Our Thoughts On and Investment Ideas for 2018

“No one’s ever achieved financial fitness with a January resolution that’s abandoned by February” – Suze Orman, American author, financial advisor, motivational speaker, and television host


“Nobody wants a prediction that the future will be more or less like the present, even if that is, statistically speaking, an excellent prediction.” – Nathan Myhrvold, formerly Chief Technology Officer at Microsoft


“It requires a very unusual mind to undertake the analysis of the obvious” – Alfred North Whitehead, English mathematician and philosopher


The start of a new year is as a good time as any to take stock of one’s portfolio and by extension the investment views underpinning it. Having undertaken the exercise internally, we take this opportunity and share some of our thoughts and investment ideas for the year ahead.

The ideas we present here are amongst our top convictions based on a 6 to 12 month investment horizon. As ever, we remain flexible and should circumstances and / or the data change our investment views too may change.


  1. Japan continues to outperform

We issued a piece on Japan last month, where we argued that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle. This view is predicated on the fact that Japan is already at the forefront of the robotics revolution and has a demographic profile that makes it uniquely sheltered from the potentially negative socio-economic consequences of the increased proliferation of artificial intelligence. Moreover, Japanese companies are flush with cash – cash holdings of companies listed on the Tokyo Stock Exchange are now more than 140 per cent of Japan’s GDP – that they can use to invest in robotics and automation.

Long iShares MSCI Japan ETF ($EWJ).


  1. A bull market in uranium

 “The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

– Excerpt from Capital Returns Investing Through the Capital Cycle: A Money Manager’s Reports 2002 -15 edited by Edward Chancellor


When it comes to uranium sector, plenty have cried wolf over the years as the commodity’s price crashed following the Fukushima Daiichi nuclear disaster in March 2011. When prices fell below the cash cost of the marginal producer, many felt the bottom was close. Instead, prices continued falling and even dropped below the cash cost of the most efficient producer.

Uranium 308 Physical Spot Price UraniumSource: Bloomberg

Uranium miners cut capital expenditures in response to the decline in price. Some producers even went as far as buying from the spot market to fulfil their deliveries as it became cheaper to buy in the market than to produce. Despite the struggles, supply cuts were few and far between – given tepid demand, the lack of capacity curtailment became a major impediment to any improvement in prices. That is, until recently. In January, 2017, KazAtomProm, the national operator of Kazakhstan for import and export of uranium, announced plans to cut production by 10 per cent – representing approximately 3 per cent of global uranium production. Spot prices rallied in response to the announcement but faded due to slow implementation of the cuts while demand also remained tepid. This past November, Cameco Corporation ($CCJ) – the world’s largest publicly listed uranium company – announced that it would suspend production at two of its mines, representing approximately 9 per cent of total global production,  for ten months by end of January, 2018. Less than a month later, Kazakhstan announced that it would cut 20% of its production for the next three years. These announcements sparked a yearend rally in uranium prices.

Our analysis suggests that the announced production cuts, without any improvement in demand dynamics, are sufficient to bring the uranium market into balance over the course of the next 18 months. If demand picks up, however, the market could quickly fall into a deficit, which would push prices up to much higher levels.

Long Global X Uranium ETF ($URA).


  1. US inflation, wage growth and velocity of money all pickup

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WG

Sources: Bureau of Labor Statistics, National Federation of Independent Business

This discrepancy is largely due to headline figures masking the underlying trend. The outsized impact of a handful of industries distorted the average. Based on the data from the Bureau of Labor Statistics (BLS) wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

 Annualised Wage Growth by Industry (2014 to 2016) Wage Growth IndustrySource: Bureau of Labor Statistics

As the oil and gas extraction industry is no longer a drag on headline wage growth, there is increasing evidence of wage growth picking up. Based on a recent article, “In Cities With Low Unemployment, Wages Finally Start to Get Bigger”, in the Wall Street Journal:

“Workers in metro areas with the lowest unemployment are experiencing among the strongest wage growth in the country. The labor market in places like Minneapolis, Denver and Fort Myers, Fla., where unemployment rates stand near or even below 3%, has now tightened to a point where businesses are raising pay to attract employees, often from competitors.”

Rising wages in the US will have disproportionately higher impact on the disposable incomes of low and lower-middle class households. As poorer households’ disposable income increases, they are more likely to increase consumption as opposed to increasing savings, especially when compared to upper and upper-middle class households. Moreover, the spending patterns of poorer households are starkly different to those of richer households – for one they are more value conscious. Retailers and quick service restaurants catering to lower and lower-middle income households are likely to be amongst the greatest beneficiaries of higher wages.

The inevitable corollary is the rising wages will place increasing pressure on businesses to improve productivity. This coupled with the incentives within the new US tax bill for increasing capital spending – cutting the corporate tax rate from 35 to 21 per cent and a capital expensing provision – we expect capital expenditures in the US to pick up during 2018.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex Plans

 Source: National Federation of Independent Business

The combination of increased capital expenditures and higher wages means corporate cash piles will start turning away from financial engineering and toward investment. Flows out of Wall Street and into Main Street should translate into velocity of money picking up ergo higher inflation.

Long Wal-Mart Stores ($WMT), Dollar General ($DG) and Dollar Tree ($DLTR).


  1. Industrial commodities continue to rally

In our last post of 2017, we outlined our bullish view on industrial commodities. To summarise, on the demand side we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China which, given the Chinese Communist Party’s goal to make housing more affordable and transform rural residents into urban residents, should remain strong over the course of the year. The second is US capital investment, which we expect to pick up in 2018 given the incentives for capital investment created by the new tax bill. On the supply side, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results of these reforms thus far have been largely positive. Given the supply and demand dynamics, we are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

Long Vale SA ($VALE) and United States Steel Corporation ($X).


  1. Emerging markets: Oil exporters outperform oil importers

The sharp drop in oil prices in late 2014 has been a welcome windfall for oil importing emerging markets. Money that was previously being used to pay for oil imports has gone into productive investments as well as increasing consumption. Since the number of oil importing nations far outstrips the number of oil exporting nations, the drop in oil prices has supported the synchronised global economic recovery that we are enjoying today.

As the old saying goes, “Low prices, cure low prices”, the synchronised pickup in global economic activity caused in part by lower oil prices is resulting in demand for oil exceeding expectations. At the same time Russia and OPEC are maintaining high levels of production discipline. Moreover, our analysis suggests that the likes of Mark Papa and Harold Hamm are correct in calling out the Energy Information Administration (EIA) for its optimistic projections for shale production. We think that shale production will disappoint leading to higher oil prices in 2018.

Higher oil prices should lead to oil exporting emerging markets outperforming at the expense of oil importing emerging markets.

Long iShares MSCI Russia ETF ($ERUS) and long iShares MSCI Saudi Arabia ETF ($KSA).


  1. Robotics and artificial intelligence adoption accelerates

 At a human level, the pace of adoption of robotics and artificial intelligence, while being cognizant of the possibilities for human advancement, concerns us. We worry that the blind, unchecked development of artificial intelligence could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe. The business case for artificial intelligence adoption, however, is very strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive. Companies have no choice but to invest in robotics and artificial intelligence.

Our advice: learn a foreign language. If you have children, encourage them to learn a foreign language too. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

Long ROBO Global Robotics and Automation Index ETF ($ROBO).


  1. The first trillion dollar company

While this may not materialise in 2018, we think before this bull market is done we will have witnessed the world’s first publicly listed trillion dollar company. It could be one of tech giants – such as Apple, Amazon or Google – or it could be the successful listing of Saudi Aramco. Either way, we think a trillion dollar company will ring the bell at the market top.


  1. China bears disappointed

 After the botched currency devaluation efforts of 2015 and 2016, the Chinese government has deftly managed its economy by balancing between fiscal stimulus, risk management within the financial system, and supply-side reforms on the industrial side. While there have been hiccups, such as the gas supply crunch witnessed late last year, the economy has continued to grow smoothly. We expect 2018 to be not too dissimilar with the Chinese government continuing to strike a balance between using the stick and offering the carrot. We expect China bears to have little to celebrate in 2018.


  1. Onslaught of cyber-attacks

 In 2017, cybercrime came of age:

  • US-based consumer credit reporting agency, Equifax, suffered a massive data breach compromising the data of over 143 million of its customers
  • WannaCry a ransomware was unleashed in May 2017 and targeted computers running Microsoft Windows by encrypting data and demanding ransom payments in the Bitcoin cryptocurrency
  • NotPetya ransomware attack forced shipping giant Maersk to halt operations at 76 port terminals around the world, which translated into an estimated financial cost of USD 300 million
  • Television network HBO was hacked in late July. A group of hackers claimed to have stolen roughly 1.5 terabytes of information from the company, including scripts and episodes of popular TV show Game of Thrones

The above are but a few examples of the cyber-attacks that took place in 2017. In an increasingly hyper connected world, we expect the scale and frequency of cyber-attacks will only increase.

Long Cyber Security ETF ($HACK)


  1. Household consumer stocks underperform

 We wrote about avoiding household consumer names in October last year – namely constituents of the Consumer Staples Select Sector SPDR ETF ($XLP). We maintain this view for 2018 as we consider their valuations to be stretched for businesses that are increasingly susceptible to disruption and shifting consumer preferences towards more niche brands.


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. 

Industrial Commodities: A Sustainable Bull Market?

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

– Excerpt from Xi Jinping’s speech at the 19th Communist Party of China National Congress


“Commodities tend to zig when the equity markets zag.” – Jim Rogers


“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise


“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx


Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial IndexCRB

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

  Ratio of China Money Supply M1 to China Money Supply M2M1 to M2 China

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy.  As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

CRB US Spot Raw Industrial Index vs. China M1 YoY Growth (Lagged 6 Months)M1 YoY China vs CRB Industrial Metals

Sources: The People’s Bank of China, Commodity Research Bureau

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The government is clearly very serious about developing the rental housing market. And key private sector participants are responding to the government’s signals. Not long after the National Congress, China Construction Bank – one of the big four banks in China – launched a loan product for home renters.  China Vanke, a leading residential real estate developer in China, indicated that it aims to provide up to 100,000 apartments for long-term leases, up from the 24,000 rental units operated currently. AliPay, Alibaba’ mobile payment platform, announced that it would enable users across eight cities and based on their credit history to rent residential properties through the platform without having to pay deposits.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

  1. Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
  2. Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.


Investment Perspective


Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market?  What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.  


Follow us on Twitter @lxvresearch


 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. 


Japan: Bullish Because Of Not In Spite Of Demographics

“The aging and decreasing population is a serious problem in many developed countries today. In Japan’s case, these demographic changes are taking place at a more rapid pace than any other country has ever experienced.” – Toshihiko Fukui, the 29th Governor of the Bank of Japan


“I have experienced failure as a politician and for that very reason, I am ready to give everything for Japan.” – Shinzo Abe


“Here is the reality of Japan’s demographic crisis: at eight births per 1,000 people, Japan’s birthrate in 2013 was among the lowest in the world. Meanwhile, the proportion of the population over 65 is now 25%, the highest in the world. In 2010, Japan’s population peaked at 128 million. Current projections show the population dropping below 100 million by 2048 and as low as 61 million by 2085. The country’s working-age population has been declining since the late 1990s, making it increasingly difficult to care for Japan’s retirees.” – Saskawa Peace Foundation USA


Japanese stocks are breaking out (have broken out?). Irrespective of which measure of market performance you prefer, the TOPIX or the Nikkei, the recent performance of Japanese stocks has been impressive. And, if you are wondering, it is not because of a weakening yen.

Tokyo Stock Price Index (TOPIX)topix

Source: Bloomberg

Nikkei 225 Indexnikkei

Source: Bloomberg

Japan’s demographic challenge is well-documented. More than a quarter of the population are 65 years old or older. Birth rates are at record lows. And since one of the market truths many of us have come to know and accept is that “demography is destiny”, we know that Japan’s economy will only continue to struggle. With the prevalence of this type of thinking, it is no surprise that many have been confounded by the recent rally in Japanese stocks.

Channelling our inner Charlie Munger we inverted and asked ourselves: under what scenario would Japanese-style demographics be the precursor to an economic boom? In our attempts to answer this question we have to come to the conclusion that the Japanese economy is quite possibly on the cusp of a virtuous growth cycle because of demographics not in spite of them.

We arrived at this conclusion due to one simple reason, we think that the Japanese economy is well-placed to lead and reap the benefits of the coming robotics revolution. Concurrently, Japan’s demographic challenge means, while the country is not entirely immune, it is uniquely sheltered from the potentially negative socio-economic consequences that may arise from the increased proliferation of robotics and artificial intelligence. (We have previously articulated some of our concerns around the unbridled development of artificial intelligence in Artificial Intelligence and Meaningful Work.)

Unemployment is low. Labour force participation levels are high. The overall population is declining while the elderly population is increasing and the labour force dwindling. Corporates are hoarding cash – companies listed on the Tokyo Stock Exchange just set a new record –their cash holdings are now more than 140 per cent of Japan’s GDP. The enormity of the level of cash holdings is better appreciated when compared to the 43 per cent of US GDP equivalent held in cash by US corporations – this 43 per cent includes the much talked about cash held offshore by the likes of Apple and Microsoft.

Japanese Unemployment Rate (%)unemployment

Source: Bloomberg

Japanese Labour Participation Rate (%)labour participation

Source: Ministry of Internal Affairs and Communications

The confluence of all these factors makes Japan ripe for the uptake of robotics to really accelerate but for one missing ingredient: capital investment. Although there is some evidence of capital investment picking up, Japanese companies have continued to demonstrate high levels of restraint when it comes to capital spending.

Despite the investment restraint shown by corporations, necessity, invention and a focused robotics strategy introduced by the government in 2015 – New Robot Strategy – has already positioned Japan at the forefront of the robotics revolution. We think there are a number of factors that will push Japanese corporations towards increasing capital investment and lead them to aggressively adopting robotics and artificial intelligence.

During the campaigning for the recent elections, opposition leader Yuriko Koike – governor of Tokyo and former Minister of Defense – called for a punitive tax on corporate cash reserves in order to encourage companies to invest more. While Koike’s new Party of Hope was resoundingly thumped by Prime Minster Abe’s Liberal Democratic Party (LDP), Koike’s criticism of corporate cash hoards resonated with members of the LDP. The government of Japan, we expect, will exert increasing amounts of pressure on companies to force them into spending their cash piles by increasing capital investment and paying higher wages.

When President Trump came into office he promised to shake up global trade in order to put America first and cut the US trade deficit. He brought in global trade hawks – Secretary of Commerce Wilbur Ross, Director of the White House National Trade Council Peter Navarro, and Trade Representative Robert Lighthizer – to form part of his administration. To date, very little of note has been achieved by the Trump administration on the trade front. With Trump also having failed to deliver on the domestic policy front, however, we think he will seek to overcompensate by taking a more aggressive stance on US trade policies. Especially as the president has the power to levy trade tariffs on countries without needing approval from Congress. More importantly for Japan, however, we think the Trump administration is also likely to become more aggressive in calling out countries they deem to be “currency manipulators”. And with the yen significantly undervalued in terms of its real effective exchange rate, there is little room for the Bank of Japan to talk down the yen. Moving forward, Japanese companies are unlikely to be able to rely on an undervalued currency to drive exports. Quality and sophistication – two traits that have traditionally been the hallmarks of Japanese products – will have to come to the fore. And that requires capital investment and potentially re-shoring of some manufacturing capabilities back to Japan.

The Chinese government’s strategic plans are progressively more focused on increasing local consumption and having much more of its population employed in higher-paid positions. This requires Chinese businesses to move up the value chain. And it is in response to such government objectives that industrial companies in China have started to move into the production of higher-value added goods – venturing into territories normally occupied by Japanese companies. As the threat from China intensifies, Japanese industrials will have to respond by increasing the complexity and quality gap between them and the competition. The Japanese, however, do not have the luxury to call upon a deep pool of labour. They instead will have to invest in robotics and automation if they are to have a chance of staving off the Chinese threat.

Given all the above factors, we think it is not a question of if but when Japanese companies will start increasing capital investment. And we think that the time has come.

Japanese Industrial Production vs. the Unemployment RateIP vs UnemploymentSources: Ministry of Economy Trade and Industry, Bloomberg


Investment Perspective

Corporate profits as a share of GDP, in Japan, are making new highs. Higher profits combined with high levels of cash and low levels of leverage encourage companies to undertake capital expenditures. Capital expenditures increase private sector profits and create demand for credit to the benefit of banks. Et voilà, a virtuous economic cycle.

Japan Credit to Private Non-Financials (% of GDP) vs. TOPIX IndexTopix vs Private Credit

Sources: Bank for International Settlements, Bloomberg

While not so simple, Japan indeed is on the cusp of a virtuous private sector profit cycle. So the question to our minds is not whether one should have an allocation to Japan or not but rather should the allocation be currency hedged or not. And to do that we say, ignore those calling for the yen to 200 and do not hedge. On a real effective exchange rate basis, the yen is significantly undervalued.

 Japanese Yen Real Effective Exchange RateYen REER

 Source: Bank for International Settlements

While this is a broad market call, we do want to highlight two sectors – one to overweight and the other to avoid. One of the sectors we are most bullish on in Japan is the healthcare equipment and services sector comprising of companies such as Olympus Corporation and Terumo Corporation. Japan is at the forefront of elderly patient care – its population has the longest average lifespan in the world. Healthcare equipment and services providers in Japan have supported the Japanese healthcare sector in facing the challenges posed by a rapidly aging population by delivering cutting edge solutions. As the US and Europe increasingly face up to the demographic challenges Japan has already gone through, there is an inevitable opportunity for Japanese healthcare equipment and service providers to increase their global reach and grow their exports to the US and Europe.

The one sector that we prefer to avoid in Japan is the financial sector. If a capital investment cycle kicks-off in Japan, as we expect it to, Japanese companies do not need to borrow – they are already sitting on so much cash – and this perhaps means that this spending will not automatically lead to an increase in demand for credit and nor does it imply that a meaningful rise in interest rates will be forthcoming.

We are long the iShares MSCI Japan ETF ($EWJ) as well as a select number of healthcare equipment and services providers.



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.  


Artificial Intelligence and Meaningful Work

“One of the most robust findings in the economics of happiness is that unemployment is highly damaging for people’s wellbeing. We find that this is true around the world.”

“Not only are the unemployed generally unhappier than those in work, but we also find that people generally do not adapt over time to becoming unemployed unlike their responses to many other shocks.”

Excerpts from “Happiness at work”, CentrePiece magazine, Autumn 2017, London School of Economics and Political Science


“Participating in the satisfying work of innovating enriches lives by endowing them with purpose, dignity, and the sheer joy of making progress in challenging endeavors. Imaginative problem-solving is part of human nature. Participating in it is essential to the good life – and no elite minority should have a monopoly on that.”

“The technologies our species is developing might either hold the keys to unlocking human potential — or to locking it up more tightly than ever.”

Excerpts from “Meaningful Work Should Not Be a Privilege of the Elite”, Harvard Business Review, 03 April, 2017


“Viewed narrowly, there seem to be almost as many definitions of intelligence as there were experts asked to define it.” – “Abilities Are Forms of Developing Expertise”, Robert J. Stenberg, Educational Researcher, April, 1998


 One day the AIs are going to look back on us the same way we look at fossil skeletons on the plains of Africa. An upright ape living in dust with crude language and tools, all set for extinction.” – Ex Machina (2014)


In Matilda, the children’s fantasy movie directed by Danny DeVito and based on Roald Dahl’s book of the same name, the lead character, six-and-a-half year old Matilda, on her first day of school correctly calculates the result of 13 times 379 in her head – much to the amazement of her teacher and classmates. If such an event had taken place in our classrooms, we too would have been astounded and many, if not all, of us would have described young Matilda as being intelligent or even a genius. Yet if we told you that we have a machine that can solve the very same problem in less than a nanosecond, would any of you describe it as being intelligent? We suspect not; although, some may describe the person who designed the machine as being intelligent.

What then is intelligence?

We conducted an informal experiment (read: an impromptu poll on Whatsapp) involving our school friends. We asked our friends a simple question: who was the most intelligent person in our year group at school? The experiment covered three different schools from three different cities. Without exception, the choice was unanimous for each school.

After collecting their responses, we asked each of our friends a follow-up question: what is intelligence? Some gave us the Oxford Dictionary definition, others referenced IQ or some other standardised test scores while others still bifurcated intelligence into ‘book smarts’ and ‘street smarts’. Each person’s interpretation of what intelligence is was somewhat unique. Despite that, each person came to the same conclusion of who the most intelligent person at school was.

Exploring some of the academic research available on the understanding of intelligence, we found that opinion of what intelligence is was just as, if not more, divided amongst academics and researchers.

While we, collectively as a race, may not have a unified understanding of what intelligence is this has not impeded our shared progress. We, however, do not have the luxury of not understanding artificial intelligence, its possible evolution from here on out and what it means for the future of employment.

Millions of blue-collar manufacturing jobs have already been automated away by machines. This was the low hanging fruit for artificial intelligence. It has been widely accepted for well over a decade that technology would gradually replace workers in process-oriented roles where the objectives are well defined and the operating environment is controlled. The development of artificial intelligence, however, now threatens to automate away non-routine jobs across a vast number of industries. PricewaterhouseCoopers has predicted that 38 per cent of American jobs could be automated by 2030. They identify jobs in industries such as human health and social work, financial & insurance, education, mining & quarrying and public administration & defence as those with high level of susceptibility to automation. McKinsey Global Institute is even more apocalyptic as it estimates that as many as 800 million workers worldwide may lose their jobs to robots and automation by the year 2030.

A survey of history reveals that many new technologies have been sub-optimally utilised for years, sometimes even decades, before a more effective use of the technology has been discovered. If artificial intelligence is being sub-optimally utilised, it may not be the case for long. In May this year, Google unveiled its AutoML project, which is based on the concept of an artificial algorithm becoming the architect of another artificial intelligence algorithm without the need for a human engineer. Facebook has also started incorporating AutoML into parts of its architecture while Microsoft invited teams to compete in an AutoML implementation competition.

Why does AutoML matter?

Until now, engineers and developers have used trial and error to choose the best algorithm or set of algorithms to solve problems. After model selection engineers are also heavily engaged in the iterative process of optimising the algorithm and its parameters to the specific problem at hand. This entire process is resource intensive. It requires hundreds, if not thousands, of man hours and mind-boggling levels of computing power. As a consequence, costs of solving a single problem can run into the millions of dollars.

AutoML, on the other hand, automates the entire process of model selection and optimisation; saving computational capacity by not having to optimise and re-optimise models; and significantly reducing development time from weeks and months to days. AutoML capabilities will only grow over time and the complexity of problems it is able to solve is also likely to increase.

The progress of AutoML has been rapid. Take the case of AlphaGo, the Go playing artificial intelligence developed by Google’s DeepMind, which defeated the world’s number one human Go player. AlphaGo was a technological marvel with 48 artificial intelligence processors and data from thousands of Go matches built into it. It was no match for AutoML, however. DeepMind developed AlphaGo Zero an algorithm that was only given the rules of Go and then proceeded to teach itself and create an algorithm to play Go – all without any additional human input. AlphaGo Zero defeated Alpha Go at its own game only 40 days later. In fact, during a period of 72 hours, AlphaGo Zero beat the original by a margin of 100 to 0. What is even more startling is that the AlphaGo Zero only utilises 4 artificial intelligence processors – a 12 fold improvement over AlphaGo in terms of processing power requirement.

If the example of AlphaGo Zero is a peek into the future of non-routine, dynamic capabilities of artificial intelligence then the role of humans in the workplace is at risk of being marginalised to oversight and system refinement.

Adoption of artificial intelligence outside the technology sector remains limited. Few companies have deployed it at scale. However, the business case for artificial intelligence adoption is strong. A performance gap between early adopters of the technology and laggards will become increasingly evident over the coming years. A widening of this gap is likely to result in an adopt-or-die type of scenario for the laggards. And may even lead to a “winner-takes-all” type of environment where even second-best is not good enough to survive.

As adoption increases, the implications for the human workforce are likely to be far reaching. To quote Wired: “The AI threat isn’t Skynet. It’s the end of the middle class.” The threat of artificial intelligence is seen as being so grave that many have toyed with the idea of a universal basic income – a guaranteed living wage paid by government – as a possible solution should artificial intelligence result in widespread job losses for the middle class. But what of human dignity and the meaning we find at work in solving problems and in collaborating with our colleagues? And what of our right to pursue happiness if we can no longer fulfil our ambitions and aspirations but rather live from one government hand-out to the next?


Investment Perspective


“We are subject to the processes and trials of evolution, to the struggle for existence and the survival of the fittest to survive. If some of us seem to escape the strife or the trials it is because our group protects us; but that group itself must meet the tests of survival.

So the first biological lesson of history is that life is competition. Competition is not only the life of trade, it is the trade of life – peaceful when food abounds, violent when the mouths outrun the food.” – The Lessons of History (1968), by Will and Ariel Durant

Away from capital markets, the personal investment implications of the development in artificial intelligence are far reaching. While we can be accused of being pessimistic, we do not want to be ignorant to the challenges artificial intelligence poses. We understand and acknowledge not only the benefits the technology could deliver to businesses but also in solving problems humans have struggled with for decades and centuries. Artificial intelligence may one day help us overcome cancer or develop early warning systems for natural disasters – such possibilities excite us. The blind, unchecked development of artificial intelligence, on the other hand, scares us as it could one day tear through the social fabric that binds us together and spread the venom of protectionism across the globe.

For those of us with children, we have many difficult decisions to make and challenges to overcome in helping our children prepare for the world that awaits them. In our humble opinion, the risk-reward for teaching and learning foreign languages is skewed to the upside. While Google and others may develop tools to reduce the friction of translation, one can never truly understand a culture without understanding its language. In a world where nations are becoming increasingly inward looking, we need to increase our cross-cultural understanding and there will be, in our opinion, great reward for those that can facilitate such understanding. Learning a foreign language is the first and most critical step in this process.

We encourage all of you to learn and to encourage your children to learn at least one foreign language.

On the capital markets side, we reiterate our earlier call that we are at the beginning of a long-term secular trend towards automation and recommend positioning in a basket of automation and robotics related companies through the ROBO Global Robotics and Automation Index ETF ($ROBO).

Follow us on Twitter @lxvresearch


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.  


Hoarders: Resilience in Self-Storage REITs

Monica: How did you get in there?

Chandler: You’re messy.

Monica: Oh no! You weren’t supposed to see this!

Chandler: I married Fred Sanford!

Monica: No Chandler, you don’t understand! Okay! Okay! Okay! Fine! Now you know. Okay? I’m y’know…I’m sick.

Chandler: No, honey you’re not sick! Look, I don’t love you because you’re organised, I love you in spite of that.

Monica: Really? You promise you won’t tell anyone?

Chandler: Yes! And look, now that I know if I got some extra stuff lying around can we, can we share the closet.

Monica: Well…it’s just umm…I’m afraid you might mess it up.

–  “The One with the Secret Closet” – Season 8, Episode 14, Friends


“I’ve learned that for hoarders, every cleanup is a grieving process. We are asking them to say goodbye to items that are heavy with memories – some wonderful, some painful. But all are important and deserve respect. A hoarder finds safety in the hoard, in the stacks and piles, and he or she will grieve over the loss of those items when they are gone. The week after the house cleaning is usually the worst. Instead of being happy and enjoying the new space, hoarders go through a difficult process. They miss their possessions, which were their closest friends for years.” – Matt Paxton, The Secret Lives of Hoarders: True Stories of Tackling Extreme Clutter


“Everything is bigger in Texas, loaded double barrel blow you to pieces” – Texas Bloody Money by Upon a Burning Body


If everything is bigger in Texas, can we say it’s even bigger-er in China?

Held on every eleventh of November, Singles Day is the busiest day of shopping in the Chinese calendar. It is a day to celebrate singlehood – the anti-Valentine’s day so to speak – that has become synonymous with Alibaba, the Chinese e-commerce conglomerate that, starting 2009, turned the day into the Chinese equivalent of Black Friday. The day has turned into a retail phenomenon, so much so that in recent years more revenue has been generated on Singles Day than on both Black Friday and Cyber Monday combined.

Alibaba goes to great lengths to grab consumer attention ahead of the Singles Day event. City streets and subways across the Mainland are plastered with advertisements about its 11 November promotions. The sales during Singles Day have become a critical barometer of the health of the Chinese consumer and of Alibaba’s dominance in the Chinese e-commerce market.

The kick-off to the holiday shopping season in US is no different to the days leading up to Singles Day in China. Each holiday season starts with an intense barrage of advertisements about promotions and bargains on offer. Stores start to open earlier and stay open for longer. All these efforts are in attempt to get the consumer to spend more. Holiday shopping is a challenging time for all consumers but is an especially difficult time of the year for hoarders – compulsive shoppers that are most susceptible to fall prey to guerrilla marketing tactics.

Although research shows that only between 2 to 5 per cent of the population meets the criteria to be clinically classified as a hoarder, there is an almost universal tendency to over accumulate. And it is this tendency that has underpinned the long-running building boom in self-storage capacity across the US.

Self-storage is a segment of the commercial real estate market concerned with the provision of space for the storage of possessions. Self-storage space, in the US, has unique economic and legal characteristics including requirements such as month-to-month basis rentals; the tenant having exclusive access to their unit; and a no bailments clause on facility operators with respect to the goods stored by tenants.

The first modern self-storage facilities opened in Odessa, Texas, during the 1960’s. The industry maintained a low-profile for almost two decades, largely functioning as a pit stop for the possessions of those in transition. The rising wealth of the baby boomers, however, changed all that. Come the 80’s and 90’s, these storage facilities were increasingly occupied by old furniture and other unwanted household items. This trend has continued unabated and has even accelerated since 2001. A study by the Self Storage Association found that by 2007 more than half of self-storage clients in the US were storing stuff that did not fit in their homes – remarkable, considering the size of the average American house almost doubled over the last five decades.

The proclivity of the average person to procrastinate, especially when it comes to disposing of unwanted possessions, has underpinned the resilience of the self-storage industry. So much so, that occupancy rates in the US only declined by around 2 to 3 per cent in the immediate aftermath of the Global Financial Crisis. Occupancy levels also recovered quickly as rising foreclosures and people’s inclination to downsize their homes created an added need for storage space.

The rise of e-commerce has spurred new demand for self-storage space. It is cheaper and more flexible as compared to renting space in commercial warehouses – making it ideally suited to online retailers and Amazon Store operators who need flexible solutions to manage inventory. Even brick and mortar retailers in metropolitan areas, looking to reduce their footprint and rental costs, are turning to self-storage facilities to store their goods offsite. These trends combined with the sector’s resilience to downturns in the economy may warrant the somewhat boring and often overlooked self-storage sector having an allocation in one’s investment portfolio.


Investment Perspective

Over the decades, self-storage has evolved from being a fringe component of the commercial real asset class to a core asset within the real estate industry.  Capital flowed into the industry as it has proven its ability to deliver above average yields while showing resilience in times of uncertainty.  Despite the resilience of the sector and its improving financial performance during 2016, the Bloomberg REIT public / self-storage sub-index is down around 17% from its peak in 2016.

Bloomberg REIT Public / Self-Storage Sub-IndexSelf StorageSource: Bloomberg

Approximately one in ten American households already pays for a personal storage unit. This mass proliferation of self-storage has occurred during a period when new homes purchased by Americans have on average been larger than their previous homes. The trend of bigger homes, however, is reversing. The American citizenry is now building and buying homes with smaller square footage than in previous decades. While at the same time self-storage facilities are at around 90 per cent occupancy and a growing number of cities – New York, San Francisco and Miami to name but a few – have moved to restrict or curb the development of new self-storage facilities. In our opinion, a confluence of all these factors combined with the added demand from e-commerce and brick and mortar retailers may lead to a shortage in space and allow storage operators to raise prices. In turn the earnings profile of storage operators should improve and lead to a re-rating in the self-storage REITs.

We are long CubeSmart ($CUBE), Extra Space Storage ($EXR) and Life Storage ($LSI) and a complementary play we are also long AMERCO ($UHAL).


Follow us on Twitter @lxvresearch


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.      

Volatility Selling and Volatility Arbitrage Ideas Using Equities

“Here’s something to think about: How come you never see a headline like ‘Psychic Wins Lottery’?” – Jay Leno

 “Nothing in life is as important as you think it is when you are thinking about it.” – Thinking, Fast and Slow, Daniel Kahneman

 “I hate to lose more than I love to win.” – Jimmy Connors


Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, is a descriptive model that characterises how people choose between different options and how they estimate the perceived likelihood of each of these options. The main findings of Prospect Theory are:

  1. People care about gains or losses more than about overall wealth;
  2. People exhibit loss aversion and can be risk seeking when facing the possibility of loss; and
  3. People overweight low-probability events.

The Chicago Board Options Exchange Volatility Index, better known as the VIX, is the primary gauge used by equity and options traders to monitor the anxiety level of market participants. The VIX measures the market’s expectation of 30-day volatility of the S&P 500 index. The higher VIX is, the higher the anxiety levels amongst market participants.

Market participants can express their view on short-term market volatility through a number of instruments. Two of the most common ways used are selling options on an equity index or by shorting the VIX. As equities tend to decline as volatility rises, the preference amongst market participants is to sell puts over selling calls. Added to that, puts are usually more expensive than calls; selling puts generates a higher premium.

Selling volatility, using either equity index options or by shorting the VIX, is the capital markets equivalent to selling lottery tickets. Large losses in a strategy involving selling volatility tend to coincide with market crashes. Large but rare losses, i.e. negative skewness, justify a positive risk premium for the strategy.

Selling volatility on equity indices has provided attractive payoffs over long periods of time. The strategy had a high long-run Sharpe ratio over the two decades between the 1987 crash and the 2008 Global Financial Crisis. Even higher levels of performance have been achieved by the strategy since the equity market lows in 2009. The reason the strategy has been profitable is largely due to implied volatilityon equity indices consistently trading at a premium over realised volatility. Based on monthly data from 2005 till date, as shown in the chart below, the average differential between the implied and realised volatility on the S&P 500 index is 1.2%.

S&P 500 Index Implied Volatility less Realised Volatility

Implied vs RealisedSource: Bloomberg

Selling volatility has become a very popular trade, to say the least. The proliferation of exchange traded funds (ETFs) and exchanged traded notes (ETNs) that track either the performance or the inverse of the performance of the VIX has made selling or buying volatility, otherwise complicated trades to structure, accessible for the average investor. Investors can go long the inverse VIX instruments or short the long VIX products if they want to sell volatility.

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are under weighting as opposed to over weighting a low probability event (a market crash). At the same time, they are giving preference to negative skewness, favouring small gains at the risk of incurring large losses.

During October, 2017, the VIX recorded its lowest monthly average since the launch of the index dating back to January, 1993. What makes this statistic even more remarkable is that autumn months are generally more volatile with October being, on average, the most volatile month during the year.  The average level of the VIX for October, starting 1993, is 21.8 – more than double the 10.1 averaged last month.

Proshares Short VIX Short Term Futures ETF Price Performance Proshares Sort VIXSource: Bloomberg

With volatility recording all-times lows and equity markets at all-time highs, some have called selling volatility the “most dangerous trade in the world” while others expect an inevitable rise in volatility to cause a significant correction in US equity markets. While these views may prove to be correct, our view is slightly more nuanced.

The increased availability of volatility instruments has made trading volatility more liquid than it used to be. Just as other securities benefit from a re-rating as their liquidity improves, volatility has structurally re-priced due to the proliferation of vehicles facilitating short and long volatility trades. We do not know the degree to which this increased liquidity should improve valuation but accept that volatility should be lower than it used to be prior to this structural shift.

Another reason why we think volatility should be structurally lower today than it used to be is the rise of passive investing. Passive investment vehicles are gathering an increasing share of assets and deploying them in systematic manner. A systematic allocation strategy is by construct more predictable, less volatile than a discretionary allocation strategy.

Taleb, in his paper “Bleed or Blowup? Why Do We Prefer Asymmetric Payoffs?” featured in the Journal of Behavioral Finance in 2004, argues that the growth of institutional fund management also contributes to the rise in the negative skewness bias. We consider the case for money managers preferring investment strategies exhibiting negative skewness to be credible as such strategies superficially boost Sharpe ratio over extended periods of time, supporting asset gathering efforts.   

With all that being said, we do consider the short volatility trade to be richly valued. That does not mean we expect the equity market to crash, instead the differential between implied and realised volatility has tightened to such a degree that this gap can easily close and invert. The trade can become loss making without a meaningful correction in equity markets.


Investment Perspective

The S&P 500 index’s implied volatility is almost two standard deviations below its average over the last 7 years. Not being psychics and being cognisant of the incremental improvements in the economy, we are not calling for a significant correction in the overall market. However, such low levels of volatility, in our opinion, are bound to lead to investor complacency in areas of the market that do not warrant it. And it is these areas of the market we search for to avoid or short. While at the same time we also search for areas where anxiety levels are extended and have the potential to revert back towards the mean.

S&P 500 Index Historical Implied VolatilitySPX imp volSource: Bloomberg

In our search we have found two sectors where we find unwarranted levels of complacency: airlines and cable & satellite and broadcasting businesses.

Capacities are rising in the airline sector at a time where costs are also rising. Airlines have enjoyed a significant tailwind due to the crash in oil prices; however, oil prices are rising and we expect further upside to oil prices from here. This will be a major headwind for airlines at a time when there are already cost pressures from rising  salaries for pilots due to a shortage of qualified pilots. Despite the headwinds, implied volatility for airlines stocks are at one to two standard deviations below their averages.

Southwest Airlines Historical Implied VolatilityLUV imp vol

Source: Bloomberg

American Airlines Historical Implied VolatilityAAL Imp Source: Bloomberg

Delta Airlines Historical Implied Volatility DAL imp volSource: Bloomberg

Cable & satellite and broadcasting businesses face structural issues that bring into question the viability of their business models. These issues are similar to the challenges faced by advertising agencies that we have articulated in Unbranded: The Risk in Household Consumer Names. Despite the challenging outlook, we find investor complacency to be high in a number of names within the sector.

CBS Historical Implied Volatility CBS imp volSource: Bloomberg

We consider the shorting of stocks in the sectors with challenging prospects combined with high levels of investor complacency, as a means to selectively reduce short volatility exposure or to go long volatility without the time decay or negative carry of direct long volatility trades.

To complement our short ideas, we have also identified one area of the market where we find high levels of anxiety after significant draw downs have already taken place: the general merchandising sector. While there is still potential for further pain in the overall retail sector, we find there is an opportunity to pick up the pieces in a segment where we find some value.

Target Historical Implied Volatility TGT imp volSource: Bloomberg

 Dollar General Historical Implied Volatility DG imp volSource: Bloomberg


Dollar Tree Historical Implied Volatility DLTR imp volSource: Bloomberg

We are long target ($TGT), Dollar General ($DG) and Dollar Tree ($DLTR) and are short Southwest Airlines ($LUV), American Airlines ($AAL), Delta Airlines ($DAL) and CBS ($CBS).



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.

Quantitative Tightening May Not be as Scary as You Think

“You can be sure of succeeding in your attacks if you only attack places which are undefended. You can ensure the safety of your defense if you only hold positions that cannot be attacked.” – Sun Tzu, The Art of War

“I have absolutely no doubt that when the time comes to reduce the size of the balance sheet we’ll find that a whole lot easier than we did when expanding it” Sir Mervyn King, February 2012


In September, 2017 the Fed announced that it would start paring back its multitrillion-dollar balance sheet. The reduction will start modestly with USD 6 billion in Treasury bonds and USD 4 billion in mortgage backed securities a month. By the end of 2018 the pace of reduction is expected to reach USD 50 billion a month.

Ever since the Fed indicated its intention to gradually begin selling some of its bonds portfolio, opinions on the possible consequences of the balance sheet reduction have been divided. The equity bears argue that quantitative tightening will lead to a severe tightening of monetary conditions causing a recession and a stock market crash. The bond bears on the other hand argue that the added supply of Treasury bonds, at a time when foreign central banks are retreating from the Treasury market, will overwhelm the market, causing bond prices to fall sharply. While there are others that curiously argue that just as quantitative easing was expected to be inflationary but ended up being deflationary, quantitative tightening, which is expected to be deflationary, will cause inflation to spike.

We wonder, however, if quantitative tightening will turn out to be a non-event?

Prior to the global financial crisis, the Fed through the Federal Open Market Committee (FOMC) used open market operations – the buying and selling of government securities – as its primary tool to regulate money supply in the economy. The open market desk at the Federal Reserve Bank of New York would buy securities to increase the level of reserves held by banks – increasing money supply – or sell securities to remove reserves – to reduce money supply. There were also no interest payments on excess reserves.

As banks, in the ordinary course of business, try to maximise income on the given level of available funds, the opportunity cost for holding excess reserves prior to the crisis was high. Instead of holding excess reserves, banks, by lending or investing their assets, attempted to maximise earnings by reducing liquidity to as close to the statutory minimum as possible. According to the Federal Reserve Bank of Cleveland, from 1959 to just prior to the financial crisis, the level of reserves in the banking system remained stable, growing at an annual average of 3.0 percent over the period – in line with the growth rate of deposits. Excess reserves’ share of total reserves, outside periods of extreme uncertainty or economic stress, was also stable, rarely exceeding 5.0 percent.

Under the circumstances prior to the financial crisis, banks did not hold surplus funds needed to buy bonds from the Fed. Their only option to generate funds was to sell other assets or call in loans. So when the Fed sold bonds to the banks, the banks sold other financial instruments, driving down the price of financial assets and pushing up interest rates. This selling tightened monetary conditions and served to cool economic activity.

In response to the global financial crisis, the Fed injected large amounts of reserves into the banking system and introduced new mechanisms that encouraged banks to increase their level of excess reserves. Since December 2008, the Fed pays interest on all banking reserves, including excess reserves, thereby increasing the marginal benefit of holding excess reserves as compared to before the crisis. At the same time, the heightened levels of risk in other securities and lending combined with an increasing regulatory burden reduced the marginal benefit of the alternatives to parking money at the Fed. The decision to pay interest on banks’ excess reserves also ensured that the mass injection of liquidity did not result in short-term rates falling below zero, thereby putting a floor on short-term rates.

Interest on Excess Reserves vs. Fed Funds Rate and 90 Day T-Bill Discount RateIOERSource: Bloomberg

A number of liquidity-easing programs to alleviate some of the stress in the financial system were also implemented by the Fed. The largest of the liquidity programs implemented, quantitative easing, involved the Fed purchasing Treasury securities, federal agency debt and mortgage-backed securities primarily from non-banks. These purchased assets were then converted into deposit liabilities at the banks. As a consequence of these asset purchases and their conversion to deposit liabilities, excess reserve balances at the Fed expanded greatly and as of 25 October, 2017 stood at USD 2.14 trillion.

Excess Reserves of US Depository Institutions (USD million)Excess ReservesSource: Federal Reserve Bank of St. Louis

To undertake quantitative tightening, the quantitative easing process will have to be reversed. This will involve the Fed selling the securities it purchased to banks in order to absorb the excess funds in their current accounts. As bond bears postulate, this selling of government bonds should, in theory, cause their price to fall, driving up interest rates. In practice, however, if the Fed does not shrink its balance sheet by more than the level of excess reserves in the banking system, quantitative tightening will not be a “tightening” of monetary policy. In a tightening phase, the Fed would be selling bonds to banks to soak up market liquidity and reduce the volume of money circulating. However, for any level of quantitative tightening up to the USD 2.14 trillion in excess reserves, the funds are already available in the banks’ accounts with the Fed. As banks will not need to raise funds elsewhere, the operation, in our opinion, is unlikely to have the negative impact of a standard tightening operation, and interest rates should not rise as a direct consequence of quantitative tightening.

The next question that comes to mind then is why undertake quantitative tightening now? The answer to that, we think, lies in the very reason many feared quantitative easing would cause inflation to spike.  Quantitative easing did not result in high levels of inflation as there was little demand for debt financing, other than for corporate share buybacks and mergers & acquisitions. As long as there is no demand from would be borrowers, no amount of quantitative easing will result in inflation. However, as we argued in The Case for a Pickup in US Inflation, the capital expenditure cycle may be picking up and that may spur an expansion in credit issuance.

Of the aggregate reserves of depository institutions held with the Fed, only around USD 127 billion, as of 25 October, 2017, are required to satisfy reserve balance requirements.  Accordingly, the USD 2.14 trillion in additional reserves can potentially support a level of money supply much larger than that exists today. By absorbing these excess reserves, the Fed will reduce the possibility of a drastic expansion in bank lending and money supply that could destabilise the economy.


Investment Perspective

Much like Pavlov’s dog, we, as market participants, have been conditioned by the pairing of a neurologically potent stimulus, such as directional market action, with a neutral stimulus, such as the Fed’s policy decisions, to elicit a response. The nature of our response is ultimately conditioned by our most formative experiences within markets. The direction of market action that was most recurrent subsequent to the application of a particular Fed policy during this time is most likely to become our default expectation whenever the policy is implemented again.

The market regime experienced by the vast majority of market participants today is the one where banks’ excess reserve levels were modest and the Fed selling bonds resulted in interest rates rising. Quantitative tightening involves selling of bonds by the Fed, ipso facto, financial conditions will tighten and interest rates will rise so sell bonds. We consider this to be a systematic error caused by conditioning under an altogether different market regime.

Quantitative easing was a compelling reason to buy long-dated government bonds. Quantitative tightening, on the other hand, is not a sound reason to be selling or shorting long-dated Treasury securities.


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.

Unbranded: The Risk in Household Consumer Names

“Advertising is based on one thing, happiness. And you know what happiness is? Happiness is the smell of a new car. It’s freedom from fear. It’s a billboard on the side of the road that screams reassurance that whatever you are doing is okay. You are okay.” –  Don Draper, Mad Men season one

“Identities are the beginning of everything. They are how something is recognized and understood. What could be better?” – Paula Scher, first female principal at Pentagram, the world’s largest independently-owned design studio

“A brand is the set of expectations, memories, stories and relationships that, taken together, account for a consumer’s decision to choose one product or service over another.” – Seth Godin, bestselling author



A wise man was he Don Draper. He understood the human need to belong, to feel safe. And his contemporary would understand, that today, reassurance comes from counting the likes for your Facebook status update, having an Instagram following that exceeds the following enjoyed by your friends, or your ramblings on Twitter being retweeted by someone even moderately famous. The lowly billboard barely gets a look anymore. And household consumer brands, not unlike many of Don Draper’s fictitious clients, are none the better for it.

On 15 August, 2017 the Wall Street Journal ran an article titled “This Isn’t An Advertisement: Time to Buy Shares in WPP” in which they argued that “As the stock market climbs ever higher, traditional advertising agencies look like a rare pocket of value – none more so than the largest, WPP”. And as if almost on cue, WPP cut its revenue forecast – blaming weak client spending – and sent its stock price crashing.

WPP’s announcement received all manner of reaction. The idea that it is only a matter of time before the rot spreads to digital advertising juggernauts Facebook and Google, in particular, received plenty of airtime. This conjecture resonated with those calling for the FANG “bubble” to pop. For many, Procter & Gamble’s revelation that it had cut digital marketing spend by over USD 100 million with it having very little impact on its business, only a few weeks prior to WPP’s announcement, only further confirmed this hypothesis. A chart not too dissimilar to the one below may also have been used to argue that the disconnect between FANG and WPP stock price performance will duly close. We consider this type of thinking to be a formulaic type II error.

WPP and Google Share Price Performance (Normalised)WPP GoogleSource: Bloomberg

An advertising agency’s business model is to aggregate advertisement placeholders across disparate media outlets and to provide an access point for advertisers to its network of placeholders. As the advertising market is becoming increasingly concentrated, with Facebook and Google grabbing all advertising spend growth, aggregating ad space is becoming a redundant competitive advantage. Especially when there is limited need for human interaction, and by extension privileged access, to place adverts on Google and Facebook. Advertising agencies have increasingly been disintermediated as access to ad space has become democratised.

Internet Share of Total Advertising Spend Advertising Spend ShareSource: Bloomberg Intelligence

Advertisers use ad agencies to communicate a uniform message about their product or brand to reach as much of their target market as is feasible. They typically focus on two types of advertising, one is the promotional kind to boost sales over a short period of time and the other is to increase awareness of their brand and to shape consumer perception – to create, in essence, a halo effect to drive long-term brand loyalty and sales. Household consumer brands, the likes of Andrex, Kleenex and Tide, produced by consumer goods corporations such as Procter & Gamble and Kimberly-Clark, generally spend the majority of their advertising budget on trying to create strong brand identities for their products.

Consumer goods companies combine their products’ strong brand identities with far reaching distribution. In turn, making their products available to as many consumers as is feasible. Awareness and availability have been the moats exploited most effectively by the largest and most successful consumer product manufacturers.

At a time of scarcity of information, consumers relied on brands as proxies for reliability and of quality assurance. You could be pretty much anywhere in the world and be comfortable with the fact that if you bought your regular brand of coffee, cereal, or soda that you would get what you expected. There would be no discovery, no adventure but there would also be no disappointment.

Today, however, the brand too is being disintermediated. We no longer need proxies. We have smartphones giving us access to a plethora of information at all times. We can instantly check reviews or recommendations for products, restaurants or hotels made my people who have experienced them. And being socially conforming animals, we tend to trust the judgement of other people over perceptions created by brands. Access to information has freed us to discover and try new things, which further frees us to make choices based on preference over perception.

Household consumer brands have been the mainstay on shelves across all major retail grocery and supermarkets chains for decades. Limited availability has made it difficult for little known brands to get much shelf space, especially as purchasing managers tend to take the low-risk decision of sticking to the tried and tested. Amazon and online retail in general, however, has no such constraints. There is no limit to the number of products that can be promoted on an online platform. At the same time, door-to-door delivery and third party logistics solutions have become far more affordable, enabling small businesses and sole proprietors to match delivery solutions offered by the largest of companies.

Distribution, too, is losing its lustre as a source of sustainable competitive edge.

The design services ad agencies offer their clients are a tax on the advertiser to gain access to an agency’s ad network. Advertisers have been willing to bear this tax historically. However, the effectiveness of traditional media outlets, particularly television, in getting the message across to the masses is being challenged by social networks and other disruptive technologies. It is unsurprising that advertisers are reigning in their ad spend budgets.

If digital advertising platforms have been so effective at disrupting traditional advertising channels, how does one reconcile that Procter & Gamble cut digital spending and it had minimal impact on their business? Firstly, the company has long been the largest spender on advertising in US and the cut represents less than 5% of their total annual ad spend. Secondly, and more importantly, the company has spent billions year in and year out for decades in building brand identities for its product. Consumer behaviour patterns suffer from inertia. Brand loyalties and affinities will not be wiped out immediately but are likely to gradually fade away. Somewhat akin to the explanation on how one goes bankrupt in Ernest Hemingway’s The Sun Also Rises:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Lastly, digital advertising platforms’ major strength is targeting specific consumer groups based on precisely defined criterion. Such platforms are best suited to products that have a great deal of appeal to a select group of consumers. In such instances, the return on investment will tend to be high.  In contrast, household consumer brands have been built upon creating mass awareness and offering acceptable levels of quality – traits that are unlikely to garner much consumer enthusiasm and therefore likely to result in a low return on investment on digital media spend.


Investment Perspective

In our opinion, the decline of WPP is not a signal for the coming decline of Facebook or Google but rather a confirmation of their strength as legitimate advertising platforms. We expect the demise of the traditional advertising agency model to accelerate. The next great businesses of our generation are unlikely to rely on the advertising models of the past. While existing clients of ad agencies will continue to cut back spending or take away their business altogether. Neither outcome supports the flow of talent into the advertising industry. Without fresh and new talent entering to disrupt the industry, the industry is likely to cling even more strongly to the past. Traditional advertising agencies do not represent pockets of value, in our opinion, they are value traps.

The weakness in traditional advertising agencies also represents potential for deterioration in household consumer names, much like many of the constituents of the Consumer Staples Select Sector SPDR ETF ($XLP) and iShares US Consumer Goods ETF ($IYK). We would avoid investing in either of these ETFs at present and potentially look to get short some of the weaker names within the sector.

WPP vs. Consumer Staples Select Sector SPDR ETF (Normalised)WPP XLPSource: Bloomberg

Our analysis suggests that well-known consumer stocks such as PepsiCo ($PEP), Philip Morris ($PM), Kimberely-Clark Corp ($KMB), The Clorox Co. ($CLX), Dr Pepper Snapple Group ($DPS), Pinnacle Foods ($PF) and Tupperware Brands Corp. ($TUP) are susceptible to significant deterioration in fundamentals. We may cautiously look to short a basket of these names opportunistically.

To counterbalance our negative stance on a number of consumer stocks, if one is to get long consumer plays we find that the greatest upside potential is in aspirational brands.

We define aspirational brands as premium products that have appeal not only in the US but beyond its borders also. These brands have far more potential to benefit from the rising disposable incomes of consumers in emerging markets than do household brands. Companies that fall in the aspirational brand category include the likes of Michael Kors Holdings ($KORS)*, Estee Lauder ($EL) and Tempur Sealy International ($TPX).

* Note: We recommended $KORS as a long idea to LXV Research subscribers on 13 September, 2017

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

Saudi Arabia: Excited by the Market not Transformation

“All change is not growth, as all movement is not forward.” – Ellen Glasgow

“The stock market is just too important to leave to the vagaries of an actual market now.” Babar Rafique, CFA of Setter Capital

“Successful offense brings victory. Successful defence can now only lessen defeat.”  – General Curtis Lemay

Gabriel:  Have you ever heard of Harry Houdini? Well he wasn’t like today’s magicians who are only interested in television ratings. He was an artist. He could make an elephant disappear in the middle of a theatre filled with people, and do you know how he did that? Misdirection.

Stanley: What the f*** are you talking about?

Gabriel: Misdirection. What the eyes see and the ears hear, the mind believes.

Swordfish (2001)


Failures and negative outcomes are often followed by a call to action. College football teams regularly fire successful coaches after a poor season, companies replace senior executives following a series of public relations mishaps, and rarely does an administration overseeing a recession survive the electorate.

The Great Recession gave us the Obama presidency. Coca-Cola losing market share to its rivals gave us the “New Coke” debacle. A spate of bad press and multiple revelations of past misconduct ultimately cost Travis Kalanick his job as chief executive of Uber. After failing to win a grand slam for three years in a row, Roger Federer parted ways with Stefan Edberg and started training with Ivan Ljubicic. The examples are countless. The results mixed.

One such recent call to action, with its own wrinkles, has been the national transformation plan announced by Saudi Arabia. The kingdom has come under severe economic pressure since the collapse in the price of oil. A monarchy has little appetite for political change. Any change therefore has to be either economic or social in nature with a view towards prolonging the political status quo. Prolonging the political status quo remains paramount.

Central to Saudi Arabia’s transformation plans are a more equitable participation by the private sector in the economy, enhancing downstream petrochemical capabilities and a reduced reliance on oil revenues. To reinforce the message of transformation, Mohammed Bin Salman (MBS), the driving force behind the plans and favoured son of King Salman, announced plans to publicly list Saudi Aramco, the state oil company.

The headlines have come thick and fast since MBS unveiled the kingdom’s Vision 2030 in April 2016: a USD 3.5 billion investment in Uber; a USD 17 billion international bond offering – the largest ever by an emerging market nation; a USD 20 billion commitment to a Blackstone infrastructure fund; an anchor investment into Softbank’s Vision Fund; King Salman’s dismissal of Mohammed bin Nayef – dubbed as the “the prince of counter-terrorism” in Washington – as Crown Prince and the ascension of MBS as successor to the throne; Saudi Arabia along with the UAE, Bahrain and Egypt placing economic sanctions on Qatar; and MSCI placing the Saudi equity market on its Emerging Markets Index inclusion watch list.

These are the headlines, the real change, however, is happening on the ground. Nowhere is change more visible than in the socioeconomic framework that has been the staple of the Al Saud dynasty. To understand these changes, let’s take a step back and understand Saudi Arabia’s economic model.

The Saudi Arabian economic model is straightforward and not too dissimilar to the economic model of other emerging markets generously endowed with natural resources. It is a model of government largesse in return for compliance and forsaking political freedom. It is a model where the lion’s share of profits in the economy is provided by the government.

Some of the ways the government provides profits include:

  • Transferring natural resources to the private sector at below market prices
  • Infrastructure spending
  • Being the largest employer in the country – even excluding the large government controlled private sector entities

The private sector is largely organised to exploit the profit making opportunities provided by the government. Refiners and converters acquire natural resources at subsidised rates and convert them to mid-stream and downstream products to capture the difference between subsidised prices and market prices plus a refining / converting margin. Energy intensive industries take advantage of subsidised energy prices. Contractors and construction companies bring in low cost labour from countries such as Egypt, Pakistan and the Philippines and bid for lucrative infrastructure contracts. Traders and retailers cater to the bulk of remaining local demand through imports.

The banking sector remains steeped in traditional lending practices with an almost non-existent shadow banking sector. There is limited participation by international creditors beyond lending to government and government related entities subsequent to the Al-Gosaibi / Saad Group scandal that rocked the Saudi financial sector in 2009. Topping it off, the Saudi Arabian Monetary Agency (SAMA) has adopted a tough and conservative regulatory framework requiring banks to remain well capitalised and adhere to prudent lending practices.

The Saudi Arabian economic model is unsustainable and true to Herbert Stein’s Law – “if something cannot go on forever, it will stop” – in 2016, it came to a stop. The government signalled that it was not willing, nor able to be the source of ever increasing private sector profits. It admonished the private sector for not doing its fair share in supporting the economy and addressing the challenges of youth unemployment.

Gasoline and diesel prices were increased. Feedstock subsidies for petrochemical producers restructured. Electricity and water tariffs revised. Municipal fees introduced for commercial activities. Airport taxes increased. Cigarette prices doubled with the introduction of “selective” taxation. Roll-out of a value added tax proposed.

These were some of the fiscal reforms. Austerity followed.

The government stopped awarding contracts for a large number of projects, vaguely classified as projects where the “scale of spending was not compatible with the economic and development returns hoped for them.” Contractors stopped receiving payments, which coupled with public sector borrowing crowding out private sector credit snowballed into an epic liquidity squeeze. With pressure mounting, the government, towards the end of 2016, pledged to settle its dues to the private sector.  Despite the pledge, around 70% of outstanding dues to contractors of public projects in Saudi Arabia remain unpaid, according to local broadsheet Okaz.

The Saudi Riyal Interbank Average Offered Rate – 3 Months Source: Bloomberg

Perks and financial benefits for public sector employees were also cut – based on our discussion with locals, we found that Saudis from all classes unanimously had the a priori belief that public sector pay was sacrosanct. By cutting public sector pay, the government crossed the proverbial line in the sand and we are not surprised that decision has since been reversed.

After fiscal reforms and austerity came protectionism.

According to McKinsey Global Institute, 4.4 million jobs were created in the kingdom from 2003 through 2013 – a decade of booming oil prices – about 1.7 million were taken by Saudis with the remaining being taken by foreign workers.

Much to its chagrin, the government remains the employer of choice for Saudis.

The public sector is bloated. Salaries and allowances accounted for 45% of government spending in 2015. Efforts to rein in spending will be in vain unless the private sector hires more Saudis. Half the population is under the age of 25. Attitudes of and towards the private sector must change. The government appears unwilling to take any chances and has, much to the private sector’s displeasure, opted not for the carrot but the stick.

Starting July 2017, the government implemented a “dependant fee” on all expatriate employees. This levy entails an expatriate employee paying SAR 100 (USD 27) per month for each of his or her dependants holding a residence permit. The fee will be increased annually till 2020. An expatriate employee with a wife and two children living in Saudi Arabia will be out of pocket SAR 14,400 (USD 3,840) annually from 2020 onward. Expatriates, holding work or residence permits, require exit and re-entry visas to travel in and out of Saudi Arabia. The cost of obtaining exit and re-entry visas was also increased starting July 2017. Predictably, we are receiving anecdotal evidence that expatriate employees are starting to relocate their dependants back to their home countries or leaving the kingdom all together.

During 2012, the government doubled the cost of expatriate employee work permits from SAR 100 (USD 27) per month to SAR 200 (USD 53) per month. It also introduced a fee to penalise companies that employed more expatriate staff than Saudi staff. Companies with 50% or more of the workforce comprised of Saudis did not incur any additional direct costs. Companies that failed to meet the 50% “Saudisation” threshold were required to pay a monthly fee of SAR 200 (USD 53) multiplied by the number of expatriate staff in excess of Saudi staff. For example, a company with 100 employees, 60 expatriates and 40 Saudis, would be required to make a monthly payment of SAR 4,000 (USD 1,067) to the government. These payments were to be utilised to support the training and development of the existing and prospective Saudi workforce. Starting January 2018, the monthly fee will be increased and will be applied to every expatriate employed and not just the number in excess of the total number of Saudi staff. The fees will be increased annually till 2020. In 2018, a company with 100 employees, 60 expatriates and 40 Saudis, will be required to make a monthly payment of SAR 14,000 (USD 3,733).

The introduction of the “expat levy” in 2012 created demand for Saudi staff. Predictably salaries for Saudis went up, an intended consequence of policy. However, given the challenging economic environment and based on a number of discussions we have had on the ground, this time companies are more likely to shed expatriate staff over hiring additional Saudi staff.

Cost of doing business is going up. Capital investments are shrinking. The consumer is retrenching and the expatriate population maybe declining. All factors contributing to declining private sector profitability.

New Letters of Credit Opened – Six Month Moving Average (SAR in million)Source: SAMA

Where will the growth in profits come from to drag the economy out of its doldrums? Government plans highlight seven industries that will receive concentrated government support; chief amongst them is the petrochemical sector.

The petrochemical sector is at the core of Saudi Arabia’s non-oil economy. In 2015, petrochemical products accounted for USD 30 billion in exports, representing almost two thirds of total non-oil exports. Olefins – ethane and LPG derivative products – account for three quarters of total petrochemical capacity. While aromatics – naphtha derivative products – contribute 13% of capacity.

Local production is skewed towards commoditised chemicals – unsurprising given the generous subsidy regime, which incentivised management teams to capture the spread relative to market prices as opposed to venturing further downstream. A lower price of oil and expectations of further subsidy reform places the onus on producers to increase value creation by focusing increasingly on specialty chemicals. This is not without risks. Producing specialty chemicals requires technical expertise that is in limited supply both locally and regionally. Developing technical expertise requires time and investment. There also needs to be a cultural shift towards innovation and research & development – no mean feat given the government’s majority ownership of and influence over a number of the major producers.

Shale, not for the first time, may scupper Saudi ambitions. As a major new source of natural gas, shale has revived the US petrochemical industry. With the Permian Basin’s level of natural gas production expected to increase by 5.5 million cubic feet per day between 2016 and 2020, the revival is only getting started. Majors such as Dow Chemical and ExxonMobil have already announced major investment plans to expand their production capacities in the US. Even Saudi petrochemical giant SABIC is looking at investment opportunities in the US.

Economic reform is one aspect of the transformation. Privatisation (read: selling state assets to shore up finances) is another. Everything is up for sale.

The success of the government’s privatisation efforts hinges not only on the quality and price of assets but also the robustness of the legal and regulatory framework governing those assets. With a judicial system steeped in bureaucracy and a reputation for arbitrary interpretations, the system is in real need for change. Yet, signs of legal and regulatory transformation remain largely absent. As a case in point, the kingdom still does not have a bankruptcy law. The absence of which has long discouraged failure and by extension curtailed innovation.

Saudi Arabia is only at the very beginning of a long and arduous journey towards sustainability.  Rational thinking dictates that Saudi Arabia must remain committed to transformation. Political will to stay the course, however, remains untested with signs already emerging that it is waning. Ultimately, all decisions in a monarchy come down to one person and their desire to do the right thing weighed against their need to be celebrated. In Saudi Arabia, that one person happens to be a thirty-something prince who has designs on becoming king. In a world where Donald Trump is President, we now know popularity tops all.


Investment Perspective

The Saudi Riyal is the primary determinant of the cyclical direction of the equity market. At first glance, that may appear to be a strange statement given the currency is pegged to the USD. The peg, however, is precisely why asset prices must adjust to reflect the value of the currency. As the currency moves from being undervalued – real effective exchange rate (REER) below 100 – towards fair value, equity market performance deteriorates, as witnessed late 2014 onwards. While cyclical upturns in the equity market are witnessed as the currency moves from being overvalued – REER above 100 – towards fair value, as witnessed near the start of the millennium.

Tadawul All Share Index vs. Saudi Riyal REER (Inverted)Sources: Bank for International Settlements, Bloomberg

The Saudi Riyal is the most overvalued it has been in over fifteen years. The question, therefore, for those weighing up the opportunity of investing in the Saudi market, is whether they believe the currency can become even more overvalued. The answer to which lies in whether you (i) are an oil bull or bear; (ii) believe the Saudi government can reduce its budget deficit; and (iii) are in the Saudi Riyal devaluation camp or not.

Whilst all three points require a discussion, in and of themselves, to summarise our views on the first two, we are of the opinions that (i) oil price risk lies to the upside; and (ii) the Saudi government has undertaken a number of initiatives that will enable it to reduce its budget deficit. For these reasons, we are of the opinion that the Saudi market may be at the beginning of a cyclical upturn.

With respect to the USD peg, we contend that the peg is inextricably linked to political stability and maintain that prolonging the political status quo remains paramount. In a country where local demand is almost entirely met through imports while exports are largely commoditised goods priced in USD, the political concerns relating to a de-peg or devaluation outweigh the potential for economic gains. We think, the powers that be will maintain the peg till the point of maximum absorbable pain. And the willingness of the government to sell its assets only confirms our thinking.

To some our scepticism over the transformation plans and concerns around shrinking private sector profitability may appear contradictory to our view of a potential cyclical upturn in the equity market. To that we would counter that markets are made at the margin. We are seeing evidence of economic activity picking up; improving money supply metrics; and we expect the government to move from a heavy- to even-handed approach to reform. That being said we do have a number of concerns that we highlight below.

Saudi Arabia Money Supply M2 YoYSource: Bloomberg

A quote from Babar Rafique of Setter Capital best captures our major concern around the Saudi equity market: “The stock market is just too important to leave to the vagaries of an actual market now.” In a country bereft of social activities, the equity market is embedded in the social fabric – making it ripe for policymaker intervention. Our discussions with brokers and asset managers lead us to believe that is indeed what has happened.

Take for instance, the performance of the equity market on 25 April 2016, the day MBS’s interview unveiling plans for the country’s transformation was aired. It is important to note that the interview was pre-recorded and most of the facts had already been drip fed to the public or revealed in a Bloomberg article published on 21 April 2016.

Tadawul All Share Index (19 to 26 April 2016)Source: Bloomberg

We leave it to you to guess at what time the interview started airing.

As a second case in point, we consider the best performing stock across the Saudi market since Salman bin Abdulaziz Al Saud became king. The stock happens to be Saudi Research and Marketing Group (SRMG). The performance of this stock is staggering. So much so that its return is more than 2.5 times the return of the second best performing stock over the period. When we consider that the company has failed to turn a profit since 2012, the performance is even more remarkable.

Why has this company caught our attention? We quote from the company’s profile on Wikipedia:

From 1989 to his death in 2002, Ahmed bin Salman was the chairman of the company. Then, his younger brother Faisal bin Salman became the chairman of the company. On 9 February 2013, Turki bin Salman succeeded Prince Faisal as chairman of the SRMG when the latter was appointed governor of the Madinah province. Prince Turki’s term as chairman ended in April 2014 when he resigned from the post.

From 1989 to April 2014, each appointed chairman happened to be a son of King Salman.

While we have found other instances of curious market action coinciding with government announcements, we do not want to belabour the point any further.

Another concern we have is valuation. The market is not cheap at around 18 times trailing twelve months’ earnings as compared to the MSCI Emerging Markets Index which trades around 16 times trailing twelve months’ earnings.

Lastly, any discussion related to Saudi Arabia is incomplete without considering geopolitics. We are not political analysts and therefore will limit the discussion to matters that we consider important to investing in Saudi Arabia. To that end, we find it important to highlight concerns around the Qatar Crisis. Saudi Arabia traditionally opted for a defensive stance and used backchannels and its wealth to achieve its geopolitical ambitions. The current leadership, however, has opted for offense. We believe the change in stance has been caused by insecurities that arose out of Obama’s Asian pivot and US disengagement in the Middle East region. As an added benefit, geopolitical tensions redirect the population’s attention away from economic hardship and foment nationalism. Irrespective of the motivations behind the move, we believe that Saudi Arabia’s and its partners’ move to isolate Qatar damages the investment case for the GCC region as a whole. Further, if Saudi Arabia continues to take the more aggressive approach it only increases the political risk premium that should be attached to investments in the region.

We are long the iShares Saudi Arabia Capped ETF $KSA.    

The Case for a Pickup in US Inflation

“Given the right economic conditions, business will make substantial efforts to train workers. When the economy is moving along at a healthy pace and firms are eager to hire additional personnel, individuals with few qualifications begin to find opportunities.”

“Labor is the largest cost of the business sector. It has two determinants: employee compensation rates and worker productivity. When employee compensation rates increase, labor costs increase. When worker productivity increases, business pays less to get a job done. Both rising compensation rates and stagnating productivity in the United States have made critical contributions to inflation.”

– Excerpts from Profits and the Future of American Society, S Jay Levy and David A. Levy (1983)


“[I]nflation will remain rather limited as long as bad money, here the vellon, is still driving out the good silver money. For this means that the total money supply is scarcely changing.”

“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”

– Excerpts from Monetary Regimes and Inflation, Peter Bernholz (2003)


Inflation principally comes in one of two forms:

  • Rising resource prices; or
  • Wage growth outpacing productivity growth.

Given the services-biased structure of the US economy, wage growth outpacing productivity growth has a far greater and more sustainable impact on US inflation than do rising resource prices. With wage growth in structural decline, inflation has remained tepid in the US despite the best efforts of policymakers.

Services as a Share of GDPServices ShareSource: The World Bank

During the recent Fed meeting, the Federal Open Market Committee downgraded its 2017-18 inflation forecasts lower. Despite this, Fed Chair Yellen argued that weak pricing pressures are transitory. We are in agreement with Janet Yellen and find that US inflation is on the cusp of turning sustainably higher.

To assess the prospects of US inflation on a look forward-basis we analyse the relationship between inflation, wage growth and productivity growth. As proxies, we use the annual change in US CPI for urban consumers to represent inflation, the US unit labour costs for the nonfarm business sector to represent wages and US output per hour for all persons for the nonfarm business sector as a measure of productivity.

Comparing inflation to wage growth less productivity growth, we find the relationship to have moderately positive correlation. The R-squared using quarterly data from Q4 1997 to Q2 2017 is 0.52. This relationship is much stronger during periods the two measures are trending, either positively or negatively.

Change in the Consumer Price Index vs. Wage Growth less Productivity GrowthCPI vs WG less PGSources: Bureau of Economic Analysis, Bureau of Labor Statistics

The differential between wage growth and productivity growth has been trendless since 2011, swinging from negative to positive and back on an almost quarterly basis. No wonder then that the inflation environment has remained benign, much to the frustration of the Fed, who has pulled out all the stops to fight deflationary tendencies within the economy.

Despite the seeming absence of inflation, we find that inflationary forces have been gathering steam since 2014. This has failed to show up in the headline data due to the outsized impact of a handful of industries caught up in downturns.

Based on data provided by the Bureau of Labor Statistics, wage growth has outpaced productivity growth across a majority of industries from 2014 through 2016. However, workers in the oil and gas extraction, media related and retail focused industries have suffered from declining wages and this has kept a lid on overall wage growth.

Annualised Wage Growth less Productivity Growth by Industry (2014 to 2016)WG less PG IndustrySource: Bureau of Labor Statistics

As the base effects of the negatively impacted industries unwind, we fully expect, headline inflation measures to turn up and begin to exceed consensus expectations. Giving further credence to our assertion is the tightness in the US labour market. The jobs opening rate and the number of small businesses identifying job opportunities as hard to fill are either at or near their highest levels since the turn of the century. At the same time, US U-3 unemployment is at its lowest level since 2000.

US Jobs Opening RateUS Job Openings RateSource: Bureau of Labor Statistics

 US Small Business Job Openings Hard to FillJobs hard to fillSource: National Federation of Independent Business

US U-3 Unemployment RateUS UnemploymentSource: Bureau of Labor Statistics

Historically, periods of labour market tightness when businesses are facing difficulty in filling job openings have preceded increasing wage growth. Comparing the US Small Business Job Openings Hard to Fill index to US wage growth lagged by one year, we find this to be the case up until the end of 2012. Since 2013, however, the relationship appears to no longer hold true. The number of businesses reporting job opportunities difficult to fill has been increasing while wage growth has remained largely absent.

Small Business Job Openings Hard to Fill vs. Wage Growth (Lagged One Year)Job Openings vs WGSources: Bureau of Labor Statistics, National Federation of Independent Business

Once again, the relationship is seemingly impaired at the headline level due to the outsized impact of a handful of industries. Based on data provided by the Bureau of Labor Statistics, wage growth has been positive across a majority of industries from 2014 through 2016. The oil and gas extraction industry, unsurprising given the collapse in the price of oil in 2014, has been a major drag on overall wage growth.

Annualised Wage Growth by Industry (2014 to 2016)Wage Growth IndustrySource: Bureau of Labor Statistics

Going forward, the oil and gas extraction industry should no longer be a drag on headline wage growth and may even have a positive impact on it if oil prices continue to increase. We therefore expect wage growth to pick up as businesses increasingly pay up or hire lower skilled labour and train them up to fill outstanding job openings.

Small Business Job Openings Hard to Fill vs. Capital Expenditure PlansJobs hard to fill vs Capex PlansSource: National Federation of Independent Business

The effects of the structural deflationary forces of globalisation, migration / labour mobility and declining trade union membership are also abating. The lion’s share of gains from outsourcing has already been realised. Politicians are increasingly pandering to populous movements and turning to protectionist policies, making labour migration far less frictionless. Trade unions have held very little appeal to younger workers that entered the workforce in recent years.

The inevitable corollary is the rising labour share of corporate profits will place increasing pressure on businesses to improve productivity. We therefore expect capital expenditures to pick up. Businesses will increasingly invest in automation and robotics to overcome the challenges of wage inflation and labour market tightness.

Small Business Capital Expenditure Plans vs. Productivity Growth (Lagged One Year)Capex plavs vs PGSources: Bureau of Labor Statistics, National Federation of Independent Business

Increased corporate spending will not only lead to improvements in productivity but to an upturn in the overall US business cycle. Capital investment has been the one missing ingredient in the US economic recovery since the Global Financial Crisis.  As businesses spend more, corporate profitability will pick up, which will lead to increased hiring and higher wages, which will feed into further investments into automation and robotics.

Our base case is, therefore, that the current US economic expansion will be the longest ever recorded. And the business cycle will only come to a turn after unemployment levels fall below 4%, inflation exceeds prevailing expectations and policymakers begin to respond to the unexpected consequences.


Investment Perspective

US median household income has been rising and we expect it to continue to rising as wage growth accelerates.

US Median Real Household IncomeUS Median Household IncomeSource: US Census Bureau

At the same time, US household balance sheets have been repaired with the household debt to disposable income ratio in decline since the Global Financial Crisis. More so, the debt service to disposable income ratio is at comfortable levels for US households. There is ample room for households to take on more debt, especially for the poorest households who are the likeliest to benefit as wage growth picks up.

US Household Debt to Disposable IncomeUS Household debt to disposable incomeSource: Bloomberg

 US Household Debt Service RatioUS Household DSRSource: Bloomberg

As poorer households’ disposable income increases, this cohort is more likely to increase consumption as opposed to increasing savings, especially when compared to upper-middle and upper class households. Poorer households shop at Walmart not Whole Foods. They eat at McDonald’s not Shake Shack. We expect retailers and quick service restaurants catering to lower and lower-middle income households to be amongst the greatest beneficiaries of higher wages. We are particularly bullish on the prospects of Walmart ($WMT).

Consider the relationship between US wage growth and $WMT revenue growth lagged by one year. The revenue growth measure does not adjust for store openings, corporate actions and other extraordinary events that may have occurred during intervening periods. Despite the lack of adjustments, this dirty measure has shown a strong relationship with wage growth.

$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 and rotate out of Amazon and into $WMT.

US Wage Growth vs. Walmart Revenue Growth (Lagged One year)WMT vs WGSources: Bureau of Labor Statistics, Bloomberg

A derivative of accelerating wage growth and labour market tightness is business’ increasing investment in automation and robotics. We are at the beginning of a long-term secular trend towards automation. Rather than picking winners at this early stage in the trend, we recommend positioning in a basket of automation and robotics related companies. The most obvious way to play this theme is the ROBO Global Robotics and Automation Index ETF ($ROBO).

Lastly, another derivative of accelerating wage growth is that the Fed is likely to increase interest rates at a faster pace in 2018 than currently anticipated by the market. We expect the short end of the curve to rise faster than the long-end, resulting in a classic bear flattening.

US Wage Growth vs. Effective Federal Funds RateEffective FFR vs WGSources: Bureau of Labor Statistics, Bloomberg

We are long $WMT, $ROBO and looking to get short the short-end of the Treasury yield curve.