May 2019: Market Viewpoints

By Manish Singh | Market Viewpoints

May 27

Summary:

President Donald Trump has diagnosed the China threat to US dominance correctly, but the remedies are too late. In my opinion, the US lost the “trade war” to China over a decade ago, as successive US Presidents – Clinton, Bush, Obama sold America short by giving in to corporate greed and abandoning the “nationalist” cause, which had served America so well for over two centuries. I am afraid the current generation of US leaders will find out that trade advantages are gained over years of meticulously planned policy-making and initiatives and not claimed or given away in a deal. The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight. At stake is technological and military superiority and the dominance of the global economic system. Of course, this version of the Cold War is very different from the last one fought between the US and the Soviet Union. The Soviet Union was just a military power and not the economic power that China is. Unlike China, the Soviet Union had little influence or trade links outside the socialist bloc of nations. I suspect the US-China trade war will escalate further.

Meanwhile at the US Federal Reserve (Fed), the big concern still seems to be that inflation expectations could become fixed at uncomfortably low levels, relative to the +2% target. The most recent data indicates that the Fed’s preferred inflation gauge – the core Personal Consumption Expenditures (PCE) rose just +1.6% in March from a year earlier, down from +1.8% in January and +2% in December. In recent interviews two District Fed Presidents – James Bullard and Charles Evans, have intensified their call for a rate cut, should inflation remain lacklustre. What this means is that there will be no sustained sell-off in US equities.

My Way or the Huawei

The US-China trade war has escalated and has become a case of He said, Xi said. President Trump, in an interview with Fox News on Sunday claimed that the US and China “had a very strong deal” but “they [China] changed it”. Chinese President Xi’ Jinping’s spokesman, on the other hand, said: “We don’t know what this agreement is the United States is talking about”, pouring cold water on Trump’s claim that there ever was a deal to be done and China reneged on it. The truth of the matter is that this is not a fight about trade. This is a fight by the US to protect its global interests and influence from the onslaught of the Chinese juggernaut, which over the last decade has become a formidable force of economic and political influence, technological innovation and a major global investor.

In my opinion, the US lost the “trade war” to China over a decade ago as successive US Presidents – Clinton, Bush, Obama sold America short by giving in to corporate greed and lobbyists and abandoning the “nationalist” cause which had served America so well for over two centuries. In her book ‘The Rich and How They Got That Way,” Cynthia Crossen uses an anecdote to make her point on how America lost its way in the 20th century as wealth replaced gods, armies, and the family as the altar around which society determined and exalted its values.

Once a very rich man consulted a psychiatrist for the first time. “I have everything a man could want,” the man complained. “Great wife, kids, health, four homes, servants, my own vineyard, a young girlfriend who used to be an acrobat.”

“My dear man,” interrupted the doctor, “you should be very happy.”

“Happiness, happiness,” the patient moaned. “What is happiness? Can it buy money?”

Trump has diagnosed the China threat to US dominance correctly but the remedies are too late. I am afraid the current generation of US leaders will find out that trade advantages are gained over years of meticulously planned policy making and initiatives and not claimed or given away in a deal. The US, rather late in the day, is making a valiant attempt to shoe-horn China and stop its relentless rise. The US-China trade spat, therefore, has moved on from accusations and tariffs to the US imposing a formal ban on American and even foreign companies from doing business with China’s Huawei Technology, the world’s second largest smartphone maker. Huawei’s growth is impressive if you consider the fact that it is largely locked out of the US market, and up until the trade war, was a largely unknown mobile brand in the West. Huawei’s global procurement totals around US$67 billion a year. That’s a lot of revenue that US companies will now miss out on.

The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight. At stake is technological and military superiority and the dominance of the global economic system. We received early signs of China’s preparedness in the wake of the US ban on Huawei. This report in The Nikkei newspaper indicates, Huawei anticipated the ban and started stockpiling crucial components more than six months ago. Stockpiling was not limited to semiconductor chips alone but spanned a wide range of electronics, including passive components and optical parts. At the beginning of the year, Huawei also started certifying more suppliers of semiconductor chips, optical components, camera-related technologies and other parts in places outside the US.

The world is witnessing a new Cold War – a Technology war – and both China and the US are digging in for a long fight.

Of course, this cold war is very different from the last one fought between the United States and the Soviet Union. The Soviet Union was just a military power and not the economic power that China is. Unlike China, the Soviet Union had little influence or trade links outside the socialist bloc of nations. Trade between the United States and the Soviet Union peaked at $4.5 billion in 1979. The Soviet Union continuously ran a trade deficit with the US. By contrast, China as the world’s largest manufacturer and exporter, occupies a central position in the global supply chain. China has been the world’s largest exporter of goods for over a decade now and last year, its exports totalled over US$2.2 trillion. China’s total trade with the US last year was US$737 billion. China has run a trade surplus with the US for well over 30 years. China is the world’s second largest recipient of foreign direct investment (FDI) behind the US. Over 70,000 US companies have invested over US$265 billion in China. Chinese counterparts have US$140 billion of investment in the US.

S&P 500 Index and VIX (last 12 months)

Many in the US (and indeed the West) still hold the dangerously naive view that China is home to “cheap and cheerful” copycat items. Huawei leads in 5G patents and Chinese smartphones now account for over 40% of global sales from less than 5% in 2012. While China is rolling out the 5G technology, not just in China but abroad, the US risks falling behind at home. There are only five companies with a reliable and proven ability to provide 5G services, none of them American. As this article in The Vergeindicates, 5G is still just hype for US telecom companies Verizon and AT&T. Delayed rollouts, limited hardware tests, conflicting standards, and political wrangling indicate that the mess of 5G will only get worse in the US as the rollouts continue. No wonder the UK approved Huawei’s 5G technology roll out in the UK and other European countries are doing the same, despite US warnings. 5G promises to be – “the first network built to serve the sensors, robots, autonomous vehicles and other devices that will continuously feed each other vast amounts of data, allowing factories, construction sites and even whole cities to be run with less moment-to-moment human intervention,” according to the national security reporters at The New York Times. Any nation without a suitable and reliable alternative to Huawei will be foolish to ban Huawei and imperil its own future economic prosperity.

As things stand, the probability of a grand deal is greatly reduced and suspicion will only grow. China will go full steam ahead with its “Made in China 2025” industrial policy to the annoyance of hawks in the United States Trade Representative (USTR). You can be sure that a new operating system to rival Google’s Android and Apple’s iOS is in an advanced stages of development. Google and Apple are at greatest risk from Huawei. Amazon and Microsoft not so much. China is an important market for Apple. A Huawei smartphone with its own operating system is a game changer. Not only does it hurt Apple sales in China, but it also eats into Android’s market share. The Huawei operating system would most certainly be banned in the US but not necessarily in Europe. According to one estimate, China will be importing $30 trillion of merchandise and $15 trillion of services over the next 15 years. Europe, which has a large export-driven economy, will do everything to get a good chunk of that China demand for merchandise and services, even if it displeases the US.

The US has accused China of unfair trade practises, economic espionage and government links. If you are a student of history and international trade or take great interest in it, you will know how hypocritical such claims are. The reality is that all successful nations have copied technology and methods be it Britain, France, Italy, Germany, the US, Japan, Korea and now China. China copying US technology, therefore, is not in some way unique but a continuation of what’s been happening for hundreds of years. As historian Doron Ben-Atar observes in his book “Trade Secrets” – “the United States emerged as the world’s industrial leader by illicitly appropriating mechanical and scientific innovations from Europe.” America was the China of the 19th Century.

Samuel Slater, often called “the father of the American Industrial Revolution” emigrated to the US in 1789 but not before he had “stolen” the secrets of textile mills from England. Slater brought with himself an intimate knowledge of the leading British inventor (and a leading entrepreneur during the early Industrial Revolution) Sir Richard Arkwright’s spinning frames that had transformed textile production in England.

The efforts of Thomas Digges, America’s most effective industrial spy was praised by President George Washington for “activity and zeal.” While sending one consignment, Digges proudly reported to US Secretary of State Thomas Jefferson that “a box containing the materials and specifications for a new Invented double Loom” was about to depart to America. The US government often encouraged such piracy. US Treasury Secretary Alexander Hamilton, in his 1791 “Report on Manufactures,” called for an aggressive policy of technology piracy and the need to reward those who brought to the US “improvements and secrets of extraordinary value” from elsewhere. Only a constant influx of immigrants, later on, lessened the necessity for the US to recruit skilled artisans in Europe. Although US federal patents were supposed to be granted only to people who came up with original inventions, Ben-Atar shows that, in practice, Americans were receiving patents for technology pirated from abroad.

Not that the British didn’t have a long history of piracy themselves. The most famous of course was the Great British Tea Heist of 1848, when Britain’s East India company sent botanist Robert Fortune on a trip to an area in China forbidden to foreigners, in order to steal the secrets of tea horticulture and manufacturing. Although the concept of tea is simple – dry leaves infused in hot water—the manufacture of it is not intuitive at all. At the time of Fortune’s visit, the recipe for tea had remained unchanged for two thousand years, and Europe had been addicted to it for at least two hundred of them. This great robbery allowed the British to grow tea in India, breaking China’s stranglehold on the market and paved the way for the renewed prosperity of Britain after it had lost the US colonies. There are many such instances in history – the French trying to steal the technology of James Watt’s steam engine, the Japanese copying from the Americans, the Koreans taking from the Japanese and the Americans etc.

The Culture and Preparation of Tea, China (1843), by English artist Thomas Allom

I suspect as the US-China trade war escalates further, China will impose many restrictions on US companies operating in China, and it could easily start with Boeing. China is slated to surpass the US as the world’s biggest aviation market by as early as 2022 and Boeing predicts China will need more than 7,200 new aircraft worth over US$1 trillion in the 20 years through 2036. Unlike the US case against Huawei of “engaging in illegal activity” which is yet to be proven, Boeing has proven to be dangerous to air passengers. China could ban the Boeing 737 MAX from China’s airspace even after the Federal Aviation Administration (FAA) approves it to fly again. This will have a knock-on effect, discouraging airlines from other countries with regularly scheduled flights into China from buying the Boeing 737 MAX, if they still want to operate in China’s airspace. The US may retaliate by refusing to sell aircraft parts to China. Europe’s Airbus will only be too happy to step in and sell aircraft and aircraft parts to China.

A fair and a compromise deal takes time to agree unless emergencies arise.

A trade deal is never about one side wins all. A fair and a compromise deal takes time to agree unless emergencies arise. Trump has already pivoted on some of the key trade issues with the EU, Japan, Canada and Mexico. Last week he lifted tariffs on metal imports from Canada and Mexico while delaying for six months tariffs on autos from the European Union and Japan. Right now, perhaps, the only possibility of a fair deal is sometime next year when Trump really focuses on re-election and burnishes his “deal-making” credentials by signing a compromise deal with China and declaring victory.

Markets and the Economy:

Given the overhang of the US-China trade war, equity markets have not fared well this month. You will recall, in last month’s newsletter,  I recommended to “take profits” on any long positions ahead of an anticipated slowdown in May and the elevated levels reached by the equity markets. The US equity market had its strongest first-quarter in more than two decades, as we witnessed a V-shape in the S&P 500 Index (SPX) –  from 2900 to 2400 and then back over the 2900 level during a 7-month period from October to April.‎

The US equity indices have fared better than the Emerging Market indices ( see table below), except for India where Prime Minister Narendra Modi has now secured a fresh 5-year mandate, in a landslide victory in the recently concluded national elections. Modi’s National Democratic Alliance (NDA) won more than 350 seats, far above the 272 required for a majority in India’s lower house of Parliament. I expect Modi to double down on reforms and accelerate growth even further. India will be a key market for investors to focus on in the years to come. India is the fastest growing G-20 nation and, this year, is forecast to become the world’s fifth largest economy, surpassing the UK, behind only the US, China, Japan and Germany. The International Monetary Fund (IMF) expects India’s Real GDP to grow by +7.3% and +7.5% in 2019 and 2020 respectively – the highest of any G-20 nation.

Benchmark Equity Indices Performance (year-to-date)

Given that the trade war is spreading and the prospect of a quick deal is reduced, there will be little conviction among market participants to be long the SPX beyond the 2900 level. Therefore, strategies that monetise income are my preferred way of trading such markets. Please reach out to your Crossbridge Capital contact to find out how to invest in such income strategies.

At the US Fed, the big concern still seems to be that inflation expectations could become fixed at uncomfortably low levels, relative to the Fed’s +2% target “if inflation did not show signs of moving up over coming quarters,” according to minutes released this week. The most recent data indicates that the Fed’s preferred inflation gauge – the core Personal Consumption Expenditures (PCE) which excludes the volatile food and energy categories, rose just +1.6% in March from a year earlier, down from +1.8% in January and +2% in December. Even though the minutes revealed no discussion of a rate cut at the meeting, in recent interviews two District Fed Presidents –  St. Louis Fed President James Bullard and Chicago Fed President Charles Evans have intensified their call for one, should inflation remain lacklustre. Bullard remarked that the Fed may need to cut rates even if the economy wasn’t slowing, “to help maintain the credibility of the [Fed’s] inflation target going forward”, and Evans said persistently low inflation “is justification for deciding that our setting of monetary policy is actually restrictive and we need to make an adjustment downwards.”

What this means is that there will be no sustained sell-off in US equities as a Powell Put and Trump Put are in place. The opportunity, therefore, lies more in sector rotation. I continue to advocate buying the recent weakness in the Financial sector (XLF), Industrials (XLI) and Consumer Discretionary (XLY) and to reduce holdings in Technology (XLK) and Communication Services (XLC), in anticipation of the tech war between the US and China getting worse before getting better.

US Equity Sectors Performance (year-to-date)

Meanwhile, in the Eurozone, both growth and inflation continue to look dire, even as the negative interest rate policy, introduced as a temporary measure by the European Central Bank (ECB) has now run for 5 years. Based on current data and evidence, the ECB’s deposit rate is likely to stay at -0.4% for at least another 18-months and possibly through 2021. A low or negative rate threatens pensions, creates real-estate bubbles and doesn’t fully quell the spectre of deflation. It also disadvantages the banks who struggle with weak interest income and thin margins on loans, therefore, making it harder for them to finance any economic growth. As if that were not enough, pain already for an economy struggling to get better, populism is on the rise. In the European Union (EU) elections taking place this weekend, the EU-sceptics are set to gain more leverage. According to projections by opinion-polling company Kantar, the EU-sceptic parties could win up to a third of the seats in the EU Parliament. This would force centrist pro-EU groups to form a three or even four-way coalition, complicating even further the EU’s cumbersome decision-making process. The EU is about to enter into a long period of stalemate in decision making. I, therefore, continue to be underweight European equities.

Some thoughts on the recent tech IPOs and particularly, Uber. So is it 1999 all over again or is it worse?

It’s too soon to say how this recent set of IPOs will end up, given the amount of liquidity in the market, but it is worth looking at the recent round of tech IPOs and compare them to 1999. The differences first:

  • The companies debuting now are far bigger and far older. According to research by Jay Ritter of the University of Florida, the median age for tech companies going public in 1999 was four years. It is 12 years today. Amazon went public in early 1997, just three years after Jeff Bezos founded it in his garage
  • The median sales then were about $12 million compared with $173.6 million today
And the similarities of the Class of 2019 with their predecessors from 20 years hence? They’re all still losing money (chart below).

On its second day as a public company, UBER’s stock slid -11% to $37.10 placing it -18% below the IPO price of $45 (UBER has since recovered to $40.5).

Let’s look at UBER’s journey, which was founded ten years ago:

  • Uber has raised over $24bn in funding to date
  • Uber has amassed operating losses in excess of $12bn
  • Uber’s loss in the 12 months through March 2019 rose to more than $3.7bn, by far the largest ever for a US start-up in the year before an IPO
  • IPO documents show UBER lost $1bn on $3bn in sales in just the past three months

I often hear this refrain from Uber bulls – “In its early years, Amazon lost money too. Uber is another Amazon just wait and see.” So let me point out that, Amazon lost $3bn in its first seven years (1996-2002). Uber lost more than than in the past nine months alone.

More importantly, however, loss-making companies rely on “growing” revenue to become profitable i.e. spreading the “fixed cost” over a larger revenue. I fail to see what Uber’s “fixed cost” is ? The trouble with Uber is that most of its costs are “variable”. The cost, therefore, rises with each $ of revenue it makes i.e. more trips do not translate to higher profitability.

Besides, ride-sharing apps are only growing in numbers and competition is fierce. Yesterday, I downloaded a new ride-sharing app which advertises itself as – the ride-hailing app that takes care of its users. Well, it did take care of me, as I paid only £4.15 for a journey from Mayfair to Chelsea. To do my research, I struck a conversation with the driver. I found out that the driver was getting paid £20 bonus for this journey beside his fare. So the company is making £4.15 and paying out nearly £25 pound? I wonder how long this can continue. The driver was very candid and said that as soon as the bonus period is over, he will leave and move on to the next new app.

Such discounts and promotions used by tech companies to ramp up sales at any cost are a little like the negative deposit rates in the Eurozone. It was only ever meant to be used sparingly but the patient became addicted. The way to make money in the current tech IPO craze is to invest in the early rounds when the company is still private and ride the valuation high. IPO’s then become the exit point and not the point from which prices ramp up. Uber in its IPO document warned that it “may not achieve profitability.” I’d take that warning very seriously.

For specific stock recommendations, please do not hesitate to get in touch.

Best Regards,
Manish Singh, CFA

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