Peak US Exceptionalism?

‘The right thing for the Fed to do is to maximize economic performance. The right thing for the president and Congress to do is to adjust the tax system to make a fairer economy. We should have higher corporate tax rates, full taxation of carried interest and capital gains, close loopholes that allow capital gains to escape taxation, tax penalties on leveraged buybacks and limit corporate interest deductibility.’ Former Treasury Secretary, Larry Summers interviewed recently

The points made in a note entitled ‘Fed Firepower Overwhelms Fundamentals and IB Consensus…’ back in early April are now widely accepted and remain key. Policymakers were attempting to make everyone ‘whole’ on their pandemic losses, from furloughed workers to mismanaged hedge funds and until bond markets stage a mutiny, will continue to do so – there was no point overthinking it. The past couple of months is a reminder that the intuitive notion that markets and economies track together is hugely misleading and gives economists a deluded claim to be able to help (rather than usually hinder) the investment process.

There is almost no correlation between US stock returns and real GDP growth contemporaneously, and it remains modest even a year ahead. Unlike say last summer, when PMI inventory/sales data etc. were giving a lead to a growth reacceleration and risk on signal, in the current situation, there has been little practical gain in poring over diffusion indices – granular data on consumer activity and corporate outlook statements have been more useful guides.

There has been too much ‘the pandemic changes everything’ analysis, but we’ve highlighted the underlying strength in the US economy coming into this crisis e.g. in housing, with its household formation as well as mortgage cost underpinnings. The MBA Purchase Applications Index is another ‘V’, soaring from 180 in April to 325 in June, up 20% y/y, while median home listing prices have jumped from -1% in April to +8% on Redfin data.  Whether the pandemic has boosted per capita housing demand on a sustained basis (urban apartments to suburban houses with dual work from home space) remains to be seen, but regardless Millennials who have married and started families later than previous generations for a variety of reasons (not least student debt) will be buying houses at a faster pace. Starts should rebound strongly in H2, and resurgent lumber prices bear watching as a signal – it would also add support to the copper rally. On Google trends data, new vehicle related search traffic has turned positive y/y for the first time since February, confirmed by the Mannheim used car index rebound since May.

Often the headline numbers have been misleading in any case e.g in relation to US unemployment and the perverse incentives of workers and businesses to game the system. That macro data will become relevant again as the ‘bungee jump’ distortions abate and economies reopen further to confirm or refute investor assumptions on the speed of the potential earnings recovery, as in China right now. The cross asset return expectations distribution curve is still skewed to deflationary outcomes, which looks dangerous as redistribution and reshoring become dominant political themes, against the backdrop of fiscal and monetary policy convergence. Assuming there is no ‘fiscal cliff’ in July and most support measures are extended (adding another 4-5% of GDP in stimulus), bond investors risk a shock by mid-late 2021 if the labour market re-tightens surprisingly fast in a post vaccine world and inflationary pressures accordingly return.

The consensus has capitulated since May on views including that we were likely to see a retest of the March lows, that this was ‘just a bear market rally’, that negative US rates were even a possibility worth discounting etc. The ‘Great Depression’ economic analogues and technicians overlaying 1930 price charts on 2020 ones have been shelved. Aside from the historic scale of global stimulus, three factors have been pivotal to sparking the risk-on frenzy: firstly, the rapid rebound in Chinese industrial activity, reflected in mainland oil, copper and iron ore demand, to feed resurgent infrastructure spending and housing starts. Excavator sales have also jumped in Q2, and the GPS tracked utilisation rate for Komatsu excavators in China has hit the highest since late 2018. Secondly the reduction in Eurozone tail risk via breakthrough debt mutualisation proposals, aggressive German fiscal reflation and expanded ECB peripheral buying and thirdly the unemployment insurance/PPP transfer windfall in the US which has offset the household earned income impact of the lockdown, and exaggerated the scale of the (still severe) employment downturn.

So far, reopening in Europe and Asia is proceeding remarkably well despite inevitable regional/city level clusters, the US clearly less so as sensible public health advice gets politicised and dragged into the culture wars. Consensus expected 2021 EPS is about $164, putting the 2021 forward PER at 20x, versus 18x at the February high – the Fed trillions are surely worth a couple of points of multiple expansion, but now as the data improves, things get more nuanced from a policy perspective. An optimistic forecast at this point might be 2021 EPS of $175 (i.e. the 2020 EPS expectation pre lockdown) but a growing risk for US equities after record outperformance relative to ROW is that the Democrats sweep to power and push through a progressive agenda, from tech regulation to tougher ‘gig economy’ labour legislation.

The partial rollback of the 2017 tax cuts Biden has endorsed would take $20 or so off whatever EPS number you project for next year. The other key issue for relative US performance into next year is belated anti-trust scrutiny of the tech sector. So far, fitful attempts at a pro-cyclical value rotation have faltered on Covid headlines, despite the overextension of tech growth/the quality factor and the risk that we have seen a ‘front loading’ in Q2 of secular online transition trends. At historic EV/sales and FCF multiple software sector valuations, any disappointment would trigger a deep selloff given crowded positioning. Fifty state attorneys general are probing Google’s digital advertising business practices, alongside a similar probe being led by the Department of Justice, which marks the first serious attempt (with bipartisan support) to overhaul anti-trust law and curtail the inherently winner takes all dynamic of web platforms. In the EU, Apple faces new investigations extending from its app download duopoly with Google to NFC payments.

The systematic tax arbitrage of digital IP (notably via Ireland) which has suppressed effective tax rates for US tech (and pharma) over the past decade faces OECD scrutiny and an inevitable move to some form of local revenue based inferred minimum tax. While the Trump administration is willing to risk a transatlantic trade war on the issue, a Biden one seeking multilateral consensus almost certainly won’t. That earnings tailwind would likely drive a rotation out of large cap tech, which dominates most portfolios (including fast growing ESG ones) and has reached a record share of US and global indices. Meanwhile, a successful vaccine this autumn would clearly be a game changer for the economic outlook beyond 2021 and justify a more procyclical, value oriented portfolio stance. Among several promising candidates, Astra Zeneca’s vaccine partnership with the Oxford Jenner Institute and the Gates Foundation bears close watching, which is heading into Phase 3 trials in Brazil and is scaling production capacity to 2bn doses, succeeds this autumn.

We’ll know in September…what will that do, after the astonishing monetary/fiscal stimulus seen globally, to the growth and inflation outlook beyond next year? We would enter a classic end of cycle blow off phase, because the fiscal and capex spending drags which had delayed it are gone – politics now matters more than anything, and tacking inequality and climate change in the wake of the pandemic implies a generational regime shift for asset markets. Rather that worrying about ‘V’ shapes and trying to second guess epidemiologists, the bigger questions right now for asset allocators are whether the US is approaching a peak share of MSCI AC and if we are beginning a shift to a structurally inflationary environment. Both look reasonable bets to us…

Product Cycles Imply Looming PMI Inflection Point…

‘I even think the President has recognized it’s not cost effective to push the tariffs anymore, and if he wants to continue pressure on China, which I think he probably does, I think this would be a good path to pursue. I do think we reached the end of the road with regard to cost-benefit analysis on the tariff side. In fact, I think a lot of the tariffs that have been recently suggested on the last tranches aren’t going to take effect…this is a matter, in my mind, of consumer protection…” Economist Larry Lindsay, former Fed governor and director of the National Economic Council under President GW Bush, speaking recently

In the course of recent client meetings in London and Asia, I’ve reiterated the message contained in the notes since late August  – tariffs had outlived their usefulness for the US as a trade policy tool given the negative feedback via consumer and business.  Even if this ‘phase one’ trade agreement hadn’t been announced, it seemed doubtful the December hike would have been implemented and further US containment measures will likely shift toward technology and capital flow restrictions, with a narrower market impact. China and the US acted in their narrow self-interest and therefore this ‘non-deal’ which has attracted much dismissive comment stands a good chance of surviving to a Trump-Xi photo opportunity in Chile.

As usual, sentiment will follow price action into year end, and extremely defensive positioning is fitfully unwinding and that will accelerate if we see a second derivative improvement in the macro data through year-end. The market has been  braced for more bad news and hugging long duration bonds and their equity expression via quality/low-vol equities as an expensive comfort blanket. In fact, we’ve seen a strong rally over the past six weeks in high global beta, deep cyclical markets from the DAX to KOSPI and Topix. For students of behavioural finance, the next few BoAML institutional surveys will be fascinating to read after the ‘hunkered in the bunker’ fearful tone of recent ones. The dollar index reacted predictably to trade relief,  crucial to EM participating in a wider risk appetite reversal and for the White House is as important as selling more pork and soybeans (even if the FX ‘stability’ aspect of the deal is a theatrical stunt).

To sustain the recent rotation toward cyclical value, we need a rebound in two key industrial sectors we’ve been structurally bearish on since 2016/17 – autos and smartphones. In both cases, a technology shift (diesel to hybrid electric in Europe/Euro 6 equivalent in China, 4 to 5G in mobile) and the rapid rise of a second-hand market in China have dented new sales. Those postponed consumption/extended replacement cycle headwinds are now abating – mainstream German car brands have electrified, and buyers of ICE cars worried about residual values can now choose a VW e-Golf over a Tesla.

Indeed, the Ifo survey of German auto sector confidence is showing signs of stabilisation, while annualised output is also likely bottoming at just over 5m units. Last month, EU demand for new passenger cars increased by 14.5% to 1.2m units – the growth is certainly flattered by a low base following the introduction of a new emissions testing regime last year, but its striking that four of the five major EU markets saw double-digit gains. Over the first nine months of 2019, new car registrations were down 1.6% y/y but that should be turning positive into early 2020 – much of the slump in demand has been due to a technical industry transition creating consumer confusion over residual values etc. Tighter emissions standards have also been a drag in China, which adopted the local equivalent of Euro 6 for ICE engines in June this summer – sales have begun to recover since.

As for smartphones, while 5G handsets are still only about 1% of Chinese sales, with 40 cities fully networked by mid-2020 and operators offering 30-40% discounts on 3000-4500 RMB handsets (taking them closer to 4G prices), that proportion should surge toward double digits through H1. Given this upgrade cycle and flattering base effects, the overall market which has been falling 5% or so y/y in recent months should turn strongly positive by mid-2020. Pre-registrations for 5G service are approaching 10m users, even with just a handful of handsets currently available (although dozens more Chinese designs will be launched by mid next year).

Making China the biggest and fastest 5G deployment is a key technology priority for Beijing, not only for the direct benefits in terms of stimulating the service economy with related new products but the scale economies it affords to then dominate the global market for handset and infrastructure hardware. It’s critical to dig beneath the headlines to understand the role of say weaker semi pricing in the slump in Korean exports by value and the resurgence in the Chinese current account surplus YTD, as much as the role of Boeing’s 737 fiasco in US export/durables data. A semi restocking cycle into Q1 now seems plausible and the divergence between chip equipment names like ASML and the commodity chipmakers in Asia, who have lagged US peers YTD, should close.

Against this backdrop of a nascent cyclical recovery in key global sectors which have been a drag on PMI and trade data, you can be constructive on risk exposure at this point while utterly realistic about the low odds of any comprehensive trade settlement over the next year. The weakness seen in global PMI and other industrial data over the past 12-18mths was as much about a transition in key technology product cycles as it was trade uncertainty…that will be true of any ‘surprise’ rebound in H1 20 also.






ECB Risks Igniting Currency War…

‘We have not had a rules-based international monetary system since President Nixon ended the Bretton Woods agreement in August 1971. Today there are compelling reasons—political, economic, and strategic—for President Trump to initiate the establishment of a new international monetary system. The current monetary regime permits governments to knowingly distort exchange rates under the guise of national monetary autonomy while paying lip service to avoiding trade protectionism. We make America great again by making America’s money great again.’ Fed nominee Judy Shelton making her job pitch via a Cato Institute essay last year

Bond markets have been caught up in aggressive front running of ECB easing, the greater fool theory being practiced on a scale of trillions. The big question now is whether markets are over discounting the impact of Fed/ECB easing in DM sovereign and credit markets – the move in peripheral debt underlines the ‘never mind the price, we can flip it to the ECB’ frenzy. This may be framed in terms of anchoring inflation expectations, but also via FX markets implies using the ECB balance sheet to grab a bigger share of weak global demand. Shelton’s views above that this is a form of de factor competitive devaluation are becoming more mainstream in Washington; it’s ominous that Trump is taking an unhealthy interest in ECB policy in his Twitter feed.

Given the current extremely low absolute level of inflation expectations and rates versus prior QE programs, diminishing returns are inevitable. Similarly, we are approaching a limit (even with tiered deposit rates) on how negative rates can go without the adverse consequences via the banking and insurance/pensions sectors overwhelming any lending or wealth effect impetus. Some central bank researchers (even at the BoJ) have belatedly begun focusing on the ‘reversal rate’ (the policy rate at which accommodative monetary policy becomes contractionary for lending). Christine Lagarde’s beach reading  should include Capitalism Without Capital: The Rise of the Intangible Economy, exploring the dematerializing nature of incremental growth, a key theme in our research.

Traditional economics is focused on managing resources in conditions of scarcity and high fixed costs, when abundance and zero or at least negligible marginal cost models are beginning to predominate. The DGSE models beloved of central banks ignore these huge structural shifts and hence the risk of unintended negative feedback loops. The ECB already faced a tricky technical challenge if it wishes to maintain an orderly, liquid Eurozone bond market. Further QE will involve difficult political trade-offs for EU governments touching on the essence of EMU; the clear danger of a divergence with US monetary policy as a catalyst for a transatlantic political confrontation may reinforce German intransigence.

For instance, buying fewer German and Dutch bonds, where the current 33% limit looms, and more Italian and French would add about €700bn to QE capacity, but the current split is based on capital contributions to the ECB. Changing it implies in the mind of a Berlin taxi driver a transfer from industrious German savers to spendthrift Italians. If the Fed simply delivers a 25bps ‘insurance cut’ In July or September, late cycle dollar resilience into 2020 will become a key risk to US growth, earnings and Trump’s re-election hopes. We’ve seen a concerted effort begin to bully currency ‘manipulators’, with wider EM Asia now (e.g. Vietnam steel tariffs) being dragged into that category. With the USD at its highest in REER terms since 2002, the US trade deficit has grown 6.4% y/y in the first five months of the year.

The Treasury has recently tightened its criteria for assessing possible currency “manipulation” in its latest Foreign Exchange Report. Of course, much of the Chinese deficit with the US is in reality a disguised Korean and Taiwanese one via reprocessing imports of high value components (notably semiconductors from TSMC and Samsung etc.) but as supply chains move out of China the true bilateral trade picture will become more obvious. The number of major US trading partners liable for scrutiny will extend well beyond China to include large current account surplus Asian countries like Thailand and Vietnam as well as Taiwan and Korea.

The Commerce Department has also proposed a regulation that would make currency “undervaluation” a countervailable subsidy, while the Treasury also cut the current account surplus threshold for triggering closer scrutiny from 3 to 2% of GDP. With the US bilateral trade balances reduced to a form of Trumpian national P&L, and the ex-oil deficit at a record, bond markets risk turmoil unless the Fed and ECB policy paths re-converge. If the White House can’t bully the Fed into matching ECB easing as an exercise in FX management, it will likely attempt via trade intervention to limit the extent of that easing.

Germany with (stalling) exports at almost 50% of GDP and domestic content in its US made cars at half Japanese levels is acutely vulnerable – pushing a further 10-20bps off Bund yields hardly justifies the growth shock risk of a full blown transatlantic tariff war. There is now a real danger that consensus hopes for the scale and impact of ECB action are overblown and yields face mean reversion volatility this summer. It may be constrained not only by its likely impotence in terms of boosting inflation expectations but the risk that asset buying proves entirely counterproductive if the US trade focus shifts from China to Europe.  If buying more BTPs implies Americans buying fewer BMWs, Lagarde will need all her famed political skills to keep Germany on board…

Huawei Quarantine Accelerates Tech ‘Balkanization’ Trend

“The three core issues of concern to China are the cancellation of all tariffs, that trade purchases be in line with reality, and that the text of the agreement be revised so as to be more balanced. These issues must be resolved. This trade friction has made us more aware that we have shortcomings in terms of economic structure, quality of development, and core technologies. [We must] enhance the sense of urgency in accelerating indigenous innovation and resolve the bottleneck imposed by insufficient mastery of core technologies. CCP Propaganda Department Commentary on the US confrontation in People’s Daily newspaper last Friday

We have regularly covered the rise of China’s tech sector over the past decade and the complacency in Silicon Valley which has only recently been shattered by Huawei’s threatened dominance of the global 5G rollout. The ‘balkanization’ trend already evident in software ecosystems from messaging to payments will now extend to hardware throughout the supply chain – there will be a China centric physical internet architecture over the next decade centred on Huawei as much as a software one around companies like Alibaba, Tencent and Bytedance with the big ‘neutral’ EM markets like India a key battleground.

In the near term, the notion that China can be quarantined as a technology supplier looks naïve – alternative vendors like Nokia and Ericsson make 5G hardware with Chinese partners in mainland factories for sale globally, leaving their equipment vulnerable to malicious tampering – will they have to relocate production to ‘safe’ locations to sell into the US? If so, the global rollout will be significantly delayed…

Huawei has been rapidly vertically integrating with its own chip making subsidiary, HiSilicon, producing highly advanced 5G designs, albeit fabricated (as for Apple and Google) by TSMC. As a Chinese tech VC contact told me in Shanghai last October, cut China off from TSMC and it would be casus belli like the Japanese oil embargo in 1940. If the US is serious about confronting China’s competitive threat on a sustained basis, it needs to boost government R&D spend on basic science (instead it’s been cut), deepen the capacity of domestic tech supply chains via education investment and targeted tax credits or cutting off broader Chinese access to advanced GPU chips and postgraduate student access to STEM courses at colleges such as MIT and Stanford. Those moves would be expensive and disruptive for the US economy and are still possible future steps if relations become even more antagonistic.

China offers uniquely low (marginal) consumer electronics assembly costs plus high-volume flexibility. You can never replicate the mainland factory dormitory model in the US or even Korea and Taiwan. The increasingly well educated rural migrants filling Foxconn factories are the ultimate ‘on demand’ workforce – manufacturing elsewhere would mean higher assembly costs/decreased flexibility thanks to the constraints of current generation assembly line robotics.

Even with high levels of automation, a fully US assembled iPhone would likely cost about 40% more at the factory gate (with Apple gross margins at ~37%, the current tariffs imply a price rise of about 15% to offset the impact, unless the RMB plunged toward 7.5 versus the USD). For instance, Quanta Computer, the largest laptop maker in the world with clients from Apple to Dell, warned last week that the logistical costs of shifting consumer electronics production out of China could prove as expensive as the tariffs themselves. 

Automation is part of the answer to offshoring from China but changes the business model – assembly by Chinese migrant workers is a marginal cost for a factory owner; robots are a fixed cost, although the assembly of an additional unit has zero marginal costs (excluding overheads like maintenance etc.). New AI software will help but it’s still expensive and time consuming to program factory robots to perform multiple tasks.

The implication of this shift from marginal to fixed costs is that there is a heavy incentive to stick with a specific design: any change requires significant capital investment to update the robotic assembly line – the flexibility of the entire consumer electronics sector will deteriorate, with higher inventories and fixed overheads once it loses China’s unique attributes as a global production base – given wafer thin margins, consumer prices will trend higher even if a face saving deal could avoid further tariffs.

Relocating the supply chain for smartphones or laptops will be hugely disruptive, wherever the destination and it certainly won’t be the US – the much-hyped Foxconn factory to make TV screens in Wisconsin has become a fiasco, despite $4bn in tax breaks and subsidies. The lack of a skilled manufacturing workforce will be a key constraint on US re-shoring, as much as logistics considerations – flying components in from Taiwan/S. Korea to assemble phones in the US makes little sense.

The effort to lobotomise Huawei looks ill thought out and will have generated intense lobbying by the most adversely impacted US suppliers – there will likely be some nuance in the implementation. However, the endgame is now clear and US tech companies will have to mitigate ongoing compliance risks by reducing exposure to Chinese SOEs. We’ve seen a few companies like Go-Pro begin relocation (to Mexico in this case), but this will now accelerate while China will race to become a ‘full stack’ technology power by mastering semiconductor fabrication and an indigenous mobile operating system.

In the case of both Iran and Huawei, the US has unilaterally exercised its global power over international bank payments systems and key technologies like the Android OS to exercise brute force geopolitical leverage – the lesson drawn by many in Europe and Asia is that alternative architectures are now needed. Ultimately, China which remains the only country apart from the US to understand the critical value of ‘platform’ software and is catching up rapidly in AI and quantum computing research, will become an even more formidable competitor to the US tech giants. The Xi 2025 plan, whose ambitions triggered panic in Washington from the Pentagon to Congress, will now be implemented sooner, by any and all means possible.


Google Takes Gaming From Console to Cloud

‘…with EA’s cloud gaming service and Microsoft’s plan to build a streaming, subscription-based service. Faster average broadband speeds mean lower latency is achievable – although graphic-heavy games may require the equivalent of the 5G network rolling out initially in Asia. The EA system uses essentially the same content delivery technology as used by Netflix and it is betting that the technological shifts that upended the music and movie industries are now coming to games, which looks shrewd. The advantage of owning the distribution platform which is the essence of the Tencent/NetEase strategy is clear in the mobile games space…the industry is slowly evolving toward subscription-based cloud gaming – game ownership, whether via disc or download, will become redundant and gaming publishers will boost recurring revenue. Of course, the flipside is that missing out on a key title launch can reverberate through lower earnings trends for several years – the quality of earnings improves for sector winners, but the volatility is higher for losers so sector performance dispersion will rise sharply.’ –  Weekly Insight, September 18th 2018

“Games are no longer episodic consumptive media for most people — they are now really the basis of new massive online communities that are a lot more like social networks in the way that they function and that we invest spend time in them. So much happening in the pattern of consumption of this medium that no one is paying attention to. You can’t put humans in a space like [Fortnite] for that long and not have massive, profound social consequences. We are just not seeing them yet. I’m almost a little bit ashamed as a gamer myself not to have seen just how big this is. This is staggeringly large.” Improbable co-founder Herman Narula interviewed recently

He’s right about the potential for massive multiplayer games to become the ultimate social network, and it behoves every equity portfolio manager to understand how fast this sector is now evolving. I’ve been a secular bull of the global gaming sector as a key play on the dematerialisation of consumption and the rise of the digital ‘metaverse’ in which real money is spent on acquiring virtual utility and status. As immersive technology becomes more sophisticated (particularly as AR/VR becomes practical via edge computing), more and more incremental consumption will shift from tangible ‘stuff’ to virtual experiences.

We remain long a global gaming exposure stock basket which is up almost 20% YTD and the point I made in that note last September was that the video gaming industry, which looks set to become the dominant form of entertainment for under 30s (directly playing, watching on video and other forms of live engagement such as esports), was inevitably set to follow the wider media transition to an on-demand subscription model. The legacy model of creating a hardware platform, such as Sony’s PlayStation and Nintendo’s Switch, and then charging publishers for the right to access it, is now under relentless pressure. The Japanese companies have responded by creating subscription services and offering content other than games, but Google’s push into the industry is a seminal moment. The search giant however not only has to provide a smooth lag-free experience, but also convince key game title publishers to port their content.

As Nintendo prepares to launch two new models of its Switch console (which generates over 80% of total revenue) the risk of annual sales peaking at just under 18m units is growing as the industry undergoes a paradigm shift. As cloud subscription-based streaming goes mainstream, the company’s real value may lie in its well-known game franchises, such as Pokémon licensed to the web giants hungry for content. The US web giants are likely to follow Tencent in vertically integrating to obtain content. The Netflix analogy is relevant – we are set to see a bidding war for game IP and an M&A surge for publishers over the next couple of years.

On its earnings call last month, Sony’s CFO said cloud gaming could pose a threat to PlayStation in the next five years but that the company believed that would take a much longer time horizon – that looks dangerously complacent. Google has set the bar at producing images in ultra-HD (also known as 4K) which is ahead of today’s consoles and at a fast-enough frame rate to make movements appear smooth (Google is matching the 60 frames per second of the latest Xbox and PlayStation consoles). Google’s data centres are among the world’s most powerful – to render images smoothly for Stadia, Google has built optimised new server “blades” that can be slotted into racks in its data centres.

These are embedded with custom-designed GPUs produced by AMD and in terms of raw computing power these generate over 10 teraflops to the individual user versus Microsoft’s Xbox One X at about 6 teraflops (though the next generation of consoles will likely double that). A key technological challenge will be to eliminate the latency, or lag, that can slow the response time when a player presses a button on the game controller. Google claims more than 7,500 nodes on its global computing network, increasing the chance that players will be close enough to see a fast response time but users outside large cities could find themselves many miles from a Google node. The new game controller is connected through Wi-Fi and communicates directly with Google’s data centre, but it will rely on local network operators for the household connection. Google must be betting that its latest video compression algorithms will be able to deliver the seamless quality of service required to be competitive.

Recent progress in this field has been impressive. For instance, Microsoft’s new Project Zipline compression algorithm is fast enough to compress data while it’s being written to an SSD or uploaded from an IoT device and can deliver up to 96% compression of the original data on the Microsoft internal network. The reason it’s so fast and so efficient is that it uses a custom hardware accelerator to look for many times more patterns than compression algorithms can usually handle; data that matches any of those patterns gets replaced by a reference to the pattern, taking up much less space.

The long-term implications for the hardware storage market of this AI pattern recognition/compression software approach are clearly adverse – the optimisation of slack which defines the tech sector is coming to data transmission and storage hardware. Google said it recommends broadband speeds of at least 25mbps to deliver HD images (known as 1080p). Some potential customers won’t have enough bandwidth. It also limits playing games on mobile devices, unless they are connected over Wi-Fi to wired networks. Future upgrades to mobile networks will help, but tellingly Google itself made no mention of the potential of 5G networks, which in the US/Europe won’t go mainstream until the mid-2020s given the gradual planned telco rollout.

As highlighted in that sector note last year, viewing activity on Twitch or Huya offers a useful insight into overall game popularity – watching expert players live-stream on these platforms correlates highly with game download/in app purchase activity. While Fortnite still has the largest number of Twitch channels, its share of viewers have been declining in recent months, down from a peak of 19% to 9%, being displaced the Apex Legends, which accounted for over 20% of viewers after its recent launch before settling at around 6-7% viewership while the PUBG share of viewers has been steady. Apex Legends has had the best launch month of any free-to-play game in history, having generated $92m last month from in-app spending. Fortnite (which is constantly updated) has been impacted, but recently reached over 250m players since launch.

While new game approvals in China have resumed, Tencent has yet to get permission to monetise Fortnite or the mobile version of PUBG. Sales from the Value-Added Services unit, which includes online games and messaging, climbed 9% to 43.7bn RMB but costs surged 43% y/y as investment in content and server financial technology surged. Tencent plans to introduce a new category of sales when it next reports to break down specific categories in the “others” revenue section in its financial statement. Tencent’s one-off costs contributed to a 19 ppt drop in operating margins to 20% but as a result its biggest revenue growth now comes from cloud services, where sales more than doubled last year, to 11% of revenues.

This is a crucial infrastructure investment for Tencent, not just to diversify away from gaming/WeChat revenue dependence but also to create the infrastructure to launch its own cloud gaming system (which is apparently already in beta testing). The web giants will likely demand exclusivity/original publisher content to drive subscription package differentiation as Microsoft, Tencent and Google launch competing cloud platforms within 12-18mths. As elsewhere across the media sector under the impact of streaming, content creators are in the sweet spot…

China Consumption Shifting From Property to Pensions…

One of the biggest issues for global investors over the next 3-5 years is that China may be running out of prospective home buyers as the prime household formation age cohort shrinks, creating a secular slowdown in a sector which directly generates 13-15% of GDP and in its wider spillover impact closer to 22-25%. Consumption in China doesn’t neatly fit the Western ‘life cycle’ model of neoclassical economics (e.g. housing tends to be bought in advance of marriage/household formation and left unfinished and empty until that point) but the structural demographic shift will transform housing demand as much as the shape of monetary and fiscal policy. Beijing’s efforts since 2015 to boost the birth-rate by easing restrictions on family size always looked likely to fail, given the ever-rising costs of child rearing and fertility trends across developed urban Asia.

Japan’s experience in recent decades indicates that when rapid growth begins to slow in an economy with very high corporate and household savings driving fixed investment, demand can prove extremely difficult to manage, particularly when demographic decline sets in simultaneously. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. The tactical stance has been overweight China and AXJ despite still poor earnings and macro momentum but structural growth constraints are becoming binding as rising debt and declining demographics interact to radically change policy trade-offs, while the US is now intent on blocking or at least slowing significantly the technology upgrade path.

The real story behind China’s well documented economic imbalances is not just about structurally weak consumption versus investment as a share of GDP but also a large-scale net transfer of savings from abroad (and particularly the US) to the mainland corporate sector, a process which the White House, with broad bipartisan political support now seems committed to ending, whether a new trade deal is concluded or not. China’s plan to move up the value chain rapidly by ‘acquiring’ foreign IP to boost productivity as the workforce and investment intensity declines will now be much harder to achieve, even if it doesn’t in the worst case lose access to advanced semiconductor imports.

The country has an ongoing growth tailwind from urbanization (currently at 59% on official data, but by global standards likely 5-6 points higher), a remarkably advanced digital economy and payment systems, first world transport infrastructure in and between the major cities (and soon communication via 5G), and a growing number of globally competitive companies in mid-tech industrial and consumer markets. However, its economic dynamism will face a growing demographic drag as resource are diverted (whether public or private) to fund rising healthcare and pension costs.

Births last year dropped by 2m to 15.2m, and the median age will reach 48 by 2050, or about 10 years older than the US now. The total number of working-age adults (aged 16-59) fell by 0.44 % to just over 897m while the growth in the pool of rural migrant workers fell sharply, rising just 0.6% to 288m, down from 1.7% in 2017. The national old-age dependency ratio is already at 15%, and twice that in some depopulating peripheral provinces. The population on official data grew by 5.3m last year or 0.38% and Beijing has estimated that China’s population won’t peak until 2029 at around 1.44bn, but some demographers believe that tipping point has already arrived.

The ‘extensive’ growth model of adding more workers and capital becomes untenable as demographic decline starts. So too is the highly expansionary monetary policy that saw the PBoC balance sheet and M2/GDP ratio explode. That never generated much consumer inflation, as it was largely sterilised via housing which absorbed excess migrant labour and industrial capacity as a concrete inflation sink isn’t sustainable much longer. At the same time, the sterilisation of exporter dollar earnings and build-up of net foreign assets on the PBoC balance sheet and Treasury buying by SAFE is also winding down, as FX reserve growth peaks peak.

US demands to eliminate the bilateral deficit simply hasten the existing trend toward a current account deficit. Whatever the exact demographic glidepath, China is going to have to employ its human capital much more efficiently over the next couple of decades and refocus on intensive, productivity led growth. Global investors are going to have to adjust to the perpetual motion machine that drove global capital flows from the late 1990s not just stalling but going into reverse i.e. China will likely become a substantial net portfolio capital importer over the next decade, as it needs to fund soaring fiscal deficits, just as aging households begin running down savings…

With 12% more males than females in the 15-29 age cohort, having an apartment boosts prospects for marriage, and that factor as well as migrants buying properties to retire to in their home provinces helps explain much of the 45-50m ‘empty’ apartments that generate scare headlines. In China, housing has taken on the role of a ‘dowry’ for male offspring that gold has traditionally for female ones in India, but the 34m overall male surplus will rise and create a growing pool of involuntarily unmarried men (so-called “bare branches”). The home ownership rate among young Chinese households is consequently very high, thanks to help from parents who in a major city will have built up huge housing equity. Demographics will clearly begin to impact this cultural support for real estate, as the number of 20something males enters steep decline.

The 20-29 age cohort, the main source of new demand for housing, will have declined by about 80m by the mid-2020s from its peak in 2012/13 and the proportionate decline is similar for the teenage cohort behind them, slowing pre-emptive parental demand. A rising divorce rate and proportion of never married (in the case of many males, not by choice but economic circumstance) will offer some support to housing demand, but alongside a dramatic slowdown in migration, the overall fundamental demand picture will deteriorate materially.

Pension coverage is now relatively high for a country at China’s income level but the income generating assets to fund defined benefits are hugely inadequate and this is where boosting private assets and returns becomes critical to maintaining systemic solvency. The pension funding deficit covered by central government is likely to reach over $150bn annually by next year. Deeper capital markets (including ultimately access by foreign mutual funds with local distribution partners) supported by pension savings inflows are a key part of the wider reform agenda. Current contribution rates for state/SOE pensions are far too low; private pensions and employer annuities (i.e. the addressable market for the insurers) are just over a quarter of total assets with the basic pension/national social security fund comprising the balance.

That ratio will gradually shift over the next decade in favour of private assets – the public pension system’s 43% replacement rate (ratio of annual benefits to final salary) implies a significant cash flow deficit will open up that could amount to over $1.5trn within a decade. Insurers will be a key part of the funding solution – weak capital markets and regulatory changes slowing premium growth have been a drag but they remain a key China exposure as inadequate social provision, from healthcare to pensions, is funded directly by individuals.

Total pension assets are just over 10% of GDP compared to 35% in Korea and HK. Assets will have to grow dramatically over the next decade to close the funding gap and the private share of total pension assets (currently sub 30%) will become dominant. Beijing already has the fallout from local government deleveraging and SOE restructuring to absorb which will see central government debt/GDP double to 70-80% over the next 3-5 years from the currently reported 37% – bailing out the pension system as well simply isn’t realistic. Assets managed by Chinese insurers have already reached over $2.6trn, even as new policy premium sales have slowed since 2016.   Solvency rules are now closer to international norms – capital requirements had been based on simple metrics of size but will now vary in line with how quickly policies turn over and how premiums are invested. Firms that rely excessively on short duration policies or invest heavily in equities must hold a much bigger capital cushion.

The slide in bond yields and A-shares has inevitably hit investment returns (as evidenced by the recent China Life profit warning), but offsetting this is an improving competitive landscape. The restrictions on wealth management product issuance (bank WMPs were offering yields of about 5.4% a year ago versus an average guaranteed rate offered by universal insurance products 30-70 bps lower) has seen retail investors return to insurers. Even with foreign firms likely to grow their share from the current low 5% base as the market opens, investors seem too bearish on life insurer growth prospects, with the key stocks on sub 1x price to embedded value multiples. As with education, investors in the asset gathering/private pension theme have to see through regulatory volatility to focus on the secular tailwind for revenue growth.

‘Peak Smartphone’ Slams Tech Hardware

‘…we are reaching ‘peak smartphone’ and the upgrade cycle is lengthening as new features prove less than compelling – the mobile app landscape has certainly become stagnant. Heavy discounting of the Samsung S8 ($150 plus) is apparent already in the US and the recent profit warning by the UK’s largest phone retailer highlighted a consumer behavioural shift. While the hype cycle will intensify ahead of this month’s launch of a premium advanced OLED screen model with facial recognition security, if the queues outside Apple shops for the new iPhones prove surprisingly short (or short lived), watch out below.’ Weekly Insight, September 6th, 2017

‘The ‘Peak Smartphone’ theme justified an underweight stance back in Q4 across the most heavily exposure Asian supply chain stocks, with DDR4 DRAM prices down about 20% from its January peak and NAND flash down a third. Many DRAM bulls put premature faith in AI and AVs as incremental demand drivers, certainly valid medium term, but not on a scale to offset smartphone/PV weakness this year while for chip makers the end of the crypto mining frenzy is starting to impact. TSMC said this week that sales will rise by only a ‘high single-digit’ percentage in USD terms, down from a previous (reduced) projection of 10%.’ Weekly Insight, July 20th 2018

The smartphone saturation risk we covered over a year ago has gone mainstream and rippled through the global hardware supply chain, with NAND flash prices crashing this year, DRAM also now peaking while production volumes for premium new phone models have disappointed across the sector. It’s hard to believe that most tech analysts missed this pretty obvious inflection point, when even the IMF noticed the industry had topped out as an Asian growth driver (smartphone shipments were about a sixth of global trade growth last year), but mindless extrapolation of the prevailing trend remains the default setting of bottom up analysts.

Smartphones have seen little innovation beyond camera quality and biometric security since 2016; the lack of compelling new hardware features (or new apps requiring them), and the growing ‘digital detox’ trend as awareness of the adverse productivity impact of notification addiction rises have both dragged on demand growth. Tighter network upgrade policies as well as limited ‘must have’ innovation have seen US and European consumers replacing phones every 2.5 plus years, a rise of 7-8 months since early 2016.

As we highlighted a year ago, the refurbished market has seen explosive growth and was the fastest growth segment last year, reaching over 140m units and is still growing at a mid-late teens pace. Three-year old ‘as new’ iPhones and Samsungs have been flooding emerging markets at typically a third of the price but nearly all the functionality of new. The weak outlook was confirmed by several Apple suppliers this week including Lumentum, Japan Display and UK chipmaker IQE this week – Apple as a ’luxury’ tech brand has finally succumbed to wider sector dynamics, although higher ASPs and the shift to services mean that the component supply chain takes a bigger hit.

Until 5G rolls out at scale from 2020 (and compelling new use cases beyond watching Netflix on the move have yet to appear), it’s hard to see the wireless sector regaining much impetus. While Samsung and Huawei plan foldable screen launches next year, initial volumes are likely to be modest at a price point above $1,000. Valuations now certainly look far more reasonable and expectations more realistic, but the downgrade cycle looks set to run into Q1 19. Our view remains to focus exposure  on stocks with high exposure to the nascent autonomous vehicle/automation sensor and emerging consumer segments such as smart speakers.

However, there will be an opportunity in the 5G rollout in niche areas such as high-end optical chips/dark fibre as well as smart antennae. Chinese producers will have a head start and gain critical mass, as the country embarks on the telecom equivalent of the hugely impressive high-speed rail network, which I used several times on a research visit last month. There will certainly be opportunities in China for specialist foreign vendors like Nokia, but the ‘full strength’ 5G being implemented via a new national core network is a critical component in the effort to drive domestic suppliers up the hardware value chain, in both phones and wireless infrastructure.

As EM Bulls Capitulate, Is Shale Oil Next?

‘The rise in offshore leverage across EM since 2009 has been broad, although focused in some markets in the banking system (e.g. Turkey where the loan to deposit ratio has reached 120%) and in others non-financial corporate. There is certainly no immediate prospect of a rerun of the 1982 Mexican or 1997 Asian crisis but the IB “buy the dip, this time is different” mantra looks as misplaced as their blind panic on the asset class in early 2016 deflation scare. When it comes to analyst group think, this time is never different…’ May 18th 2018 blog post

The views expressed back then and indeed since late 2017 have been vindicated by the relentless selloff across EM assets since, led by FX and the most crowded equity longs like Tencent –  the consensus has now reversed decisively to being bullish USD and bearish EM.  The Trump agenda was essentially to grab growth from the rest of the world and bring it home, thus delaying the potential end of US geopolitical dominance, and that is in GDP and equity market performance terms being achieved. We highlighted coming into this year the potentially toxic combination of a simultaneous USD and oil rally for vulnerable twin deficit emerging markets, notably Turkey, which has seen its oil import bill soar to 2008 levels.

EM FX correlations have risen sharply this year, but as with EM government and corporate bond yields still sit below the highs of early 2016 when the China deflation scare was at its peak. On a real effective terms of trade basis, several EM currencies now look cheap (including the TRY, BRL and ZAR) and corporate spreads are back at more ‘normal’ historical levels versus US high yield. There is certainly a risk of a further rise in correlations amid forced selling by investors if the IMF can’t effectively backstop Argentina and/or Turkey fails to adopt more orthodox monetary policies. However, we’re turning more constructive – we recently closed our DXY long and industrial metals tactical short positions from Q1. While the latest US employment and PMI data remains strong, the extreme divergence between US and Europe/EM relative economic momentum looks set to close in coming months.

One factor to watch closely is US shale oil, where there is growing evidence that we have seen an inflection point this summer for capex and production growth momentum, with Q4 outlook downgrades across the oil service sector. A reversal will have a high multiplier effect across the real economy and would likely shrink the WTI-Brent discount and squeeze US refining margins/utilisation rates lower while underpinning our $90/bl Brent crude price target into H1 19. While logistical congestion in the Permian is a factor, we’ve long argued that analysts are underestimating the risk that shale productivity is approaching a secular peak at a time when the sector is belatedly being forced by investors to generate positive free cash flow. In that scenario, assumed US production growth of about 1.5m bpd annually through 2020 will fall far short of expectations. This may well be the next overwhelming market consensus to crumble, with wide ranging macro implications…

Oil and USD Rallies Shake EM…

The oil rally reflects the fundamental tightening we were writing about since late Q2. Crude futures moving into backwardation last summer saw oil tanker storage turn uneconomic and the popular ‘glut’ narrative which saw several high profile bank analysts predict $40-45/bl Brent this year is now shifting…keeping 1.2 mb/d (plus nearly 0.6 m bpd from non-OPEC) offline for another year could push the market into a deficit situation, leading to accelerated inventory drawdowns and prices heading to the $80-90/bl range in H1 19. That’s a scenario worth stress testing in portfolios…’  4th January 2018 blog post

The macro outlook described back in December was for an asset allocation environment of rising rates, oil and the USD – the dollar rally took a long time to arrive, but JPM’s emerging market currency index has tumbled to its lowest level since early 2017. We’re seeing an unusual divergence between the declining broad EM USD carry index versus rising broad commodity indices, with which it usually correlates positively – that will have blown up a few hedge fund macro books.

That anomaly is partly because energy has dominated the commodity rally YTD and diverged from industrial metals impacted by slower Chinese credit/fixed investment (indeed short metals versus energy was one of our December resource trades) and US shale capturing some of the windfall from higher oil prices. We downgraded our view on EM equities to neutral coming into 2018, having been overweight since Q1 16. Arguing for the ‘cheapness’ of EM equities by looking at price to book or PER discounts to DM is simplistic; on an EV/Sales versus operating margin basis, the picture is far more nuanced across the EM universe with Asia looking most compelling, albeit distorted by IT where H2 earnings are now being broadly downgraded. Indeed, Asian tech was one of the most crowded bets cross global portfolios in Q4 an hasn’t delivered, while overall MSCI EM earnings momentum on a three-month rolling aggregated net analyst revision basis is now negative, as indeed is European.

Our view was that a growing divergence between Chinese growth and US inflation (and rates) momentum would become a key portfolio factor as dollar liquidity peaked and ebbed.  On that basis, the consensus long EM and euro trades looked vulnerable to sudden reversal, and indeed popular  carry trades have become lossmakers over the past month as the first signs of an offshore dollar funding squeeze emerge. For the euro, 2-year yield and relative macro data  differentials versus the US suddenly matter again and positioning remains very vulnerable to a further selloff, even if Italy’s new populist coalition avoids further antagonising Germany with ECB write-off talk.

We’ve been long DXY as well as global oil equities in our tactical portfolio, although the crude rally is now extended, with Brent at our year-end target and discounting immediate geopolitical risks. We noted bearish cognitive bias as a factor back in the January post, but the growing number of $100 forecasts from the same IB analysts calling for $40 a year ago reflects the career incentive to herd and momentum chase.

If Q1 was a dollar inflection point and DXY is headed for 100 plus alongside crude in the $70-80 range and 10-year yields sustaining a move above 3%, EM will be a net loser as QE morphs into QT through H2 at a time when import bills surge for twin deficit countries like India and Indonesia after recent FX weakness. The pressure to curtail current account deficits/domestic demand will intensify as funding tightens while more aggressive FX intervention running down official reserves  and pressure to hike rates (as in Indonesia this week)  will become widespread policy responses over the next few months – it’s hard to see even Turkey resisting for long more.

The rise in offshore leverage across EM since 2009 has been broad, although focused in some markets in the banking system (e.g. Turkey where the loan to deposit ratio has reached 120%) and in others the non-financial corporate. There is certainly no immediate prospect of a rerun of the 1982 Mexican or 1997 Asian crisis but the IB “buy the dip, this time is different” mantra looks as misplaced as their blind panic on the asset class in early 2016 deflation scare. When it comes to analyst groupthink, this time is never different…



Facebook Debacle to Accelerate ‘Self-Sovereign’ Privacy Innovation?

We highlighted coming into 2018 that investors faced an inflection point in the ‘zeitgeist’ for US web stocks, which have been engaged in a form of classic rent seeking and regulatory arbitrage as they built natural monopolies in which the user is the product. We have been secular bulls on global tech over the past few years (although broadly preferring the Chinese to US internet names since 2015 on more diversified business models) but the blind faith of some portfolio managers I’ve met this year has seemed almost cult like. At one meeting last month, an investor whose biggest single holding (in a value fund) was Facebook informed me after an hour of debate that Zuckerberg was a business genius who would prove our bearish thesis wrong, end of.

Perhaps, but he’ll have to do better than the self-servingly sanctimonious ‘building a community’ mantra to restore user and more advertiser faith. Of course, even if revenue growth and margins now almost certainly disappoint, Facebook is at least highly solvent and cash generative. Tesla isn’t without a significant capital infusion by end summer and is still struggling to scale up manufacturing, as evidenced by the disastrous Model 3 launch. The last car so badly built in the factory that it had to be effectively reassembled by dealers was the Soviet Lada, exported to Europe to earn hard currency in the 1980s. At least the Russians could knock out (literally) serious volumes.

Our tactical portfolio has recently been short the US web names, even as tech-focused stock funds have attracted net inflows equivalent to half of those seen in all of 2017. The almost viral, social media inspired retail frenzy that infected crypto in Q4 moved on a handful of leading tech names despite extended valuations priced for execution perfection. Just as belated regulatory action has slammed the crypto sector, so it will for several leading web names. The end of crypto and ICOs as an advertising revenue stream for Google/Facebook is a risk to H2 numbers as it will be for the GPU chip names as coin mining approaches marginal profitability.

There is no question that companies such as Microsoft retain strong earnings momentum (and Microsoft’s ‘software as a service’ reinvention via Office 365 cloud subscriptions etc. has been mirrored by many other legacy software names such as  Adobe). There are plenty of attractive themes in tech but the vulnerable areas to an investor exodus are those with unsustainable business models. and extreme positioning. It’s now widely accepted that ‘weaponized AI’ was used to micro-target voter groups based on interpolating preferences from their social media activity in both the US Presidential and Brexit votes, but intrusive data trawling looks far more widespread than yet realized, including via Android phone records.

I’ve compared social media in research notes to digital nicotine or casino gaming, with the adverse addictive fallout only now becoming apparent. However questionable ethically, until now this activity has remarkably remained almost wholly unregulated. Indeed, the same psychological design features that casinos use in slot rooms to maximize ‘time on device’ and engagement are embedded in multiplayer games, Facebook timelines etc. As that view of the negative externalities becomes widespread, ESG investors will likely begin reducing exposure.

Just the threat of regulation will drive up compliance costs which will be a medium-term earnings growth drag (the employment of thousands of outsourced ‘screeners’ over the past few months checking for offensive content to appease advertisers is just the start). The aggregation effects that fuelled social media/search and e-commerce platforms drive natural oligopolies if not monopolies, albeit with market power difficult to identify within a classic consumer welfare anti-trust framework.

Facebook was misunderstood in the sense that it was an inherently weak business model than the consensus believed in just how much relevant user data it could collect directly for advertisers. Unlike say Google, that forced it to rely on elaborate inference to discover user tastes and needs. It had to collect, share and ‘harvest’ as much behavioural and relationship related user data as possible beyond its own network via its Graph API partnerships until 2015. Most users when they agree via a single click to the complex disclaimers on apps simply can’t understand the implications of the agreements they are entering into and as with sectors from banks to airlines, consumer protections will now gradually be legislated, with the EU’s GDPR rules from May the first step.

With personal data privacy now becoming a priority for many, ‘self-sovereign identity’ systems are emerging to make it easier to take back control. These imply that individuals control the data elements that form the basis of their digital identities, not unaccountable private companies. This digital equivalent of a wallet contains verified pieces of our identities (passport, biometric etc.) which we can then choose to share with third-party apps and sites on a selective basis. This type of online identity uses standard key cryptography,  enabling a user with a private key to share information with recipients who can access the encrypted data with a corresponding public key.

By allowing individuals to control their online reputation and privacy, self-sovereign identity may ultimately become the most valuable and widespread blockchain application and would make it much harder for data hackers (or harvesters) to access sufficient data to interpolate income level, political beliefs etc. That would erode the business model of the ‘Apex Server’ web giants, but for software companies not based on stockpiling user data, decentralized identity should be a boon for customer acquisition and management.

In a recent blog post, Microsoft announced that it would start supporting decentralised identification technology within its existing verification application. Apple is also likely to take advantage of Facebook’s humiliation with a privacy focused product – its iOS phones have been immune to Facebook’s trawling of SMS and call records on Android devices for close contacts on the social network. Indeed, tech investors need to start thinking of data privacy winners and losers across the sector in a regime shift for the Silicon Valley ‘consumer as the product’ advertising led revenue paradigm.