ourselves far too closely aligned with consensus – as George S. Patton is known to have said: ‘If everyone is thinking alike, then somebody isn’t thinking’.)

In the instances our positioning and views prove correct, the high level of short interest acts like leverage and greatly amplifies returns in a relatively short amount of time.

Earlier this year we went long Under Armour based on our view that consensus earnings expectations had been deflated to such a degree that there was very little chance for the company to disappoint – with the stock price languishing at multi-year lows we deemed there to be little downside even if the company disappointed. As it transpired, the consensus view was indeed far too bleak and the stock quickly re-rated higher as the company outdid lowball expectations.

More recently, on 24 July, we went long and remain long kitchenware and home furnishings company Williams Sonoma $WSM. Short interest for the stock stands at over 20 per cent of free float, the company generated a best-in-class operating return on invested capital of 18.4 per cent in 2017 and trades at around consensus forward price-to-earnings of 15.4 times.

The retail and consumer goods sectors remain our preferred areas to search for heavily shorted stocks where we may have or develop a differentiated view.

 

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. 

Financial Misery and the Flattening Yield Curve

 

“Every day is a bank account, and time is our currency. No one is rich, no one is poor, we’ve got 24 hours each.” – Christopher Rice, bestselling author

 

“He tried to read an elementary economics text; it bored him past endurance, it was like listening to somebody interminably recounting a long and stupid dream. He could not force himself to understand how banks functioned and so forth, because all the operations of capitalism were as meaningless to him as the rites of a primitive religion, as barbaric, as elaborate, and as unnecessary. In a human sacrifice to deity there might be at least a mistaken and terrible beauty; in the rites of the moneychangers, where greed, laziness, and envy were assumed to move all men’s acts, even the terrible became banal.” – Excerpt from The Dispossessed by Ursula K. Le Guin

 

“A bank is a place that will lend you money if you can prove that you don’t need it.” – Bob Hope

 

Before we get to the update, just a quick comment on the New York Times op-ed “I Am Part of the Resistance Inside the Trump Administration” written by a hitherto anonymous member of the Trump Administration, which we suspect many of you have already read. Our reaction to the piece is that an “elite” politician issuing an editorial in a highbrow broadsheet and talking of resistance against the President is far more likely to stoke populism than to weaken it. Moreover, as angry as President Trump may appear to be about the editorial on television, it gives him just the kind of ammunition he needs to drum up the “us against them” rhetoric and rouse his core supporters to turn up to vote during the forthcoming mid-term elections.

Moving swiftly on, this week we write about US financials.

 

Financials have not had a great year so far. The MSCI US Financials Index is up less than one per cent year-to-date, tracking almost 7 per cent below the performance of the S&P500 Index. While the equivalent financials indices for Japan and Europe are both down more than 11 per cent year to date.

At the beginning of the year, investors and the analyst community appeared to be positive on the prospects for the financial sector. And who can blame them? The Trump Tax Plan had made it through Congress, the global economy was experiencing synchronised growth, progress was being made on slashing the onerous regulations that had been placed on the sector in the aftermath of the global financial crisis, and banks’ net interest margins were poised to expand with the Fed expected to continue on its path of rate hikes.

 

So what happened?

We think US financials’ under performance can in large part be explained by the flattening of the US yield curve, which in turn can result in shrinking net interest margins and thus declining earnings. The long-end of the US yield curve has remained stubbornly in place, for example 30-year yields still have not breached 3.25 per cent, and all the while the Fed has continued to hike interest rates and pushed up the short-end of the curve.

 

Why has the long-end not moved?

There are countless reasons given for the flattening of the yield curve. Many of them point to the track record of a flattening and / or inverted yield curve front running a recession and thus conclude with expectations of an imminent recession.

The Fed and its regional banks are divided over the issue. In a note issued by the Fed in June, Don’t Fear the Yield Curve, the authors conclude that the “the near-term forward spread is highly significant; all else being equal, when it falls from its mean level by one standard deviation (about 80 basis points) the probability of recession increases by 35 percentage points. In contrast, the estimated effect of the competing long-term spread on the probability of recession is economically small and not statistically different from zero.”

Atlanta Fed President, Mr Raphael Bostic, and his colleagues on the other hand see “Any inversion of any sort is a sure fire sign of a recession”. While the San Francisco Fed notes that “[T]he recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession”.

Colour us biased but we think the flattening of the yield curve is less to do with subdued inflation expectations or deteriorating economic prospects in the US and far more to do with (1) taxation and (2) a higher oil price.

US companies have a window of opportunity to benefit from an added tax break this year by maximising their pension contributions. Pension contributions made through mid-September of this year can be deducted from income on tax returns being filed for 2017 — when the U.S. corporate tax rate was still 35 per cent as compared to the 21 per cent in 2018. This one-time incentive has encouraged US corporations to bring forward pension plan contributions. New York based Wolfe Research estimates that defined-benefit plan contributions by companies in the Russell 3000 Index may exceed US dollars 90 billion by the mid-September cut-off – US dollars 81 billion higher than their contributions last year.

US Companies making pension plan contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference this year is the tax rate cut and the financial incentive it provides for pulling contributions forward.

Given that a significant portion of assets in most pension plans are invested in long-dated US Treasury securities, the pulled forward contributions have increased demand for 10- and 30-year treasuries and pushed down long-term yields.

Higher oil prices, we think, have also contributed to a flattening of the yield curve.

Oil exporting nations have long been a stable source of demand for US Treasury securities but remained largely absent from the market between late 2014 through 2017 due to the sharp drop in oil prices in late 2014. During this time these nations, particularly those with currencies pegged to the US dollar, have taken drastic steps to cut back government expenditures and restructure their economies to better cope with lower oil prices.

With WTI prices above the price of US dollars 65 per barrel many of the oil exporting nations are now generating surpluses. These surpluses in turn are being recycled into US Treasury securities. The resurgence of this long-standing buyer of US Treasury securities has added to the demand for treasuries and subdued long-term yields.

 

Investment Perspective

 

A question we have been recently asked is: Can the US equity bull market continue with the banking sector continuing to under perform?

Our response is to wait to see how the yield curve evolves after the accelerated demand for treasuries from pension funds goes away. Till then it is very difficult to make a definitive call and for now we consider it prudent to add short positions in individual financials stocks as a portfolio hedge to our overall US equities allocation while also avoiding long positions in the sector.

We have identified three financials stocks that we consider as strong candidates to short.

 

Synovus Financial Corp $SNV 

 

SNV

 

Western Alliance Bancorp $WAL

 

WAL 

Eaton Vance Corp $EV

 

EV

 

 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 Stocks: Long, Short and Interesting

“We often plough so much energy into the big picture, we forget the pixels.” – Silvia Cartwright

As highlighted last week, the focus is on equities this week. Instead of the usual text heavy approach, we do a quick run through of more than a handful of US stocks including some that we already hold, would like to add to our holdings, and consider as candidates for the short side.

The approach we have taken is as thematic as we could possibly make it. Stocks that do not fall under a theme have been left out of today’s piece, we will aim to issue a follow-up piece in the next week or two to cover  individual stocks that we are monitoring but do not neatly fit under a clear investment theme at present.

[Note that our typical investment horizon ranges from 6 to 18 eighteen months for any position. With the caveat that if a stock significantly re-rates higher or lower due to a material development or otherwise, we may exit the position sooner.]

Semiconductors and Fabrication

In AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote:

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

Supply related concerns and forward earnings expectations reaching unreasonable levels have certainly slowed the upward march of semiconductor stocks; and we are seeing weakness across the semiconductors and fabrication spectrum. We consider the following stocks as potential candidates for shorting.

ON Semiconductor $ON

A spin-off of Motorola, $ON supplies semiconductor products across a wide spectrum of end-uses including those for power and signal management, logic, discrete, and custom devices for automotive, communications, computing, consumer, industrial, LED lighting, medical, military/aerospace and power applications.

As per Bloomberg, there are 21 analysts recommendations for the stock, 14 of them buys, an 5 holds and only 2 sells.

If the company disappoints, as we suspect that it will, a flurry of downgrades could well push the stock much lower.

ON.PNG

Cypress $CY

$CY designs and manufactures programmable system-on-chip integrated circuits, USB and touchscreen controllers, and programmable clocks for the automotive, industrial, home automation and appliances, consumer electronics and medical products industries.

CY.PNG

Entegris $ENTG

$ENTG  designs and manufactures contamination control, microenvironment, and specialty materials products and systems to purify, protect, and transport critical materials used in the semiconductor device fabrication process.

As per Bloomberg, the stock current trades almost 30% below the average target price of the 11 analysts that cover the stock.

ENTG.PNG

Marvell Technology $MRVL

$MRVL designs analog, digital, mixed-signal and microprocessor integrated circuits for storage, telecommunications, cloud storage and consumer markets.

MRVL.PNG

Retail

According to data released earlier this week, retail sales rose a seasonally adjusted 0.5 per cent in July from the prior month, well ahead of economists’ forecasts for a 0.1 per cent increase.

Year-over-year retail sales are up a robust 6.4 per cent, tracking well ahead of inflation, as measured by the consumer price index.

Low unemployment levels combined with the windfall from tax cuts is contributing to strong consumer sentiment and high levels of spending across the majority of retail categories.

We have already witnessed Walmart $WMT reporting  its strongest US sales growth in more than a decade, which sent the stock soaring higher. We have been long $WMT since September last year and at the time of initiating the positioning, we wrote:

$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential

WMT.PNG

Another retail name we have been long  is Dollar General $DG, we initiated a position in the stock in November last year.

DG.PNG

We still expect further upside in both $WMT and $DG and continue to hold them. Generally, we continue to see strength across the retail complex and may look to add long positions in at least two more stocks.

Burlington Stores $BURL

$BURL operates more than 630 off-price department stores across the US.

The company is expected to report quarterly earnings on 22 Aug with consensus analyst estimates for earnings growth of 33 per cent for the quarter, and 37 per cent growth for the full year. Annual earnings estimates were recently revised upward.

BURL.PNG

Dunkin’ Brands Group $DNKN

$DNKN is a restaurant holding company and franchiser of two chains of quick service restaurants: Dunkin’ Donuts and Baskin Robbins. The company franchises over 20,000 Dunkin’ Donuts and Baskin Robbins ice cream parlours in the US and across 60 international markets.

DNKN.PNG

Payment Processing

Driven by the rise of global e-commerce and internet-connected mobile devices, physical money is being snubbed in favour of cards and other digital payment options. According to Capgemini, global non-cash transactions are expect to grow at CAGR of 10.9 per cent between 2015 and 2020 and reach US dollars 725 billion.

This secular trend toward ever increasing non-cash transactions is in favour of payment processors – both the near ubiquitous players (e.g. VISA and MasterCard) and niche solutions providers.

We added FleetCor Technologies $FLT to our long trade ideas in June.

$FLT is an independent provider of specialised payment products and services to commercial fleets, major oil companies and petroleum markets.

The company’s payment cards provide significant savings and benefits to local fleets, including purchase controls, lower fraud, and specialised reporting. Penetration levels for the payment cards are relatively low at around 50% and there is significant potential for the company to gradually increase penetration levels.

We continue to hold the stock.

FLT.PNG

Cardtronics $CATM

We will be looking to add $CATM as a second name under the payment processing theme.

$CATM is the world’s largest non-bank ATM operator and a leading provider of fully integrated ATM and financial kiosk products and services.

The company owns Allpoint, an interbank network connecting ATMs. Allpoint offers surcharge-free transactions at ATMs in its network and operates in the US, Canada, Mexico, United Kingdom, and Australia.

Allpoint is in the business of supporting any financial institution provide an ATM network to rival the very largest banks. Allpoint today offers more than 55,000 surcharge-free ATMs to over 1,000 financial institutions.

$CATM’s has recently updated its strategy to increasingly focus on expanding Allpoint’s network and penetration amongst financial institutions.

The company’s strategy update has been accompanied by a strong level of insider buying.

CATM.PNG

Energy Infrastructure and Mid-Stream Services

In April we issued a piece on the opportunities arising out of the infrastructure bottlenecks in shale patch in the US – Oil: Opportunities Arising from Infrastructure Bottlenecks

At the time we identified two industrial equipment suppliers that could benefit from increased demand originating from the shale patch: SPX Flow $FLOW and Flowserve $FLS. Although the stocks have yet to perform we continue to see significant opportunities in the energy infrastructure space and hold on to them.

FLS.PNG

FLOW.PNG

Given the scale of the opportunity in the sector, we think there is a lot of room to add additional names to better play the overall theme.

IDEX Corp $IEX

$IEX is engaged in the development, design, and manufacture of fluid handling systems,  and specialty engineered products.Its products include pumps, clamping systems, flow meters, optical filters, powder processing equipment, hydraulic rescue tools, and fire suppression equipment, are used in a variety of industries.

IEX.PNG

UGI Corp $UGI

$UGI is a holding company with interests in propane and butane distribution, natural gas and electric distribution services.

UGI.PNG

Targa Resources Corp $TRGP

$TRGP  is one of the largest providers of natural gas and natural gas liquids in the US. The company’s operations are predominantly concentrated on the Gulf Coast, particularly in Texas and Louisiana.

TRGP.PNG

Digitalisation

Digitisation is the process of converting information from a physical format into a digital one. When this process is utilised to automate and / or enhance business processes and activities, it is referred to ‘digitalisation’.

Digitalisation is concerned with businesses adopting digital technologies to create new revenue streams and / or improving operational processes. Digitalisation is not something new, businesses have been actively engaged in digitalising their operations for decades. The rise of big data, Moore’s law continuing to hold true as it relates to integrated circuits and the ever dropping cost of electronic components, however, has meant that its adoption has started to accelerate in recent years.

Amazon’s supermarket with no checkouts is an example of an outcome when a business fully embraces digitalisation.

We currently do not have any open positions under this theme. We are looking to add longs in two names.

Trimble $TRMB

$TRMB developer of Global Navigation Satellite System receivers, laser rangefinders, unmanned aerial vehicles , inertial navigation systems and software processing tools. The company is best known for its for GPS technology.

The company provides integrated solutions that enable businesses to to collect, manage and analyse complex information.

$TRMB is renowned for having deep domain knowledge of the industries it provides integrated solutions for and generally caters markets ripe for or undergoing rapid digitalisation.

TRMB

Zebra Technologies $ZBRA

$ZBRA  is in the business of  enterprise tracking and manufactures and sells marking, tracking and computer printing technologies primarily to the retail, manufacturing supply chain, healthcare and public sectors. Its products include direct thermal and thermal transfer printers, RFID printers and encoders, dye sublimation card printers,  handheld readers and antennas, and card and kiosk printers.

The  company achieved an adjusted EPS of US dollars 2.48 a share in the second quarter, up 64 per cent year-over-year. Sales rose 13 per cent to US dollars 1.012 billion. The company beat consensus estimates of  US dollars 2.23 in EPS and sales US dollars $989 million.

ZBRA.PNG

Software as a Service (SaaS)

We quote from venture capitalist Marc Andreessen’s seminal essay from 2011:

“This week, Hewlett-Packard (where I am on the board) announced that it is exploring jettisoning its struggling PC business in favor of investing more heavily in software, where it sees better potential for growth. Meanwhile, Google plans to buy up the cellphone handset maker Motorola Mobility. Both moves surprised the tech world. But both moves are also in line with a trend I’ve observed, one that makes me optimistic about the future growth of the American and world economies, despite the recent turmoil in the stock market.

In short, software is eating the world.”

Mr Andreessen’s words ring just as true today as they did back in 2011. Software, specifically SaaS, has continued to proliferate and we have increasingly witnessed the rise of SaaS companies that provide solutions tailored to the needs of individual industries or specific functions within a business.

We are looking to go long two names under this theme.

Paycom $PAYC

$PAYC designs and develops cloud-based human capital management software solutions to support businesses in managing the entire employment life cycle.

$PAYC is a highly disruptive company that is successfully displacing entrenched incumbents across the payroll management space.

Businesses tend to use software to make their employees’ lives easier and to reduce their day-to-day administrative burden. Ask any business, big or small, they will tell you that compliance is a major headache. And there is a lot businesses have to comply with, particularly in the US. Payroll software allows businesses to comply with tax and other payroll related laws. $PAYC started life as a payroll management software provider.

$PAYC’s software solutions have long since evolved beyond payroll management and include applications for talent management, recruitment and general human capital management. Payroll management is serves as the company’s entry product for new customers and the added solutions provide $PAYC with the opportunity to gradually up sell existing customers.

PAYC.PNG

Veeva Systems $VEEV

$VEEV is a cloud-computing company focused on providing solutions for the sales and marketing functions within the pharmaceutical and life sciences industries. The company’s software helps pharmaceutical companies manage customer databases, track drug developments, and organize clinical trials. The software has been widely adopted by ‘Big Pharma’.

The company’s lower-cost and tailored approach has enabled it to upend the on premise software providers such as SAP and Oracle in the pharmaceutical and life sciences sectors.

While the company maintains its core focus in life sciences, it is gradually broadening its products’ functionality to enable it to up sell existing clients and to potentially enter into new industry segments.

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Plenty of names for you to chew on for this week. If you would like to discuss any of the names in more detail or to talk you through our more detailed investment cases, feel free to reach out to us over email or by direct message on Twitter.

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. 

Continued Strength in the US Dollar | China’s Line in the Sand | Germany Between a Rock and a Hard Place

 

“One benefit of summer was that each day we had more light to read by” – Jeanette Walls, American author and journalist

 

“The best of us must sometimes eat our words.” – J. K. Rowling

 

“Increasingly, the Chinese will own a lot more of the world because they will be converting their dollar reserves and U.S. government bonds into real assets.” – George Soros

 

We have a mixed bag here for you this week folks with commentary on:

  • The strength in the US dollar
  • China’s response to Trump’s latest threats to escalate the trade war
  • Germany’s energy needs placing it between a rock and a hard place

 

Continued strength in the US dollar

A number of you have messaged us about the recent strength in the US dollar and our take on it. For the benefit of all readers, we briefly wanted to touch upon where we stand after the latest move higher by the greenback.

Back in March – Currency Markets: “You can’t put the toothpaste back in the tube” – we wrote:

 

The major central banks of the world are now in a competitive game. While markets may enter an interim phase where the Fed’s hawkish posturing leads to a strengthening dollar, this phase, in our opinion, is likely to be short-lived.

 

The line in the sand beyond which we would consider our view to be invalidated is a sustained move above 96 on the US dollar index.

 

At the time we wrote the above, we were unaware of how or why the 96 level was going to prove to be a significant level for the US dollar. However, we felt that psychologically it was a critical level for market participants. The dramatic plunge in the Turkish lira today, the sentiment being displayed across key media outlets and the general tone on Twitter all seem to validate that around 96 on the DXY is indeed an important level.

For now all we would add is that we are in wait and see mode. If the US dollar continues to move higher or remains above the 96 for a prolonged period (6 to 8 weeks), we would have to accept that our bearish view on the US dollar was wrong. If, however, the greenback fails to sustain above 96 we would likely look to put on carry trades in emerging market currencies and go long the euro and Japanese yen.

Until we have more clarity we will remain on the side lines.

 

China’s Line in the Sand

Last week, the People’s Bank of China (PBoC) imposed a reserve requirement of 20 per cent on some trading of foreign-exchange forward contracts, effectively increasing the cost of shorting the Chinese yuan. The move has offset some of the pressure from President Trump’s threats to further escalate the trade war and has brought stability to the currency.

Official statements indicate that the PBoC made the move to reduce both “macro financial risks” and the volatility in foreign exchange markets.  To us the move by the PBoC, however, suggests that China is not yet ready to trigger a sharp devaluation of its currency in the trade war with the US.

What is more confounding, however, is figuring out what China can do to respond to the threats of further escalation of the trade war by the Trump Administration. Initially China tried to appease Mr Trump by:

  • Lavishly hosting him in China;
  • Offering to increase imports from the US to reduce its trade surplus;
  • Proposing to gradually opening its local markets to US corporations; and even
  • Engaging in commercial dealings in favours of Mr Trump’s family;

Failing at that, China has tried to respond by:

However, China’s retaliatory efforts have not swayed Mr Trump either.

The problem, as we described in Trade Wars: Lessons from History, is one of creed:

 

President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain.

 

Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

The only way we see the Trump Administration relenting in its push to corner the Chinese is if Trump the “dealmaker” takes control of proceedings. That is, in his desire to make a deal and claim victory, President Trump tells his band of trade warriors and security hawks to take a backseat and instead strikes a deal with China that involves a combination of China buying more from the US and opening up its markets to more foreign ownership (something we suspect China wants to do any way, but on its own terms).

 

Germany: Stuck Between a Rock and a Hard Place

President Trump began his visit to the annual summit of NATO allies in June this year by breaking from diplomatic protocol and verbally attacking Germany:

 

“We’re supposed to protect you from Russia, but Germany is making pipeline deals with Russia. You tell me if that’s appropriate. Explain that.”

 

In May 2011 Germany decided to abandon nuclear power in favour of greener sources of energy such as wind and solar. Nuclear power accounted for almost a fifth of Germany’s national electricity supply at the time Chancellor Angela Merkel announced plans to mothball the country’s 17 nuclear power stations by 2022 following the Fukushima Daiichi nuclear disaster in 2011.

Germany, however, failed in its attempt at adequately fulfilling a greater proportion of its energy needs through alternative sources of renewable energy. And the direct consequence of Chancellor Merkel’s decision to drop nuclear power has been that Germany has become increasingly dependent on Russia’s plentiful natural gas supplies.

Germany has a difficult decision to make. Does it choose to maintain its geopolitical alliance with the US and abstain from Russian gas or does it choose cheap gas and re-align itself geopolitically?

German Foreign Minister Heiko Maas’ interview on 9 August suggests that Germany may well be leaning towards the latter (emphasis added):

 

“Yes, in future we Europeans will have to look out for ourselves more. We’re working on it. The European Union has to finally get itself ready for a common foreign policy. The principle of unanimity in line with which the European Union makes its foreign policy decisions renders us incapable of taking action on many issues. We’re in the process of transforming the European Union into a genuine security and defence union. We remain convinced that we need more and not less Europe at this time.”

 

Russia is under US sanctions. China is under pressure from the US. And now Germany – in no small part due to its massive trade surplus with the US – finds itself in the cross-hairs.

What if Russia, China and Germany were to form an economic, and dare we ask political, alliance? Something that would have seemed far-fetched less than a year ago, does not seem to sound so crazy anymore.

 

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

Trade Wars: Lessons from History

 

“There is nothing new in the world except the history you do not know.” – Harry Truman

 

“Give us a protective tariff and we will have the greatest nation on earth” – Abraham Lincoln

 

“If a nation expects to be ignorant and free, in a state of civilisation, it expects what never was and never will be.” – Thomas Jefferson

 

At the Luzhniki Stadium in Moscow last week, France defeated Croatia in the final of 2018 FIFA World Cup. As the French toasted their second FIFA World Cup triumph, pundit upon pundit and football fan after football fan debated the manner of France’s victory and the controversial decisions that went France’s way. Our small group of friends and colleagues also got caught up in a debate on whether the referee rightly or wrongly rewarded the penalty that led to France’s second goal. Our debate was not limited to those of us that watched the match together but rather extended to our WhatsApp groups and roped in friends from all over the world.

It is often said that it is human nature to see what we want to see and ignore that which goes against our expectations.

As our arguments for and against the penalty went round and round in circles, we decided to watch replays of the incident from the match to try and settle which side of the debate had more merit. The funny thing is as we watched the replays the conviction levels on either side of the debate became even stronger. By some means what each of us saw, or at least thought we saw, reaffirmed our predisposition.

Of course, whether it was a penalty or not (it wasn’t) does not really matter. The record books will show that the French defeated the Croats by four goals to two. There will be no asterisk next to the record to note that arm chair fan Joe Schmoe disputed the validity of France’s victory due to the award of a dubious penalty.

Reflecting upon the harmless nature of our argument, we think of the oft quoted words of Winston Churchill:

“Those who fail to learn from history are doomed to repeat it.”

Powerful statements can often hide as much as they reveal.

Can we learn what actually happened from studying history? Unlike the final score of a football match, the record of any past event that cannot be definitively quantified is likely to be clouded by the prejudices of historians and distorted by our individual partisanship.  And if we do not truly know what happened, can we really be doomed to repeat it?

Reality or not, below we examine the recorded history of American protectionism, reflect upon the successful adoption of the ‘American System’ by China and consider the possible outcomes of the rising trade-related tensions between the US and China.

 

American Independence and British Retaliation

On 18 April 1775, a clash between the British redcoats and the local militia at Lexington, Massachusetts, led to the fighting that began the American War of Independence.

Fifteen months after fighting began the American colonists claimed independence from the British and Thomas Jefferson drafted the Declaration of Independence.

The British did not take the colonists’ declaration lying down and made attempts to forcibly regain control over America. Economic warfare was one of the tools used by the British to inflict pain upon the Americans.

Britain closed off its markets to American trade by raising tariffs on American manufactured goods. US exports to England and its colonies fell from an estimated 75 per cent of total exports prior to the Declaration of Independence to around 10 per cent after it. The sharp fall in trade brought on an economic depression in the US.

Britain did not stop at just tariffs. It wanted to halt the US’s transformation from its agrarian roots to an industrialised nation and in this pursuit it went as far as outlawing skilled craftsmen from overseas travel and banning the export of patented machinery.

 

The American System

The American System, also known as the American School of Economics, is an economic plan based on the ideas of Alexander Hamilton, the first Secretary of the Treasury of the United States, which guided the US national economic policy from first half of the 19th century till the early 1970s. The system is widely credited as having underpinned the US’s transformation from an agrarian frontier society to global economic powerhouse.

The American System is rooted in the mercantilist principles presented by Alexander Hamilton to Congress in December 1791 in the Report on the Subject of Manufactures. The three basic guiding economic principles of the system demanded the US Government to:

  1. Promote and protect American industries by selectively imposing high import tariffs and / or subsidising American manufacturers;
  2. Create a national bank to oversee monetary policy, stabilise the currency and regulate the issuance of credit by state and local banks; and
  3. Make internal improvements by investing in public infrastructure – including but not limited to roads, canals, public schools, scientific research, and sea ports – to facilitate domestic commerce and economic development.

These guiding principles are based on Alexander Hamilton’s insight that long-term American prosperity could not be achieved with an economy dependent purely on the financial and resource extraction sectors. And that economic self-sufficiency hinged upon the US Government intervening to protect and to support the development of captive manufacturing capabilities.

Alexander Hamilton’s ideas were not immediately accepted by Congress – Congress was dominated by Southern planters, many of whom favoured free trade. One Thomas Jefferson, in particular, vehemently opposed Hamilton’s protectionist proposals.

Congress and Jefferson became much more receptive to Hamilton’s ideas in the aftermath of the Anglo-American War of 1812, during which the British burnt down the White House. The government’s need for revenue and a surge in anti-British fervour, in no small part, made favouring Hamilton’s proposals politically expedient for Congress.

In 1816 Congress passed an import tariff, known as the Dallas Tariff, with the explicit objective of protecting American manufacturers and making European imported goods more expensive. The legislation placed import duties of 25 per cent on cotton and wool textiles and manufactured iron; 30 per cent on paper and leather goods and hats; and 15 per cent on most other imported products. Two years later, and in response to predatory dumping of goods by the British, Congress further increased import duties.

American industry blossomed after the imposition of tariffs and vested interests lobbied to keep or even increase import duties. With the public strongly in support, Congress continued raising tariffs and American import duties rose to around 40 per cent on average by 1820.

Also in 1816, Congress created the “The President, Directors, and Company, of the Bank of the United States”, commonly referred to as the Second Bank of the United States, and President James Madison gave it a 20-year charter to handle all fiscal transactions for the US Government, regulate the public credit issued by private banking institutions, and to establish a sound and stable national currency.

The third and final tenet of the American System, federally funded internal improvements, was never fully adopted. Nonetheless, the US Government did end up using a part of the revenues generated from the import duties and the sale of public lands in the west to subsidise the construction of roads, canals and other public infrastructure.

Abraham Lincoln, Theodore Roosevelt, and many of the other great leaders from American history supported the American System. That is, they were all protectionists. Republican protectionist instincts used to be so ingrained that even if there was the slightest liberalisation of trade made by the Democrats, it would be reversed as soon as the Republican regained power. For instance the Revenue Act of 1913, passed during the early days of President Woodrow Wilson’s administration, which lowered basic tariff rates from 40 to 25 per cent, was almost entirely reversed after Republicans regained power following World War I.

It is only as recently as 1952, upon the election of Dwight D. Eisenhower, do we find a notable Republican leader that favoured free trade over protectionism.

Coincidentally, or not, President Eisenhower’s willingness to betray the Republican protectionist heritage in favour of free trade policies just so happened to be around the same time funding of the Marshall Plan ended. By 1952, the economy of every participant state in the Marshall Plan had surpassed pre-war levels; economic output in 1951 of each and every participant exceeded their respective output in 1938 by at least 35 per cent.

Happenstance or not, the economic recovery of Western Europe and its growing alliance with the US, created powerful inducements to free trade and overall wealth creation.

 

China’s Adoption of The American System

In 1978, China initiated the transformation of its economy towards a more liberal and market-based regime. The reforms, as it would become glaringly apparent over the following decades, were predicated on promoting exports over imports by adopting a combination of mercantilist and protectionist policies. The government supported exporters by waiving duties on materials imported for export purposes, creating dedicated export-processing zones, and granting favourably priced loans for capital investment. At the same time, the government supported the creation of national champions and industry leaders by limiting (or altogether prohibiting) foreign participation in strategic industries. These steps were in adherence with the first tenet of the American System.

The Chinese government also tightly managed monetary policy and kept its currency artificially undervalued through the combination of capital controls and intervention, driving capital exports and the build-up of trade surpluses – the second tenet.

A significant portion of government directed investment in China, especially since the early 1990s, has been in increasing the amount and improving the quality of public infrastructure. Investment was directed into all forms of public infrastructure including but not limited to developing power and telecommunications networks, public buildings, dams, rural road networks, manufacturing facilities, and academic institutions – the third tenet.

Much as the US economy flourished under the mercantilist tenets of the American System, China too has flourished over the last four decades by adopting the very same system.

Just as the Republicans in America were willing to make a turn toward free trade as the global economic environment became conducive to a US led global order, the Chinese leadership is beginning to espouse the virtues of free trade as its version of the Marshall Plan, the Belt and Road Initiative, gathers steam.

The Chinese leadership has guided its economy to such great heights based on, we suspect, their acute understanding of American economic history. It is China’s demonstrated adherence to the American System, which leads us to believe that just as Alexander Hamilton understood that America’s long-term stability hinged upon its transition from an agrarian to industrial society, the Chinese leadership deeply appreciates the need to transition its economy from being the toll manufacturer of global industry to playing a leading role in the high-tech industries of tomorrow.

 

Investment Perspective

 

Chinese Premier Li Keqiang and his cabinet unveiled the “Made in China 2025” strategic plan in May 2015. The plan lays out a roadmap for China take leadership role in 12 strategic high-tech industries and to move up the manufacturing value chain. The Council on Foreign Relations believes Made in China 2025 is a “real existential threat to US technological leadership”.

Just as the British insisted upon the US remaining an agrarian society in the 18th century, President Trump and his band of trade warriors are hell-bent on stopping the Chinese from moving up the manufacturing value chain. Short of going to war, the Trump Administration is even following the same playbook by imposing tariffs, blocking technology transfer and withholding intellectual property.

President Trump, however, appears ready to go further and even upend the global trade system and call into question the US dollar’s global reserve currency status. Mr Trump’s stated objective is to revive the US’s industrial base. This objective, however, is unachievable in a global trade system in which the US dollar is the world’s reserve currency. The privilege of having the world’s reserve currency comes with the responsibility of consistently running current account deficits and providing liquidity to the rest of the world.

 

Imposition of Tariffs

Unlike any other currency, the global reserve currency cannot be easily devalued. As we discussed in Don’t wait for the US Dollar Rally, its Already Happened, as the US dollar weakens international demand for the greenback increases. For this reason, it is probably easier for the US to pursue alternative means that have the same effect as a devaluation of its currency.

The imposition of tariffs, from foreign manufacturers’ perspective, is the equivalent of a devaluation of the US dollar. For US based buyers and consumers, tariffs lower the relative prices of US manufactured goods with respect to foreign manufactured goods. Tariffs, however, are only effective if their imposition does not result in an equivalent relative increase in the price of the US dollar. It is perhaps no coincidence then that the Chinese yuan started to tumble as soon as the US moved to impose tariffs on Chinese goods. And in response Mr Trump is turning on the Fed and its tightening of monetary policy.

 

The Nuclear Option

Mr Trump always has the nuclear option in his bid to revive industry in the US. He can attempt to overturn the global trade system and the status of US dollar as the world’s reserve currency by limiting the amount of US dollar available to the rest of the world – pseudo-capital controls. If this were to happen, any and every foreign entity or nation that is short US dollars (has borrowed in US dollars) will suffer from an almighty short squeeze. In response, China specifically would have to take one of two paths:

  1. Open up its economy to foreign investment and sell assets to US corporations to raise US dollars.
  2. Loosen capital controls to allow the settlement of trade in yuan.

 

A G2 Compromise

The final, and in our minds the most painless, alternative to the above scenarios is that of a G2 compromise i.e. China and the US come to an agreement of sorts that results in China making significant concessions in return for the US maintaining the current global trade system.

What such a compromise will look like we do not know but it most definitely involves a weakening of the US dollar.

 

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.

 

 

Don’t wait for the US Dollar Rally, its Already Happened

 

“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss

 

“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln

 

“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry

 

According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.”  What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange Holdings1aSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis

 

In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign Holdings1Sources: US Treasury, Securities Industry and Financial Markets Association

 

Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign Holdings2Source: US Treasury

 

Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar Index3Source: Bloomberg

 

In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury Yield4Source: Bloomberg

 

Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower.  The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital Outflows5Source: Bloomberg

 

The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.

 

Investment Perspective

 

  1. Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment

 

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index 6Sources: US Treasury, Bloomberg

 

The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.

 

  1. European and Japanese US treasury Holdings have started to decline

 

European and Japanese US Treasury Holding 7Source: US Treasury

 

The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.

 

  1. Positive correlation between US dollar and oil prices

 

One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar Index8Source: Bloomberg

 

The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.

 

  1. As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation

 

Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.

 

  1. To fund its twin deficits, the US will need a weaker dollar and higher oil prices

 

In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)9Source: Bloomberg

 

With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) 10Source: Willis Tower Watson

 

Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.

 

 

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.