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The Incumbent’s Challenge

“Washington is an incumbent protection machine. Technology is fundamentally disruptive.” – Eric Schmidt

“I ordered a soda – caffeine-free, low sodium, no artificial flavours. They brought me a glass of water.” – Robert E. Murray, Chief Executive Officer of Murray Energy Corporation, one of the largest independent operators of coal mines in the United States

“Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.” – Rob Siltanen, the creative genius behind the much celebrated commercial “To the Crazy Ones” that launched Apple’s Think Different campaign

When Mr. Warren Buffet decides to buy a stock it is a big deal. When he decides to sell a stock, however, it is a much, much bigger deal. We have just learnt that Mr. Buffet dumped most of his IBM’s shares during the fourth quarter last year. IBM is no ordinary company. It is a stalwart of the technology industry. It generates over sixty percent return on equity. Sixty per cent! Oh and by the way 2017 marks the twenty-fifth consecutive year of US patent leadership for IBM.

Unfortunately for IBM, invention does not always equal innovation. And it most certainly does not equal disruptive innovation.

IBM’s seemingly obsessive pursuit of patents, to us, is symptomatic of a zero-sum view of the world. That is, we think underlying IBM’s hunger for patents, is a convoluted assumption that by having a larger share of patents issued will somehow translate into them capturing an increasing share of the value generated by the technology sector. Value, however, is not finite. And technological progress is certainly not a zero-sum game.

A faltering technology company is not exactly news. Casualties in the technology sector are par for the course. IBM is not the first technology company to struggle and it is unlikely to be the last.

Disruption of long-standing and successful consumer staple businesses, however, is far more interesting. PepsiCo – the bluest of the blue chip consumer staple companies – is one company whose trajectory we are following with much intrigue especially after we outlined our bear case for household consumer brands last year.

When PepsiCo announced its USD 15 billion stock buyback plan, shortly after disclosing full year and fourth quarter 2017 earnings, our toes curled a little. PepsiCo is trading at 21x price to trailing earnings and 20x price to consensus 2018 earnings. Surely there are better ways to put the cash to work? It was only a few days prior to announcing the buyback plan that the company introduced Bubly, its new brand of sparkling water, which in and of itself is not a groundbreaking development but an encouraging sign of the company coming to terms with changing consumer preferences nonetheless. And it also signaled that the company was willing to invest in new markets.

The relatively small size of new or emerging markets is a well-documented hurdle for large companies. Investing in small markets just does not move the needle when it comes to meeting Wall Street’s quarterly earnings expectations; pursuing large-scale share buybacks does . Moreover, executives destined for the C-suite do not get there by slogging it out in risky, small-scale pursuits. As anyone who’s worked in an organisation of meaningful size will tell you, projects that do not have a strong sponsor get orphaned very quickly. The harsh reality, however, is that all great businesses start off small and it is therefore paramount that incumbents find ways to overcome their structural inability to enter small markets.

PepsiCo’s recent introduction of Bubly, while a relatively positive sign, is also yet another example of a large company playing catch-up due to their failure in either understanding or pursuing the potential of a small market. The company is entering the US sparkling water market only after LaCroix has proven that it is a big market and has established itself as a clear market leader.

An inability to timely enter high-growth potential markets is far from PepsiCo’s only challenge. The company is under attack on multiple fronts.

JAB, the investment vehicle backed by Germany’s Reimann family, bought Dr Pepper Snapple (DPS) for USD 19 billion last month. JAB plans to merge DPS with its coffee interests to create a giant distribution network to better compete against the likes of PepsiCo and Coca-Cola.

Consumer attitudes towards sugary sodas are also quickly shifting. Sugar is widely acknowledged as enemy number one when it comes to western dietary habits. We can see this PepsiCo’s soda sales in the US, which continue to decline despite a new marketing blitz to promote the company’s soft drink brands.

Investment Perspective

PepsiCo like other great consumer goods companies has leveraged its products’ strong brand identities in combination with far reaching distribution to make its products available to as many consumers as possible. Awareness and availability are perhaps the company’s widest and most effectively exploited moats. The company has proven to be a great investment for long-term, buy-and-hold type investors over the years.

The second-order effects of technological innovation, however, are such that we think the effectiveness of PepsiCo’s moats is eroding fast. People are watching far less television and spending less time reading newspapers and magazines. Instead, they are on YouTube, Facebook, Snap, or watching Netflix. Traditional mass media is great at creating awareness and shaping consumer preferences at a mass scale, which is exactly what consumer product companies needed to keep their their brands at the top of consumers’ minds. So much so that they came to monopolise advertising slots during peak programming. The sky-high prices paid for Superbowl half-time advertising slots just go to show the value of mass media to consumer products companies. It also demonstrative of the fact that traditional media advertising is deeply rooted in a zero-sum world.

The major strength of social media and digital advertising platforms, in contrast to traditional media, is targeting niche consumer groups based on precisely defined criterion. Such platforms are far better suited to products that have very high levels of appeal to a niche group – making them ill-suited as advertising platforms for large consumer product companies. The increasing popularity of social media and other non-traditional forms of media, in our opinion, will result in the increasing awareness of niche brands relative to the awareness of mass consumer brands. We see this as a secular trend that will have a profoundly disruptive impact on incumbent consumer product businesses like PepsiCo.

We do not, however, expect the incumbents to go down without a fight. Unfortunately, the following quotes from senior executives of PepsiCo suggest that, while they do realise they are in a fight, they are still stuck in a zero-sum world and do not yet understand the new rules of engagement:

“We have patents on the design, the cutter, the mouth experience. This is multiple layers of IP.” – Dr. Mehmood Khan, Vice Chairman and Chief Scientific Officer of PepsiCo

“The consumer has turned the definition [of healthy] upside down. If it is non-GMO, natural, or organic, but high in sodium and high in sugar and fat, it’s okay.” – Indra Nooyi, Chairwoman and Chief Executive Officer of PepsiCo

Active management, we think, is as much about avoiding losers as it is about picking winners. We think PepsiCo and other businesses like it are squarely in the loser camp.

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

The Bull Market is Not Dead.

“Bulls do not win bull fights. People do.” – Normal Ralph Augustine

“Stocks fluctuate, next question.” – Alan Greenberg, former CEO and Chairman of the Board of Bear Stearns, in response to questions about the crash, October 22, 1987

“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – Jack Bogle

November last year, in Volatility Selling and Volatility Arbitrage Ideas Using Equities, we wrote:

Based on the tenets of Prospect Theory, the popularity of short volatility strategies is somewhat confounding. By investing in such strategies, investors are underweighting as opposed to overweighting 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.

…

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.

Poorly structured short-volatility products and the limited – almost non-existent – down-side risk to going long volatility has, in our opinion, led to the emphatic short-squeeze in volatility witnessed over the last ten days or so. The tail has well and truly wagged the dog. That is, higher volatility has led to the sharp correction in the market. Not the other way round. The late-afternoon equity sell-off on Monday 5 February is indicative of as much.

S&P 500 Index on 5 February, 2018 SPX 5 Feb Source: Bloomberg

XIV, SVXY and other products of their ilk are not the first, and are almost certainly not going to be the last, poorly conceived investment products to blow-up. Think back to portfolio insurance, synthetic collateralised debt obligations (CDOs) and CDO-squared as a reminder. There has been plenty of commentary, and no shortage of memes, lambasting regulators of and speculators in short-volatility products alike – many of the critics make valid arguments that should give regulators pause for thought. For investors the time, however, is not to reflect on the flaws of these products but rather to focus on whether the blow-up of these products can lead to a contagion into adjacent markets or is this just a shake-out of weak hands.

The most convincing argument for the recent correction being a shake-out of weak hands comes from the US corporate bond market. US corporate spreads have been benign in the face of the recent spike in volatility – a first in a very long-time.

US Corporate Yield Spreads vs. VIX Index Corporate yields and VIX Source: Bloomberg

The narrative of rising inflation expectations leading to the correction in equity market has taken hold in some quarters. Firstly, looking at the USD 5-year, 5-year inflation swap rate, there has not been a sharp increase in market-based inflation expectations. In fact, the increase in inflation expectations was much sharper immediately after Trump won the election than at any time during the last year. Secondly, high inflation does not negatively affect equities. If inflation is high but stable, it is nominally positive for equity markets and is unlikely to cause any damage to the real economy. Moreover, historical data suggests that the highest levels of price-to-earnings multiples are witnessed during periods when inflation ranged from 2 to 3 per cent.

An unexpected acceleration in inflation followed by unanticipated changes in monetary policy, however, can have significant negative consequences for the economy. The Fed, to date, has not shown any signs of panic. As long as the Fed continues on the path of slow and steady rate hikes, we do not expect Fed rate hikes to derail the economy or the equity market. If, however, the US economy overheats in response to the recently passed tax reforms and the tight labour market, the Fed may be forced to react aggressively, which could be catastrophic for both the economy and equity markets.

USD 5-Year, 5-Year Inflation Swap Rate 5Y5Y Source: Bloomberg

The one change coming out of the recent sell-off, in our opinion, is that volatility has made its secular low. We suspect that retail investors are unlikely to return to short volatility in droves. We also have a hunch that private banks and wealth managers will not be offering short-volatility products to their high-net worth clients any time soon. Volatility, therefore, should stabilise closer to its longer-term average – we do, however, expect volatility to be structurally lower than the past due to the increased prevalence of passive and systematic strategies, which implicitly dampen volatility during a stable market environment.

A necessary corollary of higher volatility is that investors have to be more discerning in security selection. Active management may soon be back in vogue.

Investment Perspective

In the after-math of the recent market sell-off we have heard market legends claim that “macro is back” or that it is an “exciting turn for macro trading”. At the same time, we have heard old hands speak of the trauma of 1987 and how it shaped their approach to markets going forward. What we do not hear or read of enough though is that as traumatic as 19 October, 1987 was, it was also the buying opportunity of a generation. The S&P 500 compounded at an annualised rate of 18.9 per cent over the next ten years.

We do not expect returns from equity markets for the next ten years to be like those witnessed between 1987 and 1997. We, however, also cannot ignore that global equity markets had a major break out last year.

MSCI All Cap World Index MSCI ACWI Source: Bloomberg

We have one simple, singular thought when it comes to equity markets today. Until we come across evidence to the contrary, we think investors should figure out what they want to own and buy it with both hands.

Beyond the Minsky Moment: The Wisdom of Crowds or the Madness of Mobs?

“I must say a word about fear. It is life’s only true opponent. Only fear can defeat life. It is a clever, treacherous adversary, how well I know. It has no decency, respects no law or convention, shows no mercy. It goes for your weakest spot, which it finds with unnerving ease. It begins in your mind, always … so you must fight hard to express it. You must fight hard to shine the light of words upon it. Because if you don’t, if your fear becomes a wordless darkness that you avoid, perhaps even manage to forget, you open yourself to further attacks of fear because you never truly fought the opponent who defeated you.”

– Excerpt from Life of Pi by Yann Martel

Doctor: You do not fear death. You think this makes you strong. It makes you weak.

Bruce: Why?

Doctor: How can you move faster than possible, fight longer than possible, without the most powerful impulse of the spirit? The fear of death.

Bruce: I do fear death. I fear dying in here while my city burns. And there’s no one there to save it.

Doctor: Then make the climb.

Bruce: How?

Doctor: As the child did – without the rope. Then fear will find you again.

― The Dark Knight Rises (2012)

The Minsky Moment – a term coined by Paul McCulley of PIMCO that refers to the central concept underlying American economist Hyman Minsky’s theory on the inherent instability of financial markets – has been ubiquitously quoted by just about every major research publication and financial periodical in the aftermath of the Global Financial Crisis. Based on yesterday’s market action, we may have just witnessed another Minsky Moment. And it was not pleasant. Many of you will have experienced fear – we certainly did – and felt your neurologically programmed fight or flight reflex kick-in. While fight or flight responses have their benefits, such responses tend not to be helpful at times of stock market crashes. We overrode our urges to react, turned off our screens, silenced our Twitter feed and spent the rest of the day reading – everything and anything except the financial news.

As we immersed ourselves, once again, into the frantic and frenzied world of financial markets this morning some of the reactions from the media, sell-side, FinTwit and the like have been predictable, the usual suspects – risk parity funds, the Fed, Goldman Sachs, the US government and algorithmic traders – have all been blamed in one form or another. The question, for market participants, however, is not whose fault it is but what, if anything, should we be doing with our portfolios at this juncture.

In the process of portfolio construction we, as analysts, make, in effect, choices amongst several different competing hypotheses. Analysis of competing hypotheses involves:

identifying the evidence and assumptions with diagnostic value in assessing the likelihood of each hypothesis; and

outlining future milestones that may indicate whether events are following the expected path or not.

In our opinion, one’s view on the medium-term direction of the US dollar is central to the type of portfolio that one constructs today. So the hypothesis and its alternative in this case are:

Hypothesis: We are in a structural lower US dollar environment

Alternative hypothesis: The US dollar has bottomed and is headed higher

Over the last few months we have written about or initiated trade ideas related to a number of themes, most notably Europe’s domestic recovery, the potential for a strong rally in agriculture commodities, rising inflation in the US and higher oil prices. Central to all of these investment themes is the view that we are in a structurally lower US dollar environment. This view is predicated on a number of factors, including but not limited to:

The US faces a public pension funding gap estimated to be USD 3.85 trillion. This funding gap may never be filled but it certainly will not be filled if we have a strong US dollar and declining equity markets. History has shown time and again that elected officials and unelected rulers, alike, have long understood the benefits of tampering with the value of their currency. Given the choices available we expect President Trump to be an advocate of a weak dollar policy. A weaker dollar improves the profitability of US large caps, which in turn should be supportive of equity markets.

The weakening of the US dollar over the course of 2017 suggests that both US growth and higher short-term interest rates had been priced in; the market, however, did not fully appreciate the economic recovery underway in the rest of the world. The surprise was amplified by the prospects of earlier than anticipated tightening of monetary policy by the ECB.

The US budget deficit is forecast to exceed USD 1 trillion in 2019 and the Congressional Budget Office expects US budget deficits to continue to grow.

The US dollar is very much in a bear market at the moment. As with any bear market we should expect bear market rallies, which can be sharp and painful – especially when positioning is stretched in one direction. For our weak dollar hypothesis to be nullified we would need to see at least one of the following:

continued strength in the US dollar from now till the end of summer i.e. a period of at least six months;

a reversal in US fiscal policy; or

a sharp acceleration in monetary policy tightening by the Fed.

At this stage and given the sharp decline in the US dollar, cyclical rallies are par for the course. The recently enacted tax reform is likely to increase the flow of capital into the US and at the same time boost capital spending and the profitability of US companies. Moreover, if the Republicans are able to consolidate power in the mid-term elections, this too should temporarily strengthen the US dollar – somewhat counter intuitively we think a consolidation of power would strengthen the case of a weaker US dollar as President Trump would have more leeway in increasing fiscal deficits.

Investment Perspective

The question then is what type of portfolio should one have under a structurally weak US dollar environment. In broad strokes, our thinking is as follows:

US bonds have more value than other developed market bonds. Any bond allocation should be tilted towards the US with a bias towards shorter duration instruments.

International equities have more value than US equities. Use periods of intermittent US dollar strength to build positions in mid-cap equities in Europe and add to our exposure to Japan.

Within US equity markets, give preference to large caps over small- and mid-caps. A weaker dollar has an outsized impact on the profitability of large caps relative to domestically focused small and mid-cap businesses.

Commodity and commodity producers should benefit from a weaker dollar and, as previously discussed, higher capital spending arising both from the US and from China’s Belt and Road Initiative.

Oil, after speculative positioning re-adjusts to less frothy levels, should benefit from a lower US dollar and robust global demand.

Emerging markets to outperform developed markets.

In the final analysis, we consider the recent surge in market volatility as a signal for the shift in momentum as opposed to the start of a bear market. The analogue of the fifteen year US dollar cycle best captures our thinking:

Dollar Index Analogue – 15 Year Cycle (Normalised) DXY normalised Source: Bloomberg

Similarly, consider the fifteen year cycle analogue of the ratio of the MSCI Emerging Market Index to the S&P 500 Index.

MSCI EM Index to S&P 500 Analogue – 15 Year Cycle (Normalised) MXEF SPX Source: Bloomberg

The Risks for this Bull Market

“It was the best of times, it was the worst of times.” – Charles Dickens

“We must expect reverses, even defeats. They are sent to teach us wisdom and prudence, to call forth greater energies, and to prevent our falling into greater disasters.” – Robert Edward Lee, commander of the Army of Northern Virginia in the American Civil War from 1862 until his surrender in 1865

“Some risks that are thought to be unknown, are not unknown. With some foresight and critical thought, some risks that at first glance may seem unforeseen, can in fact be foreseen. Armed with the right set of tools, procedures, knowledge and insight, light can be shed on variables that lead to risk, allowing us to manage them.” – Daniel Wagner, co-author of Global Risk Agility and Decision Making

In Our Thoughts On and Investment Ideas for 2018 we struck a distinctly bullish tone reflective of our top convictions over a six to twelve month investment horizon. We would be remiss, however, to ignore the potential risks that could stop this bull market in its tracks.

The MSCI All Cap World Index is up fourteen months in a row and barring a calamitous fall today, it will extend this unprecedented streak to fifteen months. While the bull market can continue, the momentum of month-over-month gains is unlikely to last. It is in the moments when this momentum breaks do we need to assess whether it is an ordinary market correction or a shift in market regime. Below, we consider some of the key events that we think would signal a shifting regime and not just a mere correction.

The European Central Bank (ECB) tightens earlier than expected

The path forward for ECB monetary policy has been clearly laid out. The ECB will first end its asset purchases and only after that will rate hikes commence. Mario Draghi, at the Governing Council’s meeting on 25 January, indicated that based on current projections, the first rate hike could occur around mid-2019 with a very low probability of a rate hike in 2018. His admission that the asset purchase programme could end entirely in September this year instead of being tapered over the course of the fourth quarter, however, does create some policy uncertainty.

Given the robustness of the Eurozone’s recent economic performance – stronger than what the Governing Council expected for the second half of 2017 – and the potential for rising wage pressures, particularly in Germany, if the ECB abruptly ends asset purchases in September, as opposed to tapering, and starts to hike rates ahead of schedule, equity markets could face strong headwinds.

Germany – Unemployment Rate vs. Wages & Salaries Annual Growth Germany wages Sources: German Federal Statistical Office, Bloomberg

Take, for example, the case of Italy, which has seen the absolute cost of servicing its debt drop by 7.7 per cent between 2010 and 2016 while general government debt outstanding has increased by 19.8 per cent. Crudely speaking, the ECB’s asset purchase programme has translated into a 23 per cent reduction in the interest rate Italy pays on its debt. By the same token, the ECB also holds close to a fifth of all outstanding Italian government debt. Monetary policy normalisation by the ECB could send Italian debt servicing costs meaningfully higher and severely dent Italian growth and business sentiment, both of which are at their highest levels since the Euro crisis. By extension, under such a scenario, the same challenges would apply to other peripheral states in the Eurozone.

Italy – Interest Expenditure vs. General Government Debt Outstanding Italy debt Sources: ISTAT, Bloomberg

As discussed in Europe: A Domestic Recovery Story, given the still high levels of unemployment across the Eurozone and relatively low levels of friction in European labour mobility, we expect nominal wage growth to remain subdued until there is a significant tightening of the labour market. And this, we think, will keep the ECB from abruptly ending its asset purchases and raising short-rates ahead of schedule. Moreover, with coalition formation negotiations underway in Germany, there is the not so trivial possibility that Chancellor Angela Merkel will have to forfeit control of the finance ministry in favour of the pro-European Social Democratic Party of Germany in order to secure one more term. If this indeed does happen, German policy is likely to be far less hawkish than it was under Wolfgang Schäuble, which may well serve to embolden the ECB in prolonging or at least seeing through their accommodative policy. We, therefore, see little risk of the ECB abandoning its accommodative policy ahead of schedule.

Rising oil prices

The sharp drop in oil prices in late 2014 has had a huge impact on global liquidity. Part of the money previously used to pay for oil imports has been redirected towards productive investments as well as increasing consumption, which in turn has contributed to a revival in global trade and capital investment. While oil at USD 70 per barrel will not derail the synchronised global economic growth we are witnessing today, a major supply disruption or rising geopolitical tensions in the Middle East boiling over to armed conflict may well push oil prices over the USD 100 per barrel level and that would put a real squeeze on global liquidity.

A 40 to 50 per cent increase in oil prices from today’s levels would result in inflationary pressures picking up and force the Fed, the ECB and quite possibly the Bank of Japan to tighten monetary policy. An environment of rising oil prices and tightening monetary policy tends not to be favourable for financial assets.

We think being long equities of non-Middle Eastern oil exporters, such as Russia and Malaysia, is the simplest means of neutralising this risk.

Inventory build-up causes the business cycle to roll over

Business cycles do not die of old age. They roll over when businesses are forced to liquidate excess levels of inventory and write-off excess capacity built up during periods of strong economic growth. The prolonged prevalence of deflationary forces, however, has discouraged businesses, particularly in the developed world, from making capital investments and acquiring excess levels of inventory. While at the same time, access to cheap capital, has encouraged businesses to, instead, undertake financial engineering. A lack of capital investment and low levels of inventory mean that there is little excess capacity to write-off and no surplus inventory to forcefully liquidate. Without write-downs or liquidation, the business cycle continues, albeit unimpressively.

US tax reform, higher short-term interest rates and rising commodity prices, however, have tilted the balance in favour of making capital investments and building up inventory as opposed to undertaking financial engineering. Given that business inventory levels are depleted and productive capacities have shrunk, especially after Chinese supply-side reforms, if companies become overzealous to the extent rising commodity prices lead to rising demand the business cycle would in all likelihood come to an abrupt end.

The Fed gets ahead of the curve

“[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.”

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

Most of the commonly followed leading indicators for inflation and wage growth are signalling that the Fed’s two per cent inflation target is likely to be met by the end of 2018 and barring a recession exceeded in 2019. The Fed, however, prefers to remain data dependent, choosing to be reactive as opposed to pre-emptive in its policy making. This approach is unlikely to upset the apple cart. If, however, the Fed decides to get ahead of the curve this would in all likelihood be negative for risk assets, while being positive for long-dated bonds.

The last great secular bond bear market in the US started in 1946 and lasted up until 1981. We have been in a secular bond bull market since. One of the more fascinating aspects of the last bond bear market is the fact that short-term rates bottomed in 1941 and started rising. While long-term rates continued to decline all the way until 1946. Making 1941 to 1946 a rare period of history where short- and long-term rates moved in opposite directions for a prolonged period of time. To us this curious period is symptomatic of how long it can take for a deflationary mind-set to be overcome.

Psychological inertia at mass or institutional level is a powerful force against change. Although the behaviour of the Fed under new leadership is likely to be different, we struggle to imagine a scenario under which the Fed frees itself from the shackles of the deflationary mind-set that prevails today without sufficient data confirming that deflationary forces have given way to inflationary pressures.

Chinese reform goes too far

At the 19^th Party Congress in October last year, Xi Jinping made it clear that economic growth alone would not be the determinant of success. Softer facets relating to the social well-being of its citizens such as the level of pollution, reduction in wealth inequality, and increased access to quality education and healthcare would carry much greater weight in measuring China’s development.

While the probabilities are low, we worry that this shift in policy may incentivise government officials across China to pursue policies akin to the “battle for skies” with great fervour causing a sharp slowdown in Chinese economic activity.

Investment Perspective

Invoking Occam’s razor we try to search for the simplest solution to any problem. So if your problem is that you are worried about this market, our proposed solution to you is neither to short this market nor is it to buy protective puts. Instead, if you want portfolio protection, buy two-year Treasuries. Why? Well as they say a picture is worth a thousand words:

US Two Year Treasury Yield vs. S&P 500 IndexSource: Bloomberg

China’s Strategic Gains

“Let a hundred flowers bloom; let a hundred schools of thought contend” – Chinese poem that inspired the name for Mao Zedong’s Hundred Flowers Movement

“Everything is relative in this world, where change alone endures.” – Leon Trotsky

“Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time.” – Winston Churchill

Democracy, according to Freedom House, peaked in 2005. Between the years 1970 and 2005 democracy flourished greatly. As recently as 1973, countries such as Spain, Portugal and Greece were dictatorships, and only forty-five out of the world’s then 151 countries were counted as free democracies by Freedom House. Driven by massive social change at a global level, the number of free democracies had grown to 120 nations by the end of the twentieth century.

Over the last decade, however, democratic institutions have experienced a significant decline. And 2017 saw this trend accelerate. The reversal in fortunes of democracy has emboldened the likes of China and Russia to push for increasing acceptance of the ideologies underpinning their respective brands of governance across the developing world.

The Trump Administration’s inward looking policies and hostility towards pluralist international agreements have opened the door for China to replace the United States as the key power broker in Asia and the developing world. Take, for example, Trump’s decision to withdraw the US from the Trans-Pacific Partnership (TPP), which was followed up by Xi Jinping’s rousing support for globalisation at Davos in January 2017 and again at the Belt and Road Forum in Beijing in May 2017. And it is not just bravado; China is pushing for greater integration amongst Asian economies by driving negotiations for the Regional Comprehensive Economic Partnership (RCEP) – a proposed 16-nation free trade agreement that includes the ten member states of the Association of Southeast Asian Nations (ASEAN) and Australia, China, India, Japan, South Korea and New Zealand.

Chinese efforts to wrestle away US influence in Asia are not limited to the RCEP alone.

In May 2014, Xi called for an “Asia for Asians” – a security concept encouraging Asian nations to step up and assume leadership in administering regional order. Xi’s words were provocative at the time but are progressively coming to reflect the emerging reality in Asia.

The China-Pakistan Economic Corridor (CPEC) – a collection of infrastructure projects under development across Pakistan valued at USD 62 billion – is a formalised strategic alliance that will connect landlocked parts of China to the port of Gwadar on the Arabian Sea and gives China substantial influence over Pakistan.

China has also deepened ties with countries, such as the Maldives, Sri Lanka and Nepal, that have traditionally fallen in India’s sphere of influence. Leveraging its position as the Maldives’ biggest debt holder, China has entered into a free trade agreement with the Maldives in November last year and also received the government’s endorsement for its “Maritime Silk Road” plan. Sri Lanka too has capitulated under the burden of Chinese debt and has handed over the strategic port of Hambantota to China on a 99-year lease. Chinese firms also control a container terminal in Sri Lanka’s capital Colombo. In Nepal the Left Alliance, a pro-China and communist party, propelled by China’s pledge to invest over USD 8 billion in developing Nepal’s infrastructure won the recent elections by a landslide and will take power in March 2018.

China’s deepening ties within Asia, while true to Xi’s “Asia for Asians” mantra, form part of its much larger vision: the Belt and Road Initiative. The Belt and Road Initiative, at times dubbed the Chinese Marshall Plan, is an ambitious economic policy centred on international infrastructure development. It will span four continents and encompasses the construction of two broad networks:

– The “Silk Road Economic Belt” a land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and

– The “Maritime Silk Road” a network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe

Scepticism, when the Belt and Road Initiative was unveiled by Xi Jinping in October 2013, ran high. For all its ambition, the fact remains that there are few countries that trust China. The US retreat and the promise of new infrastructure, however, have seen bottlenecks and political roadblocks fall by the wayside and the initiative has started to gather momentum. Quoting from Caterpillar Inc.’s fourth quarter earnings call (emphasis ours):

“Lastly, we expect to see continued growth in Asia Pacific, led by China. Our forecast is for China to remain strong through the first half of the year, and then slow in the second half, which reflects normal seasonality. In addition to China, we expect most other countries in Asia Pacific to grow, largely driven by investments in infrastructure.”

Equipment manufacturers such as Caterpillar are seeing increased demand out of China and the Asia Pacific. Excavators and loaders, such as those produced by Caterpillar, are amongst the most commonly used earthmoving equipment at construction sites. The increase in orders for such equipment from China and the Asia Pacific are tell-tale signs that the Belt and Road Initiative is underway.

While sceptics will remain and there will be many hurdles along the way, the importance of the Belt and Road Initiative to China cannot be overstated. It is seen as being so important by Chinese leadership that during the Communist Party of China’s 19th National Congress, the following statement was deemed to be a necessary addition to the Chinese constitution:

“Following the principle of achieving shared growth through discussion and collaboration, and pursuing the Belt and Road Initiative.”

Some have speculated that because the Belt and Road Initiative is inseparably connected to Xi Jinping, the inclusion of the above statement into the constitution is a means by which Xi will extend his leadership beyond his term. We, however, think that this objective was already achieved by the enshrining of “Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era” into the constitution. The Belt and Road Initiative is China’s path to rebalancing its economy, creating ripe markets for its “Made in China” policy to be a success, and moving up the manufacturing value chain.

China’s expanding influence in Asia comes at the cost of increasing insecurity amongst Japan, India, and the US. The Trump Administration, while being irreverent towards globalisation, contains amongst its ranks deep-seated China sceptics – Director of the White House National Trade Council Peter Navarro and Trade Representative Robert Lighthizer chief amongst them – we think it is unlikely that the US will forfeit its position within the global order without a fight.

India, wary of the Chinese-Pakistani alliance, too, is trying to up the ante. Indian Prime Minister Narendra Modi has signalled a USD 250 billion revamp of India’s armed forces by 2025 and 2017 saw India entering into new defence deals with Israel, Russia and the US. At the same time, India is trying to shore up relations with its neighbouring countries. It extended USD 4.5 billion in project financing to Bangladesh to support infrastructure development, committed USD 500 million in investment for the Chabahar Port in Iran, and also entered into an estimated USD 2 billion agreement with Iran for cooperation in the rail sector.

While China is unlikely to win over western democracies, Japan or India anytime soon, the overtures of Chinese money-fuelled infrastructure projects are likely to prove too tempting for most developing nations. And this, we think, is the reason the Belt and Road Initiative should continue gathering momentum.

Investment Perspective

Equity markets globally have started 2018 with a bang. This year’s most eye-catching market action, in our opinion, however, occurred on 2 January at the Karachi Stock Exchange in Pakistan. Why? Well, for starters, Trump’s first tweet of the year:

“The United States has foolishly given Pakistan more than 33 billion dollars in aid over the last 15 years, and they have given us nothing but lies & deceit, thinking of our leaders as fools. They give safe haven to the terrorists we hunt in Afghanistan, with little help. No more!” – @realDonaldTrump

Given that Pakistan was to receive over USD 255 million and USD 900 million in security assistance from the US for 2016 and 2017, respectively, the freezing of these disbursements subsequent to the US President’s tweet was bad news for Pakistan. Yet the Pakistani stock market went up and has continued to go up since.

Karachi Stock Exchange 100 Index

Source: Bloomberg

Two days after President Trump’s tweet against Pakistan, China unveiled that its second overseas military base would be built in Pakistan. The base will be built at Jiwani, a port close to the Iranian border on the Gulf of Oman and will be a joint naval and air facility for Chinese forces.

China’s growing influence in Asia is real. The Belt and Road Initiative is gathering momentum. The investment implications of these developments may prove to be profound over the next decade. For now, it is a signal that China wants to increase its influence in Asia. Stability is a necessary condition in order to achieve further influence. For this reason, as we noted in Our Thoughts On and Investment Ideas for 2018, China bears stand to be disappointed in 2018.

An added corollary is that one should not be shorting the stocks of construction equipment providers.

Europe: A Domestic Recovery Story

“By hamstringing the ability of French governments to act in the interests of the French people – or, to put it more realistically, by giving them an excuse for not so acting – that embrace has destroyed political legitimacy in France. It has contributed to a contempt for democratic politics so profound, among both rulers and ruled, that the survival of the Fifth Republic may be brought into doubt in the next few years, ‘Europe’ or no ‘Europe’.”

– Excerpt from The Rotten Heart of Europe: Dirty War for Europe’s Money by Bernard Connolly

“How can you govern a country which has 246 varieties of cheese?” – Charles de Gaulle

In medieval France, there was a legislative and consultative institution, known as the Estates-General (French: États généraux), which gathered representatives from different classes of people across the land to advise on matters of national importance. When the representatives congregated in 1614 in Paris at the occasion of the uprising being organised by Louis II de Bourbon, the prince of Condé, they complained about corruption and high levels of taxation while still maintaining allegiance to the crown. The Estates-General did not reconvene again till 1789 when it was summoned by King Louis XVI. This time, however, the representatives did not merely complain but rather provoked the French Revolution.

Political change takes times. Yet Emmanuel Macron, in only 8 months since taking office and on the back of a large parliamentary majority, has been successful in effecting meaningful change in France. Most notable of all of Macron’s achievements to date is the signing of five decrees in September last year to reform France’s labour law. The implications of these decrees include:

Streamlining social dialogue

When a company hires its fiftieth employee in France, it must comply with a long list of requirements, notably the nomination of workers’ representatives and the setting up of a works council and a health and safety committee. Under the reforms, the three employee representation bodies – the staff delegates (“délégués du personnel”), the Works Council (“Comité d’entreprise”) and the Health and Safety Committee (“CHSCT”) – will be merged into one single entity, called the Social and Economic Committee (“SEC”). Companies must set the SEC up by no later than 1^st January, 2020.

The merger of the three bodies will reduce administrative costs and cut through significant amounts of red tape faced by large companies.

Decentralisation of collective bargaining

Collective bargaining was generalised by law in France in 1950. This law established collective bargaining at the industry level as it was seen as the only way in which small companies could benefit from collective agreements. The introduction of the “Auroux laws” in 1982 imposed an added obligation on companies that have a trade union delegate amongst their staff – loosely companies with 50 or more employees – to negotiate pay and working hours annually – failure to do so could result in penalties.

Under Macron’s reforms, employers, in companies of less than 11 employees, will have the freedom to negotiate directly with their employees, on all topics open to collective bargaining, at company-level instead of industry-level. Agreement of terms between the employer and employees is subject to ratification by a majority of two-thirds of the employees. This new ratification method is also applicable to companies of 11 to 20 employees that do not have a trade union delegate.

The reforms also increase flexibility for businesses with 21 to 49 employees and no trade union delegate by allowing them to negotiate agreements with elected, but not unionised, employees.

Given that over 90 per cent of French companies have fewer than 50 employees and no trade union delegates, the decentralisation of collective bargaining is a major win for business. Companies are now less susceptible to being held hostage by powerful labour unions such as the General Confederation of Labour (CGT).

Settlements for unfair dismissal

Firing employees in France has always been both challenging and costly. Up until the recent reforms, employees in France could obtain huge settlements for unfair dismissal and could make claims against their dismissal up to two years after the fact. Now, however, damages will fall within a set floor and ceiling and workers will now have twelve months to lodge their application with the tribunal for compensation for wrongful dismissal.

Damages for employees with two years of services are capped at three months’ salary with compensation increasing by a month’s salary for each year of additional service up to ten years. After ten years’ service, the annual increments are reduced to half a month’s salary. The maximum compensation is set at 20 months’ salary.

Local not global profitability to assess case for lay off

In France, any plan to layoff multiple workers must be approved by a chamber of commerce. Judges have been known to block lay off plans or penalise companies by referencing the profitability of their global operations. This oddity, too, has been removed. Judges will now only be able to base their decisions on a lay off plan on the profitability of a company’s local operations. This is a major shift as global profitability has been the central issue over company shutdowns and restructurings in France over the years, most notably in ArcelorMittal’s attempt to lay off workers at Florange steelworks in 2013.

These labour reforms are certainly good for business. Administrative costs will be lower, transparency on potential damages arising from layoffs is higher, and multinationals will not be unduly penalised for the performance of their international operations. Employees, however, should also benefit. Companies will now be more willing to hire in good times as they know they will be able to shed staff, without onerous levels of red tape, in bad times. While wage gains will be limited as the combination of employers now having more flexibility in negotiating terms and the high unemployment levels in France give businesses a stronger hand, unemployment should decline.

France’s first budget under Macron, while not without its critics, is also another early success. The budget reduced the scope of the wealth tax to real estate assets and put in place a flat 30 per cent levy on capital gains, replacing the previous progressive tax on capital gains that went as high as 45 per cent. The corporate tax rate has been cut to 30 per cent starting 2018 and will be reduced to 28 per cent on 1 January 2020, 26.5 per cent on 1 January 2021 and 25 per cent on 1 January 2022. Until 1 January 2020, the corporate tax rate will remain 30 per cent.

The early reforms achieved by the Macron government should boost the domestic profitability of French companies over the coming 2 to 3 years; while at the same time strengthening the case for capital investment into France. Moreover, the reforms come at a time when Europe, collectively, is in a cyclical upturn. Thus enabling the French economy to both contribute to and benefit from this upturn.

Europe’s cyclical upturn is real and it is broad based. Industrial production, excluding construction, is picking up across the Eurozone.

Eurozone Industrial Production Ex-Construction YoYSource: Bloomberg

If we look across some of the major European economies, the industrial production trends are similar.

Industrial Production Ex-Construction YoY for Major EU Economies Europe Industrial Production Major Economies Source: Bloomberg

Construction activity too is starting to pick up. Using the number of residential construction permits issued as a proxy; we can see that construction activity is witnessing a strong pick up in France and Spain.

OECD Construction Orders Permits – Residential Buildings IndicesSource: Bloomberg

Unemployment is declining as a result of the higher levels of economic activity.

Eurozone Unemployment Rate (%)Source: Bloomberg

This is translating into improving consumer confidence.

European Commission Consumer Confidence Indicator Source: Bloomberg

Business appetite for borrowing has also picked up with a strengthening economy.

European Central Bank Money Supply M2 YoYSource: European Central Bank

Given the still high levels of unemployment in the Eurozone and relatively frictionless labour mobility, nominal wage growth remains subdued and is likely to remain so until the labour market tightens significantly. And this, we think, will keep the ECB from tightening too quickly and instead allow monetary policy to remain accommodative for at least another 18 to 24 months, which should be supportive of profitability of Eurozone companies.

Investment Perspective

A strengthening Euro has thus far not derailed the recovery in the Eurozone. This is because the recovery is domestically driven and not by exports or as a consequence of an undervalued currency. The ECB’s accommodative policies have kept the cost of capital low, allowing companies to repair their balance sheets and increase profitability.

Comparing the price performance of the STOXX Europe Mid 200 Index – a representative index for mid-cap companies in Europe – to the trailing twelve months price-to-earnings ratio of the index, we find that over the last two years earnings growth, not multiple expansion, has driven the price performance of mid-cap European companies. In fact, the price-to-earnings ratio has contracted over the last two years by over 25 per cent while the index is up over 16 per cent.

STOXX Europe Mid 200 Price Index – Price vs. Price-to-Earnings RatioSource: Bloomberg

We prefer small- and mid-cap exposure in Europe over broad based equities exposure. We think a stronger Euro will be a headwind for many large-companies as most of them have a significant portion of their earnings coming from exports.

At a sector level in the mid-cap space, we like automobiles and components producers, consumer services companies, mid-sized Spanish banks, and insurance companies. Areas that we would avoid include food & beverage producers and distributors, media companies and mid-sized energy related plays.

* Note if you would like to discuss specific names please email us

Agriculture Commodities and Chemicals: Catalyst Needed

“The ever more sophisticated weapons piling up in the arsenals of the wealthiest and the mightiest can kill the illiterate, the ill, the poor and the hungry, but they cannot kill ignorance, illness, poverty or hunger.” – Fidel Castro

“Feel what it’s like to truly starve, and I guarantee that you’ll forever think twice before wasting food.” – Killosophy by Criss Jami

“Agriculture is not crop production as popular belief holds – it’s the production of food and fiber from the world’s land and waters. Without agriculture it is not possible to have a city, stock market, banks, university, church or army. Agriculture is the foundation of civilization and any stable economy.” – Allan Savory, Zimbabwean ecologist, livestock farmer, environmentalist, and president and co-founder of the Savory Institute

‘Qu’ils mangent de la brioche’, that is, ‘Let them eat cake’, are allegedly the famous words uttered in the 18^th century by Marie-Antoinette, the last queen of France, upon being informed that the French peasants have no bread. While these words may or may not have been spoken at the time, food shortages and the high cost of bread were most certainly the precursors to the rioting that led to the French Revolution.

With over 1.3 billion mouths to feed, members of the Communist Party of China (CCP) will be all too aware of the dire consequences food shortages or rapidly rising food prices could have on their political careers. This in turn is likely to make them sensitive to any sharp rise in agriculture commodity prices. And it is no wonder that the CCP has over recent years taken steps to influence supply-demand imbalances in key agricultural commodities.

In 2016, for example, the Chinese government announced that it was scrapping its price support policy and stockpiling program for corn, a policy that had been put in place in 2007 to encourage local production of corn. The price support policy worked well, too well some might argue, in boosting local production especially as the government kept raising the support price until the end of 2011. The support price meant that corn prices in China were higher than prices in international markets. Unsurprisingly, given the incentives, the level of corn imports into China increased and the Chinese government was left to buy ever increasing amounts of locally produced corn. Analysts have speculated, that by 2016, the Chinese government’s corn reserves amounted to around half of all global stockpiles.

Chinese Quarterly Corn Imports

Source: United States Department of Agriculture

Chinese corn imports dropped in response to the abandoning of the price support policy. The premium between Chinese and international corn prices also shrank – the premium started dwindling in 2015 when the support price was reduced for the very first time.

In May 2017, the government decided to heap further pressure on commodity markets by auctioning off parts of its corn reserves, causing an initial sell-off in futures markets. International prices have stabilised since and remain largely range bound; however, Chinese prices bottomed in January 2017 and have been gradually rising since.

Chinese Corn Price vs. International Corn PriceSource: Bloomberg

The divergence in Chinese and international corn prices witnessed since January 2017 has been witnessed in other agricultural commodities, such as wheat and soybean, as well. China’s “battle for blue skies” and reduced air pollution forced many producers, both industrial and agricultural, to suspend operations last year. These suspensions rocked Chinese commodity markets and pushed prices higher. The situation was exacerbated in the winter when government officials – in a bid to meet year-end air pollution targets and to free up natural gas supply for households forced to switch from coal-fired to gas-based heating – forced natural gas-powered fertiliser plants to shut in areas like Sichuan and Yunnan, forcing prices of nitrogen-based fertilisers, such as urea, higher.

China Urea Prill Spot Price Source: Bloomberg

With year-end government targets met and the campaign set to end in March 2018, we suspect that the pressure will ease off and some of the suspended agricultural and industrial capacity will resume operations. The government has already reversed its ban on coal for heating as gas shortages left people freezing during the winter. As some of the shuttered capacity comes back online, we expect the premium in Chinese commodity prices to decrease. Nonetheless, with Xi Jinping highlighting environmental concerns in his speech at the CPC’s 19^th National Congress, we think that campaigns, such as the recent crackdown on smog, will continue in fits and spurts over the coming years and add to the volatility in Chinese industrial and agricultural production.

Although China has built up significant agricultural production capacity over the last decade, most of this capacity is inefficient as the price support policy incentivised capacity not efficiency. With the price support policy removed and our expectations of increasing volatility due to government policies, we suspect a significant portion of the existing capacity is already or will soon be at risk of closure due to mounting losses. Despite the level of Chinese stock piles, China cannot afford to lose productive capacity as stock-to-usage levels for some of the key agricultural crops in China are at very low-levels – levels last witnessed prior to the launch of the prior support policies for critical agricultural commodities.

China Corn Percentage Stocks-to-UseSource: United States Department of Agriculture

China Barley Stocks-to-Use DaysSource: United States Department of Agriculture

The global stocks-to-use level excluding China is even more precarious.

Global ex-China Corn Percentage Stocks-to-Use Source: United States Department of Agriculture

Global ex-China Wheat Percentage Stocks-to-UseSource: United States Department of Agriculture

Global ex-China Barley Percentage Stocks-to-UseSource: United States Department of Agriculture

With global stocks-to-use levels ex-China at or near multi-decade lows – and our belief that China is unlikely to become an exporter of agriculture commodities anytime soon – agriculture commodities remain susceptible to supply side shocks. These shocks could be caused by an adverse weather event, like La Niña, that disrupts production across key regions and causes food prices to spike, trade sanctions or tariffs being placed by the US on imports from key agriculture exporters, or rising freight and input costs for farmers.

Investment Perspective

As it generally tends to be the case with commodity related investments ideas, there are a number of ways to construct trades around the agriculture commodities theme. Our preferred approach, in this instance, is to combine direct commodity exposure with feedstock producer equities.

Historically, sharp rallies in key agriculture commodities have either coincided with or been preceded by global stock-to-use levels of the commodities being low, much as they are today. Low stock-to-use levels, in our opinion, are a necessary but not sufficient condition for a sharp increase in the prices of agriculture commodities. Demand or supply side shocks are usually the catalysts that cause prices to rally. We think key agriculture commodities are primed for a rally should a catalyst materialise.

Global ex-China Corn Percentage Stocks-to-Use vs. Corn Futures PricesSources: United States Department of Agriculture, Bloomberg

Global ex-China Wheat Percentage Stocks-to-Use vs. Wheat Futures PricesSources: United States Department of Agriculture, Bloomberg

Managed money positioning in futures markets are also extremely bearish. Money managers, on a net basis, shorts in corn and wheat are at or near a record number of contracts. Unwinding of these positions, too, can add fuel to any rally in prices should a catalyst materialise.

CFTC CBT Corn Managed Money Net Total / Disaggregated CombinedSource: Bloomberg

CFTC CBT Wheat Managed Money Net Total / Disaggregated CombinedSource: Bloomberg

On the feedstock side, our preference is to allocate to the equities of nitrogen-based fertiliser producers as our analysis suggests that supply and demand dynamics are gradually shifting in favour of producers. Taking urea for instance, production capacity growth is expected to plateau in 2019 while at the same time exports from China have been dropping sharply despite the removal of export tariffs in 2017.

China 12-Month Rolling Average Urea ExportsSource: Bloomberg

At the same time, Indian imports of urea appear to have bottomed. India is one of the largest consumers of urea globally and its market went through significant disruptions over the last two years, which dampened demand for urea. Farmer subsidy payments were delayed by the government, the introduction of the general sales tax of 18% in July 2017 increased the financial burden on farmers, and the reduction of urea bag sizes from 50 kilograms to 45 kilograms reduced demand as farmers in India tend to base their usage on bags as opposed to weight.

India 12-Month Rolling Average Urea ImportsSource: Government of India Department of Fertilisers

In terms of nitrogen-based fertiliser producers, we like Yara International (Yara) – the world’s largest nitrogen fertiliser producer. Yara has boosted efficiency as the global fertiliser slump has pressured margins and has increasingly shifted its focus toward higher margin products and high-growth regions. With fertiliser prices having picked up in the fourth quarter of 2017, Yara is well positioned to benefit from improved margins and increasing volumes should fertiliser markets remain resilient over the course of 2018.

We are long ETFS Corn ($CORN.LN), ETFS WHEAT ($WEAT.LN) and Yara International (Norwary).

Note: Yara International’s ADR is available is US OTC markets with ticker $YARIY.

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.

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).

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 Uranium Source: 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).

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)

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 Industry Source: 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 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).

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).

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).

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).

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.

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.

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)

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.

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 19^th 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 Index

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 M2

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)

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 19^th 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:

Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
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.

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 29^th 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)

Source: Bloomberg

Nikkei 225 Index

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 (%)

Source: Bloomberg

Japanese Labour Participation Rate (%)

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 RateSources: 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 Index

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 Rate

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.