Financial Misery and the Flattening Yield Curve

 

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

 

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

 

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

 

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

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

 

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

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

 

So what happened?

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

 

Why has the long-end not moved?

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

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

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

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

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

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

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

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

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

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

 

Investment Perspective

 

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

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

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

 

Synovus Financial Corp $SNV 

 

SNV

 

Western Alliance Bancorp $WAL

 

WAL 

Eaton Vance Corp $EV

 

EV

 

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

US Stocks: Long, Short and Interesting

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

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

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

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

Semiconductors and Fabrication

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

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

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

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

ON Semiconductor $ON

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

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

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

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Cypress $CY

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

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Entegris $ENTG

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

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

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Marvell Technology $MRVL

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

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Retail

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

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

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

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

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

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

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

Burlington Stores $BURL

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

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

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Dunkin’ Brands Group $DNKN

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

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Payment Processing

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

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

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

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

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

We continue to hold the stock.

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Cardtronics $CATM

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

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

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

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

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

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

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Energy Infrastructure and Mid-Stream Services

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

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

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

IDEX Corp $IEX

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

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UGI Corp $UGI

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

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Targa Resources Corp $TRGP

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

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Digitalisation

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

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

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

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

Trimble $TRMB

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

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

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

TRMB

Zebra Technologies $ZBRA

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

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

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Software as a Service (SaaS)

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

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

In short, software is eating the world.”

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

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

Paycom $PAYC

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

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

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

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

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Veeva Systems $VEEV

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

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

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

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

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

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

 

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

 

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

 

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

 

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

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

 

Continued strength in the US dollar

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

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

 

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

 

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

 

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

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

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

 

China’s Line in the Sand

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

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

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

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

Failing at that, China has tried to respond by:

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

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

 

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

 

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

 

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

 

Germany: Stuck Between a Rock and a Hard Place

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

 

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

 

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

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

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

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

 

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

 

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

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

 

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

Trade Wars: Lessons from History

 

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

 

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

 

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

 

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

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

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

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

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

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

Powerful statements can often hide as much as they reveal.

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

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

 

American Independence and British Retaliation

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

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

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

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

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

 

The American System

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

China’s Adoption of The American System

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

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

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

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

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

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

 

Investment Perspective

 

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

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

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

 

Imposition of Tariffs

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

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

 

The Nuclear Option

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

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

 

A G2 Compromise

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

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

 

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

 

 

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

 

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

 

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

 

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

 

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

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

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

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

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

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

 

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

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

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

 

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

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

 

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

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

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

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

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

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

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

US Dollar Index3Source: Bloomberg

 

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

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

US 10-Year Treasury Yield4Source: Bloomberg

 

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

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

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

China Estimated Capital Outflows5Source: Bloomberg

 

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

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

 

Investment Perspective

 

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

 

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

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

 

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

 

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

 

European and Japanese US Treasury Holding 7Source: US Treasury

 

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

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

 

  1. Positive correlation between US dollar and oil prices

 

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

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

WTI Crude vs. US Dollar Index8Source: Bloomberg

 

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

 

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

 

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

 

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

 

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

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

 

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

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

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

 

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

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

 

 

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

Searching for Value in Retail

 

“A robber who justified his theft by saying that he really helped his victims, by his spending giving a boost to retail trade, would find few converts; but when this theory is clothed in Keynesian equations and impressive references to the ‘multiplier effect,’ it unfortunately carries more conviction.” – Murray Rothbard, Austrian school economist, historian and political theorist

“Star Trek characters never go shopping.” – Douglas Coupland, Canadian novelist and artist

“I went to a bookstore and asked the saleswoman, ‘Where’s the self-help section?’ She said if she told me, it would defeat the purpose.” – George Carlin

“A bookstore is one of the many pieces of evidence we have that people are still thinking.” – Jerry Seinfeld

 

Pets.com – the short-lived e-commerce business that sold pet accessories and supplies direct to consumers over the internet – was launched in February 1999 and went from an IPO on a the Nasdaq Stock Market to liquidation in 268 days. The failed venture came to epitomise the excesses and hubris of the tech bubble.

Bernie Madoff and Lehman Brothers were the defining casualties of the Global Financial Crisis and Greece became the poster child of Europe’s sovereign debt crisis.

In any prolonged bull market signs of ‘irrational exuberance’ begin to emerge prior to the onset of the inevitable bear market. And it is not uncommon in such bull markets for many a market participant to begin pointing out specific areas of the market where excesses may exist well ahead of a crash. Very few, if any, market participants, however, are able to identify a priori the very companies and assets that come to define the bull market.

In the present iteration of the bull market investors and commentators have pointed out all sorts of potential ‘bubbles’ including but not limited to negative yielding developed market bonds, 100 year sovereign bond issues by emerging market nations, bitcoin ethereum ripple crypto currencies, Chinese credit, unlisted unicorns, Australian real estate, Canadian real estate, and FAANG stocks. While any one or all of these assets may come to define the animal spirits of this bull market, to us the US equity bull market of the past decade is best captured by the fortunes of two companies: Amazon ($AMZN) and Barnes & Noble ($BKS) – the disruptor and the disrupted.

Amazon versus Barnes Noble Price Performance (04 July, 2008 = 100)

BKS AMZNSource: Bloomberg

The price of $AMZN shares is 23 times higher than it was in July 2008, while the price of $BKS shares today is approximately 60 per cent lower than it was then.

The above chart captures within it the dominant trend of this US equity bull market: growth outperforming value. Consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index during this bull market: from the indices being almost even in July 2008, the growth index is almost 50 per cent higher than the value index today.

S&P Growth Index to S&P Value Index Ratio

SGX to SVXSource: Bloomberg

In fact, the ratio of the growth index to value index is at its highest level since June 2000 when the ratio peaked at the height of the tech bubble. This ratio is now less than 5 per cent from its tech bubble peak.

 

Investment Perspective

 

Value investors have had a rough ride over the last decade and despite the significant out performance of growth during this period it is arguably even more difficult to invest in value today than it has been at any point over the last ten years.  The struggles of value investors has led to many questioning the “value of value” and even one of its strongest proponents, David Einhorn of Greenlight Capital, to joke about it. Did not someone wise one once say “There’s a grain of truth in every joke”?

For the record, we do not think value investing is dead. We do acknowledge, however, that differentiating value from value traps has probably never been more difficult in the modern era than it is today. The sheer number of incumbent business models being disrupted means that for anyone, except the most insightful, it is only hubris that would allow one to have rock solid confidence in the durability of any incumbent business model.

With that being said and given that the ratio of the growth index to the value index is reaching record levels, we would be seriously remiss to not add a value tilt to our portfolio at this stage of the bull market. Our approach in making a value allocation within our portfolio is to add a basket of stocks that may collectively prove to have had value but the failure of one or two of the businesses do not permanently impair the portfolio. In this regard, we identify three retail stocks to add to our portfolio and will look to add more value candidates from other sectors to our portfolio over time.

 

Barnes & Noble $BKS

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

$BKS has already initiated a turnaround plan which includes trialling five prototype stores this fiscal year. These stores will be approximately 14,000 square feet, making them roughly 40 per cent smaller than typical $BKS stores. The new format will be focused on books, and include a café as well as a curated assortment of non-book products including toys and games. Under performing categories like music and DVDs will be dropped.

Whether the turnaround can stop the bleeding or not remains to be seen but given where sentiment and valuation for the stock are, we think any signs of a turnaround in financial performance will be rewarded with a significant re-rating of the stock.

 

Bed, Bath & Beyond $BBBY

Trading at a price to consensus forward earnings of around 9x and with a market capitalisation of under US dollars 3 billion, $BBBY is also a viable target for activist investors or private equity funds.

$BBBY has also initiated a turnaround plan.

More importantly, however, millennials are gradually stepping into home ownership and the wave of home buying is only getting started. With increasing home ownership comes increasing consumption, new homeowners have to fill up their houses with everything from furniture to lawnmowers. The marginal dollar of conspicuous consumption will be spent on stuff. For the homeowners this will be household goods. For the non-homeowners this will be on clothes, shoes, sports equipment, and health and beauty products.

We think $BBBY could be a beneficiary of increased millennial home ownership.

 

GameStop $GME

The stock trades at a price to consensus forward earnings of less than 5x. $GME may ultimately fail but at such a low valuation and a dividend yield of around 10 per cent, if the business can simply manage to survive a few years longer than the market expects it to, it will turn out to be a very good investment.

 

We cautiously add $BKS, $BBBY and $GME to our long trade ideas.

 

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.