AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market

“The icon of modern conservatism, Ronald Reagan, imposed quotas on imported steel, protected Harley-Davidson from Japanese competition, restrained import of semiconductors and automobiles, and took myriad similar steps to keep American industry strong. How does allowing China to constantly rig trade in its favour advance the core conservative goal of making markets more efficient? Markets do not run better when manufacturing shifts to China largely because of the actions of its government.” – Robert E. Lighthizer

“Patience is essential. We should step back, take a deep breath and examine carefully the ties that bind us together.” Maurice “Hank” Greenberg, former CEO of American International Group, at the congressional hearing on US-China economic ties in May 1996

American International Group (AIG), the once venerable multinational insurance group, was founded in 1919 in Shanghai, where it prospered until the communists forced it to leave in 1950. AIG had to wait over four decades to re-enter the Chinese market. In 1992, AIG became the first foreign insurance company licensed to operate in China and established its first office on the Mainland in Shanghai.

We doubt it was sentiment that led China to grant AIG the license. After all, there is little room for sentiment in the high-stakes game of global trade.

In 1990, Maurice “Hank” Greenberg, then chief executive of AIG, had been appointed as the first chairman of the International Business Leaders’ Advisory Council for the Mayor of Shanghai. In 1994, Mr Greenberg was appointed as senior economic advisor to the Beijing Municipal Government. In 1996, at the time when China’s status as Most Favoured Nation (MFN)[1] was under threat due to a resolution put forth to the House of Representatives in the US, he was appointed as the Chairman of the US-China Business Council.

While all of above mentioned appointments may have raised an eyebrow or two, they do not amount to much in and of themselves. When we throw in the fact that Mr Greenberg had been part of the President’s Advisory Committee for Trade Policy and Negotiations since the 1970s – the official private-sector advisory committee to the Office of the US Trade Representative – we begin to realise the possible reason why the Chinese leadership took a liking to Mr Greenberg and afforded his company the luxury of becoming the first foreign insurer to operate in China.

In May 1996, Mr Greenberg, during a key congressional hearing on US-Sino economic ties, testified in favour of not only renewing China’s MFN status but also making it permanent.

There we have it: quid pro quo.

In June 1996, the House of Representatives endorsed China’s MFN status by a vote of 286 to 141. At the time of vote AIG had eleven lobbyists representing its interests in Washington. One of those lobbyists was Skadden, Arps, Slate, Meagher & Flom, where AIG’s affairs were handled by one Robert E. Lighthizer – the current United States Trade Representative.


Senior American and Chinese officials concluded two days of negotiations on trade and technology related grievances the Trump Administration has with China. As many may have suspected, the talks appear to have achieved little despite the US sending a team comprised of top-level officials including Treasury Secretary Steven Mnuchin, Trade Representative Robert Lighthizer, White House trade advisor Peter Navarro, Secretary of Commerce Wilbur Ross, and National Economic Advisor Larry Kudlow.

As part of the talks the US representatives have submitted an extensive list of trade and technology related demands. In our opinion, the demands represent a hodgepodge of objectives as opposed to one or two key strategic objectives the Trump Administration may have – symptomatic of the differing views held by the various members of the US team. We expect US Trade Representative Robert E. Lighthizer to slowly take control of proceedings and to set the agenda for US-China trade relations – after all he is the only senior member of the team with meaningful experience in negotiating bilateral international agreements.

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

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


Unveiled in 2015, “Made in China 2025” is China’s broad-based industrial strategy for it to become a leader in the field of advanced manufacturing. The strategy calls for directed government subsidies, heavy investments in research and innovation, and targets for local manufacturing content.

To date, China’s industrial base is dominated by manufacturing of basic consumer products such as clothing, shoes and consumer electronics. The overwhelming majority of technologically advanced exports out of China have been made by multinational companies. The Made in China 2025 strategy identifies ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, semiconductors, agricultural machinery and biomedicine – where China aims to become a global leader. And it is these very industries that Mr Lighthizer aims to attack for the benefit of Corporate America.

One area where China is clearly at the cutting edge of global research is artificial intelligence. According to research published by the University of Toronto, 23 per cent of the authors of papers presented at the 2017 Advancement of Artificial Intelligence Conference were Chinese, compared to just 10 per cent in 2012. And we suspect, especially given the Chinese leadership’s dystopian leanings, China is going to be unwilling to relent on its progress in artificial intelligence regardless of the amount of pressure the Trump Administration applies.

Artificial intelligence requires immense amounts of computing power. Computers are powered by semiconductors. China cannot risk its AI ambitions by being hostage to semiconductor companies that fall under the US sphere of influence. China, we believe, will pull out all the stops over the next decade to develop its local semiconductor industry manufacturing capabilities with an aim to end its reliance on US-based manufacturers by 2030.

Investment Perspective

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

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

[1] From Wikipedia: MFN is a status or level of treatment accorded by one state to another in international trade. The term means the country which is the recipient of this treatment must nominally receive equal trade advantages as the “most favoured nation” by the country granting such treatment. (Trade advantages include low tariffs or high import quotas.) In effect, a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the promising country. There is a debate in legal circles whether MFN clauses in bilateral investment treaties include only substantive rules or also procedural protections.

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

Oil: Opportunities Arising from Infrastructure Bottlenecks

“Allow yourself to stand back to see the obvious before stepping forward to look beyond” – Adrian McGinn

“The fact is, America needs energy and new energy infrastructure, and the Keystone XL pipeline will help us achieve that with good stewardship.” – John Henry Hoeven III, is an American politician serving as the senior United States Senator from North Dakota

“Is it in our national interest to overheat the planet? That’s the question Obama faces in deciding whether to approve Keystone XL, a 2,000-mile-long pipeline that will bring 500,000 barrels of tar-sand oil from Canada to oil refineries on the Gulf of Mexico.” – Jeff Goodell, American author and contributing editor to Rolling Stone magazine

“When a measure becomes a target, it ceases to be a good measure” – Goodhart’s Law

A concept that frequently occurs in the study of thermodynamics – the branch of physics concerned with heat and temperature and their relation to other forms of energy – is that of irreversible processes.  An irreversible process is a process once initiated cannot return the system, within which it occurs, or its surroundings back to their original state without the expenditure of additional energy. For example, a car driven uphill does not give back the gasoline it burnt going uphill as it comes back down the hill. There are many factors that make processes irreversible – friction being the most common.

In the world of commerce when a supply- or demand-side shock occurs in a particular industry, it sets into motion a series of irreversible processes that have far reaching consequences not only within the industry which the shock occurs but for adjacent and related industries as well. The commodity complex, more so than most other industries, is typified by regular occurrences of supply- and demand-side shocks.

When a positive demand- or supply-side shock occurs for a certain commodity, the immediate impact is felt in the price of said commodity. As the price of said commodity re-rates, the net present values and prospective returns from investing in new production capacities for the commodity obviously improve. Once return prospects start to cross certain arbitrary thresholds – be it cost of capital, target internal rate of return, or a positive net present value – the investment case for the new production capacities strengthens. In response to the strengthening investment case a new capital formation cycle starts to take root and the amount of capital employed within the industry begins to increase, in turn impacting both supply-side dynamics within the industry and the demand-side dynamics within other supporting industries.

Conversely, when a negative demand- or supply-side shock occurs for a commodity, existing producers of the capacity start to feel the pain and suffer from declining earnings as the commodity’s price de-rates.  A sharp enough decline in the commodity’s price can lead to marginal producers selling at prices well below their cash cost i.e. cost of production excluding depreciation and amortisation. At this point the capital employed within the industry begins to decline – this can occur in a number of ways including shuttering of supply, bankruptcies, suppliers changing payment terms, or lenders recalling or withholding loans.

The capital cycle set in motion by either demand- or supply-side shocks are difficult to reverse. Once capital starts entering an industry, it continues to flow in until the vast majority of the planned capacity additions are delivered, even if the pricing assumptions that underpinned the original decision making have changed for the worse. The continued flow of capital despite the adverse change in return expectations is due to what Daniel Kahneman and Amos Tversky call the ‘The Sunk Cost Fallacy’. The sunk cost fallacy is a mistake in reasoning in which decision making is tainted by the investment of capital, effort, or time that has already been made as opposed to being based upon the prospective costs and benefits. It usually takes a shock of epic proportions to alter such a behavioural bias, such as oil falling below US dollar thirty per barrel in 2016 forced OPEC to switch from a strategy of market share maximisation to that of production rationalisation.

In the scenario where capital starts fleeing from an industry even though the sunk cost fallacy may not necessarily drive decision making – unless of course the decision makers have emotionally invested themselves in the negative prospects for the industry – reversing the tide of capital outflows can still be extremely difficult even in the face of improving prospects. This is partly explained by the lingering remnants of the emotional, psychological, or financial trauma that decision makers may have suffered through when the industry went through the negative shock. It often takes a sustained recovery either in terms of length of time or magnitude of price for the trauma to give way to rational decision making.

The turns at which behaviour begins to adjust towards more rational decision making often provide the most profitable trading opportunities.

Investment Perspective

Investing in commodities or equities of commodity producers is not for the fainthearted. Even the most sound investment thesis can be derailed by any number of factors, be it geopolitics, innovation, tax or subsidy reform, cartel-like behaviour, or simply futures markets positioning. Particularly in times of high levels of uncertainty, extreme investor positioning either long or short, or after a sustained move higher or lower in the price of the commodity, investors can be exposed to very high levels of risk. It is at such times that investing in companies that form part of the commodity’s supply chain can be a superior expression of one’s view as opposed to taking a direct exposure in the commodity or its producers.

We think that given the sustained move higher in oil, that has clearly wrong footed many, extreme positioning on the long side in futures markets and impressive revival in US shale oil production, one may be able to better express a medium-term bullish view on oil prices by investing in companies that service the oil and gas industry. Specifically, we consider, at this stage, being long equities of companies with products and services targeted towards oil and gas pipeline infrastructure to represent a more balanced risk-reward trade than simply being long oil or a generic energy ETF.

Brent Crude Oil and WTI Midland Price SpreadBrent WTI Midland Spread.pngSource: Bloomberg

To quote Bloomberg from its article Crude in West Texas Is Cheapest in Three Years Versus Europe:

Oil traders with access to pipelines out of West Texas to export terminals along the Gulf Coast are raking it in from the rapid supply growth in the Permian Basin. The 800,000 barrel-a-day output surge in the past year has outpaced pipeline construction and filled existing lines, pushing prices of the region’s crude to almost $13 a barrel below international benchmark Brent crude, the biggest discount in three years. That’s about double the cost to ship the oil via pipeline and tanker from Texas to Europe, signaling U.S. exports are likely to increase.

The infrastructure bottlenecks pushing down WTI Midland prices relative to Brent Crude prices are the direct consequence of underinvestment in pipeline infrastructure. This underinvestment is the result of either (1) the expectation that oil prices would remain lower for longer or (2) that shale production would not recover even if oil prices recovered. We think the reason is more likely to the former as opposed to the latter.

Oil prices have recovered both in terms of the magnitude and the duration of the recovery to such a degree that investors and decision makers are beginning to overcome the trauma caused by the sharp decline in oil prices between 2014 and 2016. And only now are they starting to invest in pipelines and other oil and gas infrastructure to benefit from the recovery in both oil prices and shale production.  Just as there was inertia in the change in investor attitudes towards oil and oil related investments, there is likely to be inertia – should there be a significant decline in oil prices from current levels – in stopping projects that have started and gone through the first or second rounds of investment.

Companies that manufacture components such as valves, flow management equipment, and industrial grade pumps, that are essential in the development of oil and gas pipeline infrastructure, we think, will be the primary beneficiaries of the recovery in oil and gas infrastructure investment. We also think companies specialising in providing engineering, procurement, construction, and maintenance services for the oil and gas services are also likely to benefit.

We are long Flowserve Corporation $FLS, SPX Flow $FLOW and Fluor Corporation $FLR.

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 Price of Growth

 

“To act wisely when the time for action comes, to wait patiently when it is time for repose, put man in accord with the tides. Ignorance of this law results in periods of unreasoning enthusiasm on the one hand, and depression on the other.”  – Helena Blavatsky, Russian esoteric philosopher, and author who co-founded the Theosophical Society in 1875

 

“Intelligence is the ability to adapt to change.” – Stephen Hawking

 

“As soon as you stop wanting something, you get it.” – Andy Warhol

 

One of the universally accepted ideas in sport is that of home court advantage. The idea, after all, is not a difficult one to accept: Home teams have the crowd behind them, cheering them on, filling them with confidence; visiting teams, on the other hand, have to deal with the home crowd’s hostility, which saps energy. And the stats seemingly reinforce the idea. For example, over the course of the NBA’s history, home teams have won roughly 60 per cent of the games played in almost any given season.

The crowd is powerful.

When it comes to capital markets, the crowd has unquestionably been cheering on growth and mocking value. Leaving many a value investor confounded by the apparently unstoppable rise in the likes of Netflix, Amazon, and NVIDIA. While valuations may be stretched and fundamentals in some cases appear questionable, if we take a step back and consider the secular trend, the continued outperformance of technology becomes less puzzling.

Plotting total business sales of US corporates against the ratio of Nasdaq 100 Index to the S&P 500 Index, we find a strong correlation – 74.1% using monthly data – between the two data series. That is the outperformance of the technology focused Nasdaq 100 Index relative to the broader S&P 500 Index is positively correlated with US business sales.

Total US Business Sales versus Nasdaq 100 Index to S&P 500 Index Ratio Business SalesSources: Federal Reserve Bank of St. Louis, Bloomberg

Given the latency between data releases, this relationship does not provide a trading signal. The relationship, however, does appear to suggest that US business sales growth has largely been dependent upon the growth in sales at technology companies and the market accordingly has rewarded technology stocks.

Our goal here is not to espouse the merits of investing in technology or in growth. Instead, we want to focus on what we consider to be the most interesting part of the above chart – the period from 2003 through 2006. During this period US business sales grew strongly yet the ratio between the two indices flat lined i.e. the S&P 500’s price performance roughly matched that of the NASDAQ 100.[i]

Digging a little deeper, we plot the ratio of per share sales of the S&P 500 to per share sales of the NASDAQ 100 against the relative price performance of the NASDAQ 100 Index to the S&P 500 Index. Zooming in on the period between 2003 and 2007 we find that the comparable price performance of the two indices during this period coincided with the quarterly fluctuations in per share sales also being comparable. Similarly, during the years of significant relative outperformance by the NASDAQ 100 Index, we find that per shares sales of the index were increasing relative to the per share sales of the S&P 500 Index.

Nasdaq 100 Index T12M Sales to S&P 500 Index T12M Ratio (Quarterly Data)Per Share RevenueSource: Bloomberg

Next, we consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index. Comparing the performance of these two indices we find that while the Nasdaq 100 Index and S&P 500 Index achieved comparable performance during the period from 2003 through 2006, the value index significantly outperformed the growth index during this period. The value index peaked relative to the growth index in 2007.

 

Ratio of S&P 500 Growth Index to S&P 500 Value Index (Monthly Data)growth to valueSource: Bloomberg

At the time of the dotcom bubble the ratio of the growth index to the value index, on a monthly basis, peaked at 1.56. Today the ratio stands at 1.47.

The crowd may well be at the cusp of switching loyalties.

We look for clues in and around the period between 2003 and 2007 to help us determine whether the time for value is coming or not.

The cyclical low in the effective US Federal Funds Rate registered a cyclical low in 2003.

US Federal Funds Effective RateFed funds rateSource: Bloomberg

The Commodity Research Bureau All Commodities Spot Index registered a cyclical low in 2001 and MSCI Emerging Markets Index started its multi-year ascent in 2003.

CRB Spot All Commodities IndexCRBSource: Bloomberg

MSCI Emerging Markets IndexMSCISource: Bloomberg

The US dollar had its cyclical peak in 2002, the same year in which the Bush Administration imposed tariffs on imported steel.

In 2004, Congress approved a one-time tax holiday for US corporations repatriating overseas profits.

In 2005, George Bush signed a USD 286 billion transportation bill.

If we compare the events and market action that preceded and coincided with the relative outperformance of value during the years from 2003 to 2007 to that of today, we find many similarities across both policy-making and market action. With growth’s outperformance relative to value reaching levels last seen during the very same period, the signs are difficult to ignore. It may not be time to bail on growth as yet, but it certainly is not the time to have a 100 per cent allocation to it either.

 

Investment Perspective

 

Human nature is such that we desire that which is rare and take for granted that which is common. In the recent past growth has been elusive – and that which has been available has been heavily concentrated in the US and in technology. It is no wonder then that investors have rushed into US technology names without abandon.

Growth is no longer as elusive. We can find growth in Asia, Europe and other parts of the emerging world and across both old industries and new. With its abundance the price of growth should de-rate. Value, however, has become hard to find and it is this scarcity of value, we believe, that will bring about the inevitable shift in market leadership away from technology to other sectors.

Forewarned is forearmed.   

 

[i] The total return for the NASDAQ 100 Index for the period was 80.9% versus 74.05% for the S&P 500 Index.

 

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