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…

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. 

‘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.

 

Blockchain Deconstructs the Corporation…

JPM CEO Jamie Dimon recently declared that he would sack any of his traders playing bitcoin which he compared to Tulip mania, but given the broad volatility famine that has crushed Wall Street’s Q3 results, any half decent trader would surely be keeping their skills sharp in the wild world of cryptocurrencies. It’s important to differentiate between permissioned networks (e.g. across banks to settle securities) with a central authority and fully autonomous ‘permissionless’ ones such as that underpinning bitcoin, which threaten the role of banks as the apex of a longstanding financial hierarchy. Near term, blockchain offers banks, insurers and asset managers a margin windfall by slashing processing costs – long term, it threatens to undermine their gatekeeping role.

While I’ve been a sceptic of the recent ICO boom and the resulting profusion of new cryptocurrencies (supply certainly isn’t limited in the aggregate), but blockchain is probably comparable in long-term impact to the TCP/IP internet protocol in the 1990s. In other words, it could prove as significant an enabling technology in transactional terms as the original internet protocol was in transforming communications. By now, all investors are aware of the disruption risk to many incumbent business models from new technologies that shatter barriers to entry and compress margins and pricing power, but there is an even more fundamental question looming.

Could the firm, in the sense of the formal corporate entities that have evolved since Dutch spice expeditions to Asia gathered risk sharing investors in the 17th century, now become unbundled?  The information search comparative advantage of the firm versus consumer  or individual entrepreneur in classic microeconomic theory has narrowed dramatically while the cost of enforcing and supervising contract execution has tumbled via sharing economy models and soon the widespread use of digital ledgers.

As a reminder, blockchain is a distributed ledger technology, and uses a self-sustaining, peer-to-peer database to record and manage transactions in a decentralized manner. Verification of data is undertaken via complex algorithms and consensus among multiple systems, making it almost completely tamper-proof.  Data is transferred or stored using a series of blocks, each of which have a cryptographic hash protecting its contents. Any update or transaction on the data creates a new record in the form of another block, which is added to the existing blockchain.

The defining, radical characteristic of the digital economy in terms of traditional economics is its zero-marginal cost and we’ve now reached a point where something can be simultaneously digital and unique, without any tangible representation (bitcoin being a case in point). The bedrock of economic exchange is trust, and we now have technology that allows a reliable degree of trust to be established between total strangers in order to share resources, which has had profound implications for investors. That principle can be applied via the blockchain to anything from stock certificates to trust contracts, property title deeds etc. In that scenario, the elaborate hierarchy of trust we have built over several centuries via the legal system and complex compliance and oversight procedures becomes increasingly redundant.

This new distributed trust architecture could replicate much of the organization of a firm built on contracts, from incorporation to supply chain relationships to employee relations. If contracts can be automated, then what will happen to traditional firm hierarchical management structures, processes, and intermediaries like lawyers? Much of the corporate world is built on exploiting transactional ‘friction’ and information asymmetries between consumers and suppliers – the Internet over the past two decades has been a force for reducing these profit opportunities, from hotel room pricing to asset management. While crowdsourced trust between strangers via sharing economy platforms has been powerful in this respect, the advent of the blockchain over the next few years looks far more revolutionary.

As I’ve highlighted in many notes, online services and the advent of AI software are reducing slack and redundancy in the economic system – the internet from its inception has been about reducing search costs and price asymmetries between producers and consumers i.e. acting as a fundamentally deflationary force (a shift which central bankers still struggle to adapt their outdated equilibrium models to). Sharing economy platforms are zero marginal cost business models in terms of adding inventory (e.g.  advertising for Google/Facebook).

Google, Facebook, Twitter or Airbnb rely on the contributions of users as a means to generate value within their own platforms. Of course, in the existing sharing economy model, the value produced by participants is harvested by the platform owner with most of those contributing to the value production getting nothing beyond free access to services like social media, search or marketing their products.

Blockchain changes that because it facilitates the exchange of value in a secure and decentralized manner, without the need for an intermediary – to that extent, it’s a medium term threat to incumbent web giant business models, which are centralized rather than distributed and extract economic rent from often unwitting users. Digital ledgers and smart contracts reduce the capacity of the firm to enforce and exploit ‘trust arbitrage’. A far more fluid economic structure will develop over the next decade and beyond, with project focused associations of specialists coalescing and disbanding, their contractual obligations and financial entitlements will be delivered via blockchain.

Next year, we will begin to see significant blockchain and ‘smart contract’ deployment across the finance sector from maritime insurance contracts that rewrite themselves in real time to asset leasing and securities settlement. The logistics/freight forwarding business is another ripe for disruption and millions of mid-level admin jobs will be automated out of existence globally over the next few years as a result. While positive for early mover finance sector margins over the next few years, the implications for prime real estate look ominous, as office towers, which are simply warehouses of human inventory, begin to empty out.

Blockchain protocols make it technologically possible for a ‘Decentralized Autonomous Organization’ (DAO) of individuals with relevant skills to associate and organize for a specific task with the power to execute smart contracts between them and a client that can replicate many of the functions of a traditional corporate entity.  This shift marks the advent of a new generation of “dematerialized” organizations that do not require physical offices, assets, or even formal employees. Of course, this utopian vision won’t apply where regulatory compliance demands a centralized authority or significant capital/fixed investment is required but can certainly work across many ‘asset light’ service sectors from design to advertising and professional services, where freelancing is already common.

There is also a trade-off between blockchain network size versus transaction frequency. The blockchain is so far struggling to solve this trade-off between network size versus transactional frequency, and until that technical dilemma is resolved it’s hard to see this technology competing with existing payment networks like credit card networks or SWIFT on a global scale anytime soon (i.e. achieving several thousand transactions per second).

However, despite these and other limitations, the huge scale of capital now being invested in this area (some of it via the notorious ICOs) and surging interest from blue chip companies (particularly in Japan, as covered recently) suggest that every investor needs to reflect on the nature and implications of this potentially revolutionary technology. The current generation of cryptocurrencies may ultimately fall by the wayside, but the innovations that enabled them almost certainly won’t…

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…