Discussion on US dollar shortage.
Thoughts and Investment Ideas for 2020
The Speculative Phase: Software Over Semiconductors
Playing the Strength in US Housing Demand
Founder Exodus: A Reduction in Existential Flexibility
Inflation is the Enemy
US Treasury Yield Curve
Modern Monetary Theory
Five We Have Read and Recommend
Five from Our 2020 Reading List
“Can you ask a new question? It’s the new questions that produce huge advances…”
― Why Model? by Joshua M. Epstein
“A reward-sensitive person is highly motivated to seek rewards―from a promotion to a lottery jackpot to an enjoyable evening out with friends. Reward sensitivity motivates us to pursue goals like sex and money, social status and influence. It prompts us to climb ladders and reach for faraway branches in order to gather life’s choicest fruits.
But sometimes we’re too sensitive to rewards. Reward sensitivity on overdrive gets people into all kinds of trouble. We can get so excited by the prospect of juicy prizes, like winning big in the stock market, that we take on outsized risks and ignore obvious warning signals.”
― Quiet: The Power of Introverts in a World That Can’t Stop Talking by Susan Cain
“Stock prices have reached what looks like a permanently high plateau.”
― Irving Fisher (1867 – 1947)
The last twelve months, and pretty much the entirety of the last decade, handsomely remunerated the reward-sensitive ― the risk-takers, the optimists, the dip-buyers, the trend-followers, the bitcoin HODLers ― and punished the sceptics, the value-conscious, the doomers and the gloomers, and the short-sellers, without prejudice.
The sceptics, and others of their ilk, are quick to remind of the cyclicality of markets even as they lick their bull-horned wounds. That, as surely as night follows day, the years of plenty will be followed by years of famine. That valuations matter.
They, the doubters, are, as history shows, not wrong. Markets are indeed cyclical. Valuations do matter, eventually. The record shows, claiming otherwise will surely find you embarrassed, if not immediately, most definitely in due course.
There is, however, a wrinkle in the cyclicality argument.
All finite, deterministic systems are guaranteed to cycle. Capital markets, however, are neither finite nor deterministic.
Finite systems, to paraphrase James P. Carse author of Finite and Infinite Games, are comprised of known participants, fixed rules and agreed upon objectives. Infinite systems or games, on the other hand, are defined by participants both known and unknown, changing rules and an objective to keep the system or game perpetuating.
Markets are an infinite system and market participants ― investors, traders, brokers, market makers, regulators, corporations and whoever else that may choose to participate ― are engaged in an infinite game. To survive in an infinite game, participants must adapt or die. It is this process of adaptation that allows the system to perpetuate but at the same time necessitates that neither the duration nor the form of any given market cycle can be known before the fact. Just because the average bull market may have lasted 7-years or ended within a certain time period following a yield curve inversion does not in any way imply that this or the next market cycle will follow the same pattern.
Market participants should not, nay cannot, simply rely on a passing understanding of market cycles. Rather, we must all continuously strive to better understand how the game and the participants are adapting so that we may have a better shot at positioning for that which lies ahead.
In this piece, we try to ask questions ― with a bit of luck, some different, if not entirely new, ones ― and share our thoughts and ideas that, we hope, will help you, the reader, better play the infinite game over the coming six to twelve months.
- Energy: Long Chevron $CVX, National Oilwell Varco $NOV and Cactus Inc $WHD and avoid allocations to energy importing emerging markets
- Speculative Phase: Prefer software $IGV to semiconductors $SOXX in the US
- Founder Exodus: Avoid long positions in companies that have recently seen their founders exit such as Alphabet $GOOG, Under Armour $UAA, Chipotle $CMG and Alibaba $BABA
- USD: Below 95 on the US Dollar Index $DXY, short Australian dollar and New Zealand dollar
“Rise early, work hard, strike oil.” ― John Paul Getty
“Do not waste energy, make it useful.” ― Wilhelm Ostwald (1853 – 1932), winner of the Nobel Prize in Chemistry in 1909
Humans have been burning fossil fuels to generate electricity since 1882. Coincidentally, the first hydroelectric power plant also began operations in 1882. Fissioning uranium isotopes has been a source of electricity since 1956.
The technology to harness fossil fuels as a source of energy at scale has transformed everything from agriculture to industry, transportation to warfare, quality of life to the environment, and everything in-between. Fossil fuels remain the most concentrated and versatile source of energy that can be converted at affordable cost and high rates of efficiency into heat, light and motion.
The quest to harness alternative sources of energy at comparable levels of efficiency, cost and scale as to that of fossil fuels remains just that, a quest. Progress is being made and the political will to turn our collective backs on fossil fuels has never appeared stronger.
The rise of environmental, social and governance (ESG) criteria in investing, the US Democrats’ “Green New Deal” on climate mitigation, and the recent unveiling of the “European Green Deal”, are raising the cost of capital for the global energy sector. All the while, returns on invested capital being generated by the sector remain dismal.
The potential unintended consequence of a seemingly coordinated desire to penalise the global energy complex and starve it of fresh capital is the prospect of a negative energy supply shock becoming increasingly probable.
With the promises of blockbuster shale wells fracking companies made to investors turning out to be a busted flush ― according to The Wall Street Journal wells drilled recently in the four largest US oil regions were on track to produce nearly 10 per cent less oil and gas over their lifetimes than companies forecast ― and the sector facing ever increasing costs of capital, the prospects of a global energy supply shock in the near-to-medium term, we think, are under-priced.
Barring a negative-demand shock, or a breakthrough in technology that enables the harnessing of alternative sources of energy as efficiently and cost effectively as harnessing fossil fuels, we think oil prices can head higher, much higher, in the near- to medium-term.
We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average. As long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices continuing to climb the ‘Wall of Worry’ over the next 6 to 12 months.
President Trump’s decision to order the Iranian Major General Qasem Soleimani’s death via drone attack in Baghdad in the evening on 2 January saw oil prices spike by as much as 4 per cent. Such is the antipathy towards energy stocks that despite a sharply higher oil price, the SPDR Energy Select Sector ETF $XLE closed in the red on 3 January.
With that being said, oil may have to work off overbought conditions if and when the geopolitical risk premium subsides. We would hold off till that point to have a full-sized allocation to energy.
Ideas: Long Chevron Corporation $CVX, Long National Oilwell Varco Inc. $NOV, Long Cactus Inc. $WHD.
Avoid: Energy importing emerging markets.
If the US equity market is in the throes of a market melt-up, or an almighty blow-off, the rally should devolve into becoming increasingly speculative.
Last year, software stocks were leading the pack till around mid-year when, as the trade tensions between the US and China thawed, semiconductor stocks started climbing a wall of worry and ended the year at all-time highs. Software stocks were the laggards during the second-half of last year.
We think as the rubber of hope meets the road of financial performance semiconductors are likely to falter. Further, given the sensitivity of semiconductor stocks to the trade deal and with a phase one deal between the US and China more than priced in, it behoves the prudent investor to pare allocations to semiconductor stocks. Rather, as growth becomes precious once again, we think, investors are likely to turn to software afresh. And as software incumbents look for new ideas and business models, more than a few acquisitions are likely to be in the offing.
For now, in US equities, we prefer software to semiconductors.
Ideas: Long Manhattan Associates $MANH, Long Salesforce.com $CRM, Long Avalara $AVLR, Long Slack Technologies $WORK, Long iShares Expanded Tech-Software Sector ETF $IGV
Avoid: iShares PHLX Semiconductor ETF $SOXX
Falling long-term interest rates equate to more affordable housing and on a relative basis make the economics of owning a home better than of renting one. With US long rates having dropped sharply during the summer, US home purchases have picked up.
On an annual basis, sales in October increased 4.6 per month from the same month the previous year, marking the fourth straight month of year-over-year gains.
With homeowners in the US remaining in their homes thirteen years on average, five years longer than they did in 2010, and housing inventory estimated to be at an 11-year low, the surge in demand for housing is rippling through to increased applications for and issuance of building permits.
The thing about buying a home is that, once you have bought one, it comes a with a long list of mandatory and not-so-mandatory purchases. For this reason, US consumer durable goods spending tends to closely track home sales and housing permit issuance with a lag.
While demand for housing fluctuates with long-term interest rates, once a house has been bought the spending that follows it, will follow irrespective of the fluctuation in interest rates. This makes consumer durable plays, broadly the consumer discretionary sector, a less interest-rate sensitive means of gaining exposure to the robust demand for US housing.
Ideas: Long Floor and Décor $FND and conditional on high-levels of risk appetite small caps such as Bassett Furniture $BSET and Hooker Furniture $HOFT
Simon Sinek in a talk about his book The Infinite Game shares an anecdote in which Steve Jobs was almost on a whim willing to pivot Apple Inc., despite the prospect of huge near-term losses, when faced with an existential crisis. He describes this ability to be “existential flexibility”.
Founders, in general, are more likely to have the strength of character and conviction to make the difficult decisions ― that is, existential flexibility ― than do managers. A number of prominent companies ― such as Google, Under Armour, Alibaba and Chipotle Mexican Grill to name a few ― have recently seen their founders step down.
With the business cycle long in the tooth and regulatory risks, particularly for technology companies, rising, we prefer to avoid investing in companies that have transitioned from founder CEOs to manager CEOs.
Analysts, ourselves included, have spent an inordinate amount of time and energy in an attempt to ascertain the direction of an asset that has remained in a mind-numbingly narrow range. Such is the importance of the greenback, implicit or explicit, in any investment framework, however, that we would be remiss to not once again touch upon it.
We use Australia and New Zealand, given access to a longer history and better quality of data, and because they serve as good proxies for China and commodity producing emerging markets. The below charts show that on the 10-year government bond yield differential basis there is a strong case to be made for a stronger dollar relative to these currencies. (We also include Indonesia, despite the limited data, as a further example.)
From the Perspective of Select ‘Fragile’ Emerging Markets
The real trade-weighted dollar has posted a smaller advance since mid-2014 than the US Dollar Index $DXY, suggesting that the threat to the world from a stronger US dollar is not as great as is often hyped to be.
Below we share three charts of select emerging markets that suffered severe crises and saw their currencies plummet versus the US dollar in the 1990’s. Most of these countries are better placed to withstand a stronger US dollar than they were prior to the crises in the 1990’s and at the time of the ‘taper tantrum’ in 2013.
Note: Pre-crisis metrics for 1996 for all countries except India, for India we use 1990
While a stronger US dollar would be painful, it would not, we think be apocalyptic barring a a severe spike (10%+ in a matter of months).
Ideas: Using $DXY as the guidepost, long US dollar below 95 versus the Australian dollar and New Zealand dollar, given the low cost of carry.
- Macro Risks: Using rallies to reduce equity exposures tactically and increase bond allocations, take profits in European equities
- Inflation is the Enemy: Growth shocks and not inflation shocks are probably the bigger risk to diversified portfolios in the near-term
- Valuations: Gold is indicating equity market multiples have peaked
- US Yield Curve: Prefer steepeners and then the short-end of the curve
- Modern Monetary Theory: Probably not what you expect
The chart above is of the 52-week moving average of the Citi Macro Risk Index. It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator. (Rising line indicates increasing macro risks.)
With the risks that built up during the sell-off in the last quarter of 2018 and the recession fears that peaked in the summer of last year having been largely unwound, some caution is now warranted. We think equity rallies hereon should be used to gradually reduce allocations to leave powder dry for cyclically more opportune times to go on the offensive.
The chart above is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)
The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time-series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.
With the hard work to resolve Brexit still pending and the potential for a flare up in a trade spat with President Trump under-priced, we think there is more than a modicum of complacency on investors’ part with respect to risks in Europe. Profits should be taken on European equities.
Avoid: Shorting funding currencies, namely the euro, Swiss franc and Japanese yen, as they can rally sharply during risk-off periods
Generally, the main macroeconomic risk factors that drive expected returns in equities and bonds are growth and inflation. With equity returns being most sensitive to growth and bonds to inflation.
Lower expected risk-adjusted returns in equities begin to be priced in when the economy is supply constrained and central banks are tightening monetary policy to lower nominal growth. This also tends to be the more inflationary phase of the business cycle with rising unit labour costs and valuation multiples at or near cycle highs. In contrast, higher expected returns begin to be priced in when the economy is operating below potential and central banks are easing monetary policy to prop-up nominal growth. This generally tends to be a disinflationary phase in the business cycle with unit labour costs falling and valuation multiples at or near cycle lows.
The chart above is of the trailing earnings yield (inverted price-to-earnings ratio) of US stocks and realised inflation rates. Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields.
A comparable relationship between inflation and earnings yields has also been found to exist in many other markets.
The expected risk-adjusted return in bonds also tends to be counter-cyclical. Specifically, policymakers are more prone to hiking policy rates when there is little to no slack in the economy and inflation pressures begin to emerge.
At a portfolio level, risk-adjusted returns of the portfolio also depend on the correlation of constituent assets over the course of the cycle. Economic theory has it that asset prices reflect the present value of future cash flows. Given that inflation determines the discount rate for both equities and bonds, it also tends to drive both assets in the same direction. At times when inflation shocks dominate, equities and bonds become positively correlated. While, since growth rates affect equities more than they do bonds, growth shocks dominating leads to bonds and equities being negatively correlated.
The chart above is of the US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index excluding shelter.
During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with poor bond market performance.
The time-series demonstrates how the correlation between equities and bonds is not static. The implication being that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime, as described above, that determines the efficacy of bond allocations to lower drawdowns and portfolio level volatility during equity market sell-offs.
As the chart shows, the last decade, as all of us already know, was characterised by low-growth, negative growth surprises and low-and-steady inflation. That is, a decade of negative correlation between bonds equities.
A strategic asset allocation framework, it then follows, should contain equity and bond exposure levels conditioned on the phases of the business cycle.
Upside inflationary shocks make traditional 60/40 and risk-parity like allocations suffer as bonds and equities sell-off concomitantly. While periods of benign inflation with the occasional growth shock are well-suited to portfolios diversifying equity exposures with heavy bond allocations.
According to our framework, however, the probability of a near-term inflationary shock remains low. Rather, we anticipate the risk of a near-term negative growth shock to be much higher than that of inflation sustainably surprising to the upside.
“The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”
― Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman
An example of growth remaining elusive comes from the Federal Reserve’s recent senior loan officer survey, which revealed that banks left commercial and industrial lending standards mostly unchanged amid weakening demand for credit.
Bonds, rather than commodities and other inflation hedges, remain, for the near-term, the most suitable hedge for equity allocations.
Ideas: Long Japanese Government Bonds and allocations overweight bonds relative to equities and commodities (excluding gold / precious metals)
Avoid: Treasury Inflation Protected Securities (TIPS)
The chart above is of the S&P 500 Index expressed in terms of gold (in US dollars per Troy Ounce) versus the index’s cyclically adjusted price-to-earnings ratio (as calculated by Professor Robert Shiller).
While we use the CAPE to smooth out the effect of the Global Financial Crisis, using annual price-to-earnings multiples would convey the same message. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.
The price of the S&P 500 in terms of gold suggests that valuation multiples have peaked on a cyclical basis.
Ideas: Gold can serve as a hedge for equity market multiple-contraction
“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.”
― A History of Interest Rates by Sidney Homer (1864 – 1953) and Richard Sylla
The chart below is of the US yield curve (10 year minus 3 month) versus private saving less private investment. The latter points towards a further steepening of the US yield curve.
The chart below is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.
The two-time series have a correlation of -0.75 with an r-squared of 57 per cent.
(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)
The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion.
This relationship, too, points towards a further steepening of the US yield curve.
Ideas: Long yield curve steepeners or alternatively long the short-end of the yield curve
Modern Monetary Theory
“‘War Board’ Proposed
April 13, 1933
A plan to mobilize private industry under the government for expansion in the production of articles and materials in normal demand, this expansion to be coeval with the administration’s public works activities, is being developed by the President’s closest advisors and they hope to persuade him to attempt it.
Certain types of industry, under the plan, would be assembled and regulated by a government agency reminiscent of the War Industries Board. Competition would be regulated: hours of work and minimum rates of pay would be fixed; and some of the proponents of the idea also would have the government guarantee manufacturers against loss in resuming or increasing the manufacture of prescribed articles and materials.
The thought behind the plan is that a public works program standing by itself, even if the five billions is expended upon it, will not sufficiently reduce unemployment or make use of the new purchasing power. It is contended that private industry must, at the same time, be put in a position to absorb the new purchasing power, composed of the billions which the government will be putting in the hands of citizens all over the United States. To do this, it must resume manufacture, and that will restore many to private employment in the factories themselves and in the retail establishments which will dispose of the products of these factories. This will, in turn, give purchasing power to those privately as well as those governmentally employed. A part of the billions will then flow back to the Treasury in various forms of taxation.
The argument which seems to have been most effective in bringing the administration to support the public works appropriations is that the deflationary policy has cut down the purchasing ability of the country by seven billions. Of this five billions is in closed banks, one billion in the budget savings and another billion in reductions made by the several State governments.
The vast public works program having been definitely agreed upon, with the probability that it may involve an expenditure of as much as five billions, it soon became evident to the architects of administration policy that this plan needed a companion.
It was all very well to balance the budget, and, with government credit thus establish, to borrow billions for roads, buildings, flood control and the like. But this question remained: How could private industry get the full use of those billions for purchase? Without some form of government stimulation and aid, it was felt that manufacturers of ordinary consumers’ commodities would wait to clear their stocks, while retailers were clearing theirs, and when the manufacturers did resume production, they would simply proceed at “depression pace.”
The result of these considerations was the plan to set up a government agency to induce industrial expansion, to quicken and regulate it meanwhile, to protect it against loss and perhaps even to fix the prices of labor’s product as well as the wage of labor itself.”
― In The Nation: 1932-1966, Arthur Krock (1886 – 1974)
Modern Monetary Theory (MMT) advocates fiscal measures and the role of government in the creation of money over monetary policy and as such stands in almost complete contrast to traditional macroeconomic theory. A key to understanding MMT is to appreciate the difference between users of currency, primarily the private sector, and the monopoly issuer of said currency, the government.
Beginning with the economic assumptions of full employment and full capacity utilisation ― that is, a country facing real resource constraints. Under such a scenario, inflationary pressures can become a genuine and immediate danger and monetary policy can, arguably, play a critical role play to dampen excess demand and by extension inflationary pressures. For instance, by raising the level of interest paid on excess reserves, the central bank could increase the opportunity cost of lending activities, encouraging banks to instead place more cash with the central bank or demand a higher rate of return from potential borrowers. Thereby raising the cost of capital.
Proponents of MMT contend that adjustments to the government’s fiscal policy could just as easily be used to achieve the same objective. For example, excess demand could be dampened by raising tax rates, be it income, sales or value-added taxes.
The reality today, however, is that few, if any, economies face resource constraints. Rather, interest rates persist at or near historic lows, inflationary pressures have remained transitory at best and the global commodity complex remains largely mired by excess capacity. Monetary policy has proven impotent in reflating the economy and zero-bound interest rates have neither spurred demand for credit nor compelled banks to lend.
In the current state of the global economy, MMTers argue, is when the prescriptions of the theory are most potent. Tax cuts, for example, can be utilised to immediately increase private sector disposable incomes.
By divvying up the economy across private and public sectors and recognising that the balance sheet constraints across the two sectors are incongruent, MMT perceives fiscal policy as a means to lessen (increase) private sector funding pressures, when the economy is operating below (at or above) capacity.
In a fiat currency system, the government has the flexibility to affect changes in private sector behaviour by fine-tuning its budget deficit. At a time when the private sector is deleveraging, if government fails to offset this by widening its budget deficit, it effectively starves private sector activity. In a fiat currency system, it is government, not the central bank, that creates new liabilities that become the assets of the private sector.
So, at any level of income, if the private sector decides to deleverage, the public sector must by definition, end up saving less by running a larger budget deficit or shrinking a budget surplus. In an ideal world, any shifts in the private sector’s propensity to save would be matched by an immediate change in the tax rate, and the combined income of the public and private sectors would remain stable. A key policy prescription stemming from MMT, then, is to keep monetary policy steady and to manage the economy by adjusting the tax rate.
The Practical Implications
Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.
And as far as the path is concerned, it is not unreasonable, in our opinion, that, initially, MMT, or any other form of government led fiscal activism, reinforces deflationary not inflationary forces. That is, by opening up the fiscal spigot policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts. Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.
- Surfing the Edge of Chaos: The Laws of Nature and the New Laws of Business by Richard Pascale, Mark Milleman and Linda Gioja
- The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals by Frank Partnoy
- The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman
- The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy by Michael Pettis
- How Global Currencies Work: Past, Present, and the Future by Barry Eichengreen, Arnaud Mehl, and Livia Chitu
- The Education of a Speculator by Victor Niederhoffer
- The Model Thinker: What You Need to Know to Make Data Work for You by Scott E. Page
- Micromotives and Macrobehavior by Thomas C. Schelling
- Clash of Empires: Currencies and Power in a Multipolar World by Charles Gave & Louis-Vincent Gave
- Energy and Civilization: A History by Vaclav Smil
Thank you for reading and please share!
This document 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.
“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
- 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”
- 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.
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.
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.
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 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
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.
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.
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, 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 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.
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 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.
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.
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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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.