The Stock Market is not a driver of growth – it is the price investors are willing to pay for their perceptions of future value of stock market assets, a price which is relative to other assets, including factories, property, intellectual capital and infrastructure. Do not confuse the stock market with the economy. “Trade war” weakness may worry investors about the value of their stocks, but, should equally cause investors to finance and build new economic assets (ie factories, farms, infrastructure, schools, etc) to benefit from the opportunities “trade war” opens long term to the US economy.
While reducing rates to near zero levels to finance a Trade War with China may seem a logical decision, experience shows the unintended consequences of zero rates will achieve sub-optimal results. Since 2009 “lower for longer” rates have not caused a regeneration of manufacturing, infrastructure or other productive assets. Instead, low rates have encouraged corporates to buy back their own stock, pay their owners larger bonuses and dividends, and fooled investors to buy these same stocks as the most attractive relative asset – which is distortion.
A second unintended consequence is burdening the economy with unproductive assets and obsolete capital assets. Corporate borrowing to convert equity into debt raises systemic weakness across the economy. The Darwinian Selection process which drives growth and causes firms rise and fall according to their ability to manage themselves becomes distorted and lose momentum, leading to too many weak zombie indebted going-nowhere companies to block market niches more nimble new firms could more profitably fill. The long-term consequences are long-term rentier behaviour by owners, and declining real wages (and rising income inequality) as productivity across the nation slides as capital assets are not replaced and upgraded.
Long term, investment in replacing obsolete infrastructure, and the normalisation of interest rates to levels that create real returns to encourage real investments (into productive capital projects) rather than unproductive financial investments (such as already distorted stocks), would benefit the economy.
There is, however, a strong argument that 10-years of financial distortion through low interest rates, and the deliberate transfer of risk assets from the now heavily regulated banking sector into the more diverse investment management sector, now leaves the pension savings of millions of American’s vulnerable in the case of a stock market downturn.
This is an issue for the committee to determine…
The fact The Fed is feeding the stock markets addiction to low rates will also play to Trumps re-election is irrelevant(ish).
The cycle is turning from consolidation to diffusion.
For
more than a decade, the consolidation of economic power — both on the corporate
and individual level — has been the key dynamic determining the returns of
nearly every asset class. It
has shaped the dominant trends in equity markets, whether growth’s
outperformance versus value, passive investing’s meteoric rise, the
low-volatility regime, or the concentration of capital in U.S. stocks.
It has defined the tech-venture capital ecosystem, with funds concentrating in
a small number of firms believed to have blitzscaling potential. It has
determined global real estate values, with high-end jobs and wealth clustering
in “superstar” cities. Even luxury collectables reflect the dynamic, with
extreme wealth driving the top-end of the art, car, wine, and whiskey markets
to extreme values.
In WILTW
March 7, 2019, we penned an article titled: “Market participants
still don’t understand the power of the cycle that turns from wealth
accumulation to wealth distribution. But they will.” Week after week, we see evidence of intensification on all three key
fronts driving the cycle shift — political, technological, and cultural.
Consider only a few recent developments:
Bayer’s C-suite is facing a
shareholder revolt for failing to see the risks of its biggest acquisition
ever, Monsanto.
Recently-released data revealed
California’s
population growth rate slipped to 0.47% in 2018, the slowest sincedata
collection began in 1900.
Disney-heiress Abigail Disney
spoke publicly against Bob Iger’s salary, telling CNBC: “Jesus
Christ himself isn’t worth 500 times his median workers’ pay.”
Bitcoin spiked more than $1,200
in a single day on Monday, pushing the token’s price above $8,000 for the
first time since last July.
On the downside:Real estate prices in
megacities around the globe are falling — in some cases,
sharply. Key megamergers are backfiring. Uber’s IPO floundered as its
private valuation exceeded the public market’s estimation of its worth.
And regulatory and legal actions are threatening the business models of
behemoths in several sectors.
It may not yet be time to
entirely abandon consolidation as an investment theme. However, to our mind, it is increasingly clear
the cycle shift is gaining momentum.
Last week (WILTW May 9, 2019), we
dissected why the SaaS boom has only begun and the
market is likely to be defined by diffusion rather than monopolism (unlike the
consumer-data-dominated era). 5G combined with the IoT will
dramatically spike the volume of data generated by enterprises. And SaaS
companies with best-in-class products and sector-by-sector and region-by-region
expertise will see the greatest upside. It is unlikely mass-market,
legacy-cloud giants like Microsoft, Salesforce, or even Amazon will alone be
able to service those idiosyncratic challenges. Meaning, niche SaaS providers will be able to carve out
lean, highly-profitable businesses.
As an example of this dynamic
already in action, we referenced freight-forwarding startup Flexport, which saw
its annual revenue spike 95% in 2018 to $441 million. We quoted its founder,
Ryan Peterson, who made an essential point to Forbes
earlier this year: “Of
the top 100 freight forwarders, we are the only one founded after Netscape.”
In these pages, we have explored
why the shipping industry has lagged in its digital transformation, and in
turn, underperformed. As we wrote in WILTW
March 21, 2019: “The [maritime transport] group is now at ‘maximum
pessimism’ with stocks down 90% and in many cases trading at less than half of
NAV.” SaaS firms like Flexport that can offer shipping
an on-ramp to digital transformation will not only see significant upside
themselves, but could rejuvenate profit growth — and equity sentiment — for the
entire sector.
And the shipping industry is by
no means the only old-line industry that is ripe for digital transformation. In
WILTW April 6, 2017, we cited
calculations from McKinsey Global Institute (MGI) measuring value seized from
big data by sector, finding retail had captured only 30% to 40% of potential
estimated value; manufacturing just 20% to 30%; and the public and healthcare sectors a mere 10% to 20%.
If old-line industries effectively digitize, it would have seismic implications for the investment ecosystem’s status quo. Just consider the underperformance of value versus growth over the past decade. As The Irish Times pointed out last month, value stocks, by one valuation metric, outperformed growth stocks by an average of four percentage points a year between 1926 and 2008 and in 90% of 10-year periods. However, since the market bottomed in early 2009, growth stocks have been on their longest run of dominance on record.
Source: The Economist
While there is much debate about why this has happened — with some even claiming “value investing is dead” — one contributing factor is clear: growth’s dominance has been highly dependent on the ever-consolidating power of tech giants. Just consider the not-surprising, but still-shocking, chart below. Published earlier this month by Bloomberg’s John Authers, it shows FANG 6 earnings — Facebook, Amazon, Apple, Netflix, Google and Microsoft — relative to the rest of the MSCI world index over the past five years:
A handful of firms seizing the
vast majority of profit growth globally year-after-year has deprived active
investors of the ability to identify undervalued growth opportunities and
outperform passive indexes. When
diffusion supplants consolidation as the dominant market dynamic, it will be a
headwind for passive and a major tailwind for active investing.
The pace at which the shift from
wealth accumulation to wealth distribution occurs will depend on several
factors. To name three: Will a pro-antitrust democrat win the White House in
2020? Will Gen Z and millennial tastes and politics solidify or change as they
age and gain spending power? How quickly can innovators solve blockchain’s
scalability questions?
Yet, regardless of the speed of
the transition, the progression away from consolidation and towards diffusion
has begun. We will continue to dissect the risks and
opportunities in these pages every week. However, the broad
implications already appear clear: Bet on decentralizing innovations. Bet on
specialization over scale. Bet on the neglected and undervalued over assets
where wealth has concentrated. And prepare
for volatility as most market participants will be caught flat footed by this
seismic shift.
This article was originally published in “What I Learned This Week” on May 16, 2019. To subscribe to their weekly newsletter, visit 13D.com or on Twitter @WhatILearnedTW.
Who is Australia’s largest trading partner? China. Who is Canada’s largest trading partner? The United States Shorting AUD vsCAD is one of the best ways of playing America winning the trade war versus China.
Junk
has been the place to be for credit investors, as the Bloomberg Barclays High
Yield Index has delivered an 8.3% total return year-to-date, topping the 7.1%
gain in the iBoxx Liquid Investment Grade Index and outpacing the 5.7%
generated by the S&P/LSTA Leveraged Loan Index. Even after a recent
pullback in prices, the ICE BAML High Yield option-adjusted spread sits at just
403 basis points over Treasurys, well below the 552 basis point average going
back to 1997.
What’s
driving the superior performance in high-yield? The prospect of an easier Fed
is one key contributor, helping increase the perceived value of fixed-rate junk
bonds as opposed to floating-rate loans. Relatively robust economic growth (GDP
growth has averaged an annualized 3.3% over the last four quarters) has
likewise helped, as has a buoyant stock market. Meanwhile, defaults have
remained low, with Fitch Ratings forecasting that May’s trailing 12-month
high-yield default rate will settle at 2%. That compares to 4.7% in calendar
2016 and 14% in 2009, per Fitch.
Some
investors expect the good times to continue. Vivek Bommi, senior portfolio
manager at Neuberger Berman, told Bloomberg over the weekend that the junk bond
market “is very attractive, given that the fundamentals are still very good and
corporate credit quality is still good.” Bommi notes that the post-crisis boom
in leveraged loan issuance has shifted risks away from high-yield: “In the last
10 years, a lot of the more aggressive issuance that may have gone into the
high-yield market has gone into other markets like private credit or loans.”
But
with the economic expansion set to match the post-World War II record of 110
months in June and the stock market still less than 5% below its closing
high-water mark, some concerning signs have emerged. Economic growth looks set
to slow, as the Atlanta Fed’s GDPNow tracker indicates second quarter output
growth at just 1.2%, revised down from 1.6% on May 14. Retail sales for April
fell by 0.2% on a sequential basis, vs. expectations of a 0.2% gain. Resource
prices likewise look to be rolling over, with the Goldman Sachs Commodity Index
down 5% over the last month.
Broad cracks in credit are also appearing. On Monday, the Financial Times published an analysis showing that non-performing loans among the 10 largest commercial lenders in the U.S. jumped by 20% sequentially in the first quarter, snapping a streak of improvement in that metric dating back to 2016. Brian Foran, a bank analyst at Autonomous Research, tells the FT that unlike three years ago, when plunging oil prices pushed a number of energy-related borrowers into distress, the recent uptick is broad-based: “There hasn’t been a clear theme.” Meanwhile, rich valuations leave little room for error. Marty Fridson, chief investment officer of Lehmann, Livian, Fridson Advisors, LLC, writes in S&P Global’s LCD publication that his fair value estimate of the ICE BAML option adjusted spread is 648 basis points, far above the 405 currently on offer. “That qualifies as an extreme overvaluation even if one interprets the Fed’s more recent retreat from its strongly stated intention to tighten rates as an effective reinstitution of quantitative easing.” Reached by Grant’s this afternoon, Fridson added that even supposing a new round of QE, high-yield is overvalued by more than 100 basis points by his analysis .
John Greenwood chief economist for Invesco’s view is that, broadly, we are at mid-cycle, not late cycle. He argues in an interview with macrovoices, I know the cycle has been going on for ten years almost. In fact, in June will be the 10th anniversary of the trough of the last business cycle. So we’ve been expanding for 10 years. And in July this current business cycle expansion will become the longest in recorded US financial history. But, nevertheless, I believe that it has several years to run. And, basically, I think there are three reasons for that.
First, money growth has been low and stable.
Second, private sector leverage in the US remains low, despite some concerns about the nonfinancial corporate sector.
And, thirdly, inflation is not a threat, nor do we face a major financial accident. Those are the two main causes why previous business cycles have come to a premature end.
In my view, if we take a historical analogy, we’re at something like 1995 in the cycle that went from 1991 to 2001, which was the previous longest expansion cycle. So I think we have several years to go because the central bank, the Fed, doesn’t have to take any drastic action at this point. And I don’t believe that there are serious problems in the private sector that will cause a premature end to the expansion.
The
Gauls are on the rampage, The Wall Street Journal reports today. Citing
data from Dealogic, The Journal notes that French corporations have
allocated a post-2008 high of roughly $100 billion to foreign acquisitions in
each of the last two years (equating to roughly 4% of France’s 2018 nominal
GDP) with the United States a particularly attractive target. Eighteen
stateside deals have been consummated by French companies already this year.
That
shopping spree coincides with an increase in France’s corporate debt load, now
at 143% of GDP, up from 116% in 2008 and well above the 74% seen in the U.S.,
per the Bank for International Settlements. The rise in corporate debt comes as
the European Central Bank marks the fifth anniversary of its foray into
negative interest rates, along with the recently-paused corporate bond buying
program which was in place since 2016 and held some €178 billion in assets as
of April 30.
A
spokesperson for drug maker Sanofi S.A., which bought Waltham, Mass.-based
Bioverativ, Inc. for $11.6 billion in March 2018, got to the crux of the
matter, explaining to The Journal: “Obviously, cost of funding is one of
the key elements to take into account for debt-funded deals.”
While
the ECB’s aggressive monetary policy has helped spur corporate consolidation,
underlying economic activity remains turgid. Thus, euro-area core CPI rose to
1.3% year-over-year in April, the highest reading since April 2017 but still
far below the near-2% threshold favored by the central bankers (core CPI growth
has averaged 1% since the ECB pushed the deposit rate below zero).
Meanwhile, the European Commission now forecasts 1.2% real GDP growth this year
in the eurozone, down from a 1.9% guesstimate for 2019 at the end of last
year.
But
hope springs eternal. Over the weekend, ECB governing council member Klaas Knot
said in an interview with Corriere della Sera that “if the economy
continues to rebound. . . then I think we are on course” to reach that 2%
inflation bogey. Knot attributed weak European growth to globalization,
stating: “the only thing that we can do is to keep the pressure up, make sure
the economy continues to perform at high levels of capacity utilization and the
economy continues to print GDP numbers in excess of potential growth.”
Taking no chances, the mandarins are prepared to go back to the well. In an April press conference, soon-to-be-outgoing President Mario Draghi said that the ECB is prepared to “adjust all its instruments” if data aren’t to their liking. More specifically, the Financial Times surmises that “additional measures [designed] to keep the cost of credit cheaper for longer” will be in store if growth and inflation continue to disappoint. Then, too, investors see no policy normalization any time soon. Interest rate futures currently predict 29% odds of a rate cut by year end and virtually no chance of a hike. One month ago, the odds of a rate cut, and rate hike were both between 7% and 8%. Meanwhile, the March 2020 three-month Euribor futures contract has risen to 100.35, suggesting a deposit rate of negative 35 basis points 10 months from now. That compares to 99.88 last spring, when investors were expecting a return to positive rates and the April 6, 2018 edition of Grant’s Interest Rate Observer suggested that call options on this instrument would be a good way to profit from the ongoing financial repression in the eurozone.
March
2020 three-month Euribor futures, one-year chart. Source: The Bloomberg
With
positive nominal interest rates not forthcoming any time soon, Europe’s
financial institutions continue to falter. The Stoxx 600 Banks Index is now
down 25% year-to-date, badly lagging the 5% decline in the broad Stoxx 600
Index. Bank valuations have descended into consignment-type depths, with that
Stoxx gauge now trading at 0.58 times book value, less than half of the 1.23
times book value fetched by the KBW Banks Index in the U.S.
The
travails of Deutsche Bank, A.G., which has seen shares plummet by 93% since
2007 and carries a €43.5 trillion ($48.8 trillion) derivatives book equal to
nearly three times 2018 Eurozone GDP, are front and center. But other
institutions are also attracting unwanted attention. Last week, BlackRock, Inc.
backed out of a deal to rescue Banca Carige S.p.A. (founded in 1483), which the
ECB had placed the Italian lender in administration in January. In response,
Italian deputy prime minster Matteo Salvini told reporters: “It’s an important
bank. Obviously, we won’t let things collapse.”
Don’t blame the ECB, according to governing council
member Benoit Coeuré. Speaking in French parliament last Wednesday, Coeuré
estimated that negative interest rates are costing eurozone banks €8 billion in
annual lost income, which he termed “really peanuts.” Instead of positive
nominal rates, Coeuré offered a familiar solution for the banks’ woes: Industry
consolidation
Rick Ackerman writes…. Unfortunately, two predictable things will now happen. China will face a credit crisis and the dollar will likely strengthen. Dangerous times for all of us. it’s not hard to imagine all the new risks that come with turning off the trade taps (if that is the real agenda). We can’t know for certain of course, but Trump is certainly playing from a position of strength. He picked a fight he is going to win. The charts already say the U.S. trade deficit will start falling, so it’s baked in the cake. An added strategic benefit is that Belt & Road [China’s strategy of building infrastructure to facilitate trade growth with Europe, Asia, Latin America, Africa and the Middle East] will be set back a decade or more. We will see if the Chinese are clever enough to see what just happened and start playing ball, or if pride will be their downfall (I think pride will win out). The problem I see is that China can ill afford to monetize all the debt that has been created. We may be about to enter a critical period of Asian corporate bankruptcies.
It’s a tell-tale sign of someone who doesn’t know what they are talking about. In the realm of global currency systems, anyone who brings up China’s massive stockpile of US Treasury assets inevitably they assign all the power to the Chinese. Xi could destroy Trump if he wanted, bringing down the US in a righteous fit of trade war anger.
Not only is this totally wrong, it is ignorant of history. Recent history. Toward the end of November 2013, out of nowhere a report appeared in Chinese State media which said officials were reconsidering their foreign reserve allocations.
The Year of the Pig in China is quickly becoming the Year of the Pig Disaster. African Swine Fever (ASF), which has been spreading across Eurasia since the late 2000s, has ravaged the Chinese pork industry after it fi rst appeared in the northeastern city of Shenyang last summer. As of late March, according to INTL FCStone’s in-country sources, some 40% of the pig feeding capacity had been destroyed, and insiders on the ground worry there may be no stopping the disease before it decimates the industry. Although ASF poses no threat to human health, it represents a twofold challenge to the global economy. First, pork is far and away the dominant meat source in China. It makes up 3% of the country’s consumer price index and is the number one driver of food infl ation. As the industry declines, it will have farreaching eff ects on the world’s second-largest economy. Second, China’s preference for pork makes it the world’s largest hog consumer, with a market share of 49%. The country is also the largest importer of soybeans, a primary protein source for hog farming. Consequently, the faltering of the Chinese pork industry will reshape global trade in both meat and feed grains.
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