The Spectre of Capital Destruction

“As the financial experts all over the world use machines to unwind Gordian knots of financial arrangements so complex that only machines can make – ‘derive’ – and trade them, we have to wonder: Are we living in a bad sci-fi movie? Is the Matrix made of credit default swaps?” — Richard Dooling

Legend has it that Alexander the Great, travelling through the Persian Empire during the fourth century before Christ, learned of an ox-cart in the city of Gordium belonging to its former king, Gordias. The ox-cart was tightly secured to a pillar in the centre of the acropolis using an intricate knot — in what is known today as a Gordian knot.

An oracle from Gordium had declared that any man who could unravel the elaborate knot securing the ox-cart was destined to become ruler of all of Asia. Many men of skill had attempted to untie the knot, but none succeeded. 

Alexander the Great too failed in his initial attempts to unravel the knot. After reflecting on how tight the knot was, he drew his sword and sliced it in half with one stroke. Then it is said that he declared, “Destiny is not something brought about by legend, but by clearing away with one’s sword.”

The Spectre of Capital Destruction

The three major central banks in the developed world — namely the US Federal Reserve, Bank of Japan and European Central Bank — have failed thus far to unravel the knot of deflation that has inhibited the global economy from achieving escape velocity. Their attempts to unshackle the global economy from deflationary forces have primarily entailed lower, and in some cases negative, interest rates.

Low (real) interest rates for an extended period, however, lead to the emergence of a different type of risk:  the permanent loss of capital.

The US has suffered from destruction of capital following a prolonged period of suppressed interest rates on three occasions over the last 100 years: 1929, 1966 and 2000. On a total return basis, it took on average 15 years for US markets to recover from these major draw downs.

Japan has had one episode of capital destruction, starting in 1989, and has hitherto been unable to recover the entirety of the lost capital.  In Europe, Italy started experience permanent loss of capital in 2008 and still remains a long way from regaining the highs.

The common theme across all these episodes of capital destruction has been the banking sector, in the respective economies, becoming insolvent, if not suffering from outright bankruptcy.

Maintaining low interest rates over a prolonged period may propel risk appetite and reduce volatility for a while but eventually such a policy increases the risk of a permanent loss of capital. Central banks’s repeated experiments with low rates have demonstrated that low rates lead to higher asset prices, higher indebtedness, lower capital investment and lower productivity. Asset owners get richer. The asset poor get poorer, and that leads to the emergence of populism and the problems that come with it.

The question then arises, after more than a decade of low interest rates, where does the greatest risk of a permanent loss of capital lie today? We think it is not in the US, not in China, not in Latin America, and not even in Italy but rather in Germany. For Germany has not only enjoyed an extended period of low interest rates but also of an artificially undervalued currency. The scale of malinvestment in Germany, particularly in the automotive sector, is likely to be staggering.

If and when the tide goes out, we suspect the level of capital destruction in Germany will prove to be unprecedented. 

The Inverted Yield Curve

The recent inversion of the US yield curve has sent alarm bells ringing for an impending recession in the US, and by extension, of a global recession. We are, however, not yet worried about an imminent recession in the US for the following reasons:

1. Bond yields remain low everywhere. In the US, real yields are now back at 0.7 per cent and should not be a drag on the economy.

2. While corporate debt is at record levels, corporate spreads remain within their historical range, after a brief rip higher at the back end of last year.

3. Oil, on a year-over-year basis, is lower and is soaking up less liquidity on the margin.

4.  The US dollar has been range bound, neither adding to nor detracting from global liquidity.

Given the above, we think the recent economic softness in the US is likely to prove to be nothing more than a pause. The US economy is already stabilising. The Atlanta Fed has revised up its estimate for first quarter GDP growth to 2.1 per cent and indicators such as mortgage applications, PMI readings and durable goods orders also indicate the same. We expect economic activity to continue picking up through the second and third quarters of 2019 underpinned by the Fed’s dovish stance, the release of dollar liquidity by the US Treasury and less tight, if not outright easy, monetary and fiscal policy in China.

And if growth does pick up, why should around  US dollars 10 trillion of global sovereign debt trade at negative yields?

Our core view is that just as global yield curves have witnessed a rapid flattening in recent months, the realisation that US, and by extension global, growth is picking up again is likely to trigger a sudden sharp steepening of yield curves. We see global equity markets, after their near record performance during the first quarter of the year, confirming as much. And there are more supporting signs such as rising copper prices and the inability of non-cyclical stocks to outperform cyclical stocks.

We expect those long duration to be nursing significant losses in second half of 2019.

What Could Push Bonds Yields Lower?

Given our repeated calls for a cyclical bottoming in long-terms yields, it is only prudent for us to consider a scenario, or scenarios, under which yields could yet go lower.

One such scenario that worries us that of a deflationary bust led by China.

Over the course of the last three decades, China has gone through the biggest capital spending boom in recorded history. All through this period, the driver of the Chinese economy has been capital spending more so than consumption. And China has not fueled this capital spending boom alone rather economies such as Australia, Brazil, Germany and South Korea have directly benefited from and contributed to the China led capital spending boom of the last thirty plus years.

If there is a deeper than anticipated slowdown in China that brings about an end to the structural ascent in global capital spending, then obviously investors should be positioning portfolios to be long duration and other yielding assets.

A China led deflationary bust, at least in the next 24 to 36 months, is not our base case view. Rather, we believe, that the steps taken by the Chinese leadership in the last 5 years have led to a curtailment of significant amounts of excess production capacities  — the evidence of which can be found in, for example, the resilience of steel prices. Moreover, with China’s belt and road ambitions and the developed world’s seeming desire to wean itself off Chinese supplies, we are more concerned with the prospect of global capacities being insufficient to satisfy future demand than that of a deflationary bust.

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.

Sugar Rush

 

 

“It’s not only moving that creates new starting points. Sometimes all it takes is a subtle shift in perspective, an opening of the mind, an intentional pause and reset, or a new route to start to see new options and new possibilities.” — Kristin Armstrong, former professional road bicycle racer, three-time Olympic gold medalist and unrelated to Lance Armstrong

 

“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.” — Vladimir Lennon 

 

 

Tech IPO Rush

 

In October last year, we wrote (emphasis added):

 

Over the last twelve months there has been little to no incentive for venture capital backed companies to go public. They have had a much better alternative that does not come with the scrutiny faced by a publicly listed company: sell to SoftBank’s Vision Fund.

 

[…]

 

Given the recent events surrounding Saudi Arabia and deceased Washington Post columnist Jamal Khashoggi, there is likely to be little appetite in Silicon Valley to accept  Saudi Arabian money henceforth.

 

[…]

 

Given recent developments and Silicon Valley likely to shy away from engaging the Vision Fund any further, we suspect many venture capital backed “unicorns” are actively soliciting proposals from investment banks to help them go public.

 

We expect a flurry of tech-led IPO activity in the first half of 2019.

 

After a delay caused by the US government shutdown, the markets are starting to see a flurry of tech IPO activity materialise.

 

  • The other ride hailing company, Lyft, has already filed for its IPO, which is said to be oversubscribed and set to surpass the US dollars 23 billion valuation the company was seeking.

 

  • Social content sharing platform Pinterest has filed its S-1 and is expected to go public in April.

 

  • Postmates, the food delivery app, announced in February that it had filed with SEC to go public. The company was last valued at US dollars 1.85 billion.

 

  • Zoom Video Communications, the video conferencing startup and one of the few profitable unicorns, recently filed to raise US dollars 100 million through an initial public offering.

 

  • Messaging platform Slack is taking a slightly approach, similar to the one taken by Spotify previously, and will be directly listing on to the markets without a public offer. A direct listing allows current investors to offer their stakes directly to new shareholders priced purely on demand. The company was valued at $7.1 billion in a $427 million funding round in August.

 

  • The biggest and the most awaited of  them all, the riding hailing company Uber is on track to publicly list at an estimated valuation of US dollars 120 billion.

 

There are, however, some startups that have indicated that they may delay their plans to go public. Notably:

 

  • Airbnb, the company recently valued at US dollars 35 billion, is also amongst the select group of profitable unicorns and recently acquired HotelTonight to expands its product offering. The company has previously expressed its intention to go public in 2019 but has recently cast some doubt on those plans.

 

  • Software and internet security services startup Cloudflare, which was rumoured to have filed for an IPO in October last year, recently raised US dollars 150 million in a financing round led by Franklin Templeton.

 

The recent flurry of tech-led IPO activity is reminiscent of the tech bubble at the turn of the millennium.

 

The S&P 500 peaked on 24 March, 2000.  Some of the notable public listings in and around the time of the market peak included:

 

  • Finnish national telecom operation Sonera Corporation’s listing in the US during October 1999

 

  • The listings of Charter Communications and United Parcel Service during November 1999

 

  • Chip manufacturer Infineon Technologies listingin March 2000

 

The biggest of the tech bubble IPOs came a little over a month after the S&P 500 peaked. AT&T Wireless Group listed on 27 April 2000.

 

Similarly, The Blackstone Group went public on 21 June 2007 and the S&P 500 peaked in October 2007 at less than 3 per cent above the level it was on the day the alternative investment manager listed. The largest pre-Global Financial Crisis IPO was of Visa, which listed in March 2008, a few months after the market peaked.

 

Will Uber’s mega-IPO mark the peak in S&P 500 this time round? We are not sure but when CNBC runs the below headline, it feels ominous!

 

From Lyft to Airbnb, investors shouldn’t worry the newest tech IPO rush signals a market top

 

 

Where Should Investors Hide?

 

Three and five years on from the S&P 500’s peak in March 2000, gold was up 14.7 per cent and 48.6 per cent, respectively. Respectable not spectacular.

 

Three and five years on from the S&P 500’s peak in October 2007, gold was up 58.1 per cent and 139.1 per cent, respectively. Spectacular.

 

You could always own some fixed income, of course. From recently published research on the the Federal Reserve Bank of New York’s Liberty Street Economics blog (emphasis added):

 

Long-term government bond yields are at their lowest levels of the past 150 years in advanced economies.

 

[…]

 

[L]ow interest rates in advanced economies are a secular phenomenon driven by global forces that emerged well before the Great Recession and that are unlikely to be connected to country-specific factors, such as national policies or other domestic developments. Therefore, whatever forces might lift real interest rates in the future must be global, such as a sustained pickup in world economic growth, or a better alignment of global supply and demand with respect to safe and liquid assets.

 

Given the above, we think it will be difficult for bonds to go much higher from here. And even if they do, whatever takes them higher is likely to take gold much higher.

 

Don’t be fully invested in gold, but have some for a rainy day.

 

 

 

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.

 

 

Where do we go from here? Credit vs. Duration

 

“Wealth does not pass three generations.” — Ancient Chinese proverb

 

“Most people do not have a problem with you thinking for yourself, as long as your conclusions are the same as or at least compatible with their beliefs.”  — Mokokoma Mokhonoana

 

Duration or Credit Risk?

 

“Real estate and mortgage credit got us in so much trouble in 2007,” he said. “Next it’s going to be corporate credit, and the breakdowns are something we have to pay attention to.”

 

The above passage comes from an article in the Institutional Investor and quotes famed hedge fund manager Paul Tudor Jones. The article goes on to detail Mr Jones’s concerns around, what he describes as, a probable “global debt bubble”.

 

Global corporate borrowing reached  US dollars 13 trillion at the end of last year — more than double the level prior to the Global Financial Crisis.  The Paris-based Organisation for Economic Co-operation and Development (OECD) estimates that global corporations will need to repay or re-finance as much as US dollars 4 trillion in debt over the next three years.

 

Given the amounts involved, it comes as no surprise that Mr Jones is not alone in warning about the high levels of corporate debt being a potential systemic risk. Stanley Druckenmiller has been outspoken about it. Bank of America Merrill Lynch expects “corporates, not consumers or banks,” to be source of the next recession. Mr Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, cautioned in December 2018 that “the bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors”.

 

PIMCO, one of the world’s leading fixed-income investment managers, being a little more sanguine than the aforementioned, started advocating a more selective approve to US corporate debt allocations at the start of 2018.

 

From PIMCO’s research piece published in January 2018:

 

Crucially, the share of the U.S. investment grade (IG) nonfinancial bond market that is rated BBB (i.e., the lowest credit rating still considered IG) has increased to 48% in 2017 from around 25% in the 1990s. Drilling down into the riskiest part of the BBB market segment, the universe of low BBB rated bonds is now bigger than that of all BB rated bonds (i.e., the highest-rated speculative grade bonds) combined.

 

[…]

 

We think investors may want to consider taking a more cautious and selective approach to BBB nonfinancial corporate bonds, particularly those in the low BBB rated segment where the risk of downgrades is higher and the room for error is lower. Of note, we are not advocating a generic underweight to BBBs, but rather suggesting a more selective approach in this environment. We still see opportunities in select BBB nonfinancials, especially in sectors with high barriers to entry, above-trend growth and strong pricing power.

 

 

PIMCO’s timing, in hindsight, was prescient. US corporate bond spreads bottomed, on a cyclical basis at least, in January 2018, having tightened through most of 2016 and 2017 on the back of a recovery in oil prices and then the enactment of the Trump Tax Cuts. Spreads blew out in the second half of 2018 as global risk-off sentiment gathered steam.

 

US Corporate BAA spreads to 10 year US Treasuries bottomed at around 150 basis points, approximately the same level as the pre-Global Financial Crisis low. Today, spreads are below 230 basis points, having partially retraced the move to above 250 basis points from late last year.

BICLB10Y Index (US Corporate BAA 2019-03-19 12-11-52.png

 

US High Yield spreads to 10 year US Treasuries bottomed at around 295 basis points, failing, however, to break their 2014 low of  approximately 230 basis points. Incidentally, high yield spreads bottomed around 230 basis points prior to the Global Financial Crisis as well. Presently, spreads stand at approximately 390 basis points, having come in from over 530 basis points at the end of 2018.

 

CSI BARC Index (BarCap US Corp H 2019-03-19 12-13-00.png

 

A catastrophic event, widely experienced or one reported on extensively, can scar the collective imagination. The scarring can in turn heighten the sensitivity of individuals or the collective to signs pointing to the possible recurrence of said catastrophic event.

 

In the run up to the Global Financial Crisis, the investment community was long, very long, corporate credit —  investment grade and high yield spreads were at or near multi-decade lows between 2005 and 2008. Following the Lehman bankruptcy, credit spreads spiked to multi-decade highs, leaving many investors nursing significant mark-to-market losses.

 

We are therefore not surprised that corporate debt is widely cited as a major risk to global markets in the event of a recession or another financial crisis.

 

What is often overlooked, however, is that investors, particularly institutional investors, were not long duration in the run up to the Global Financial Crisis — rather, it could be argued, they were quite possibly short duration. Using the 10 year US Treasury term premium as an indicator — the higher the term premium, the shorter the market is duration and vice versa — we can see term premium, in the below chart, rising rapidly in the two years running up to the Lehman bankruptcy, i.e. the market punishing duration.

 

ACMTP10 Index (Adrian Crump & Mo 2019-03-19 12-06-34.png

 

As we all know, those who had the wherewithal to remain long duration were rewarded most handsomely soon after the collapse of Lehman.

 

Today, term premium for 10 year US Treasuries is negative —  more than 70 basis points negative versus over 150 basis positive in 2007. If the next crisis or recession is unlike the last one, and it usually is, could it be that long duration, not long credit risk, is the pain trade?

 

When duration is punished, the entire spectrum of fixed income instruments feels the pain. In the next crisis there may be few places for coupon clippers to hide.

 

 

The Hypothetical Family Office

 

The story is clichéd but bears repeating.

 

A patriarch from humble beginnings and limited employment opportunities establishes a small business, works hard, starts employing relatives into the business and later his villagers. Benefiting from macroeconomic tailwinds and nonexistent competition, the business expands at a rapid pace and starts spitting out cash the patriarch continues to put back into the business.

 

As the patriarch grows older, he encourages his children to join the business. In this instance, the patriarch has three sons. The first, having grown up when his family had little wealth, shows no interest and is far more concerned with spending his father’s newfound wealth than increasing it. The second, having had a comfortable, if not luxury laden, upbringing, wants to prove his worth and is eager to join his father in his entrepreneurial pursuits. The third, still young and having experienced little else except luxury, pursues formal education  at a school surrounded by the scions of other business magnates.

 

After decades of re-investing in the business and expanding it across the country, comes a point where the cash being generated by the business far overwhelms any of its investment needs. So the patriarch did, what any wealthy man in any developing economy has done over the last five decades, invests in real estate and then appoints his second son to manage and grow the real estate portfolio.

 

Real estate prices witness a parabolic rise over the next decade, driven by rapid population growth, urbanisation and lack of avenues to direct excess capital as local capital markets remain underdeveloped.  The income from the family’s real estate portfolio exceeds that of the patriarch’s original business.

 

Come the late-1990’s, the third son graduates from university and joins the family business with fresh ideas and aspirations. He tries to convince his father and elder brothers to establish a family office and diversify wealth across geographies and asset classes. The second son averse to change, urges his father to stick to what they know and not to pursue the third son’s ideas. The third son, being his father’s favourite, however, is able to get his way. A family office is established, the second son continues to manage real estate and the third son is given a small amount of capital to diversify the family’s wealth.

 

As the first order of business, the third son feels that his family must gain some exposure to the dot.com boom. He connects with private bankers to help him  allocate small amounts of capital to venture capital and technology funds.  Just as the family’s capital is deployed into these funds, the tech bubble bursts and the funds are quickly marked down to zero. Mistake number 1.

 

The second son gains the upper hand and continues expanding the family’s real estate portfolio. The ageing patriarch with little ambition to manage his original business decides to take a step back, handing over the business to his sons. The sons enamoured by the world of investing, show little appetite for day-to-day operations. Instead, with the local capital markets starting to take off and growing public interest in stocks, the family appoints an independent management team, lists the business on the local stock market and enjoys a cash windfall. They are no longer millionaires, but multi-billionaires. It is now the mid-2000’s.

 

The losses from the tech-bubble long forgotten, the third son is given purview over some of the windfall profits. Erring on the side of caution this time, he engages the services of strategy consultants and investment consultants. Their advice is to allocate capital to big-name private equity and real estate managers. Capital is allocated to the likes of Kohlberg, Kravis & Roberts, Carlyle Group, JP Morgan and Goldman Sachs, amongst others, albeit it through private wealth management structures loaded with upfront and hidden fees.

 

The timing of allocations was not great but not spotting the hidden fees was criminal. Eventually, the returns were respectable gross of fees but atrocious on a net basis. Mistake number 2.

 

With large amounts of dry powder still at his disposal, the third son starts directly and aggressively investing the family’s wealth into the financial services sector — “look at the return on equity financial institutions enjoy,” he said.

 

Come the back end of 2008, Lehman Brothers goes bankrupt and those high returns on equity are history.  Mistake number 3.

 

In 2011, the third sons starts investing small amounts of capital into biotechnology start-ups, directly not through funds — “we are investing alongside brand name venture capital funds without paying fees” he said. As it often happens, start-ups burn through cash and need to raise more capital. Not wanting to be diluted, the family participates in each subsequent round of financing. Come 2014 the handful of biotech start-ups are no longer small investments, rather the family is even the single largest shareholder in some instances.

 

In 2015, the biotech bubble pops and all of the start-ups invested in by the family prove to be duds. Mistake number 4.

 

In 2019, the family office allocated capital to venture capital funds for the first time since their late 1990’s debacle. 

 

Everything in the above tale is true, except for the family office being hypothetical.

 

 

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.

 

 

 

 

 

 

 

 

 

 

 

 

Notes on Russia and Oil & Gas

“My problem is that my imagination won’t turn off. I wake up so excited I can’t eat breakfast. I’ve never run out of energy. It’s not like OPEC oil; I don’t worry about a premium going on my energy. It’s just always been there. I got it from my mom.” — Steven Spielberg

“Russia is tough. The history, the land, the people — brutal.” — Henry Rollins

We recently met with the management team at Rosneft — the third largest company in Russia and one of the top 25 oil & gas exploration companies in the world by revenue —  for a wide ranging discussion on oil & gas, Russian macro, the deal with Saudi Arabia and OPEC, shale oil and geopolitics. In this week’s piece we share our notes from the meeting.

On Russian macro:

  • Russian budget balances at an oil price of around US dollar 47 per barrel.
  • Government and corporate external debt has declined from around US dollars 730 billion in 2014 to approximately US dollars 450 billion by the end of 2018.
  • 50 per cent of crude oil production is exported unrefined, 50 per cent of production is utilised for refined products of which 50 per cent are exported. Directly and indirectly, approximately 75 per cent of oil produced is exported.
  • The government is actively running a weak ruble policy, which is benefiting exporters at the cost of lower domestic economic growth and lower purchasing power for the Russian consumer. This is translating into Russian economic growth being investment-led as opposed to consumption-led.
  • Moreover, the policy is resulting in weaker than potential economic growth. Real GDP growth is around 2 per cent while the economy has the potential to grow between 3 to 5 per cent annually.
  • To counter the below potential growth, the government is trying to attract foreign direct investment into the economy — Russia moved up to 31st in the World’ Bank’s ‘Doing Business’ rankings in 2018, up from 120th in 2011. The spectre of further economic sanctions, however, has thus far deterred foreign capital.
  • To implement the weak ruble policy, the Central Bank of Russia sterilises all oil revenues above US dollars 40 per barrel. At current oil prices, the central bank purchases between US dollars 200 to 300 million from the open market on a daily basis
  • Russia is able to implement its weak ruble policy as the majority of costs, even for oil & gas exploration companies, are priced in rubles. For example, Schlumberger and Haliburton price onshore oil rigs lease rates in rubles, not US dollars. Oil & gas companies are only impacted if they are engaged in offshore drilling as offshore drills are not available in Russia. At present none of the Russian oil & gas majors are engaged in offshore drilling.
  • Pension reforms implemented in 2018 raised the retirement age from 60 to 65 years for men and 55 to 60 years for women.  The reforms were deeply unpopular  amongst the populace and instigated protests across the former Soviet Union. Eventually only a watered down version of the originally proposed reforms were implemented.

On the deal with OPEC / Saudi Arabia:

  • The production quotas / deal between Russia and OPEC holds far greater significance for Saudi Arabia than for Russia given Russia’s lower budget break even price, free floating currency and ruble based cost structure.
  • Russian oil production peaked in October 2018 at 11.4 million barrels per day. It has been cutting daily production levels by 65,000 barrels each month starting January 2019 and will reach the agreed upon production level in May 2019, which should be between 220,000 to 230,000 barrels per day lower than levels recorded in October.
  • Saudi Arabia has already cut production by more than the levels they had committed to as part of the deal with Russia and they expect the Kingdom to enact further cuts in the coming months.
  • Subsequent to our meeting, Bloomberg reported that “Saudi Arabia will supply its clients with significantly less oil than they requested in April, extending deeper-than-agreed production cuts into a second month”.
  • Although Rosneft is opposed to the production quotas, they expect the deal between Russia and OPEC to be extended beyond June 2019.
  • Rosneft, which accounts for 41 per cent of Russian oil production, could have increased its output by 5 per cent in 2019 but will limit growth to 2 per cent. In return, they have submitted a request for tax breaks to the Russian Ministry of Finance to compensate for the lost revenue.
  • One of the unintended consequences of the production cuts has been heavy, high-sulphur (or “sour”) crude trading at a premium to Brent crude in parts of North West Europe and the United States despite its lower grade. This has occurred as the majority of OPEC producers, predominantly Saudi Arabia, have focused their production cuts on high-sulphur crude and at the same time sanctions have been enacted on Venezuela, a major producer of high-sulphur crude. Demand from US refiners, which are configured to operate only with high-sulphur crude, and China’s preference for it as well — a byproduct of refining heavy crude is bitumen, which is used in the construction of roads  — has caused the squeeze.

On demand:

  • Demand erosion from electric vehicles has not been evident and it will take a much higher adoption rate for it to have a meaningful impact. Whatever adoption that is taking place is being more than compensated for by first time automobile buyers in emerging markets, particularly India and China.
  • Global demand is robust and should remain so as long as the US can avoid a recession in 2019.

On shale oil:

  • Full cycle, operating and capital expenditures cash break even for the Permian basin is between US dollar 40 to 50 per barrel versus the widely touted US dollars 35 to 40 dollars. This excludes the cost of land, which can push break even levels to as high as US dollars 55 to 60 per barrel.
  • There are signs of high cost inflation in the shale patch, particularly in the Permian, which may push up break even levels.
  • Listed shale oil companies returning capital to shareholders are being rewarded and those increasing capital expenditures have been punished. This suggests that the capital expenditure cycle for US shale may have peaked and that an increasing number of companies will choose to return capital as opposed to increasing production. If this happens, US production growth is likely to disappoint to the downside.

On natural gas and geopolitics:

  • Nord Stream is an offshore natural gas pipeline between Russia and Germany that is owned and operated by Nord Stream AG, whose majority shareholder is the Russian state company Gazprom. It has an annual capacity of 55 billion cubic metres.
  • Gazprom has a monopoly on all Russian natural gas exports.
  • Nord Stream 2 is a project to lay two additional lines and double annual capacity to 110 billion cubic metres and due for completion in 2019 . The project was backed by Chancellor Angela Merkel and the German government despite objections from some EU and NATO member states and from the European Commission
  • Since November 25, 2015, Ukraine has no longer imported Russian gas; instead, all supplies that enter Ukraine’s gas network from Russia are transferred to Europe. The gas transit agreement with Ukraine expires in December 2019. Nord Stream 2 is incidentally due for completion in December 2019. The completion of the project would allow all Russian gas to flow directly into Germany without transiting through Ukraine.
  • The cost of liquefaction, transportation and gasification of natural gas from alternate sources means that Russian gas remains the most economically viable source for Europe. Given Germany’s reliance on natural gas, especially after Chancellor Merkel outlawed nuclear power in Germany, it is difficult to see Europe turning away from Russian gas. German dependence on Russian gas has, however, caused a rift between France and Germany in the recent past.
  • Russia is confident that it can find alternative buyers for its supplies should Europe decide to stop buying from them.
  • In 2017, Rosneft sold a 20 per cent stake in Verkhnechonskneftegaz — one of the largest-producing fields in eastern Siberia that connects Russia with China, Japan and South Korea — to Beijing Gas. This is a sign of growing collaboration between the two states and a possible step towards de-dollarization.  With the added benefit for Rosneft and Beijing Gas of undermining the domestic monopolies of Gazprom and China National Petroleum Corporation.

Some data points:

  • Organic reserve replacement costs in Russia are approximately US dollar 0.20 per barrel of oil equivalent vs. US dollars 1.10 for BP, 1.00 for Chevron, 2.90 for Royal Dutch Shell and 5.70 for PetroChina
  • Lifting costs (the cost of producing oil and gas after drilling is complete) is US dollar 2.50 in Saudi Arabia and US dollars 3.10 in Russia vs. US dollars 5.60 for Total, 7.30 for BP, 10.60 for Royal Dutch Shell, 11.40 for Chevron, 11.50 for PetroChina and 12.30 for ExxonMobil.

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.

China Aplenty | Another Cloud Long Idea

 

“Plans are nothing; planning is everything” — Dwight Eisenhower

 

“Ultimately, the cloud is the latest example of Schumpeterian creative destruction: creating wealth for those who exploit it; and leading to the demise of those that don’t.” — Joe Weinman

 

 

This week we discuss China A-Shares, China’s 2019 budget announcements and share another cloud-based solutions providers as a potential long-idea.

 

China A-Shares Update

 

Global equity and fixed income indices provider, MSCI, has decided to quadruple the inclusion factor of China A-Shares in its Emerging Markets Index from 5 to 20 per cent over three phases. The result is the weight of China A-Shares in the index will increase to approximately 3.3 per cent from the current 0.7 per cent, leading to an estimated US dollars 13 billion of passive inflows into the market. While flows from actively managed funds could be as high as US dollars 50 billion dollars according to sell-side estimates.
MSCI, originally intending to increase the weighting of China A-shares in its Emerging Markets Index by May next year, is fast-tracking the increased weighting to be in effect by November this year.

 

The X-trackers Harvest CSI 300 China A-Shares ETF $ASHR has returned 28.6 per cent year-to-date (as at market close on 1 March 2019) as compared to the S&P 500 Index returning 12.3 per cent during the same period.

 

The strong performance of the broader Chinese market, particularly following the Chinese New Year, have coincided with a significant increase in daily trading volumes.

 

ASHR.PNG

A thawing of US and China trade tensions and the rebound in credit growth witnessed in January have provided welcome relief for the Chinese equity markets. Although negative economic surprises may lead to pullbacks in the nearer term,  with the increase in the weighting of China A-Shares in the MSCI Emerging Markets Index, we think Chinese equities remain good value for the remainder of 2019.

 

 

China: Notable Announcements from the Annual Legislative Session

 

At the Annual Legislative Session, which kicked-off in Beijing on Tuesday, Premier Li Keqiang announced that the government is targeting GDP growth in the range of 6.0 to 6.5 per cent for 2019, down from the 6.5 per cent guidance maintained over the last two years. Signalling the Chinese leadership’s preference for stability and all but ruling out the possibility of another credit binge of the likes witnessed following the global financial crisis and in 2015/16.

 

Announced value-added tax cuts came in higher than expectations. The highest VAT bracket, which applies to the manufacturing sector, was cut by 3 percentage points to 13 per cent, providing some welcome relief for industrial business. The VAT bracket applicable to the construction and transportation sectors was cut by 1 per cent to 9 per cent. The lowest bracket remained unchanged at 6 per cent.

 

To manage its fiscal deficit and balance the reduction in revenues from VAT, total government spending is budgeted to increase 6.5 per cent in 2019, down from the 8.7 per cent increase in 2018. The targeted fiscal deficit is 2.8 per cent, up from 2.6 per cent last year. Premier Li emphasised that China would not resort to a “flood of strong stimulus policies” to drive economic growth. The quota for local government bond issuance, however, is budgeted to  increase by Chinese yuan 800 billion, or almost 60 percent, to Chinese yuan 2.15 trillion in 2019, which should support spending on new infrastructure projects and  credit growth.

 

Overall, the announcements seem to reaffirm our view that following a marked slowdown in the first quarter, the economic environment in China should get incrementally better, not worse, over the course of 2019. Fiscal spending, however, is likely to prove more conservative than we had anticipated at the start of year — the Chinese leadership appear unwilling to undo the effort put in to reduce systemic risks in 2018 by meaningfully increasing the flow of credit in the economy. Nonetheless, we believe credit growth, which has been slowing since the first half 2016, has bottomed and should pickup.

 

A flaw in reading too  much into budgetary announcements, however, is that Beijing can always use state-owned enterprises (SOEs) to implement policies through unofficial means. If SOEs are directed to markedly increase capital expenditures and investments, this should have the same result as a significant increase in fiscal spending done by the government. We think the risk to state led capital spending, direct or indirect, is to the upside.

 

We have been bullish on long-dated Chinese government bonds for some time but now think it time for fixed income investors to tactically close out any long positions they may have. 

 

 

One More Cloud-Based Solutions Play

 

At the tail end of last year, Conlin Matthew, Founder and President, bought shares worth more than US dollar 450,000 representing 2.6 per cent of the company, in Fluent Inc. $FLNT.

 

Fluent is a cloud-based mobile user and data acquisition services providers that creates marketing programs to deliver superior digital advertising experiences for consumers with measurable results for advertisers. The company claims to interact with over 1 million consumers on a daily basis from its “proprietary first-party data asset” consisting of over 190 million opted-in consumer profiles to gather “self-declared” data. This data is used to create targeted advertising solutions on the company’s proprietary digital properties for brands to connect and interact with consumers.

 

The company in its present form was created through the business combination of the international digital media assets of BlueFocus International Limited, a wholly-owned Hong Kong subsidiary of BlueFocus Communications Group (a publicly traded Chinese Company), and the performance marketing platform of Cogint Inc. $COGT.

 

The company has a market capitalisation of US dollars 405 million with a free float of 43 per cent of outstanding shares and short interest of 3 per cent of free float.

 

We are long Fluent Inc. $FLNT with a stop-loss at US dollars 4.50.

 

FLNT.PNG

 

 

 

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

 

 

 

 

 

 

 

 

 

Will Europe be the Fall Guy in the Trade Deal?

 

“Capable, generous men do not create victims, they nurture victims.”  — Julian Assange

 

“Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.”  — Stone Gossard, lead guitarist for Pearl Jam and member of the Rock and Roll Hall of Fame

 

A slightly shorter piece than usual this week as we recover from  jet lag following a ten day trip to the US. This week we discuss, the potential fallout from a US-China trade deal.

 

 

In 1978 China accounted for less than one hundredth of global trade. By the turn of the millennium, its share had increased threefold. In a decade’s time, by 2010, its share of global trade had tripled again and in 2013 China surpassed the United States, becoming the world’s largest overall trading nation.

 

As China’s share of global trade has increased so too has the number of trade disputes it has been involved in. Between 2006 and 2015, China was party to, as either complainant or respondent, in more than a quarter of the trade dispute cases lodged with the World Trade Organisation (WTO).

 

Notably, according to Harvard Law Professor Mark Wu, there has been a notable shift in the “pattern of WTO cases among the major trading economies — the United States, European Union, Japan, and China”. Up until the global financial crisis, the US, Japan and the European Union would regularly file complaints against one another. Following the crisis, however, only three cases have been brought by the three major developed economies against one another. Instead, the cases brought by the major powers have almost exclusively been focused on China — 90 per cent of the cases they brought to the WTO between 2009 and 2015 were China-related.

 

The meteoric rise of the Chinese economy and its growing influence on global trade has challenged the pretext under which the WTO was formed. The WTO has struggled to adapt and to develop an equitable dispute settlement system to counter China’s, at times, egregious trade practices. The WTO cannot, given China’s importance to global trade, make rulings or draft new rules that China sees as discriminatory or unfair but at the same time it cannot seen to be a lame duck and see other member countries turn away from it. The inability to effectively settle this dilemma has weakened the institution’s credibility.  So much so that the WTO Appellate Body no longer has enough members to hear all possible cases — the US has vetoed all appointments to the body. Many see the US vetoes as a death knell for the WTO — signalling a return to  a world where trade disputes are settled through bilateral negotiations and the WTO’s dispute settlement system is defunct.

 

The United States Trade Representative, Robert E. Lighthizer, has, since taking office in May 2017, pursued a campaign against China based on the statutes of Section 301 of the 1974 Trade Act, which allows unilateral action by the US President against trade policies deemed unfair. In effect, the US Trade Representative’s strategy sidelines the WTO.

 

The Trump Administration’s approach of using Section 301 has been seen, by many, as both aggressive and likely to lead to negative consequences for the Chinese economy.  What if, however, President Trump has come to the realisation, that also afflicted his predecessors, that the American and Chinese economies are too closely intertwined for either side to be a victor in a trade war? If so, we wonder, is Europe going to be the fall guy in the trade deal?

 

Europe’s Trade Surplus with the US

 

From the Wall Street Journal:

 

The European Union reported a record trade surplus with the U.S. last year, a development that could weigh on slow-moving U.S.-EU trade talks and comes as the Trump administration prepares to deliberate hefty tariffs on European car imports.

Meanwhile, slowing exports from Europe to other trading partners, most notably China, in 2018 suggest the flagging EU economy could cool further this year. Failure of the U.S.-EU trade talks and fresh duties from the U.S. could compound Europe’s economic pain in 2019.

 

President Trump, we suspect, is going to look for an alternative win should the trade dispute with China be resolved amicably. We suspect, Europe, with its record bilateral trade surplus, is likely to find itself in the line of fire. For it was only days before Trump’s visit to Europe last year that President Macron called for the creation of a “true European army” and agitating the US President in the process.  Moreover, Europe is in a mess —  with the small matter of Britain’s exit from Europe imminent and a leadership vacuum with Angela Merkel a lame duck in office, Emmanuel Macron too occupied trying to contain the yellow vest movement, Italy moving from one crisis to another — meaning there is little hope for a coordinated response from the trade bloc, should President Trump throw down the gauntlet.

 

With any resolution of the US-China trade dispute likely to come with conditions for China to increase purchases of US goods and services, China is likely to reduce purchases of European goods and services in response. This is will only compound Europe’s problem further.

 

We think there is little reason to be overweight, or even equal weight, European equities at present.

 

Extending the same line of thinking, we think China is likely to increase its purchases of agricultural commodities from the US by reducing purchases from Brazil. For emerging markets exposure, we would underweight Brazil.

 

Semiconductor Leadership

 

 

Were the above tweets a wink to the national security hawks in the Trump Administration to end the pursuit of Huawei and stop placing export controls on US semiconductors producers?

 

If so, we think $SOXX should continue to be amongst the leaders in the US market. If, however, if there is sudden weakness in the semiconductor space we would be concerned about the prospects of an amicable trade resolution.

 

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.

 

 

 

 

Environmental Concerns: Ideas on the Long Side

 

I met a traveller from an antique land,
Who said—“Two vast and trunkless legs of stone
Stand in the desert. . . . Near them, on the sand,
Half sunk a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal, these words appear:
My name is Ozymandias, King of Kings;
Look on my Works, ye Mighty, and despair!
Nothing beside remains. Round the decay
Of that colossal Wreck, boundless and bare
The lone and level sands stretch far away.”

— Ozymandias by Percy Bysshe Shelley

 

In this week’s piece we discuss the Paris Agreement — a global accord signed in 2015 with the aim of mitigating global warming —  and the progress made on curbing carbon emissions since the signing of the accord. We also identify two long ideas in the clean & renewable energy and waste management sectors. Finally, we briefly touch upon the surge in Chinese credit growth during January.

 

Environmental Concerns

 

On 12 December 2015, at COP 21 in Paris, the 190-plus parties to the United Nations Framework Convention on Climate Change (UNFCCC) signed onto the Paris Climate Agreement, which committed countries to do their best “to combat climate change and to accelerate and intensify the actions and investments needed for a sustainable low carbon future“.

The agreement was seen as  “a turning point in the history of common human endeavour, capturing the combined political, economic and social will of governments, cities, regions, citizens, business and investors to overcome the existential threat of unchecked climate change“.

Three years since the Paris accord was negotiated,  we were amazed to learn that there has been no reduction in global emissions. In fact, there has not even been a decline in the rate of increase in emissions. Much rather, the rate at which emissions are being added to the atmosphere has increased!

Coal-fired power generation is still increasing — coal powered plants continue to be built and existing plants are not being removed as fast as new ones are being added.

What has gone wrong?

The lack of progress since Paris is attributed, by some, to the opacity of pledges made in the agreement, and the parties to the agreement remaining vague on the specific policies they will adopt to meet them. Further, there is no official mechanism for measuring progress.

The governing body and framework for the agreement, we think, are both highly bureaucratic and politicised. As is their wont, politicised bureaucracies are as much about not offending their stakeholders as they are about effective governance, if not more. The implications of this, we think, are that the goals of the Paris Agreement are likely to prove far too ambitious and meaningful, if any, progress on curbing global emissions will have to be made through the participation of the private sector.

The private sector, however, is unlikely to participate of its own volition. Rather, the powers that be, as ever, will need to create incentives, if, of course, they want profit seeking enterprises to participate in the mission to curb global emissions. Incentives can come in the form of regulations —  a cost of doing business, per say — or rewards — profits or higher relative valuations.

Higher relative valuations would be a result of supranational, multi-lateral and public institutions limiting their investment allocations to securities of companies adhering to a set of predefined environmental, social and governance (ESG) standards. Thereby increasing the relative demand for ESG-compliant securities ipso facto a higher relative valuation to  that of non-compliant securities.

 

Ideas on the Long Side

 

Below we highlight two stocks we consider to be interesting  potential long-ideas in the clean & renewable energy and waste management sectors below.

Advanced Emissions Solutions $ADES

Advanced Emissions Solutions is an emissions solutions provider with a focus on mercury and gas control solutions for coal-fired power plants in the United States. The company supplies electric coal-fired generation facilities with systems that chemically pre-treat various types of coal prior to the burn process. It also up sells  existing customers by providing consulting services and chemicals used to remove mercury and other hazardous airborne pollutants from the emissions resulting from the burning of coal.

The company supports coal-fired electric generation facilities in complying with the United States Environmental Protection Agency’s Mercury and Air Toxics Standards (MATS) for Power Plants.

$ADES has a market capitalisation of US dollars 233 million, trades at estimated 2018 price-to-earnings of 6.5 times and dividend yield of 8.5 per cent.  Short interest in the company is high at more than 11 per cent of free float.

 

ADES US Equity (Advanced Emissio 2019-02-19 14-33-04.jpg

 

Heritage Crystal Clean $HCCI

Heritage-Crystal Clean is a US-centric company that helps businesses clean parts and dispose of highly regulated waste materials, such as cleaning solvents, used oil, and paint, that cannot be discarded through municipal trash systems or standard drains. Customers, primarily small to midsize companies, include car dealerships, auto repair shops, trucking firms, and manufacturers such as metal fabricators. $HCCI serves customers in 42 states in the central and eastern US.

$HCCI has a market capitalisation of US dollars 600 million, trades at a rich valuation of estimated 2018 price-to-earnings of 36 times. The company, however, has a strong growth profile with earnings estimated to increase by more than 70 per cent in 2019.

 

HCCI US Equity (Heritage-Crystal 2019-02-19 14-54-41.jpg

China: Soaring Credit Growth

 

From Bloomberg:

 

China’s credit growth exceeded expectations in January amid a seasonal lending surge at the start of the year.

  • Aggregate financing was 4.64 trillion yuan ($685 billion) in January, the People’s Bank of China said. That compares with an estimated 3.3 trillion yuan in a Bloomberg survey
  • Financial institutions made a record 3.23 trillion yuan of new loans, versus a projected 3 trillion yuan. That was the most in any month back to at least 1992, when the data began

 

The Chinese leadership’s efforts to reinvigorate credit growth and support economic activity in the latter half of 2018 may be beginning to bear fruit. Credit growth, in January reached 10.6 per cent  year-over-year — welcome relief given the less than stellar showing in the latter half of last year.

The data from January is the first sign that the Chinese credit cycle may have bottomed out.

Chinese banks originated new loans amounting to CNY 3.23 trillion, increasing by more than 13 per cent year-over-year and setting a new monthly record in the process. The reading was well above both the CNY 1.08 trillion distributed in December and market expectations of CNY 2.80 trillion.

Net corporate bond issuance came in at CNY 499 billion, the highest level in almost in three years. As impressive as this may seem, state-owned enterprises accounted for more than nine tenths of gross corporate bond issuance.  Suggesting that Beijing’s recent calls for banks to provide greater support to the private sector has not yet had the desired effect. Moreover, credit growth tends to be higher in January, and ahead of the Chinese New Year. We will not be surprised if February data is less encouraging and only expect greater clarity after March.

If, indeed, credit growth remains strong over the coming months, it will still take time to show up in economic data. Typically, a spike in Chinese credit growth has led a corresponding spike in domestic demand by nine months. We still expect first quarter data to be weak as exporters suffer a hangover from the fourth quarter rush to get US orders out ahead of the original tariff hike deadline.

Nonetheless, early indications from credit growth and the looser monetary policy stance of the People’s Bank of China are of Chinese economic activity, as we have posited previously, to get incrementally better, not worse, in 2019.

 

 

Recently issued premium research:

Trade Wars: Portfolio Hedges | 3-D Printing

Pick-and-Mix

The Fed’s Permanently Big Balance Sheet & More

Emerging Market Stock Picks

Two Investment 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.

Trade Wars: Portfolio Hedges | 3-D Printing

“It’s easier to hold your principles 100 percent of the time than it is to hold them 98 percent of the time.”  — Clayton M. Christensen

“Character, like a photograph, develops in darkness.”  — Yousuf Karsh

In this week’s piece we discuss hedges to provide some portfolio protection under the different potential outcomes to the US-China trade dispute as the 1 March deadline to  reach an agreement approaches. Also this week, we discuss 3-D printing — the one time darling and now much maligned corner of the technology sector — and consider potential long ideas within the segment.

Trade Wars: Portfolio Hedges

US trade representative, Robert E. Lighthizer, and US Treasury Secretary, Steven Mnuchin,  are heading to Beijing this week, ahead of the 1 March deadline to reach an agreement and prevent a further hike in tariffs.  As part of the on going negotiations, the Trump Administration is demanding China to (1) reduce its trade surplus with the US, (2) stop enabling the theft or forced transfer of intellectual property and trade secrets from US businesses operating in China, (3) ease restrictions on foreign investment and foreign ownership of Chinese companies, and (4) put an end to industrial subsidies and the preferential treatment given by the Chinese government to state-owned enterprises.

In broad terms, we think there are four possible outcomes to the on-going trade related negotiations between the US and China. These outcomes are:

  1. A compromise much akin to kicking the can down the road whereby China agrees to reduce its trade surplus with the US and increases its purchases of US products and services. Nothing else of material consequence is agreed upon and both parties make assurances of negotiating over unresolved matters in the near future.
  2. Both parties make some concessions and meaningful progress is made on trade, giving Corporate America greater access to the Chinese market and intellectual property theft by China.
  3. One of the two parties capitulates. In the case of China capitulating means agreeing to an overwhelming majority of the Trump Administration’s demands. While the US capitulating means most demands unrelated to the China’s bilateral trade surplus are dropped.
  4. There is no agreement and a hike in tariffs goes ahead as planned.

The type of hedge a portfolio may need depends on how said portfolio is positioned.

A portfolio positioned for an amicable resolution to the trade dispute needs hedges for the first and fourth scenarios briefly outlined above. While a portfolio positioned for a prolonged trade war requires hedges under the second and third scenarios.

Positioned for an Amicable Resolution

Given China’s ambitions on the technology front and the Trump Administrations to rein Chinese technological through use of national security measures and export controls, the semiconductor industry is likely to be a key battleground in the dispute.

Investors positioned for an amicable resolution to the trade dispute can hedge themselves, we think, by going long South Korean semiconductor companies — China will need to turn to them in the event export controls are imposed on US semiconductor companies. Investors can further hedge themselves by shorting Taiwanese semiconductor companies because, if China’s thirst for semiconductor supplies is as strong as we think it is, the risk of annexation of Taiwan by China to secure supply rises significantly in the event of a less-than-amicable end to the negotiations.

Positioned for a Prolonged Trade War

Investors positioned for a prolonged trade war can hedge themselves, we think, by going long US agriculture commodity producers — one of the simplest ways for China to shrink its bilateral trade surplus is to increase purchases of agricultural commodities from the US.

3-D Printing: Inflection Point?

At the beginning of 2018, Bugatti revealed it had developed the first series-production 3-D printed brake caliper for use in its vehicles. In December last year, the Volkswagen Group released a video of the finished product in action.

In October last year, Dutch robotics company MX3D completed the 3-D printing of a steel bridge and announced that it will be installing the bridge across a canal in Amsterdam during 2019. Two months later, the Marines from the 1st Marine Logistics Group at Camp Pendleton, California –  with the help of the Marine Corps Systems Command Advanced Manufacturing Operations Cell and the Army Corps of Engineers —  successfully 3-D printed a concrete bridge on site as opposed to in a factory setting.

NOWlab, the innovation arm of German additive manufacturing company BigRep, unveiled NERA — a fully 3D-printed motorcycle – in November 2018.  All parts of the motorcycle — excluding the electrical components that power the bike — have been 3-D printed, including the tyres, rims, frame and seat.

In January, Relativity Space — a rocket-building company founded by former SpaceX and Blue Origin employees — revealed that it has been granted permission by the US Air Force to launch its, almost entirely 3-D printed, rockets from Launch Complex 16 at Cape Canaveral in Florida. And just last week, UK-based space startup Orbex publicly unveiled its Prime rocket — the world’s largest 3-D printed rocket engine — at the opening of its new headquarters and rocket design facility in Forres in the Scottish Highlands.

The Innovation S-Curve

Many investors have turned their backs on 3-D printing after exhibiting irrational exuberance towards the technology over years past. After a failed promise of endless growth, and a bursting of the stock price bubble that sent shares of publicly traded 3-D printing companies tumbling, we wonder if interest in 3-D printing stocks may be rekindled as the potential benefits of the technology begin to be realised?

Everett Rogers, previously professor of communication studies at the University of New Mexico, popularised the theory of diffusion of innovations in his book Diffusion of Innovations. The theory is amongst the oldest theories in social science.

The theory postulates that the adoption of an innovation within a social system is determined by four factors, namely:

  1. The innovation itself;
  2. Communication channels;
  3. Time; and
  4. The characteristics of the social system.

Over the years,  the innovation S-curve has been popularised a means of measuring the adoption of existing technologies.  The innovation S-curve is an application of Professor Rogers’ theory.

S-Curves-New-Products.pngSource: ideagenius.com

3-D printing has gone through its early adoption phase. The recent delivery of a number of innovative solutions based on 3-D printing makes us wonder if 3-D printing technology is now at an inflection point within its innovation S-curve and ready to enter a phase of rapid growth? If indeed it is, many of the publicly listed 3-D printing stocks could, in a few years time, trade at many multiples of the prices they trade at today. 

3-D Printing Stocks

Below we highlight two 3-D printing related stocks that caught our attention upon initial screening,

The ExOne Company $XONE

$XONE is a micro-cap stock with market capitalisation of US dollars 172 million. Short interest in the stock is high at more than 27 per cent of free float.

The company  was spun-off from Extrude Hone Corporation, a global supplier of precision nontraditional machining processes, 2005.

$XONE is a global provider of 3-D printing machines, 3-D printed products and related services to industrial businesses operating across the aerospace, automotive, pumps, heavy equipment and energy industries. The company’s product and services offering revolves around industrial strength sand castings and moulds and directly printed metal parts.

Following a transition year in 2018, during which the company took measures to improve operating efficiencies and reel in costs,  the company’s management expects net income and operating cash flows to be positive in 2019. Further, the company will be introducing larger format 3-D printing machines during the year to increase the size of its addressable market and to up sell existing clients.

Stratasys Limited $SSYS

$SSYS has a market capitalisation of US dollars 1.4 billion. Short interest in the stock stands at almost 12 per cent of free float.

The company manufactures 3-D printers used by designers, engineers, and manufacturers for office-based prototyping and direct digital manufacturing to visualise, verify, and communicate product designs. Engineers, for example, use Stratasys systems to model complex geometries in a wide range of thermoplastic materials such as polycarbonate.

$SSYS’s CEO,  Ilan Levin, resigned in May 2018 and its Chairman has been serving as its interim CEO since. Levin’s exit came after the company posted losses of of almost US dollars 40 million in 2017 and US dollars 13 million during last year’s first quarter.

The company has been witnessing growth in 3-D printing system orders since the second quarter of last year and management expected this trend continue into 2019. They are also see their customers moving from experimenting with 3-D printing to deploying and expanding the capacity of these systems in true production environments.

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.

Pick-and-Mix

“The whole world is simply nothing more than a flow chart for capital.” – Paul Tudor Jones

“It’s still true that the big players in the public markets are not good at taking short-term pain for long-term gain.” – Jeffrey W. Uben, ValueAct Capital

In this week’s piece we (i) revisit our call on cloud-based software stocks, (ii) touch upon Dollar Tree Inc. $DLTR, which we think is poised to outperform in the near term, and (iii) consider the possible ramifications of the recent policy statements by the US Treasury and the Fed.

Cloud-Based Enterprise Software Update

We highlighted cloud-based enterprise plays as a potential long idea in Two Investment Ideas on 14 January, 2019. Two out of our three preferred names, Veeva Systems $VEEV and Workday Inc. $WDAY, are up 16.46 and 13.92, respectively, from market close on 14 January through 2 February. In comparison, the S&P 500 Index is up 4.88 per cent during the same period.

We think it is a good time to tactically take profits in both names and to continue playing the theme through Benefitfocus $BNFT and the two additional names we highlighted in our weekly piece on 21 January. We will look to re-enter long positions in $VEEV and $WDAY at lower levels, should they correct.

Dollar Tree Inc.

We have been long $DLTR for more than a year now. Initially the stock did really well,  outperforming the S&P 500 Index. Alas, it did not last and performance was lacklustre between February and December last year.

DLTR US Equity (Dollar Tree Inc) 2019-02-04 14-06-14.png

The underwhelming performance of the stock stems from the declining sales and earnings at its Family Dollar franchise. The company acquired Family Dollar for US dollars 9 billion in a fiercely contested battle with Dollar General $DG during the second half of 2017.

The Family Dollar acquisition was motivated by management’s desire to scale up to better compete with larger players such as $DG and Target $TGT. What transpired, however, is the company ended up buying an under performing business that it has, to date, been unable to turnaround.

What has made the failure to turnaround Family Dollar even more vexing, for shareholders and management alike, is that following $DLTR’s ill-fated acquisition, its direct competitor, $DG, has managed to grow strongly, open up new locations and increase its market share.

$DLTR’s troubles with Family Dollar have attracted the attention of activist investors and in January of this year Starboard Value – the New York Based activist hedge fund – announced that it owned 1.7 per cent of the company and had nominated seven directors to its board.

Starboard wants $DLTR to consider a sale of Family Dollar, even if it means selling it for significantly less than it paid for it. It has also suggested that the company should make changes to its current business model including selling some items at price points above US dollar 1, such as US dollar 1.50 or 2 – something that $DLTR’s competitors already do.

Whether a sale of Family Dollar transpires or not, having an activist hedge fund as a vocal shareholder, we think, is likely to place pressure on $DLTR’s management to make meaningful improvements in the company’s operational performance and create shareholder value.

We have waited on commenting on the stock following Starboard’s announcement as we wanted the initial euphoria to die down and for long frustrated shareholders to take the opportunity to sell following the news.

We think $DLTR is well placed to out perform in the near term and we will be adding to our existing position.

US Treasury Refunding Statement

From the US Department of the Treasury’s press release issued on 28 January:

  • During the January – March 2019 quarter, Treasury expects to borrow $365 billion in privately held net marketable debt, assuming an end-of-March cash balance of $320 billion. The borrowing estimate is $8 billion higher than announced in October 2018. The increase in borrowing is driven primarily by a lower than previously assumed opening cash balance.
  • During the April – June 2019 quarter, Treasury expects to borrow $83 billion in privately-held net marketable debt, assuming an end-of-June cash balance of $300 billion.

The US Treasury’s deposits held in its general account with the Fed stand at US dollars 411.4 billion as of 30 January 2019.

Based on the US Treasury’s press release, around US dollars 110 billion of deposits held with the Fed will be injected into the global banking system between now and 30 June.

This announcement is important because deposits held by the Treasury with the Fed are unlike deposits held with banks. Outside periods of extreme economic instability, the Fed is not engaged in the business of lending money, it only takes money in as deposits. Cash taken in by the Fed does not percolate through the global banking system, rather it sits idly in Fed’s accounts in New York.

Consequently, the build up of cash in the Treasury’s general account, to park funds generated through the issuance of Treasury bills, tightens monetary conditions while withdrawals from the account tend to ease monetary conditions. With the US Treasury contributing to tightening financial conditions for the better part of 18 months, it will for the next five months, at least, reverse course and become a source of monetary easing.

The Fed’s U-Turn

From the Wall Street Journal:

In what arguably was Mr. Powell’s most significant statement on Wednesday, he struck a dovish tone on this process of “balance-sheet normalization.” The signal was that so-called quantitative tightening would continue for now but end sooner than expected. Moreover, he also raised the possibility that the balance sheet could be “an active tool” in the future if warranted—in other words, more bond purchases if markets or the economy cry out for help. Until recently, Fed officials had been insisting the balance-sheet shrinkage was on autopilot.

As discussed last week, the Fed has little choice but to maintain a large balance sheet if it wants the US banking sector to continue being governed under the stringent Basel III framework. Chairman Jay Powell confirmed as much during his press conference on Wednesday last week.

The combination of:

(i) the US Treasury releasing dollars into the banking system;

(ii) the Fed putting interest rate increases on and introducing language that opened up the possibility that the next move in interest rate could either be down or up; and

(iii) increased clarity on the Fed’s plans for shrinking its balance sheet

we think, should be conducive for risk-assets during the first half of the year.

After a strong showing by global markets in January and the little matter of the US-China trade resolution deadline fast approaching, we think caution is warranted in February. Nonetheless our highest conviction ideas for the first half of the year are: long selective emerging markets, long precious metals, short US dollar and long selective US technology companies. 

With respect to precious metals, the Chinese New Year holidays have more often than not proven to be periods of weakness. Those with a bullish disposition should take advantage of this seasonal weakness.

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 Fed’s Permanently Big Balance Sheet & More

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“I’m not in this world to live up to your expectations and you’re not in this world to live up to mine.”  – Bruce Lee

 

“The Federal Reserve has a responsibility to ensure the safety and soundness of financial institutions and to contain systemic risks in financial markets.” – Bernie Sanders

 

In this week’s piece we discuss the possibility of the Federal Reserve ending quantitative tightening sooner than the markets expect. We also briefly touch upon precious metals, Amazon’s growing advertising business and potential short candidates in the advertising space.

 

The Fed’s Permanently Big Balance Sheet

 

From the Wall Street Journal:

Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.

Officials are still resolving details of their strategy and how to communicate it to the public, according to their recent public comments and interviews. With interest rate increases on hold for now, planning for the bond portfolio could take center stage at a two-day policy meeting of the central bank’s Federal Open Market Committee next week.

 

From the Financial Times:

Some cracks have emerged in short-term lending markets that lubricate the supply of dollars through the financial system, said analysts. After the crisis, the Fed bought assets by crediting banks’ reserve accounts, increasing the cash available for short-dated lending activity. As the Fed’s assets decline, so do bank reserves, reducing the money available for things such as overnight repo trades, where cash is lent in return for Treasuries, or commercial paper issuance, where corporates can borrow cash for short periods.

 

The fed funds market used to be US dollars 250 billion in size prior to the Global Financial Crisis. US banks were active participants in the market on a daily basis to secure funds to meet on-going regulatory reserve requirements.

Since the crisis the market has shrunk to about US dollars 50 to 60 billion today. Following the introduction of quantitative easing and as US banks built up excess reserves held with the Fed, there was no incentive left for US banks to borrow as there were no reserve requirements to meet. On top of that, the introduction of Basel III and its stringent liquidity coverage requirements means that banks are now penalised for lending in the unsecured inter-bank market.

The fed funds market is now primarily limited to transactions between Federal Home Loan Banks (FHLBs), as lenders, and a handful of US and foreign banks, as borrowers.

Before the Fed started shrinking its balance sheet, the US and foreign banks were borrowing from FHLBs, amongst other reasons, to arbitrage the difference between the fed funds rate and the interest rate on excess reserves (IOER) paid by the Fed.

Since the Fed started shrinking its balance sheet – swapping banks’ reserve accounts with Treasury and mortgage backed securities – it has become apparent that the majority of the excess reserves held with the Fed were not truly ‘excess’. The implementation of the Basel III framework has made high levels of reserves a permanent fixture within banks’ balance sheets. And by extension, the big Fed balance sheet is here to stay.

In the chart below the yellow and magenta lines are the fed funds rate and the IOER, respectively. In the years when reserves were in excess, there is a gap between the feds fund rate and the IOER. This gap was exploited by the banks borrowing from FHLBS and depositing with the Fed.  In 2018, the fed funds rate converged with the IOER – indicating that a need for reserves not arbitrage were now driving the fed funds market.

 

US Federal Funds Rate, Target Rate and Interest Rate on Excess Reserves

Fed Funds Rate.png

Source: Bloomberg

 

In response to the convergence between the two rates, the Fed placed the IOER below the upper bound of it the fed funds target rate – the IOER had always been at the upper end of the target range prior the move in the summer of last year. The issue with this move, however, is that if banks are no longer active in the fed funds market for arbitrage purposes but rather to meet reserve requirements then the IOER is unlikely to act as a cap on rates. Rather, a deficiency of  reserves, which banks cannot afford to have at any cost, could well push the fed funds rate beyond the upper bound, not only IOER.

The fed funds rate pushing through the upper bound is likely to send a signal that the Fed is losing control of short-term interest rates. Something we are certain none of the member of FOMC want. For this reason, and not due to the sharp drop in S&P 500, do we think that Chairman Jay Powell may hint at, as the Wall Street Journal suggests, ending  quantitative  tightening sooner than the market expects when the Fed meets this week.

If the Fed does indeed hint as much, we think it is likely to spur risk-appetite and be one more reason to be long emerging markets.

 

Precious Metals Update

 

Following up on a discussion from late last year, gold having briefly dipped below its 48-month moving average has moved back above it and started to created some distance.

XAU Curncy (Gold Spot $_Oz) 48 2019-01-28 13-26-59.png

 

We see little reason not to own precious metals, or miners if you have the stomach for it, especially if silver manages to move above its 48-month moving average – something it has failed to do since it dropped below it during the first quarter of 2013.

 

XAG Curncy (Silver Spot $_Oz) 4 2019-01-28 13-26-20.png

 

Amazon’s Advertising Flex

 

From the New York Times:

Ads sold by Amazon, once a limited offering at the company, can now be considered a third major pillar of its business, along with e-commerce and cloud computing. Amazon’s advertising business is worth about $125 billion, more than Nike or IBM, Morgan Stanley estimates.

 

Eyeballs combined with targeting capabilities based on actual spending patterns – ask any data-centric advertising professional and they are likely to tell you that that is the ‘holy grail’ of advertising. And Amazon has it.

While there are bound to be repercussions for Google and Facebook from the outgrowth of Amazon’s advertising business, we think it is likely to prove much worse for the more conventional advertising businesses. Many of these businesses are probably zeros in the long-run.

We think the following advertising companies are potential short-candidates:

  1. Clear Channel Outdoor Holdings $CCO – outdoor advertising company.
  2. JCDecaux SA $DEC.FP – Paris-listed outdoor advertising company with a stronghold on advertising across public transport networks including airports, business, and train stations.
  3. The Intepublic Group of Companies  $IPG – a consortium of advertising agencies and marketing services companies.
  4. Omnicom Group $OMC – a group of advertising and market agencies.
  5. Telaria Inc $TLRA – digital video advertising services provider.

 

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.