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…

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…

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.

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…

‘Volatility Volcano’ Erupts…

Changes in the real Fed funds rate have historically led realised equity volatility by about two years, due to the lags between official rate moves and risk-taking (the Fed started hiking in December 2015, albeit at a glacial pace). Low realized volatility feeding into quant based theoretical models has always fuelled the intellectual hubris of finance PhDs (think LTCM etc.) and ultimately proved toxic. The pre-crisis period shows that misplaced correlation assumptions can lead to a far more benign assessment of overall asset risk than is prudent.’  Weekly Insight ‘Sitting on the Volatility Volcano…’ Oct 12th 2017

‘That issue of deteriorating market depth and the proliferation of highly correlated factor based strategies which are de facto short volatility/long equity beta (including long duration corporate credit as an equity proxy) will become a big story next year…the value at risk models are in this sustained low realized volatility environment at maximum exposure to (particularly US) equities. A shock to consensus positioning, be it from inflation, policy or politics could see an ‘air pocket’ liquidity event. Overall, it looks wise to look for ways to trade against to trade the prevailing bias that growth, inflation and interest rates are anchored permanently lower.’ Weekly Insight, 18th December 2017

Our view coming into 2017 was that market structure rather than macro was the biggest risk and to prepare for both higher rates and volatility. That meant underweighting rate duration, being long equity reflation winners and finding volatility hedges. The importance of this selloff is to signal a shift to more nuanced risk appetite after the simplistic ‘melt up’ hype. As highlighted in those Q4 notes referencing the ominous LTCM precedent, the quant/factor investing boom was vulnerable to a paradigm shift in its input variables. While the financial engineers tinkering with factor models suffer a reality check, it’s unlikely that the multi-year bull market is over with earnings growth momentum still accelerating in many markets. Most systematic momentum following funds which soared in January are now down YTD, but given limited leverage overall, this doesn’t look a systemic event like LTCM threatened to become.

However, the role of ultra-low interest rates as a discounting mechanism and low realised volatility as a driver of equity appetite for factor-based strategies such as risk parity has belatedly come into focus for the consensus. If Q1 16 was about investors stress testing portfolios for deflation risks, this time the adjustment is to a higher risk-free discount rate; the 2-year bond overtaking the S&P dividend yield last month was a cautionary signal. When we initiated a VIX long in our tactical portfolio in October, it was one of the most glaring anomalies across markets and generated a 2.6x return when we took profits in this week’s panic.

The length of this correction will be determined by whether a ‘buy the dip’ mentality prevails among an influx of new Millennial investors evident in recent statements from online brokers like TD Ameritrade, as much as whether 10-yr yields will top out at 3% term. It’s unclear if some have been buying stocks on their credit cards, as they clearly were crypto coins in Q4 according to MasterCard’s latest results call (and watch for a spike in card delinquencies in Q2).

The rise in long-term US rates so far is less about Fed policy or inflation expectations as it is a looser fiscal stance. As highlighted in that December note, the supply of US bonds will rise sharply this year at the same moment that demand potentially ebbs as real economy demand for capital in Europe/EM rises. Meanwhile, the Fed will buy $420bn fewer Treasuries than it did in 2017 and in 2019 will reduce purchases by another $600bn. It certainly helps that the ECB and Bank of Japan will be buying nearly all local sovereign issuance and the jump in yields may encourage some active multi-asset managers to re-weight fixed income over equities, as well as the automatic risk-parity rebalancing.

Exposure to key secular themes such as autonomous vehicles/robots, the shift to ‘biological software’ in the drug industry etc. should be opportunistically accumulated into weakness. Earnings momentum globally remains strong;  the scale of guidance upgrades in Japan which has a dominant position in several emerging technology supply chains such as Lidar, vision sensors, monoclonal antibodies and EV batteries should offer support once markets settle. Meanwhile, active investors can take some comfort from the humiliation of the quants whose share of the market has risen to unhealthy and potentially destabilising levels.


Easy Money Made in Tech?

The simplistic ‘Trumpflation’ trade has now almost fully reversed as expected in December when we suggested a non-consensus overweight in global tech, with the USD back at pre-election levels mid surreal chaos at the White House. The growing dysfunction in Washington has been offset by the broadly positive tone to Q1 corporate results as well as political tail risks in Europe receding until the Italian election next year – global earnings momentum continues to be led by Europe, Japan and HK/China while India was the weakest major market yet again in April and its re-rating looks unjustified.

Since late Q4, we’ve seen a steady value into growth rotation, as tech has become the biggest global overweight bet on institutional positioning surveys (notably in EM where active fund tech allocations have now overtaken financials) followed by banks (notably Eurozone, which have substantially outperformed US YTD) while defensives  are being shunned.

Tech has now become a momentum trade, although parallels to 1999/2000 are (with a handful of exceptions) unjustified, in that rising earnings expectations have broadly underpinned soaring stock prices as nearly every leading global web and hardware name has beaten (rising) consensus expectations, from Nvidia to Tencent. Investors and sell side analysts back in Q4 underestimated scale/aggregation effects for the global internet names and the strength of the demand/pricing environment for semiconductors, and underweight funds have had to close bearish bets.

A longstanding theme is that we’re seeing an explosion in tech innovation driven by ever cheaper data collection/analysis and that aggregate market earnings power will increasingly concentrate in this sector. That’s reflected in the S&P 500 IT sector forward margin on consensus IBES data reaching more than double that of rest of the market (9.7% vs. over 20%). From the 2009 trough at about 9%, the IT sector has seen a spectacular level of margin expansion, as well as revenue growth (over 10% forecast this year vs. 3.5% ex IT).

US equity margins ex IT remain well below pre-crisis trend and the tech weighting now at 22% as much as relative risk asset inflows explains much of US equity outperformance in recent years versus Europe/Japan. Nonetheless, the overall tech sector has moved from a consensus underweight to overweight since December while the risk of a deeper than expected Chinese slowdown in H2 amid signs that pricing in more commodity chip markets like DRAM is now peaking suggest it’s time to be much more selective. The growing popular pushback against perceived monopolistic Silicon Valley economic ‘rent seeking’ and corporate tax arbitrage is also becoming a medium-term risk.

The tech smartphone supply chain in Taiwan has seen a notable recent deterioration in analyst estimates, dragging the overall index revisions ratio negative. I’d expect memory chip names to see similar downgrades this month and next. The easy money has been made in the overweight Asian tech hardware trade which was a suggested allocation in Q4 and we would now be taking profits and reallocating toward unloved energy and rate sensitives.

Contrarian Bets Pay Off in Q1…

‘Wall Street has projected its wildest fantasies onto the largely blank canvas Trump provided, but this is politics reinvented as performance art. As the lack of policy coherence or even consistency becomes painfully clear, investors risk a degree of buyer’s remorse. Many of the key policy suggestions look contradictory, such as the border adjusted corporate tax system and its impact on boosting the already ‘too strong’ USD or the proposed tax cuts… political gridlock is now a risk if he also splits the Republican Party with what is fast looking more like a Silvio Berlusconi than Reagan style administration.’ Weekly Insight, 23rd Jan 2017

A key theme since December was that the consensus assumption of a rampant USD,  10-yr Treasury yields testing 3% and accelerating US growth looked as misguided as the deflation panic a year ago. The implosion of what we termed a month ago as the ‘incoherent mess’ healthcare proposal occurred during our recent Asian roadshow, further shaking complacency. The overweight bet in EM equities paid off, with a 13% return the best quarter in five years while a resumption of carry trade inflows boosted EM FX to its second-best quarter led by the 11% Mexican Peso rally (18% from its January low), distilling the broader Trump reassessment across markets.

Global growth has outperformed value as expected and our preference for North Asian cyclical exposure (notably tech) has been justified – Korean exports surged almost 14% last month led by semis while Samsung is one of several regional tech names hitting new highs. Chinese and European demand rather than US has been the key upside driver for Asian trade this year. India’s rally has been surprisingly strong and driven further multiple expansion on a surge in domestic mutual fund inflows YTD, but the credit and earnings growth backdrop remains very weak. Reflecting the rapid shift in sentiment, on IIF data net capital flows to EM were positive last month, with China seeing the first  inflow since 2014.

With the yield curve flattening again, US banks have now joined the reversal of crowded post-election consensus trades. The hope that feuding Republicans factions can now regroup and move swiftly on tax and regulatory reform looks optimistic – the CBO projected $839bn in savings on Medicaid spending over a decade as 14m beneficiaries were removed, a key offset for deep corporate tax cuts. The border adjustment tax was meant to be a revenue windfall to cut the headline rate, but is already mired in Congressional wrangling and the conservative Freedom Caucus looks set for a war of attrition ahead of next year’s mid-term elections.

The Washington swamp has drained Trump, whose ignorance of even basic policy details and lack of a core political base in Congress were always obvious weaknesses which will have to be addressed but this is not a man with any experience in building coalitions. Before tax reform can even be discussed seriously, the highly controversial budget has to be passed, with many Senators angry as brutal cuts to key departments and basic scientific research budgets. Our view remains that tax cuts will be both more modest and later than most expect.

With the dollar index testing four month lows, we have taken profits on the tactical short on USDJPY and the FTSE 350 mining sector, which has corrected with the sharp iron ore reversal. In contrast to further upside (particularly for surprises in Europe, recent US data looks soft. That ranges from the slump in gasoline and supermarket food sales (both branded and generic) to a broad downturn in bank credit growth.

With investment banks belatedly noticing the divergence between ‘soft’ survey and hard reported data, consensus inflation and growth expectations look vulnerable for H2. We’ve been highlighting rising stress in the auto loan market since Q4 and the auto market bears close watching in Q2 for deterioration in sales volumes, loan delinquencies and residual values.  New vehicle incentives are reaching new highs at about $3500 per unit while second hand values are now falling at an almost 8% y/y pace, as subprime repossessions spike after a 5% decline in 2016.

These signs of underlying US consumer weakness will be key to Q2 asset allocation, as will be the risk of China tightening policy more broadly to slow a still booming housing market. For the US consumer, while belated IRS tax refunds will help, the shock of absorbing 20% plus hikes in healthcare insurance costs will squeeze discretionary spending across low income households in H2. Growth is more likely to slow to about 1.5% rather than accelerate and we remain underweight US ex tech versus EM and Europe.

There are signs that the recessionary style freefall in gasoline demand is now abating, which drove US inventories to a record in February and has been a bigger factor in the crude selloff than shale output rebounding. If we see an OPEC output cap extension, as seems likely give the Saudi desperation to get the Aramco deal away next year, a bullish stance on energy should pay off and we’re now adding long global oil E&P exposure to the tactical portfolio. Downside on that trade would require  US gasoline sales to sustain the remarkably weak trend seen in Q1, in which case the wider economy is heading for a much deeper slowdown and the 10-year is more likely to test 2 than 3% by mid-year…

Tech Growth Rebounds as USD Reverses

“This year has been about deep value mean reversion, but next should see underlying secular growth themes reassert…” –  Weekly Insight, 5th December 2016

‘Poker has been one of the hardest games for AI to crack, because you see only partial information about the game state. There is no single optimal move. Instead, an AI player has to randomize its actions to make opponents uncertain when it is bluffing…’ Andrew Ng, chief scientist at Baidu

Having been tactically overweight value (resources and industrial cyclicals) all of last year, we suggested in December that the post US election selloff in global tech as investors belatedly rushed to make reflation bets looked like an attractive contrarian opportunity. Since then both Chinese and US large cap tech names have outperformed from Alibaba to Facebook, with even Tesla enjoying a sharp rally. The overwhelming consensus expected a rampant USD, but this wasn’t consistent with the Trump trade agenda – the dollar index has had its worst January in over a decade. We remain tactically long EM local currency debt and short USDJPY but have now closed the long Japan exporter position for a 24% gain – Japan is still well represented in our long industrial automation and Embedded Intelligence sensor stock baskets. The dollar selloff has certainly helped the US tech sector given its high overseas exposure, but superior earnings momentum/visibility remains the key support, underpinned by broadly above expectations Q4 results.

At 22x earnings, the S&P 500 premium rating looks reasonable given a series of multi-year product cycles – the shift to cloud computing, rapid progress in AI/machine learning and a steady rollout of internet of things sensors as well as augmented/virtual reality offer sequential and overlapping growth drivers through end decade. The latest results from Microsoft, Intel and Alphabet indicated that cloud computing is the most significant near-term driver of growth while the recent CES hardware event in Las Vegas was dominated by new AI applications.

Meantime, a key theme remains that portfolio diversification will increasingly be embedded within 15-20 tech ‘conglomerates’ as they disrupt adjacent legacy sectors with lagging productivity.  Amazon and Uber have both recently expanded into ocean freight and trucking logistics respectively. The key advantage these tech groups have is their ability to optimize slack capacity and automate scheduling via superior data algorithms. The latest developments in ‘reinforcement learning’ AI are remarkable, notably the Libratus program which has exceeded the much hyped achievement of Google’s AlphaGo by mastering the most complex form of poker. It learned the game from scratch using an algorithm called counterfactual regret minimization (which sounds like it might prove useful to many investors).

By playing at random initially, over several months of iterative ‘training’ (involving several trillion hands of poker) it reached a level where it could outwit elite human players by predicting their moves, playing a much wider range of bets and randomizing these bets  – all without ever first being given the rules of the game. As we have long highlighted, the real long-term shareholder value in technology investing is in the layers of proprietary software that bind networks together and aggregate their data flow. The rapid progress in the models used for AI application development and associated processing hardware amplifies the scale of that opportunity (and also boosts the value of niche hardware sensor makers collecting the newly valuable data).

It seems inevitable that well paid ‘pattern recognition’ type roles from insurance claims assessors to junior M&A lawyers, auditors and hospital radiographers face automation over the next decade by increasingly intelligent software. AI technology has leapt with astonishing speed from facial recognition to putting on a poker face, and as it evolves further investors and politicians will struggle to absorb the profound economic implications, but one will be a growing concentration of incremental corporate earnings and free cash flow growth within the technology sector.

Reflation Trade Becomes Consensus…

In a vintage year for contrarian asset allocation, the trajectory for markets has been to overreact to China deflation/devaluation risks, the shock of the misguided negative rates experiment (which served to confirm deflation fears and therefore backfired as a signalling tool) and what we termed the  ‘sideshow’ of Brexit. Overly pessimistic expectations were reset from Q2 as macro data such as PMIs and net earnings revisions across the MSCI AC index rebounded (led by EM), reflected in the turn in bond yields from July as ‘macro hypochondria’ peaked.

Positioning for the commodity cycle and EM bottoming in Q1 looked to us like a compelling bet, as did overweighting value as a style factor. Globally, value has outperformed by about 20 ppts since July, the second-best run versus ‘quality’ as a portfolio factor in almost 40 years. Our rotation from bond yield flattening to steepening sector exposure mid-year (including long Eurostoxx banks) also generated huge alpha in the tactical portfolio. If there was one issue this year which reflected a spectacular failure of nuanced analysis and caused global shock waves, it was the Q1 panic over Chinese FX reserves and the risk of a ‘shock devaluation’ which coincided with equally hysterical forecasts of oil going to $20 to generate a deflation panic rippling across markets.

Our view was that at least half the apparent capital flight was in fact rapid FX debt deleveraging and that rather than a deflationary shock, China was poised to inject an inflationary impetus to the global economy as the investment cycle turned. Ironically, the rebound in China’s fixed investment (particularly residential construction) has been weaker than we expected but the surge in industrial commodity prices even stronger, now that reflation is suddenly fashionable as an investment thesis. We stuck with a $50-60/bl end 2016 oil price target as market rebalancing began, making global E&P stocks and US HY energy debt a contrarian overweight. Meanwhile, the RMB correcting from very overvalued real effective levels was something to be welcomed, so long as orderly.

The US election has provided an alibi for sell side strategists to wipe the slate clean on an astonishing series of analytical errors and belatedly jump on the reflation trade. If the overwhelming investor consensus a year ago was for further EM/commodity downside and long quality/growth, this year it is long USD and reflation winners and positioning has shifted accordingly but simplistic extrapolation remains the default forecasting tool of most analysts. Indeed, almost comical herding behaviour continues to define markets from oil to the JPY (for instance, the yen has seen consensus targets versus the USD gyrate from 125 in mid-2015 to 90 by mid-2016 and now back to 125 again). Investors have been stampeding in and out of markets with record speed as the narrative and momentum shifts. With the rise in AUM of systematic trend following funds and the retail ETF hordes that ride their coattails, markets have never been more of an ‘echo chamber’ of confirmation bias  – remaining strictly agnostic is key to getting ahead of crucial inflection points.

The consensus was hugely misguided a year ago, and the impact of the Trump regime whether in terms of tax policy or geopolitics looks less benign than it now naively expects. Ultimately, if Trump is to attract cheers rather than jeers at the rallies he intends to continue holding for his rustbelt true believers, low-skilled labour has got to get a bigger share of the economic pie i.e. companies will have to divert cash flow from shareholder distributions to capex and wages and shift their capital structure from debt to equity.

Tax cuts will accordingly come with strings attached designed to incentivise investment and manufacturing re-shoring. The USD and Treasury yields are not a one-way bet given subtle negative feedback loops and both look extended, global miners ex gold now look relatively expensive and quality growth/defensives decent value again. While 2017 is unlikely to be quite the contrarian bonanza this year was, it would be wise to read those investment bank annual outlook notes with a healthy degree of scepticism. Or perhaps safer still to ignore them completely…






China Housing Booms on Land Shortage…

‘The property sector contributes about 15% of GDP directly, but up to twice that on a broad multiplier basis on HKMA estimates, while real estate accounts for about 70% of household assets. On a cyclical basis, the housing market has been improving since mid-Q1, despite the misguided Spanish/Irish property crash parallels drawn by some observers (ignoring the huge equity cushion, the lack of securitization or a secondary market to propagate panic selling etc.). Ongoing easing measures and liquidity displacement from equity markets will boost property in the leading Chinese cities further this summer. Ultimately, the government desperately needs the fixed investment cycle in real estate to stabilize…’ Macro Weekly, May 22nd 2015

‘Mainland developer destocking continues to tighten the market as sector lending picks up. Indeed, the chart showing cumulative real estate floor space started versus sold is a critical one right now – it shows the huge inventory build-up in recent years has peaked, ex the Tier-3 cities – it’s hard to see destocking going much further. Your view on global cyclicals/materials as well as Chinese momentum hinges on whether you believe that property investment is set to stage a rebound.’  Macro Weekly, Jan 11th 2016

It was clear by mid-2015 that a cyclical rebound in China’s property market was looming, driven by healthy fundamental demand as inventory levels peaked, yet this critical macro inflection point was bizarrely overlooked by most commentators. We’ve gone from a China ‘running out of FX reserves’ consensus narrative in January to a ‘running out of apartments’ one now i.e. the feared deflationary impulse has become an inflationary one for the global economy, even before housing investment catches up with the inventory cycle.

Indeed the surprise has been the relatively weak new build response, but the suggested Q1 overweight bet in domestic deep cyclicals exposed to the construction cycle as well as global materials/mining has outperformed substantially this year. The largest Chinese cities have joined many in the West from San Francisco to Dublin and London where soaring prices have failed to generate significant developer new supply, partly because of zoned land and funding shortages.

This latest property boom is therefore very different to the 2009-2013 one, when developers and local SOEs rather than households were the driving force and leveraging aggressively. Given the fevered price surge, which is reaching even third tier cities, it’s remarkable that new starts fell over 19% y/y in September. Rapidly shrinking inventories offer fundamental support, although the recent spectacular pace of official price growth (exceeding 30-40% y/y across several of the 15 largest cities) is clearly unsustainable.

The backdrop remains broadly positive – rapid urbanization (from an official but likely understated 56% in 2015) is spurring first-time housing demand; demand for housing upgrades will increase alongside rising incomes as about 40% of urban households are living in low-quality housing built before 2000 while there are more than 230m people aged 20-29 who will be first time buyers over the next decade. The affordability ratio nationwide was at the lowest end of the historical range at just over 7x income as of the end of 2015, making property relatively attractive as interest rates fell and A-shares imploded. The ratio of house prices to household disposable income in Tier-1 cities was just under 15x at the end of 2015 and has now risen to about 20x, approaching HK levels and well above London/NY.

However, these conventional metrics are distorted by the huge amount of space hoarded as ‘concrete deposit boxes’ by the top 1% of households (who own about 25% of vacant space) and substantial undeclared ‘grey income’ for the elite. An alternative ‘reality check’ is to look at housing wealth versus national income; aggregate Spanish residential property peaked at about 460% of GDP in 2007; Australia (and NZ), considered the frothiest global real estate markets alongside Canada (and a surge in Chinese buying has been a major factor in all three) are now worth over 350% of GDP.

The US peaked at just under 200% and is now 140%. China’s property market is worth 350-400% of GDP at current price levels. Land remains the key form of collateral within corporate balance sheets and the wider financial system, as with Japan in the 1980s and national average prices are up 5x since 2004 on the independent Wharton/NSU/ Tsinghua index, and 11x in Beijing. It’s important to note that Spain, the US and Ireland all saw a dramatic supply response to rising prices which alongside the collapse in credit availability helped crash the market 40-50% peak to trough post 2008. China doesn’t face the same series of shocks but real estate is now clearly overheated and calming the market is becoming a policy priority for Beijing.

The bottleneck is what has been historically been a rapid new build response in China capping price surges is land. In the first nine months of 2016, residential land supply in 100 medium and large cities dropped by 10% y/y, even as apartment sales soared. In Shanghai and Beijing, land supply through September dropped by 33% and 80% respectively y/y. The recent trend of developers bidding aggressively for premium land is directly due to low levels of zoned land for sale (itself partly a function of the ongoing anti-corruption drive, which has created local government paralysis in what has been a very lucrative activity for city level bureaucrats).

Significantly, the Shanghai government has just tightened regulation on the financing of land purchases – developers are not allowed to buy land using financing from banks, trusts etc. but from internal funds. Developers violating the new regulations would lose the deposit they make before auctions and will be banned from purchasing land in Shanghai for three years but this looks more a supply than demand side issue.  The only sustainable solution is significantly more land and new floor space supply over the next year, further boosting producer prices and cyclical growth momentum, even as housing prices peak.