China Archives - LXV Research

Inflation Revisited and China Macro Charts

“Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.” — Joseph Schumpeter (1883 — 1950)

A quotation filled piece today as we first revisit the discussion on the near-term prospects for a spike inflation. Followed by a few charts and discussion on China’s macroeconomic context.

In March, we argued it was premature to worry about inflation:

“For as long as demand, specifically consumer demand, remains capped by the drastic measures being taken to “flatten the curve” and we do not reach a stage where demand far outstrips supply, we consider any discussion over fears of a sudden spike in inflation to be premature.”

Then a few weeks ago discussing the six to twelve month prospects for gold, we wrote:

“When liquidity creation and destruction is led by the private sector it is generally in response to rising or diminishing prospects for economic activity. Whereas government led liquidity creation and destruction usually occurs when market transmission mechanisms are failing or being corrupted.

Diminishing economic prospects typically lead to an increased demand for savings (falling velocity) while rising economic activity typically causes velocity to rise.”

This week the Financial Times reported (emphasis added):

“Bank deposits are surging across Europe as people respond to the economic and social upheaval of the coronavirus pandemic by saving more, fuelling fears among economists that consumers will not come to the rescue of the continent’s shrinking economy.

Savings rates in four of Europe’s five largest economies rose sharply to well above long-run averages in March, according to recently published data from the European Central Bank and the Bank of England.

French savers put aside nearly €20bn in March, well above the long-run average monthly change in bank deposits of €3.8bn. Separate figures from the Banque de France show that by mid-May, the total had risen to more than €60bn since the country’s lockdown began — indicating that the growth of savings accelerated as the crisis deepened.

Italian savers put aside €16.8bn in March, the ECB data show, compared with a long-run monthly average of €3.4bn, while Spanish households saved €10.1bn, up from an average of €2.3bn. UK household bank deposits jumped by £13.1bn in March, a record monthly rise, according to the BoE.”

From A History of Interest Rates by Sidney Holmer (1864 — 1953) and Richard Sylla:

“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.”

As long as savings continue to rise, inflation, and by extension bond yields, will remain in check. As we emphasised last week, the developed market bond bull market is far from over.

At the risk of belabouring the point, we turn to the US, where, even as corporations have drawn down credit facilities, banks’ loan-to-deposit ratios hit the lowest level since the 1970’s. Deposit inflows from the Fed’s security purchases as part of quantitative easing measures have more than buffeted demand for credit.

That is, only a fraction of the ‘liquidity’ being created by the Fed through asset purchases is making its way into the real economy.

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China’s Macroeconomic Context

According Co-CEO Patrizio Bertelli, Prada SpA’s sales in China rose “significantly” more than 10 per cent in May. The haves continue to prosper even as the suffering of the have nots knows no respite. This is a global, not a geographic, phenomenon.

On to the discussion on China.

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The above chart compares the annual absolute change in Chinese foreign reserves to the annual rate of change in the producer price index for iron and steel.

To state the obvious, the commodity super cycle between 2001 and 2012 was driven by the infrastructure boom in China. A recovery in commodity prices is not going to manifest on its own and, given advances in technology, supply side reform is probably not going to be enough — something that OPEC can attest to.

The world broadly, and the commodity complex specifically, needs a new source of demand — there are only so many roads to nowhere Beijing will be willing to fund to bailout the rest of world, especially as the rest of the world is becoming increasingly hostile towards China.

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In the chart above, the annual changes in the value of Chinese exports and imports is plotted against each other. The chart visualises how tightly the Chinese leadership manages the flow of capital into and out of the economy.

Imports, the outflow of US dollars, are financed, as it appears, almost exclusively through the inflow of US dollars from exports. With the rise of trade protectionism and introduction of import tariffs, Chinese export growth is expected to dwindle. This is not just bad news for China but also for the rest of the world. Any economy — Australia, Brazil, Germany, etc. — structured around exporting to the Mainland will inevitably suffer from a reduction in demand for goods and services emanating from China.

“For every country, the current account and the capital account must balance to zero. To put it another, every dollar that enters a country, either in payment for that country’s exports, in the form of royalty or services receipts, on the form of foreign investment in domestic assets, must leave that country, either in payment for imports, in the form of royalty or services expenditures, or in the form of outward investment.

Why? Because if an economic entity in any country other than the United States is in possession of an American dollar, earned either by selling an asset to an American or exporting goods to an American, either it will use that dollar to purchases something from abroad or to make a foreign payment, or it will save the dollar by purchasing a U.S. asset.” — The Great Rebalancing, Michael Pettis

In value terms, Chinese exports far exceed Chinese imports. By tying together import and export growth, the Chinese leadership, much like other Asian export-oriented economies, has instituted a policy that forces the accumulation of savings which are then funnelled into foreign assets.

With rising protectionism and the COVID-19 pandemic accelerating the trend away from globalisation, this Chinese policy prescription is now stale. Is the Chinese leadership willing to take the short-term pain necessary to pivot towards the Chinese consumer? The answer hitherto has been a resounding no.

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Financial repression taxes savers and subsidises borrowers. Chinese consumers are the savers and the state-owned enterprises (SOEs) and local governments the borrowers.

Until and unless the Chinese leadership stops penalising savers for the benefit of SOEs, any claims of rebalancing the economy towards the consumer is little more than lip service.

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.

Confusing the Cyclical with the Secular | The Iran-China Strategic Partnership

“The reason a lot of people do not recognize opportunity is because it usually goes around wearing overalls looking like hard work.” ― Thomas Edison

“The most important lesson I’ve learned is to understand and to trust abstractions. If you can learn both to see and to believe in life’s underlying patterns, you can make highly informed decisions every day.” ― Nathan Myhrvold, former Chief Technology Officer of Microsoft

Confusing the Cyclical with the Secular

We have, since late last year, been bullishly positioned in precious metals and have reiterated this view on several occasions over the course of this year. That being said, however, we are not of the view that precious metals have entered a new secular bull market and will be making a run for new highs, in US dollar terms, in the near term.

Similarly, in last week’s piece, we highlighted cyclical factors indicating that long-term US bond yields were likely to rise, in the near-term, as opposed to going even lower. Once again, this is a cyclical, not a secular, view.

Below we share two passages that provide a framework for understanding the conditions that would lead to a bond market rout and a new secular bull market in precious metals.

The following passage in an excerpt from The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money on the discussion between the author, Steven Drobny, and his (unrelated) colleague at Drobny Global Advisors, Dr. Andres Drobny (emphasis added):

Many people think there is a limit on public debt, but I am not so sure. Apart from a country constrained by a gold standard or fixed exchange rate, the only scenario where the government might bot be able to fund its debt is an inflationary scenario. However, the scenario only seems likely to emerge after the policies succeed in promoting growth. One of the reasons that a much-anticipated financing problem has never materialized in Japan is that reflationary policies failed to stimulate a sustained rebound and a return of inflation. Interest rates have remained low and fund the deficit has been surprisingly easy.

Consider what happens if the public debt and financing fears prove correct and bond markets start to tank. This is an issue that came up during a debate at our recent conference in London. Without inflation, rising nominal bond yields push up real yields and deflate the economy; bonds become more attractive again and buyers bring yields back down. Without inflation, it is hard to get a bond rout. It is only when inflation rises that government financing becomes a real and sustained problem for bond markets. That is when bonds no longer get cheaper as they sell off and nominal yields rise, which is when you get a real bond crisis.

The key takeaway from the above passage is that a secular turn in the bond market will only occur when rising nominal yields do not translate into rising real yields, that is when the rate of inflation outpaces the increase in nominal yields.

RR10CUS Index (Real 10 Year Yiel 2019-09-11 15-57-15.jpg

In the 1960’s and from the mid-1970’s through the early 1980’s, rising nominal yields in the US coincided with sharply declining real yields. Until such a disconnect begins to manifest, the secular bull market in bonds is intact.

The following passage in an excerpt from Peter Warburton’s essay The debasement of world currency: It’s inflation but not as we know it (emphasis added):

An excessive expansion of credit can create an environment where the factors of production — land, capital and labour services — appear to be in infinite supply. If sufficient (borrowed) financial resources are made available, then sterile, parched and polluted land can be fertilized, irrigated, cleaned up and turned to productive use. Similarly, more factories, kilns, assembly lines, steel mills, semiconductor plants and so on can be built using state-of-the-art technology. Idle and untrained workforces can be mobilized and organized into productive units. A rich country, with plenty of collateral assets against which to borrow, can indeed face a supply curve that is seemingly infinitely elastic. I can assure you that consumer price inflation will not be a problem for such an economy.

The United States still has plenty of collateral assets to borrow against. The US dollar hegemony may be on its last legs but there is no credible alternative making it still too early to bet against it.

BBDXY Index (Bloomberg Dollar Sp 2019-09-11 17-08-03.jpg

In the chart above, the magenta line is a custom index tracking the relative performance of US liquid assets (equities and investment grade bonds) to that of global liquid assets ex-US. The orange line is the Bloomberg Dollar Index ― the index is broader than $DXY, which is just a proxy for the EURUSD cross.

The continued out performance of US capital markets relative to the capital markets of the rest of the world is supportive of the US dollar and indicative of the superiority of US collateral relative to ex-US collateral.

The Iran-China Comprehensive Strategic Partnership

Speaking of the end of the US dollar hegemony, it was reported last week that Iran’s foreign minister Mohammad Zarif paid a visit to his Chinese counterpart Wang Li at the end of August to present a road map for the China-Iran comprehensive strategic partnership, signed in 2016.

As part of the deal, China will invest US dollars 280 billion in developing Iran’s oil, gas and petrochemicals sectors. There will be a further US dollars 120 billion of investments made by China in upgrading Iran’s transport and manufacturing infrastructure. Notably, the deal also includes “5,000 Chinese security personnel on the ground in Iran to protect Chinese projects, and […] additional personnel and material available to protect the eventual transit of oil, gas and petchems supply from Iran to China, where necessary, including through the Persian Gulf,” according to Iranian sources.

According to reports, the deal also includes a long-term commitment by China to buy Iranian oil. Based on these reports, Iran has agreed to sell its oil and gas to China at a guaranteed discount to prevailing market prices of at least 12 per cent, plus a further discount of up to 8 per cent to account for the risk ― presumably of a backlash from the US. China, of course, will pay for the oil in renminbi.

The benefits of the deal for Iran are obvious. It receives much-needed foreign direct investment. It secures a market for its hydrocarbon output. And secures a deterrent against possible military strikes by Israel or Saudi Arabia and its allies. Iran, though, does not simply want to be China’s discount oil dealer. It wants more, it wants a strategic alliance. Iranian foreign minister Mohammad Zarif penned an op-ed in the Global Times clearly articulating what Iran wants. It is unclear, however, if they will get it by “looking east”.

The benefits to China are somewhat mixed. Cheaper energy imports paid for not in US dollars but in local currency eases China’s dependence on the greenback and furthers its ambitions to form an independent monetary bloc. Buying Iranian oil and defying of US sanctions, on the other, is only likely to infuriate President Trump and further complicate ongoing trade negotiations.We see China’s willingness to defy US sanctions as a signal that its leadership is unwilling to do a deal with President Trump that it does not deem to be fair. By agreeing to buy Iranian oil, China is either hedging itself and preparing for a new economic reality or it is posturing to show strength in its negotiations with the US.

Aside from trade, the most interesting near term takeaway from China’s agreement to buy Iranian oil is that it did not lead to sharp pullback in the price of oil. Rather oil has moved higher, suggesting oil could move higher still.

Lighten Up On Semiconductors

“The good times of today, are the sad thoughts of tomorrow.” — Bob Marley

Chinese Economic Data

The Chinese economy grew at 6.4 per cent year-over-year during the first quarter of 2019, matching the economy’s growth during the fourth quarter of last year but below the 6.6 per cent growth achieved for the full year during 2018. Growth came in slightly higher than consensus expectations and appears to have been buoyed by strong credit growth — system-wide financing was up 10.7 per cent year-over during March, led by an acceleration in lending by Chinese financial institutions. Total loans extended by financial institutions increased by 13.7 per cent year-over-year in March to reach its highest rate since June 2016.

CNLNTTLY Index (China Total Loan 2019-04-18 13-38-21.png

There was a sharp recovery in the Chinese industrial sector during March, industrial value added surged to 8.5 per cent year-over-year, up from 5.7 per cent in February. Part of this growth can probably be attributed to the Chinese New Year falling in early February this year versus being in late February last year — factories are likely to have only reached stable production into March in 2018. We will look to April data upon its release for further clarity.

CHVAIOY Index (China Value Added 2019-04-18 13-54-41.png

Despite the above caveat, some of the notable metrics on the industrial side include:

Steel, glass and cement production were up 10, 8 and 22 per cent year-over-year in March, respectively. The strong growth in production figures of construction materials reconciles with the 12 and 18 per cent year-over-year increases in property investment and construction starts, respectively. The growth in construction starts was matched by the 18 per cent year-over-year growth in mortgage lending.

Smartphone, automotive and semiconductor production dropped by 7, 3 and 2 per cent, respectively.

The bad news for semiconductors was not limited to production. Chinese imports of diodes and semiconductors during March declined by 11.8 and 12.7 percent year-over-year in value and volume terms, respectively. For the first quarter imports are down 9.6 and 14.7 per cent year-over-year in value and volume terms, respectively.

The decline in semiconductors may prove to be a red herring. It is altogether possible that Chinese authorities are eager to limit semiconductor imports up until a trade deal has been struck with the United States. Unleashing a flurry of semiconductors orders from to help close the bilateral trade deficit, upon signing of a trade pact. If this indeed is the case, it would go someway towards explaining the discrepancy between the strength in China’s Purchasing Manager’s Index and the weakness in Korean and Taiwanese exports to China.

Given the softness in Chinese semiconductor imports, our conviction in our earlier call of shorting Taiwanese semiconductor companies as a hedge for portfolios positioned for an amicable resolution to the US-China trade dispute is strengthened. Further, we think shorting Taiwanese semiconductor is one of those rare situations of “heads I win and tails I do not lose” — under an amicable trade resolution, marginal Chinese demand shifts from Taiwan to the US, while under a deterioration of trade relations the risk of Taiwan being annexed increases markedly.

Away from semiconductors, given the pick up in Chinese industrial activity and credit impulse and the robustness of the property market, we reiterate our call for fixed-income investors to close out long positions in long-dated Chinese government bonds.

Lighten Up On Semiconductors

Despite the slowdown in Chinese semiconductor imports, the market has bid up semiconductor stocks to record highs. The Philadelphia Stock Exchange Semiconductors Index is up 35.4 per cent year-to-date versus 16.4 per cent for the S&P 500 Index.

The index has been buoyed by recent announcements from Intel, Apple and Qualcomm.

Apple and Qualcomm announced that the two parties agreed to dismiss all litigation between them world-wide and signed a new licensing agreement, which brings to an end the long-running legal battle over how royalties are collected on innovations in smartphone technology. Qualcomm said the agreement will add about US dollars 2 in annual earnings per share. Qualcomm’s stock jumped 23 per cent on the news.

Following the announcement from Apple and Qualcomm, Intel announced that is was withdrawing plans to make modem chips for 5G smartphones. Investor’s cheered the decision, pushing Intel’s stock to 19-year highs.

Such positive news from two of the five largest constituents of the Philadelphia Stock Exchange Semiconductors Index is a pretty high bar to set for good news to clear in the near term. And the market’s reaction function to news about the on going US-China trade negotiations exhibiting more than a tinge of buying the rumour, we are concerned that an eventual agreement will close the loop by being a sell the news event.

We think it is as a good time as any to lighten allocations in the semiconductor space.

Inflationary Pressures

From The Beige Book issued 17 April 2019 (emphasis added):

Employment continued to increase nationwide, with nine Districts reporting modest or moderate growth and the other three reporting slight growth. While contacts reported gains across a variety of industries, employment increases were most highly concentrated in high-skilled jobs. However, labor markets remained tight, restraining the rate of growth. A majority of Districts cited shortages of skilled laborers, most commonly in manufacturing and construction. Contacts also reported some difficulties finding qualified workers for technical and professional positions. Many Districts reported that firms have offered perks such as bonuses and expanded benefits packages in order to attract and retain employees. This tight labor market also led to continued wage pressures, as most Districts reported moderate wage growth. Wages for both skilled and unskilled positions generally grew at about the same pace as earlier this year.

The below chart compares the National Federation of Independent Business (NFIB) time series on businesses reporting on job openings hard-to-fill to the growth in US nonfarm unit labour costs on a year-over-year basis. (The unit labour costs time series is lagged by a year, as it takes time from businesses realising that jobs are hard-to-fill to be willing to pay higher.)

COSYNFRM Index (US Unit Labor Co 2019-04-18 16-35-16.png

As can be seen from the chart above, the disconnect between the two time series today is quite large. If we take the commentary in The Beige Book at face value, there should be some convergence between the two series, with unit labour costs rising. If that transpires, we may finally see a sustainable pick up in inflationary pressures in the US, which may also mark the cyclical top in corporate profit margins.

The acceptance for and popularity of socialism driven in part by a decade of returns flowing to asset owners at the expense of labour providers, may just be coming at very moment the structural forces are set to move in favour of labour.

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.

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.

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.

China Trade Deal (and more) in advanced stages. Relationship between our two Countries is very strong. I have therefore agreed to delay U.S. tariff hikes. Let’s see what happens?

— Donald J. Trump (@realDonaldTrump) February 25, 2019

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

I want 5G, and even 6G, technology in the United States as soon as possible. It is far more powerful, faster, and smarter than the current standard. American companies must step up their efforts, or get left behind. There is no reason that we should be lagging behind on………

— Donald J. Trump (@realDonaldTrump) February 21, 2019

….something that is so obviously the future. I want the United States to win through competition, not by blocking out currently more advanced technologies. We must always be the leader in everything we do, especially when it comes to the very exciting world of technology!

— Donald J. Trump (@realDonaldTrump) February 21, 2019

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.

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.

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.

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Trade Wars: Portfolio Hedges | 3-D Printing

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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:

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.
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.
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.
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:

The innovation itself;
Communication channels;
Time; and
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.

Source: 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.

Investment Themes and Considerations for 2019

“Every man is the smith of his own fortune.” – Iranian proverb

“Time is like a sword: if you don’t cut it, it cuts you.” – Arabic proverb

Global Liquidity
- Enhancers
- Depressants
Investment Themes
- Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?
- US Dollar: What Will the US Treasury Do?
- China: Incrementally Better, Not Worse
- Emerging Markets: Relief Not Reprieve
- Semiconductors: Led On the Way Down, To Lead On the Way Up?
- Saudi Arabia: Emerging Market Indices Inclusion
Outsiders for Outsized Returns
- Triunfo Albicelestes
- Data Driven Dystopia: “The monetization of every move you make”
Books
- Five We Have Read and Recommend
- Five from Our 2019 Reading List

Note: Our comparable piece from 2018 can be found here.

This post runs quite long, if you prefer you can click here to download the PDF.

Global Liquidity

As we reflect back on 2018, the year, in a capital markets context, was defined, in our view, by the charging and retarding forces acting upon global liquidity. On the one hand we had the tax reform driven liquidity enhancers, on the other a host of liquidity depressants, including monetary policy driven tightening, pseudo-capital controls under the guise of anti-graft measures, rising interest rates and high oil prices.

In the words of Thomas Joplin, the nineteenth century British banker and merchant, “A demand for money in ordinary times, and demand for it in periods of panic, are diametrically different. The one demand is for money to put into circulation; the other for money to be taken out of it”.

Last January, with global stock markets off to their best start in more than three decades, the world was in the midst of demand for money to be put into circulation far outstripping demand for it to be taken out of circulation. From October through to the end of the year, as markets witnessed a sharp sell-off, demand to take money out far outweighed the demand to put it back. While in the intervening months between January and October, dominance waxed and waned between the two opposing forces.

Enhancers

One of the leading sources of liquidity in 2018 was US companies’ accelerated contributions to their respective defined-benefit pension schemes. The Republican Party’s tax reforms gave American corporations till mid-September of last year to benefit from the higher 35 per cent corporate tax rate when deducting their pension plan contributions from their tax bill. US Companies making contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference last year was that the value of the deduction fell to 21 per cent following the mid-September deadline.

Pension plan contributions by companies in the Russell 3000 Index are estimated to have topped US dollars 90 billion through mid-September last year – more than 10 times the contributions made the year before.

The other major source of liquidity was also motivated by US tax reforms. The reforms, by subjecting US corporations’ offshore profits to a one-time tax of 15.5 per cent on cash and 8 per cent on non-cash or illiquid assets, eliminated the incentive to keep money offshore. In response, US multinationals are estimated to have repatriated more than US dollars 500 billion last year, a significant portion of which went toward share buybacks. The flow of money was not evenly spread throughout the year, however. Corporations repatriated the vast majority of the funds in first half of the year with the amount of cash being brought back dropping off sharply in the second half of the year.

Depressants

There were many forces working to suck liquidity out of and impede the flow of capital through the global monetary system.

1. Oil and US Interest Rates

Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global monetary system and the other fuels everything else. Barring a toppling of the US dollar hegemony or till such time when the dominance of oil as the world’s primary energy resource diminishes meaningfully, the global economy is unlikely to enjoy prolonged and synchronised economic growth in an environment in which US interest rates are rising and oil prices are high.

In the more than 30 years between end of May 1988 through December 2018, the US 10-year treasury yield and the oil price have simultaneously been above their respective 48-month moving averages for less than a fifth of the time. And only on six occasions have the two prices remained above their respective 48-month moving averages for 5 or more consecutive months. (The periods when both prices are about their respective 48-month moving averages are highlighted in grey in the two charts below.)

US 10-year Treasury Yield 10Y Source: Bloomberg

West Texas Intermediate Crude Price per BarrelSource: Bloomberg

2. Policy Driven Tightening

The two dominant liquidity centres of the world, the US and China, moved in 2018 to rein in animal spirits and tighten monetary conditions.

In China, the Communist Party’s, in a bid to bridle systemic risks, clamped down on shadow finance. The tightening of credit conditions, however, has thrown up an interesting twist: interest rates, as opposed to increasing as would be expected, have declined.

China Shadow Financing Growth Year-over-YearSource: Bloomberg

In the US, the Treasury upped issuance of short-term debt to replace maturing long-term bonds just as long-term issues were being worked off the Fed’s balance sheet through quantitative tightening.

The potential ramifications of quantitative tightening and increased Treasury bill issuance bubbling under the surface are difficult to assess. In a monetary system governed by the hitherto untested Basel III framework and the many policy tweaks enacted by the Fed, such as money market fund reform and setting the interest on excess reserves below the upper band of the feds fund rate, following the Global Financial Crisis, it is difficult to grasp what, if any, hiccups there will be in the transmission of monetary policy as the Fed continues to drain reserves from the banking sector.

Nonetheless, the tightening policies employed by the Fed and the People’s Bank of China, have squeezed global liquidity. Using year-over-year growth in money supply (M2) across the US, China and Europe, as a proxy, we can see global liquidity growth fell to multi-decade lows in 2018.

Global Money Supply Growth vs. MSCI ACWI and EM Indices Sources: Bloomberg, European Central Bank

3. Anti-Graft

A number of governments across the world have, in recent years, taken drastic measures to crackdown on corruption and the outflow of illicit funds from within their borders. We share a few examples below.

India

In 2016, in a bid to curtail corruption and weaken its shadow economy, the Indian government announced the demonetisation of all Indian rupees 500 and 1,000 banknotes. It also announced the issuance of new Indian rupees 500 and 2,000 banknotes in exchange for the demonetised banknotes. What transpired following the announcement was as, if not more, surprising than the government’s demonetisation scheme: an estimated 93 per cent of the old notes made into the banking system.

With most of the notes flowing into the banking system, they were now unsullied, legal tender. And little need for capital to flow out of India illegally through the hawala system to be held out of reach of the government remains.

Saudi Arabia

In November 2017, the Saudi government famously rounded up, amongst others, wealthy Saudi businessmen, government officials and members of the royal family in the glitzy Ritz Carlton hotel in Riyadh as part of its anti-corruption campaign. Little of what transpired within the boundaries of the five-star hotel has been confirmed by official reports. We do, however, know that billions of dollars of assets moved from private asset pools to the Saudi government’s coffers.

China

China, under the leadership of President Xi Jinping, has been pursuing a far-reaching campaign against corruption. Since the campaign started in 2012, Chinese authorities have investigated more than 2.7 million officials and punished more than 1.5 million people, including seven national-level leaders and two dozen high-ranking generals.

As governments across the world have cracked down on corruption and elicited the support of regulators across global financial centres, price insensitive bids for real estate across New York City, London, Sydney and Vancouver have started to dry up. The best gauge of the liquidity impact of the anti-graft measures described above, we think, is Dubai. Long a magnet for Russian, Chinese, Indian, Saudi and Iranian capital, amongst others, Dubai had one of worst performing equity markets globally in 2018.

Dubai Financial Market General Index DFM Source: Bloomberg

In summary, as the forces propelling global liquidity petered out over the course of last year, the squeezes on liquidity overwhelmed global financial markets taking down one market after the other, culminating with the dramatic end to the long-running US equity bull market in December.

Investment Themes

Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?

One time series that has intrigued us over recent weeks and months is that of the ratio of MSCI All Cap World Ex-US Index (RoWI) to the S&P 500 Index (SPX). The chart below is a plot of the month-end ratio of the two indices from December 1987 through December 2018. (A rising line indicates the RoWI is outperforming the SPX while a falling line indicates the SPX is outperforming the RoWI.)

Superimposed on the chart are the Fibonacci projection levels based on the relative high of the RoWI, occurring in July 1988, and cyclical low of the ratio recorded in October 1992. (You can learn more about Fibonacci projections here.)

Ratio of the MSCI All Cap World Index Ex-US to the S&P 500 IndexSource: Bloomberg

From a long-term perspective, the drastic under performance of equity markets in the rest-of-the-world relative to the US equity market is obvious. Looking at the above chart, however, we cannot help but feel that a cyclical upturn for the rest-of-the-world is due.

The question then is: What would prompt a correction in the secular trend? We think the answer is a ramp up in global infrastructure investment led by infrastructure diplomacy programmes.

The most marketed, and some might say most notorious, infrastructure diplomacy programme is China’s Belt and Road Initiative. The initiative encompasses the construction of two broad networks spanning four continents:

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

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

The Belt and Road Initiative, however, is not the only global infrastructure investment program in existence today. In 2015, worried by China’s growing influence in Asia, Japan first unveiled its “Partnership for Quality Infrastructure” initiative as a US dollar 110 billion investment programme targeting Asian infrastructure projects. In 2016, the initiative was expanded to US dollars 200 billion and to include Africa and the South Pacific.

In October 2018, the US Senate joined the US House of Representatives in passing the Better Utilization of Investment Leading to Development bill (or Build Act), a bipartisan bill creating a new US development agency – the US International Development Finance Corporation (USIDFC). The passing of the Build Act is being hailed by many as the most important piece of US soft power legislation in more than a decade.

The USIDFC has been created with the goal of “crowding in” vitally needed private sector investment in low and lower-middle income countries. The agency, endowed with US dollars 60 billion in funding, is being positioned as an alternative to China’s Belt and Road Initiative, which has at times been described as nothing more than “debt trap diplomacy”.

We think if the three distinct initiatives propel infrastructure investment across the developing economies and help them integrate into the global economy, create jobs and gain access to much needed hard currency, the rest-of-the-world can once again enjoy a prolonged period of out performance.

Investors, particularly those with an investment horizon of at least three years, should gradually reduce exposure to the US and reallocate it to the rest-of-the-world.

US Dollar: What Will the US Treasury Do?

When the US Treasury issues bills and increases its cash balances in the Treasury General Account at the Federal Reserve Bank of New York, it inadvertently tightens monetary conditions in the global banking system.

For the period starting September 2017 through April 2018, the US Treasury did just that. It increased cash balances with the Fed from under US dollars 67 billion at the end of August 2017 to US dollars 403 billion by end of April 2018. (At the end of last year, cash balances with the Fed stood at US dollars 368 billion.)

The increase in the US Treasury’s cash balances was offset by the loss of an equivalent amount of reserves and / or deposits by the US banking system. Thereby tightening monetary conditions and reducing the availability of US dollars.

The last time the US government faced the prospect of a shutdown, the US Treasury started drawing funds from its cash balances with the Fed to pay for entitlements and other government expenditures. The US Treasury’s Cash balances held with the Fed went from US dollars 422 billion at the end of the October 2016 down to US dollars 63 billion by the end of March 2017. The release of US dollars into the global banking system provided much needed relief, stimulated global risk appetite and weakened the greenback.

US Treasury General Account vs. US Dollar Index $DXY TGA Sources: Bloomberg, Federal Reserve

With the US government shutdown triggered by President Trump entering its third week and with little sign of progress in talks between the Democrats and the Republicans, the US Treasury may once again have to draw down on its cash balances with the Fed. If this does transpire and is similar in scale to the previous draw down, it could again stimulate risk appetite and weaken the US dollar.

We are bearish on the near-term (six to nine month) prospects of the US dollar.

China: Incrementally Better, Not Worse

The year has barely started and the People’s Bank of China has already announced the first reserve ratio (RRR) cut of the year, a full percentage point reduction. Unlike previous RRR cuts in 2018, the latest move is a two-step reduction, effective on January 15 and January 25.

This RRR cut will release approximately Chinese yuan 1.5 trillion in liquidity, part of which will replace maturing medium-term lending facilities during the first quarter. On a net basis, the cut is equivalent to Chinese yuan 800 billion in easing.

On the fiscal stimulus side, the government has already approved new rail projects amounting to US dollars 125 billion over the course of the last month. Beijing refrained from stepping up fiscal spending in 2018. With a slowing economy and the on-going trade dispute with the US, however, the government appears to have greater willingness to loosen the purse strings in 2019.

Beijing, in a bid to shore up credit creation, is even allowing local governments to bring forward debt issuance.

Manufacturing data coming out of China is likely to get worse before it gets better – a hangover from US companies’ accelerated orders to build inventories ahead of the initial 1 January deadline for tariff increases. Nonetheless, given that the official policy stance has now tilted towards easing, we expect Chinese economic activity to improve, not worsen over the course of 2019.

Throw in the prospect of MSCI quadrupling the inclusion factor of Chinese A-shares in its emerging markets index and there is a strong possibility Chinese A-Shares break out of their bear market in 2019.

Emerging Markets: Relief Not Reprieve

A sharp drop in oil prices, a pause in the US dollar rally, signs of increasing fiscal stimulus in China and retreating long-term Treasury yields are providing emerging markets much needed relief. While the structural challenges, particularly on the funding side, faced by many of the emerging economies are unlikely to be resolved soon, the welcome liquidity relief can certainly provide tradable opportunities for investors.

Moreover, as we noted in December, emerging markets have been outperforming US markets since early October, which may well provide further impetus for asset allocators to re-consider exposures and potentially exchange some of their US exposure in favour of emerging markets.

Ratio of the MSCI Emerging Markets Index to the S&P 500 IndexSources: Bloomberg

The simple play is to be long the iShares MSCI Emerging Markets ETF $EEM. And in times of either euphoria or despair, it can prove to be the right choice as there can often be little to distinguish between constituent level returns. Nonetheless, with the rise of China’s tech giant, we think $EEM has become both too tech and too top heavy.

For broad-based exposure we prefer being long dedicated emerging market asset manager Ashmore Group $ASHM.LN. In terms of country selection we prefer being long Russia $ERUS and Indonesia $EIDO. We would also like to be long Hungary, opportunities for direct exposure to the country are, however, limited and is instead better played with some exposure to Austria $EWO.

Semiconductors: Led On the Way Down, To Lead On the Way Up?

We were bearish on the prospects of semiconductor stocks for the better part of 2018. With technology at the centre of China’s trade conflict with the US, and no technology more critical than semiconductors, our thinking was that production capacities, led by China, would rise faster than the market was pricing in.

While China has made headway in gaining market share in the more commoditised segments of the semiconductor market, it has failed to catch up with the leading chip companies in the world. The top-end of the semiconductors market remains tightly controlled by a handful of players.

The Trump Administration’s security hawks and a slowing China, however, have, we think, had a far greater impact on the sharp drop in chip prices than the increases in production capacities.

With valuations for the constituents of the Philadelphia Stock Exchange Semiconductor Index $SOX having corrected significantly and a lot of doom-and-gloom reflected after Apple’s guidance cut, we think semiconductors are well-placed to surprise to the upside in 2019.

Philadelphia Stock Exchange Semiconductor Index Trailing 12 Month P/E RatioSource: Bloomberg

Moreover, if there is to be a favourable outcome to the trade related negotiations between the US and China, we suspect China will pony up to reduce its trade surplus with the US by offering to buy more chips.

Saudi Arabia: Emerging Market Indices Inclusion

Ignoring the human rights grievances, the fallout from the murder of Washington Post columnist Jamal Khashoggi, and the sharp drop in the price of oil, we weigh the opportunity of investing in Saudi Arabia based purely on a technicality. That technicality being the inclusion of Saudi Arabia into the FTSE and MSCI emerging market indices in 2019.

Based on broker estimates, passively managed assets of greater than US dollars 15 billion are expected to flow into the Saudi equity market on the back of the inclusions. The vast majority of these passive flows are set to materialise during the first half of 2019. Given the size of flows relative to average daily traded values of less than US dollars 1 billion, the passive flows can move the needle in a market with few other positive catalysts.

We remain long the iShares MSCI Saudi Arabia ETF $KSA.

Outsiders for Outsized Returns

Here we discuss investment ideas that we think have an outside chance of generating outsized returns during 2019. We see these opportunities as cheaply priced out-of-the-money call options that may warrant a small allocation for those with a more opportunistic disposition.

Triunfo Albicelestes

Argentina, to put it mildly, has a chequered history when it comes to repaying its creditors. It has defaulted on its external debt at least seven times and domestic debt five times in the 202 years since its independence.

Argentina first defaulted on its sovereign debt in 1827, only eleven years after gaining independence from Spain. It took three decades to resume payments on the defaulted bonds.

The Baring Crisis, the most famous of the sovereign debt crises of the nineteenth century, originated in Argentina – at a time when Argentina was a rich nation and its credibility as a borrower had been restored. Argentina had borrowed heavily during the boom years of the 1880s and Britain was the dominant source of those funds. The flow of funds from Britain was so great that when Argentina defaulted on its obligations in 1890, the then world’s largest merchant bank, Baring Brothers & Co., almost went bankrupt. Had it not been for intervention by the Bank of England, the British lender would have been long gone before Nick Leeson came along a century later.

In 1982, Argentina once again failed to honour its external debt obligations and remained in default for almost a decade. Its emergence from default was made possible by the creation of Brady bonds – a solution proposed by then US Treasury Secretary Nicholas Brady as a means for debt-reduction by developing nations.

In the 1990’s Argentina kept piling on debt until it finally defaulted on around US dollars 80 billion of obligations in 2001, which at the time was the largest sovereign default ever. The government managed to restructure 93 per cent of the defaulted debt by 2010; however, Paul Singer’s Elliot Management famously held out and kept Argentina exiled from international debt markets for a further six years. Argentina returned to the bond market in 2016 after settling with the hedge fund and bringing to an end a long-running saga, which saw Paul Singer take extreme measures such as convincing Ghanaian courts to seize an Argentinian navy vessel so it could collects on its debt.

The lessons from Argentina’s history of defaults, however, were quickly unlearned by capital markets. In little more than a year after its return to the bond markets, Argentina successfully pulled-off the sale of a 100-year bond in 2017. The good times did not last very long, however. In August 2018, Argentina was heading to the IMF cap-in-hand requesting the early release of a US dollars 50 billion loan. By end of September the IMF had increased the debt-package to US dollars 57.1 billion – making it the biggest bailout package ever offered by the IMF.

After running through Argentina’s history of debt defaults and at a time when it may appear that its future is bleak, we are here to tell you that Argentina has the foundations in place to surprise to the upside.

The days of “Kirchnerismo”, the legacy of Cristina Fernández de Kirchner’s and her late husband Néstor’s twelve years in power, defined by the concentration of power, unsustainable welfare programmes and fiscal profligacy shrouded under the guise of nationalism, are gone. President Mauricio Macri’s willingness to chart a new course, armed with a robust IMF bailout package, we think, can help revive the Argentinian economy.

What is transpiring in neighbouring Brazil, too, has potential spill over effects on Argentina. If newly elected president Mr Jair Bolsonaro remains true to his word, Brazil is likely to pursue a reformist economic agenda that liberalises the economy from the statist policies that were the mainstay of the Workers’ Party’s rule. If the economic reforms spur growth in Brazil, Argentina should benefit – Brazil is, after all, Argentina’s largest trading partner.

President Bolsonaro’s external agenda is also likely to diverge from that of his predecessors. He has openly criticised China – Brazil’s largest trading partner – and expressed a desire to forge closer ties with the US. If Brazil pivots towards the US, Argentina, as South America’s second largest economy, is likely to be wooed aggressively by China. China’s ambition to dilute the US’s influence in Latina America is an open secret. In China’s bid to acquire influence, Argentina is well placed to attract investments from Beijing.

There are many ways to play this theme be it through the bond market, the currency or the equity market. For the average equity market investor the easiest way to gain exposure is probably through the Global X MSCI Argentina ETF $ ARGT.

Data Driven Dystopia: “The monetization of every move you make”

From The New Yorker’s article “How the Artificial-Intelligence Program AlphaZero Mastered Its Games”:

“David Silver, the head of research at DeepMind, has pointed out a seeming paradox at the heart of his company’s recent work with games: the simpler its programs got—from AlphaGo to AlphaGo Zero to AlphaZero—the better they performed. “Maybe one of the principles that we’re after,” he said, in a talk in December of 2017, “is this idea that by doing less, by removing complexity from the algorithm, it enables us to become more general.” By removing the Go knowledge from their Go engine, they made a better Go engine—and, at the same time, an engine that could play shogi and chess.”

As the leading tech companies have ramped up investments in developing their artificial intelligence – or machine learning, if you prefer – capabilities, what has started to become apparent is that data not algorithms hold the keys to success. The companies that collect the most and best data, not the ones that develop the most sophisticated algorithms, are likely to reap the greatest rewards from investing in artificial intelligence.

One, much maligned, ‘wearables’ company that has been tracking and collecting data on its users’ movements for many years, with little to show for it, is Fitbit Inc. $FIT. The company has fallen out of favour amongst investors ever since the launch of the Apple Watch – particularly after Apple’s health and fitness pivot following the launch of Series 2.

We think $FIT is a viable acquisition target for Amazon.

Amazon, through the Echo, is already collecting data at home and could close the data loop with an acquisition of $FIT. $FIT’s wrist bands and watches can be integrated with Alexa and with a little investment be upgraded to better compete with the Apple Watch. Moreover, Amazon could feature $FIT’s products front and centre on the most valuable retail real estate in the world – Amazon’s homepage.

Books

Five We Have Read and Recommend

Monetary Regimes and Inflation: History, Economics and Political Relationships by Peter Bernholz
Time to Start Thinking: America in the Age of Descent by Edward Luce
Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts by Annie Duke
The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor
Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Five from Our 2019 Reading List

Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze
The Volatility Machine: Emerging Economies and the Threat of Financial Collapse by Michael Pettis
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox
These Truths: A History of the United States by Jill Lepore

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China Shadow Banking | US Foreign Funding

“[H]ope is by nature an expensive commodity, and those who are risking their all on one cast find out what it means only when they are already ruined.” – Thucydides, The History of the Peloponnesian War

“Narrative is linear, but action has breadth and depth as well as height and is solid.” – Thomas Carlyle

Continuing on from last week, we share more market observations that have caught our attention as we think about investment ideas and themes for 2019. This piece, too, will be chart heavy.

Please note this will be this year’s last weekly update, we will be back with our next piece during the first week of January.

China Shadow Banking

China’s leadership, at the end of last year, made it abundantly clear that reining in financial risk was an economic priority for the next three years. With the centenary of the founding of the Communist Party of China (CCP) in 2021, Chinese leadership would be loathe to witness the run up to the milestone be marred by an economic collapse precipitated by spiralling debt.

About the CCP it is sometimes said “to watch what they do and not what they say”. At least in this instance, they have done exactly as they said they would.

Chinese shadow finance has collapsed and there are no signs of reprieve – the drop in shadow finance has not been cushioned by stimulative fiscal policies undertaken by the central government. Monetary policy, too, has remained neutral for much of the year. It is only in recent months that we have seen some loosening of monetary policy at the margin with the reduction in reserve requirements for banks.

According to Reuters, by the end of September, 25 Chinese issuers had defaulted on
payments for 52 bonds worth a total of 60.6 billion yuan. Compared with 20 issuers defaulting on 44 bonds worth 38.5 billion yuan during 2017, and 35 issuers defaulting on 79 bonds worth 39.9 billion yuan in 2016.

China Shadow Banking

The Chinese leadership’s resolve in sticking to its financial de-risking policy is being tested by both the Trump Administration’s hawkish trade policies and, what we suspect is, a much sharper slow down in credit growth and economic activity than anticipated. Despite the economic challenges, we do not think the CCP will relent – at least not when it comes to shadow banking. Too much effort has already gone into scaling back shadow finance and slowly ridding the system of bad actors.

Emerging Markets

The fortunes of emerging markets are closely intertwined with those of China – the Mainland is, of course, the leading trade partner of the majority of emerging markets. With the collapse of shadow financing and economic slowdown in China, we have seen emerging markets fall quickly out of favour amongst investors. At the end of November, the MSCI Emerging Market Index was down 12.2 per cent for the year.

MXEF Index (MSCI Emerging Market 2018-12-14 14-08-40.jpg

In last week’s piece we highlighted that we are seeing initial signs that emerging markets may well have formed an interim bottom in October and are well placed to outperform US markets in 2019.

How do we then reconcile our expectation of emerging market out performance in 2019 with the continuation of financial de-risking in China?

Consider the following chart, which plots the 12 month moving average of year-over-year Chinese social financing growth with the Commodity Research Bureau (CRB) Spot Raw Industrial Commodities Index. The three instances since 2007 when Chinese social financing growth has bottomed and accelerated have each been preceded by a bottoming of the CRB Index.

The CRB Index peaked in January and witnessed a sharp drop from May on-wards. Recently, however, the index has started to rise again. While it is early days still, the rising CRB Index may be indicative of China once again beginning to stimulate its economy.

Instead of social financing picking up, however, we may have to look for confirmation elsewhere.

In August, China’s Ministry of Finance said local governments should complete no less than 80 percent of their special bond issuance quota by end of September. Local governments in China issue special bonds for such purposes as highway projects and shanty town redevelopment. Local governments were set a quota of 1.35 trillion yuan of special bonds issuance this year. During the first half of the year, however, local governments had utilised less than 25 per cent of their quotas.

We will be monitoring infrastructure investment growth and local government bond issuance closely to anticipate a recovery in Chinese economic activity and by extension to time an entry into emerging markets.

China Infrastructure Investment YoY

Infrastructure investment and local bond issuance aside, the Chinese economy has received some much needed relief from the recent drops in oil and semiconductor prices. In 2017, China spent US dollars 260 billion semiconductors imports, according to the China Semiconductor Industry Association. In comparison, China spent US dollars 162 billion on importing oil.

ISPPDR37 Index (inSpectrum Tech 2018-12-14 18-59-38.jpg

US Foreign Funding and US Dollar Implications

In “Is the United States Relying on Foreign Investors to Fund Its Larger Budget Deficit?“, a piece issued on the Federal Reserve Bank of New York’s Liberty Street Economics blog, the authors write (emphasis added):

“Data for the first half of 2018 are available and, so far, the country has not had to increase the pace of borrowing from abroad. The current account balance, which measures how much the United States borrows from the rest of the world, has been essentially unchanged. Instead, the tax cut has boosted private saving, allowing the United States to finance the higher federal government deficit without increasing the amount borrowed from foreign investors.”

Just because the US has been able to rely on higher private savings to fund its deficit this year does not mean it will be able to continue to fund deficits without increased foreign participation. The authors speculate:

Of course, these are early days and it will be interesting to see how the increase in business saving will play out. For example, the increase in that saving component may diminish over time, perhaps because firms pass on some of their profit boost from lower taxes to their customers via a drop in markups. Firms could also use their higher after-tax income for salary increases in the current tight labor market. A third possibility is for firms use the jump in saving to increase their capital stock through higher investment spending. Indeed, this perspective suggests that a deterioration in the trade balance is a sign that firms are passing on the gains from the tax cut to their employees and consumers.

Finally, the additional downward pressure on government saving going forward will be from higher spending. It may turn out that future drops in government saving from higher spending translate more directly into higher borrowing from abroad.

As we have argued in the past, a rising US dollar environment and add to it a shortage of US dollar funding for non-US borrowers, which increases borrowing and hedging costs, are not the conditions under which foreign institutional investors increase their participation in US Treasury instruments. We are already witnessing Japanese institutional investors scaling back their exposure to US Treasury instruments.

The below chart shows the cumulative Japanese portfolio flows into the US:

Japan Cumulative Portfolio Flows US.jpg

The US’s current account balance has been unchanged despite Japanese outflows because of higher oil prices. Middle Eastern oil exporters have recycled their petrodollars back into US Treasury instruments as oil prices have exceeded their fiscal break-even levels this year. With oil prices having corrected recently, however, Middle Eastern participation is likely to diminish.

If, indeed, the US ends up requiring foreign participation to increase to fund its deficits we expect one or both of the following to happens:

1. The US Treasury will start spending from its General Account – much like it did in late 2016 / early 2017 in anticipation of a potential government shutdown – and this will release much needed US dollar liquidity into the global banking system.

2. The Fed starts offering foreign central banks unlimited (or very high) quantities for US dollar swap lines much like it did in the aftermath of the global financial crisis. The Fed has the ability to fix the quantity of US dollars available, this results in the price of US dollars rising when demand for US dollars rises, or fix the price of US dollars, this results in unlimited availability of US dollars. Today the Fed fixes the quantity of US dollars available not the price.

Both of the above would be US dollar negative and would provide a signal to short $DXY / go long emerging market currencies.

TGA DXY

Trade Wars: Clearing the Way for a War of Attrition

“The two most powerful warriors are patience and time.” – Leo Tolstoy

“The primary thing when you take a sword in your hands is your intention to cut the enemy, whatever the means. Whenever you parry, hit, spring, strike or touch the enemy’s cutting sword, you must cut the enemy in the same movement. It is essential to attain this. If you think only of hitting, springing, striking or touching the enemy, you will not be able actually to cut him.” – Miyamoto Musashi, The Book of Five Rings

“Only an idiot tries to fight a war on two fronts, and only a madman tries to fight one on three.” – David Eddings, American novelist

A few updates relating to themes and topics we have written about in the recent past before we get to this week’s piece.

1. Two out of three companies we highlighted as potential value plays in Searching for Value in Retail in June have now announced that they are evaluating opportunities to go private.

The most recent of the announcements comes from Barnes & Noble $BKS which said on Wednesday that it is reviewing several offers to take the bookstore chain private. We are not surprised by this development and had expected as much when we wrote the following in June:

“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.”

The other company we discussed in the same piece was GameStop $GME, which at the start of September announced that it is engaged in discussions with third parties regarding a possible transaction to take the company private.

2. Following-up on Trucking: High Freight Rates and Record Truck Orders, orders for Class 8 semi-trucks increased 92 per cent year-over-year in September. Last month capped the highest ever recorded quarterly sales of big rigs in North America.

American trucking companies continue to struggle with tight capacity at the same time demand from the freight market remains strong.

We continue to play this theme through a long position in Allison Transmission $ALSN.

3. When the tech bubble popped at the start of the millennium, between 2001 and 2003, the S&P 500 and the NASDAQ 100 indices declined by 31.3 and 57.9 per cent on a total return basis, respectively. During the same period, Cameco Corporation $CCJ, the world’s largest uranium miner by market capitalisation, went up by more than 40 per cent.

Yesterday, as we witnessed global equity markets sell-off in response to (depending on who you ask) (i) tightening central bank policies and rising yields raising concerns about economic growth prospects, (ii) the accelerating sell-off in bond markets, or (iii) news that China secretly hacked the world’s leading tech companies, including Amazon and Apple, $CCJ closed up 5 per cent on the day.

Maybe history as Mark Twain said rhymes, maybe it is nothing, or just maybe it is one more sign of the increasing awareness of the nascent bull market underway in uranium.

4. With the recent sell-off in the bond market, long-term Treasury yields have surged. Yields on the ten-year treasuries rose as high as 3.23 per cent on Wednesday, recording their highest level since 2011.

Does this level in yields make the long-end of the curve attractive for investors to start to re-allocate some equity exposure to long-term Treasury bonds? We think not.

Our thinking is driven by the following passage from Henry Kaufman’s book Interest Rates, the Markets, and the New Financial World in which he considers, in 1985, the possibility that the secular bond bear market may have come to an end:

“[T]wo credit market developments force me to be somewhat uncertain about the secular trend of long-term rates. One is the near-term performance of institutional investors, who in the restructured markets of recent decades generally will not commit funds when long when short rates are rising. The other development is the continued large supply of intermediate and long-term Governments that is likely to be forthcoming during the next period of monetary restraint. There is a fair chance that long yields will stay below their secular peaks, but the certainty of such an event would be greatly advanced with a sharp slowing of U.S. Government bond issuance and with the emergence of intermediate and long-term investment decisions by portfolio managers.”

In August this year, the US Treasury announced increases to its issuance of bonds in response to the US government’s rising deficit. This is the very opposite of what Mr Kaufman saw as a catalyst for declining long-term yields in 1985. Moreover, this increased issuance is baked in without the passing of President Trump’s infrastructure spending plan, which has been temporarily shelved. We suspect that Mr Trump’s infrastructure spending ambitions are likely to return to the fore following the upcoming mid-term elections. If an infrastructure spending bill of the scale Mr Trump has alluded to in the past come to pass, US Treasury bond issuance is only likely to further accelerate.

With the window for US companies to benefit from an added tax break this year by maximising their pension contributions now having passed, it will be interesting to see if institutional investors now become reluctant to allocate additional capital to long-dated Treasury bonds due to rising short rates.

The relative flatness of the yield curve, in our opinion, certainly does not warrant taking on the duration risk. At the same time, we do not recommend a short position in long-dated treasuries either – the negative carry is simply too costly at current yields.

On to this week’s piece where we discuss the United States-Mexico-Canada Agreement, or USMCA, the new trade deal between the US, Canada and Mexico that replaces the North American Free Trade Agreement, or NAFTA, and its implications on the on-going trade dispute between the US and China.

The many months of the will-they-won’t-they circle of negotiations between the US, Canada and Mexico have culminated in the USMCA, which will replace NAFTA. The new deal may not be as transformative as the Trump Administration would have us believe but nonetheless has some important changes. Some of the salient features of the new agreement include:

1. Automobiles produced in the trade bloc will only qualify for zero tariffs if at least 75 per cent of their components are manufactured in Mexico, the US, or Canada versus 62.5 per cent under NAFTA.

The increased local component requirement is, we feel, far more to do with limiting indirect, tariff-free imports of Chinese products into the US than it is to do with promoting auto parts production in North America. The latter, we think, is an added benefit as opposed to the Trump Administration’s end goal.

2. Also relating to automobiles, the new agreement calls for 40 to 45 per cent of content to be produced by workers earning wages of at least US dollars 16 an hour by the year 2023.

This provision specifically targets the relative cost competitiveness of Mexico and is likely to appease Trump faithfuls hoping for policies aimed at stemming the flow of manufacturing jobs from the US to Mexico.

How this provision will be monitored remains anyone’s guess. Nonetheless, the USMCA, unlike NAFTA, does allow each country to sanction the others for labour violations that impact trade and therefore it may well become that the threat is used to coerce Mexico into complying with the minimum wage requirements.

3. Canada will improve the level of access to its dairy market afforded to the US. It will start with a six-month phase-in that allows US producers up to a 3.6 per cent share of the Canadian dairy market, which translates into approximately US dollars 70 million in increased exports for US farmers.

Canada also agreed to eliminate Class 7 – a Canada-wide domestic policy, creating a lower-priced class of industrial milk. The policy made certain categories of locally produced high-protein milk products cheaper than standard milk products from the US.

4. The term of a copyright will be increased from 50 years beyond the life of the author to 70 years beyond the life of the author. This amendment particularly benefits pharmaceutical and technology companies in the US. American companies’ investment in research and development far outstrips that made by their Canadian and Mexican peers

Another notable victory for pharmaceuticals is the increased protection for biologics patents from eight years to ten years.

5. NAFTA had an indefinite life; the USMCA will expire in 16 years.

The US, Canada and Mexico will formally review the agreement in six years to determine whether an extension beyond 16 years is warranted or not.

The successful conclusion of negotiations between the three countries, subject of course to Congressional approval, combined with the trade related truce declared with the European Union in the summer, should be seen as a victory for US Trade Representative Robert E. Lighthizer.

Earlier this year, in AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote (emphasis added):

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

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

Mr Trump and his band of trade warriors and security hawks are now in the clear to focus their attention on China and deal with the threat it poses to the US’s global economic, military and technological leadership.

The Big Hack

On Thursday, Bloomberg Businessweek ran a ground breaking story confirming the Trump Administration’s fears relating to Chinese espionage and intellectual property theft. The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies details how Chinese spies hacked some of the leading American technology companies, including the likes of Apple and Amazon, and compromised their supply chains.

Bloomberg’s revelations were swiftly followed by strongly worded denials by Apple and Amazon.

The timing of Bloomberg’s report – coming so soon after the USMCA negotiations were completed successfully – regardless of whether the allegations are true or not is notable.

Coincidentally, also on Thursday, Vice President Pence, in a speech at the Hudson Institute, criticised China on a broad range of issues, from Beijing’s supposed meddling in US elections, unfair trade practices, espionage, and the Belt and Road Initiative.

American Corporate Interests

The main hurdle for the Trump Administration in its dispute with China is the US dollars 250 billion invested in China by Corporate America.

We see the recent moves by the Administration in upping the ante on China, by disseminating the theft and espionage narrative through the media and new rounds of tariffs, as a means to provoke Corporate America to begin reengineering its supply chains away from China. Whether this happens, and at what the cost will be, remains to be seen.

War of Attrition

We expect US-China tensions to continue to escalate especially as we draw closer to mid-term election. And the Trump Administration to (threaten to) impose higher tariffs and use other economic and non-economic measures to pressurise the Chinese. The only near term reprieves we see from the US side are (i) a resounding defeat for the Republicans in the mid-term elections (not our base case) or (ii) a re-assessment of priorities by the Trump Administration following the elections.

From the Chinese perspective, the short-term impact of tariffs has partially been offset by the ~10 per cent fall in the renminbi’s value against the US dollar since April. A continued depreciation of the renminbi can further offset the impact of tariffs in the short run – for now this is not our base case.

The other alternative for Beijing is to stimulate its economy through infrastructure and housing investment to offset the external shock à la 2009 and 2015. However, given that Xi Jinping highlighted deleveraging as a key policy objective at the 19th National Congress, we expect fiscal stimulus to remain constrained until is absolutely necessary.

For now our base case is for China to continue to buy time with the President Trump and at the same time for it to work on deepening its economic and political ties in Asia, with its allies and the victims of a weaponised dollar.

China’s Macroeconomic Context

Confusing the Cyclical with the Secular

The Iran-China Comprehensive Strategic Partnership

Chinese Economic Data

Lighten Up On Semiconductors

Inflationary Pressures

China A-Shares Update

China: Notable Announcements from the Annual Legislative Session

One More Cloud-Based Solutions Play

Europe’s Trade Surplus with the US

Semiconductor Leadership

Environmental Concerns

Ideas on the Long Side

Advanced Emissions Solutions $ADES

Heritage Crystal Clean $HCCI

China: Soaring Credit Growth

Trade Wars: Portfolio Hedges

Positioned for an Amicable Resolution

Positioned for a Prolonged Trade War

3-D Printing: Inflection Point?

The Innovation S-Curve

3-D Printing Stocks

The ExOne Company $XONE

Stratasys Limited $SSYS

Contents

Global Liquidity

Enhancers

Depressants

Investment Themes

Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?

US Dollar: What Will the US Treasury Do?

China: Incrementally Better, Not Worse

Emerging Markets: Relief Not Reprieve

Semiconductors: Led On the Way Down, To Lead On the Way Up?

Saudi Arabia: Emerging Market Indices Inclusion

Outsiders for Outsized Returns

Triunfo Albicelestes

Data Driven Dystopia: “The monetization of every move you make”

Books

Five We Have Read and Recommend

Five from Our 2019 Reading List

China Shadow Banking

Emerging Markets

US Foreign Funding and US Dollar Implications