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

 

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

 

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

 

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

 

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

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

 

Continued strength in the US dollar

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

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

 

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

 

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

 

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

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

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

 

China’s Line in the Sand

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

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

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

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

Failing at that, China has tried to respond by:

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

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

 

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

 

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

 

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

 

Germany: Stuck Between a Rock and a Hard Place

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

 

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

 

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

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

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

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

 

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

 

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

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

 

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

Trade Wars: Lessons from History

 

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

 

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

 

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

 

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

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

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

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

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

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

Powerful statements can often hide as much as they reveal.

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

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

 

American Independence and British Retaliation

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

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

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

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

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

 

The American System

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

China’s Adoption of The American System

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

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

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

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

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

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

 

Investment Perspective

 

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

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

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

 

Imposition of Tariffs

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

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

 

The Nuclear Option

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

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

 

A G2 Compromise

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

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

 

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

 

 

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

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

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

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

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

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

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

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

There we have it: quid pro quo.

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


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

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

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

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


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

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

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

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

Investment Perspective

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

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

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

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein

China’s Strategic Gains

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment Perspective

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

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

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

 

Karachi Stock Exchange 100 IndexKSE100.png

Source: Bloomberg

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

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

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

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. 

 

Industrial Commodities: A Sustainable Bull Market?

“We must not forget that housing is for living in, not for speculation. With this in mind, we will move faster to put in place a housing system that ensures supply through multiple sources, provides housing support through multiple channels, and encourages both housing purchase and renting. This will make us better placed to meet the housing needs of all of our people.”

– Excerpt from Xi Jinping’s speech at the 19th Communist Party of China National Congress

 

“Commodities tend to zig when the equity markets zag.” – Jim Rogers

 

“Let the market, not politicians, determine the flow of rice, oil and other commodities. Lower, more stable prices will ensue.” – Steve Hanke, Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise

 

“Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.” – Karl Marx

 

Industrial metals have had a great run starting in late 2015 and early 2016; equities of industrial metal producers even more so. Given this rally and the uncertainties around the Chinese investment-led growth model, one of the more difficult investment questions we have struggled with is: whether this bull market in industrial metals is sustainable or not? Our analysis seems to suggest that it is.

Commodity Research Bureau (CRB) US Spot Raw Industrial IndexCRB

Source: Commodity Research Bureau

We have a fairly straightforward framework to help us develop our initial opinion on the outlook for industrial metals. The framework is centred on Chinese money supply metrics, both M1 and M2, and essentially functions as a heuristic for capital spending in China. Chinese capital spending, as is widely accepted, has been the primary driver of demand for industrial commodities over the last two decades.

As a part of this framework we monitor the dynamic between two measures of money supply, M1 and M2. As M1 is a more narrowly defined measure of money supply consisting of the most liquid components – such as physical cash, checking accounts and demand deposits – of overall money supply, any increase in M1 relative to M2 is indicative of a move away from saving and toward investment. For example, companies that hoard cash tend to hold it in the form of time deposits and other financial assets, should the need to make capital investments arise, they would have to unwind these financial investments. This unwinding of financial investments into cash results in M1 increasing while M2 remains unchanged. To monitor this dynamic we simply calculate the ratio of M1 to M2. A higher number means M1 is increasing relative to M2 while a low number means M1 is declining relative to M2.

The ratio of M1 to M2 has been increasing since the end of 2015, indicating a higher propensity to invest than to save in China.

  Ratio of China Money Supply M1 to China Money Supply M2M1 to M2 China

Source: The People’s Bank of China

While this ratio is informative during periods the ratio is trending, either upwards or downwards, it adds little value during periods it is stable, as witnessed between 1999 and 2007. In such periods, we rely, instead, on the year-on-year growth in M1. If M1 to M2 ratio is stable, then a growing M1 is indicative of an increase in the absolute level of investment in the economy.  As a rule of thumb, growth in China’s M1 has tended to manifest itself in higher industrial commodity prices 4 to 8 months down the line.

Chinese M1 increased rapidly between the end of 2015 and early 2017 but has started to decline since. So while this signals a decline in the rate of growth in investment, the metric remains positive. This combined with a higher propensity to invest over saving, as indicated by the M1 to M2 ratio, suggests that the level of investment in China should remain healthy during the first half of 2018 and support continued demand for industrial commodities.

CRB US Spot Raw Industrial Index vs. China M1 YoY Growth (Lagged 6 Months)M1 YoY China vs CRB Industrial Metals

Sources: The People’s Bank of China, Commodity Research Bureau

This framework has worked well as a timing tool for investing in industrial metals since the turn of the century. It may continue to work well, we suspect, as long as Chinese demand is the primary determinant of commodity prices. The limitation, however, is that the framework is purely Chinese demand centric and does not take into consideration substantial demand creation or destruction from other parts of the world; nor does it give weight to changing supply-side dynamics.

On the demand side, we think there are two key forces that will determine the trajectory of industrial commodities during 2018. The first is construction activity in China, ergo housing demand. While the second is the incentives within US tax bill for corporations to increase capital investment in the near term.

Xi Jinping in his speech at the Communist Party of China’s 19th National Congress addressed the need to “put in place a housing system that ensures supply through multiple sources”. To our mind this is as much to do with affordability as it is to do with the supply of housing, which is why Xi specifically mentioned encouraging renting as part of the solution.

Earlier in the year, the Chinese government announced that it will allow, on a trial basis, the development of rental housing projects on rural land – the trial will be conducted in 13 cities including Shanghai, Beijing, Guangzhou and Shenzhen. According to data from Centaline Property, 10 cities have already allocated land for rental housing construction. Chief amongst them is Beijing, where authorities expect to supply 6,000 hectares of land for residential housing by 2021, almost a third of which will be for rental housing. Beijing has even gone as far as announcing a new rental housing policy, which guarantees the same education rights to the children of the tenants of rental properties as the rights afforded to the children of property owner. The new policy even enables tenants renting government-subsidized housing to have their household registration (“hukou”) on their rented homes.

The government is clearly very serious about developing the rental housing market. And key private sector participants are responding to the government’s signals. Not long after the National Congress, China Construction Bank – one of the big four banks in China – launched a loan product for home renters.  China Vanke, a leading residential real estate developer in China, indicated that it aims to provide up to 100,000 apartments for long-term leases, up from the 24,000 rental units operated currently. AliPay, Alibaba’ mobile payment platform, announced that it would enable users across eight cities and based on their credit history to rent residential properties through the platform without having to pay deposits.

The Chinese government’s objective is to make housing more affordable. House prices in major cities have become exorbitantly high and this is a factor contributing to the dampening in the rate of Chinese urbanisation. If the government’s goal of transforming the Chinese economy into a consumption-led, as opposed to investment-led, economy is to be achieved, urbanisation needs to continue unabated for many more years. Simply because urban consumers clearly outspend rural consumers – after all, the Joneses do not live in rural China.

Despite the willingness shown by some of the large private sector developers at the early stage – it is not too difficult to nudge companies dependent on government largesse – the challenge for the government will be to create a system in which property developers are able to offload inventory to recoup their investment shortly after delivery, as opposed to collecting rents over many years. Solutions to this problem can involve mobilising capital from pension funds and other institutional investors into rental properties, developing capital market infrastructure to increase the number of real estate investment vehicles such as real estate investment trusts or other forms of securitisation, or simply facilitating increased investment by international real estate income funds into China.

Notwithstanding the challenges, the key point for us is that the Chinese government has a goal that ultimately creates an additional source of demand for housing and thus construction. This incremental demand can only be bullish for the demand for industrial metals.

The incentives for US capital investment created by the potential tax reform maybe somewhat more subtle than the overtures of the Chinese government but might ultimately prove to be as bullish, if not more, for industrial commodities. The key provisions in the tax bill in this regard are the:

  1. Corporate income tax rate being cut from 35 per cent to 21 per cent, effective 1 January, 2018
  2. Capital expensing provision that permits businesses to completely write-off, or expense, the entire value of investments in plant and equipment for five years. Starting the sixth year, this provision is gradually eliminated over a five year period

Cutting the corporate tax rate from 35 to 21 per cent is bound to increase investment into the US. On top of that, the capital expensing provision within the proposal incentivises both new capital that comes into the US as well as existing capital to be put into plant and equipment. At a time where companies are struggling to recruit adequately trained staff and productivity growth is non-existent, the capital expense provision is likely to result in a substantial increase in the demand for capital goods — and for industrial commodities.

Coming to supply, China’s supply side reforms are well documented – capacities at coal mines have been curtailed, steel mills have been shuttered and the supply of natural gas rationed. The results thus far have been largely positive.

 

Investment Perspective

 

Deflationary forces reward businesses that delay investment and maintain low levels of inventory. The lack of capital investment and the absence of excess levels of inventory, in turn reduces the risk of impairment, write-down or liquidation. Without write-downs or liquidation, the business cycle continues, albeit unimpressively. This has been the case since the Global Financial Crisis and especially after commodities peaked in 2011/12.

What if given the supply and demand dynamics, however, we are at the early stages of an industrial commodities bull market?  What if the depleted inventory levels combined with reduced production capacities leads to a feeding frenzy whereby rising prices result in rising demand? The latter is the very dynamic witnessed in the semiconductors market this year. And we certainly see it is a plausible, albeit low probability, scenario for industrial metals for 2018.

We are of the opinion, barring short-term volatility, the risk for industrial metals remains to the upside.

We are long Vale SA ($VALE) and United States Steel Corporation ($X). We will be looking to add other names and direct commodity plays on any meaningful pullbacks.  

 

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