Market Viewpoints

Summary

China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels, US President Donald Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. Patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to. The US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. A second wave of direct payments to farmers is likely to follow if tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price. As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, Americans will be faced with the question – at what price patriotism?

At what price patriotism?

This week we learnt that the US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. Furthermore, the US Department of Agriculture (USDA) could decide by December to make a second wave of direct payments to farmers if damages from trade tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price.

Last year, Michael Anson, who works in the Bank of England’s (BoE) archive along with Norma Cohen, Alastair Owens and Daniel Todman from Queen Mary University of London, made a startling discovery – the spectacular failure of UK’s first bond issue of the Great War in 1914 and the extraordinary role of the Bank of England (BoE) in the cover-up that followed.

In the early days of World War I, the British government sought to raise £350 million (about £38 billion in today’s money) through the issuance of “war loans.” Britain’s banks agreed to subscribe for £60 million and the BoE agreed to take £39.4 million on its books. The remaining £250 million was expected to be sold to the public by appealing to their patriotism. The issuance went ahead and the bond sale was heralded as a great success. The Financial Times reported on 23 November 1914 (clip below) that the Loan had been over-subscribed. It gushed – “by motives of patriotism no less than by thought of securing a good investment, the British Public has offered the government every penny it asked for – and more ….and still the applications are pouring in!”

Source: The Financial Times, 23 November 1914

The reality, however, couldn’t be more different. The public demand for “War Loans” was woefully low and amounted to a grand total of £91 million i.e. one-fourth of the amount the government wanted to raise from the public by appealing to their patriotism. At the time, if this failure had become public knowledge, it would’ve crashed the price of existing UK sovereign bonds and endangered any future capital raising by the British government thus undermining its preparedness for what was to follow in the Great War. The BoE officials, therefore, hatched a plan to cover up the shortfall. The BoE’s then Chief Cashier Gordon Nairn, and his deputy, Ernest Harvey, bought the securities in their own names using the bank’s money and the bond holdings were classified as “Other Securities” on the bank’s balance sheet rather than as holdings of government securities. The British Government of the day led Prime Minister Herbert Henry Asquith and his Chancellor David Lloyd George then declared the bond issuance a success and hailed it as a sign of patriotic fervour among the British people. And you thought “Fake news” was something new?

In a secret memo to the then Treasury Secretary John Bradbury, economist John Maynard Keynes called the effort of the BoE to step in and buy the unsubscribed bonds for its own account as a “masterful manipulation.” Today, we, of course, call it Quantitative Easing (QE) and we don’t make any effort to hide the “manipulation.”

Additionally, the funds that were raised from the public came from a very small group of financiers, private individuals and shipping companies that were among businesses benefitting from surging war demand for their services. Half of all investments were for £200 or less i.e. most of the wealthy British would rather have put their country in peril than part with their money. Patriotism was not enough.

Every patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to.

I continue to believe that there won’t be a full-fledged trade war between the US and China as it is not in either one’s self-interest. Over the weekend we learnt that US President Donald Trump had reached a “trade deal” with Mexico. As we know, the talks between the US and Mexico appeared close to collapse many times during the past 12 months. China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels in the US, Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. GDP growth is forecast to ease to +2.9% in the 3Q and +2.6% in the 4Q of this year. Quarterly growth is expected to average just +2.2% in 2019. Besides, China is rapidly diversifying its economy and its reliance on the US. A rising debt and a trillion-dollar deficit that the US faces can easily be exacerbated with tariffs and the window of opportunity could close sooner than Trump expects.

As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, the Americans like the Brits in 1914 will be faced with a question – at what price patriotism?

Turkey’s crisis is not a systemic risk

The big news in markets recently has been Turkey. The Turkish Lira has depreciated by over -40% this year, the current account deficit has widened to -6% of GDP and inflation runs at over +15%. Whilst it’s easy to draw parallels with the 1997 Asian Thai Bhat crisis and fear for the health of Emerging Markets in general, the only commonality between the two episodes is that it was a period of big capital inflows and then outflows, but the underlying conditions in Emerging Markets today are very different.

Robust economic growth over last two decades, floating exchange rates, high foreign reserves, and greater transparency have reduced the need for abrupt adjustments. Low single-digit current account deficits and in some cases (South Korea, Taiwan, Hong Kong and the Philippines) surpluses, are insulating these economies and the risk of contagion has consequently been reduced. Turkey defaulting on its debt – private or public – is very unlikely to cause a repeat of the Emerging Market crisis we saw in 1997. The problem Turkey faces is of its own making. A sharp increase in credit growth and government spending, financed by short-term capital flows (70% of Turkey’s debt is denominated in US Dollars and Euros) led to a rapid worsening of its current account deficit and left it vulnerable to both the USDTRY exchange rate and outright funding risk. Turkey’s crisis is not a systemic risk.

Turkey, however, does pose a risk to the European economy through its links with European banks and geopolitics. Spain’s second-largest bank Banco Bilbao Vizcaya Argentaria (BBVA) is the most exposed bank in the European Union (EU). BBVA owns 49.9% of Turkey’s Garanti Bank, the second largest private bank in Turkey. Unicredit, Italy’s biggest bank owns around 40% of Yapi Kredi (YKGYO.IS), Turkey’s fourth-largest bank, through a local joint venture. ING, the Dutch bank has a fully-owned subsidiary in the country, ING Turkey. BNP Paribas, the French bank controls 72% of the Economy Bank of Turkey (TEB), partly through a local joint venture. HSBC operates HSBC Turkey in the country. Of these five European names, only BBVA looks at risk of any meaningful capital impairment from the economic situation in Turkey. Garanti accounts for around 13% of BBVA group’s earnings. Of greater concern are the implications on geopolitics. An economic meltdown in Turkey could easily spill over into Europe and cause further unrest in the Middle East thereby triggering a new wave of immigration to Europe. Wary of this risk, Berlin is now considering providing emergency financial assistance to Turkey.

Markets & the Economy

Other than Turkey, it has generally been a positive time in the markets if you were overweight US equities. The S&P 500 index hit a new all-time high and is now above the 2900 level. The US Technology index, NASDAQ is also trading at an all-time high and is up +17.5 this year. Meanwhile Europe’s flagship Euro Stoxx 50 Index is down -1.8% and the MSCI Emerging Market Index is down -7.6%. The chart below details the performance of other key Equity Indices.

The Federal Open Market Committee (FOMC) minutes released for the July/August meeting was very upbeat and signalled more rate hikes this year. Last week, US Federal Reserve Chairman Jerome Powell, speaking at the annual symposium in Jackson Hole, Wyoming defended the Fed’s strategy of gradually raising interest rates even as he was criticised by Trump for moving too quickly. Powell reiterated his view that gradual hikes in rates will be needed as long as the economy remains healthy. “There is good reason to expect that this strong performance will continue” he said. At a fundraising event the week before last, Trump remarked that he was “not happy” about interest rate increases which the he feared would cool off the fast-growing economy. Before Trump, the last President to publicly call for lower interest rates¹ was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.” Before that in the 1970s, political pressure on former Fed chairmen William McChesney Martin by the then President Lyndon Johnson and later on Arthur Burns by the then President Nixon (before his 1972 re-election) led to inflation surges as rates were kept low. The Fed later came to view these as a costly mistake. I do not expect the Fed to yield to political pressure and make the same mistake. The Fed has raised rates twice this year, most recently in June to a range between +1.75% and +2%. I expect the FOMC to raise rates by +0.25% when they meet in four weeks’ time.

Last week also saw headlines – “The end of Greece’s marathon bailout.” Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Euphoria in Brussels and official press releases rushed to claim Greece had exited its multi-year bailout program and it was once again a “normal” country. If only that were true. Taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. Besides the Value Added Tax (VAT), small business tax rates, fresh pension cuts and new punitive income tax rates for the poorest are all scheduled for 2019. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. Give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.

The European Central Bank (ECB) has said it expects to phase out its bond-purchase programme by the end of the year, although it has also signalled that its policy rates, which include a negative deposit rate, would stay where they are at least through next summer i.e. the gulf between the ECB and the Fed policy rate will only get wider. The Eurozone still needs stimulus whereas the Fed plans to press ahead with raising rates. I am not bullish on the Eurozone growth and don’t see how the ECB will be able to end its QE policy this year in face of a growth slowdown and the fear of Trump tariffs hanging like the sword of Damocles over the head of the EU.

I continue to remain Underweight Europe and overweight US equities with a bias to Technology (XLK), Healthcare (XLV), Consumer Discretionary (XLY) and Financials (XLF). However, in Europe, few stock-specific trades are still worth holding or adding to. Luxury stocks like Louis Vuitton Moët Hennessy (LVMH) and infrastructure and industrial stocks (Vinci, Eiffage, Siemens, Bouygues) offer a good investment opportunity for completely different reasons. The world’s well-heeled shoppers are doing just fine and are unruffled by trade fears as they continue to splurge on handbags, jewellery and fine wines. Revenue at LVMH in the first half of this year hit €21.8 billion, up 10% compared with the same period a year ago and net profit jumped 41% to €3 billion. The case for industrial stocks is boosted by the urgent need for Europe to upgrade its infrastructure in the light of the catastrophic bridge collapse in Genoa. French President Emmanuel Macron is under pressure to step up spending on infrastructure after a government report warned that approximately 840 road bridges in France are in danger of collapse.

I was on Bloomberg TV last week for an hour discussing my views on Brexit, the US economy, European Banks and the crisis in Turkey. You can watch it at this Bloomberg Surveillance link (skip to 57 min).

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

¹ Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital