Last week Sid Ruttala provided us with a list of things not to worry about, this week he goes the other way and takes a look at a couple of things to keep a eye on given the current market environment.
Author: Sid Ruttala
Last week we briefly spoke about central bank policy and the reason that investors should stay calm given some of the incentives that are currently driving the market. Subsequently we have seen some calming of treasuries Stateside (whether this has been direct intervention by the Fed we will have to wait and see) as well as in Australia where the RBA has upped its direct purchases and are buying at a rate of billions per day (see the RBA announcement here). The official cash rate remains unchanged at 0.1%, though whether this makes any difference at this point is open for discussion.
This week, I would like to look at two things to watch out for given the current market environment and the implications for investors.
Watch Out for Duration
Central banks have different incentives depending on context and policy preferences. Given the amount of government debt to be issued around the world we must accept that there is very little choice but to keep a lid on yields, there are two different ways this can be done. First, the debt is issued on the short-end and kept rolling over, in which case it is the short-end that is artificially suppressed while the long-end is left somewhat on its own (a particularly bearish case for growth stocks and gold). The second is to control the entirety in the hopes of flattening (i.e. buy longer duration along with the shorter, a situation that results in a business as usual case).
Let’s look at the first scenario and the problem faced there. People and the markets look at the long-end and assume increasing inflation expectations as well as a quicker normalisation of policy even if that is not the case.
I, as a somewhat rational economic participant, might look at the long end of the curve, for example, and expect my tax or debt servicing burden to increase sooner rather than later and as a result spend a greater portion of my income to increase savings or pay down debt as opposed to spending in the real economy. This is the conundrum faced by both Lagarde and Powell, as well as the reason they wish to calm markets in fears of stopping the recovery before it even begins.
There is also a second and seemingly more important problem that comes about under the first option, a problem more acute in nations such as Australia. That is the curious case of real estate. In particular longer duration mortgages (30 years) that make up a significant portion of the real estate market. Most longer term mortgages are tied intrinsically to the long-end of the curve, which might create a headache by 1) increasingly having people on shorter-term variable rates and/or 2) pricing a substantial chunk of would-be homeowners out of the market despite the seemingly lower interest rates.
For all intents and purposes this inhibits credit growth given that there might be a greater unwillingness to fix rates longer term or creates risks to the markets in the sense that more and more go onto variable rates. Potentially exacerbating risks further down the track as the economy becomes evermore vulnerable to even slight increases in rates.
On the other hand, let’s suppose that the above risks are unpalatable and we go to the second option and assume that central banks decide to jawbone the bond market into subservience by effective yield curve control, where increasingly longer duration is bought with the hope that inflation expectations are kept in check while the recovery takes place. This creates all-together different problems. Namely, the exacerbation of existing trends, misallocation in terms of risk as we continue to see money flood towards risk assets and the market goes into bubble-like territory (or further in). There are also the risks of an increasing zombification of the markets, something the Japanese are perhaps more familiar with after close to a two decade romance with the notion.
Somehow though, my view is that central banks will go with the first option rather than the second and hope flowery language will keep the long-end in check. This is especially so in the case of the US whose Federal Reserve has a tendency towards being reactionary rather than proactive (hence the hope part of policy making) and as was made abundantly clear during Q4 2018 when I first alluded to the impossibility of monetary policy normalisation. In Australia, there is a different incentive given the level of household wealth tied to property and the necessity of facilitating credit growth in the real estate market.
The RBA, we make the call, will have a greater willingness towards yield curve control than its counterparts. A higher proportion of variable rates and shorter duration makes the system vulnerable to liquidity squeezes.
Takeaway: Understand that if central banks refuse to control the long-end of the curve, the higher growth stocks will see red and the pivot to value will be quicker than would otherwise be the case. That’s not to say companies like Apple won’t continue to be good businesses but much of their price action in recent years has been predicated upon multiples expansion which will not be sustainable if the curve is not flattened. Think the Nifty 50 during the 1970’s which came into the decade at all time highs, they continued to perform for much of the decade and earnings continued to grow but it didn’t reflect in their share price. If you want something more recent, think of Microsoft after the dot com burst during Steve Ballmer’s time at the helm. The business continued to grow earnings with net income surging 215% and revenue more doubling, this however was not reflected in the share price (the valuation just playing catchup).
Timing
I’m sure you’ve all heard some variation of the saying “it’s not timing the market but time in the market that matters”. Remember that, now more than ever, the shorter-term movements are just that. We are just at the beginning of continued fiscal dominance globally, underwritten by the monetary side of the equation. At home, the AUD continues on a strong playing field which leaves the RBA with a lot more firepower than might be imagined given the cash rate. For example, in a circular manner, as global demand for iron ore and other commodities continues to rise due to infrastructure spending, this will continue to put upward pressure on the AUD and, as a nation with monetary sovereignty, the RBA finds itself in a position to be accommodative for longer without seeing ramifications in terms of inflation (and by doing so it also continues to help exports).
For all you property owners, this is one area you might seek to stay in for a little longer. There will come a time when this changes but long-duration assets, with an accommodative central bank that is unlikely to change course on a nominal basis, is what will continue to drive asset prices in the absence of any adjustments. I am of the fundamental belief that returns in those asset classes, just as with equities, are more a function of cost of capital than so called fundamentals like population growth (they only give you alpha and don’t account for the vast majority of the returns),
Similarly, REITS, industrials and, in adjacent categories from an income perspective, mining services companies look particularly attractive in my view. REITS and industrials, being leveraged entities that would’ve locked in longer duration as mentioned last time, will see their debt wiped away in real terms while mining services will see you benefit not only from a higher commodities prices but increased capex across the space. Where I don’t quite feel comfortable are the financials. This is due to a flat curve and arguably financial suppression on the part of the central bank, though they do remain protected species in Australia and are a more viable substitute than treasuries.
How long can this keep going? Believe me, we have seen this kind of thing before and, as we often say, remember the words of Mark Twain: “History doesn’t repeat itself, but it often rhymes.” The closest thing is probably the wartime economies of the 1940s, where fiscal dominance increased money supply while deleveraging the private sector. A period that saw inflation but on a manageable basis and where most increases in money supply were a function of direct intervention. A situation where it is central banks financing and governments “spending the money into existence.” The pandemic, one might convincingly argue, has functionally created a wartime economy.
Alongside this global pandemic we find ourselves in, we have increasingly frosty relations between global superpowers and those superpowers are vying for influence across most of the planet. If that “Cold War-time” type situation isn’t a close second to a wartime economy, I don’t know what is. In the similar period that followed WWII, the music continued to play for close to two decades even after the war, reconstruction also creating some strong growth.
WWII was devastating, yes, but equities investors continued to annualise around 9.6% p.a. Apparently even wars, be they between nations or against a virus, wont stop capital from seeking a return. Who knew? It just depends on where one looks.
Here we are, February of 2021 and it has been an interesting start to the year. For those of you that have read previous articles, you know I have been one of those outliers that has been predicting inflation and the tremendous risks posed by the bond market for a good 18-months. So, in keeping with that theme, I shall try and grapple with the interesting trading action so far. It started with a sell-off in treasuries, followed promptly by a sell-off in equities and precious metals with inflation jitters coming back into the equation.
Author: Sid Ruttala
How far we have come within the space of 12 months. Negative rates, negative energy prices to the polar opposite across everything from a resurgent oil price and a decade high in the price of Dr. Copper, a favourite inflation gauge for market participants. Add in a $1.9tn USD stimulus package and we have a seemingly perfect storm lined up.
But hang on a minute, how have inflation fears catalysed a sell-off in gold? Isn’t it meant to be a hedge? And why are energy prices so resurgent despite a considerable segment of the planet still in lockdown? Moreover, the yields at the long-end of the curve that’s on everybody’s minds are at a stellar 1.37% on US 10-years, I don’t know about the readership, that doesn’t sound like a particularly attractive prospect to me. This is especially the case when official targets for inflation are around 2% (depending on country), you’re effectively telling me I should lend you money and you will pay back less than what I gave you 10-years from now? So let us try and unpack that for a moment.
Do treasury yields actually mean what they used to?
Let me give you a couple of simple statistics.
365%. That is the estimate of the global debt-to-GDP ratio to finish 2020.
106%. That was the public debt-to-GDP ratio in the US to end 2019. It is now closer to 130% (and likely to continue to grow disproportionately given the packages and budgetary measures currently under review on the Hill).
Think through this for a moment, what does even a 10 basis point increase in yield on the long-end imply in terms of debt servicing? More importantly, is any central bank likely to stomach that increase?
We have already seen Christine Lagarde of the ECB make a statement mentioning that they will be closely monitoring yields on the long-end. Stateside, Powell might very well be in a similar situation. This is not the same as the days of Volcker where debt-to-GDP ratios were a more manageable 70-80%. The tax base is not enough across most of the western world to support increases to debt-servicing requirements. The ruling out of yield curve control Stateside will, in my view, go the same direction as Lowe’s ruling out of QE in Australia back at the beginning of last year.
Source: Visual Capitalist
Simply put, yields will continue to rise as the market continues to factor in the potential for greater issuance of public debt and a resurgent economy. Where they might get it wrong, and what investors are seemingly ignoring, is a central banker caught between a rock and a hard place. There will be suppression of yields and government debt will be issued on the long-end. A scenario that increases the likelihood of inflation and yield suppression if within a reasonable range.
The government will issue, the central bank will buy, thus creating more money supply. Yes, I’ve just said it, debt monetisation. In fact, since the beginning of covid-19 the Federal Reserve has bought close $3.5tn in bonds in 2020 alone, the Bank of England allowed an overdraft of the government account and Australia has seen its central bank buy government securities, though on the shorter end of the curve, to put a lid on the yields.
Why inflation now?
It was during the depths of the GFC that central banks embarked upon then unconventional policy in the form of quantitative easing (after a certain amount of time, unconventional becomes conventional). Many doomsayers suggested that this might give rise to runaway inflation. It didn’t. Because they forgot one thing, increasing bank reserves doesn’t necessarily translate into the real economy, it just shows up in asset valuations rather than consumer discretionary spending.
However, where things change and the real economy gets impacted directly is direct stimulus measures. Take, for example, the stimulus cheques now under consideration. That is new money supply into the economy. Similarly, infrastructure projects that add to GDP but also contribute actual jobs. This comes along at the same time as increasingly frosty relationships between the major geopolitical powers of the day. I am of the view that technology wasn’t entirely the reason for the deflation of the past, rather the greatest deflationary event of the past two decades was China, which not only enabled cheaper production but stagnant wage growth across most of the western world. Something that, somewhat ironically, was good for the investor, may not have been the case for the average wage earner but, lets face it, we’ve done well out of it.
This situation of globalised supply chains led to things like Just-in-Time inventory systems, centralisation of healthcare systems, lowest cost production. All seemingly good things but what it also does is underinvestment in those very things as the costs continue to be driven down.
What happens when bottlenecks are introduced out of the blue, tough? A bottleneck like an economic lockdown due to a pandemic perhaps? Re-localisation of supply chains because of a shift in geopolitical priorities/government policy? Last week I wrote about the shortage in semiconductors within the automotive segment. We are seeing similar things in commodities, such as copper, which saw massive underinvestment for close to a decade due to uneconomic prices. But what happens if you add in potential for infrastructure projects, like renewables, while at the same time lacking an existing supply pipeline to deal with the increase? Is it any wonder that the Chinese have been the most aggressive buyers within that particular market?
So what am I trying to say?
I remain exceptionally bearish on global treasuries and USD overall. What we have seen through much of the year so far are short-term pivots. Precious metals are not selling off because the yields make such an attractive proposition, it is rather investors taking cash off the table after a run-up in the market to move towards re-allocation. If you sell-off your treasuries, the process is first to cash before you make a further allocation (thus putting a short-term upward pressure on the currency). In circular trajectory, once that happens and the yield goes up even slightly, it is the high-growth stocks (precisely those that have done well during Covid) but stand on premium valuations that get sold off (all of a sudden you can use a discount rate). Similarly, a short-term spike in the USD leads to a short-term sell-off in Gold due to the inverse correlation.
I remain of the conviction that we will see inflation coming back into the picture but not yet and yields certainly will not be going up in proportion. This is not necessarily a bad thing for the investor. It should only be concerning if said picture gets out of hand. We will continue to see accommodative monetary policy that drives markets but with the caveat that some of the higher-growth names you are used to might not see the same returns. More importantly, as fiscal expansion continues across most of the developed world, we will see every indicator of broad money supply increase and ridiculous valuations across anything that has scarcity value (even Bitcoin, though this author doesn’t quite understand that particular market).
What has been interesting to watch is the money flow towards pockets such as the Dow, industrials and emerging/Asian markets.
How to allocate?
In every economic expansion cycle over the past two centuries, inflation doesn’t hurt in the initial stages. As governments continue to occupy a greater proportion of GDP, we will see two things happen, household debt will proportionally decrease (i.e. crowding out) and corporate debt remains somewhat manageable (take a large firm such as Berkshire, for example, which issued debt at 105bps in 2020) as you effectively eat away the real value of the debt. We might quite literally have the Roaring Twenties roar back to life.
Remember that your portfolio should have three different pockets; the contrarian, income/defensive and a growth pocket. These react in different ways depending on the situation. Your defensives won’t do well in a bull market but that’s how they’re supposed to behave, precious metals fall in this category too (it doesn’t yield anything and it has no intrinsic value but it is an evergreen hedge against uncertainty, not inflation but uncertainty). Your growth will be healthcare and technology with the caveat of long secular growth stories, not the hype of the day, but SECULAR. Think about artificial intelligence, mobility or emerging markets. The third pocket, the contrarian, is the one that is an allocation assuming you have everything wrong (i.e. not contrarian to the market but contrary to your base case). Again for Australian investors, strap your belts, we are the beginning of a bull cycle in commodities.
Disclaimer: The Roaring Twenties (a name coined by Fitzgerald) weren’t “roaring” for everyone, with the most common job in the US being farming/agriculture. Harding was exceptionally kind to the investor, much like one recent ex-President, and the economy had deflation as opposed to inflation. In the words of Twain, “History doesn’t repeat itself, but it often rhymes.”
Conclusion? The music is still playing for now, it might even get louder. Dance while you can.
This is definitely worth thinking about at some point but it shouldn’t affect your investing decisions just yet.
And now a non-exhaustive list of other things life is too short to worry about:
Having one more TimTam
The lack of fundamentals behind Tesla’s share price
Ron Shamgar provides an update on a number of the companies held in TAMIM’s Australian equities portfolios. This is an excerpt from the January 2021 TAMIM Fund: Australia All Cap monthly report, you can access the full report here.
Note: Some of these stocks may have released results since publication of this report.
Healthia (HLA.ASX) provided a strong trading update and guidance for 1H21 with revenues up 45% to $64m and NPATA up 106% to $5m. Organic revenue growth of 14.5% was impressive and partially a result of pent-up demand for physio and podiatry services from the Covid lockdowns. Pleasingly the company has recruited 60 undergraduate health professionals commencing in 2021, a good sign of continued organic growth. We value HLA at $2.50.
Readytech (RDY.ASX) announced the finalised agreement to acquire OpenOffice and revised terms due to the business being shortlisted to win a $5m SaaS contract with a government agency. This highlights the quality of the OpenOffice growth prospects. We see RDY as a candidate for a profit upgrade in upcoming results. We see its major private equity shareholder selling down post-results as a positive for a share price re-rate. RDY is one of the cheapest software companies on the ASX and we see it valued at $2.80.
National Tyre & Wheel (NTD.ASX) provided another strong trading update and its third profit upgrade of the half. EBITDA is now on track for $15m in 1H. We estimate FY21 EPS of 13 cents and an interim dividend of 2 cents. The acquisition of Tyres4U is benefitting the company with good demand in the agricultural and heavy machinery sectors. NTD is a real covid winner, as border closures over the next 1-2 years will continue to see elevated demand for domestic travel and thus tyre and wheel servicing. We value NTD at $1.50.
Market freaking out about $NTD losing its distribution agreement for Cooper tyres have not read slide 11 carefully □
It clearly states the agreement is locked in until Sep 2027 □
That’s many years of profits and cash to come their way and enough time to diversify away □
Smartpay (SMP.ASX) continues to grow its Australian terminal business with transacting terminals at the end of December 2020 numbering 5,775 with quality new merchants added, higher margins and increased total transaction values. The current annualised run rate for revenue is now at $24m, with the company adding approximately 500 new terminals a month. Recent connectivity issues with its main competitor, Tyro (TYR.ASX), are only accelerating growth. We believe SMP is on track for group revenues of $100m within three years. We also believe corporate activity may emerge again later this year. Our valuation is $1.30.
Aussie Broadband (ABB.ASX) provided a trading update that was significantly ahead of prospectus forecasts. Residential broadband customers were up 86% to 313k connections and business customers exceeding forecasts, up 113% to 29.4k. Management is guiding to 1H21 EBITDA of $8.5m, which is what market analysts had for the full 2021 year. We believe ABB is taking significant market share from competitors while offering excellent customer service. Business customer connections are adding higher margin revenue. We value ABB at over $3.50.
Humm Group (HUM.ASX) is now officially the most profitable BNPL company in Australia and possibly the world. Management has given guidance of 1H cash NPAT of $43m, up 25% on the prior period. 2H of year will see increased marketing costs and investment into the entering of two new international markets. We estimate that HUM will achieve NPAT of approximately $70m for FY21 and is trading on a PE of 9x. Unfortunately, HUM is extremely profitable and investors valuing BNPL companies are ascribing higher valuations to their loss-making competitors. Eventually that bizarre paradigm will shift and the stock will re-rate to our estimated valuation of $2.00+.
Disclaimer: All stocks highlighted in this article are held in TAMIM portfolios.
This week we take a look at three stocks that are both defensive in nature but still in their high growth emerging phase of their business evolution. All stocks are high conviction holdings in the TAMIM Fund: Australia All Cap portfolio.
Authors: Ron Shamgar
Unity group (UWL.ASX) is our top pick for 2021 and not so coincidentally one of our largest holdings. In our mind, owning UWL is like owning a mini version of the NBN but with better growth prospects. 75% of group revenues come from fibre services to residential Greenfield developments. We believe fibre should be viewed as a core infrastructure service by investors, one that is defensive and has a very long use life.
Source: UWL company filings
Since UWL has 18% market share versus NBN in its sector, we think the stock should be valued more like a core infrastructure asset rather than a telco. UWL recently acquired the Telstra Velocity fibre asset for $180m. This will add Telstra as an internet service provider on the network and will increase group EBITDA to $120m. UWL is currently trading on a one-year forward EBITDA multiple of 12x but we believe it should be closer to 15x. Our valuation is approximately $2.50, so we see another 30% of potential upside.
Smartpay (SMP.ASX) is a high growth payments and terminal provider. By now we all know that Covid-19 further accelerated the take up of electronic payments and, like its bigger competitor Tyro (TYR.ASX), SMP has benefited accordingly. The merchant terminal market in Australia is around one million terminals and growing at 3% p.a.. About 30,000 new terminals are added each year and the banks dominate 90% of the market, followed by TYR (approximately 5%) and then SMP with about 5000 terminals of their own.
Source: SMP company filings
There is a pool of about 300 000 small merchants that SMP is targeting. On their current run rate SMP is adding over 5,000 terminals p.a.. Every 5000 terminals equates to approximately $20m of annual recurring revenue. Recently TYR has been having a serious connectivity issue with its terminals and this provides SMP with a unique opportunity to grab market share. At the moment SMP’s market cap is ~$200m and, based on current growth rates, we believe that SMP can add up to $150m of value to shareholders each year. With the sector consolidating, SMP is a takeover target and we think the stock will double over the course of 2021.
Healthia (HLA.ASX) is an allied health rollup of podiatry, physiotherapy and optometry clinics around Australia. The business plays into thematic focused on the aging demographic around the country with 650 Australians turning 60+ every day. Accordingly, we see further increased demand for HLA services. We estimate that HLA is on track for $180m revenue and $40m of EBITDA in Financial Year 2022.
Source: HLA company filings
So why do we like HLA:
Management are ex-Greencross (GXL, now privately held), which was a very successful vet clinics roll up that eventually got acquired and delivered significant value to shareholders.
HLA has now hit scale financially and has delivered a track record of execution since listing over two years ago.
The sector is consolidating. We see HLA as interesting because they could be both an acquirer and/or a potential takeover target in future.
Lastly but most importantly, HLA is cheap. Trading on 11.5x PE multiple, 6x EV/EBITDA multiple, and offering a 5% gross dividend yield. We value HLA at approximately $2.50
What an eventful year 2020 was! But with a change in administration Stateside we thought we should take a moment to dig out the crystal ball and try to grapple with what this means for us in the year to come and the markets in general. As with all predictions, please take this with a grain of salt.
Author: Sid Ruttala
Some Context
Since the days of FDR, any Presidency or change in administration has been seen and judged on the first hundred days. Roosevelt had inherited issues ranging from a close to collapsed banking system, the Great Depression and a tumultuous time when the fabric of American society was seemingly tearing itself apart. With large segments of the population questioning the notion of capitalism and US institutions. Sounding somewhat familiar? Roosevelt moved with great speed initially, getting the Federal Deposit Insurance Scheme passed through Congress and large swathes of legislation that formed the basis of the “New Deal”. A Presidency that saw the great man give “fireside” speeches and radio broadcasts directly to the American public in order to build back trust and reiterate what had been accomplished in his first hundred days via the now unforgettable broadcast of July 11, 1933.
The Biden administration inherits the nation and the state apparatus in similarly tumultuous times. Domestically, the nation is seeing some of highest unemployment since the GFC, a divided political landscape, a crippled economy, new debt issued since the advent of Covid-19 reaching the tune of 27% of pre-crisis GDP. Foreign policy-wise an expansionist China, a Russia unbalanced by protests whose cooperation is still required for its foreign policy agenda, allies who have been left in limbo by the former Tweeter in Chief and will inevitably consider any deals inked with the current administration up for debate by the time the next one comes along.
With this in mind, we come to the present. To quote Roosevelt himself, “The more you know about the past, the better prepared you are for the future.” Like Roosevelt before him, Biden too will look to act fast. The vast array of new incentives will focus on domestic issues including boosting unemployment, infrastructure spending and tackling climate change which remains a central issue especially to those further to the left of the party. So what does this mean for Australia and the Australian investor?
US Senate Committee on The Budget Chair Bernie Sanders at the Biden inauguration
Boosting Domestic AD (Aggregate Demand) & Employment
Many of the recent headlines have been dominated by the sheer scale of the proposed stimulus bill (to the tune of US $1.9tn), something that has already seen substantial pushback from the Republicans. Many have consistently said that, given the fact that the current $300 weekly unemployment benefit expires in Mid-March, for the sake of expediency and given the lack of Republican support we might see a much watered-down version of the same being passed. This is because in order for any legislation to be filibuster proof in the Senate, the numbers required are around 60 votes and not the usual 51 majority. For those of you unaware of what this means, the simplest explanation is that there is no time-limit on how long a senator can spend on speaking on an issue (any issue, a Senator could read fairy tales if he/she chose). If a cohort of the Senate wanted to block certain legislation, they could choose to speak on any topic they chose for an indefinite period of time one by one, blocking said legislation. That is, in the absence of a three-fifths majority (i.e. 60 votes) bringing the debate to a close by invoking cloture. Given the time constraints, some commentators have assumed that there will be an inevitable watering down in order for legislation to pass.I, however, would make the call that legislation in the first hundred days will be speedy and spending bills will be passed in Democrat favour irrespective of the filibuster rules. In the case of the budget, the bill will simply be put to “reconciliation” whereby a certain committee, in this instance the US Senate Committee on The Budget, can be called upon to “change spending, revenues, or deficits by specific amounts.” The committee puts together the bill with an ability to pass with 51 votes with the newly minted VP Kamala Harris breaking any tie. By the way, guess who happens to be the new Chair of the Budget Committee. None other than the internet’s favourite Senator from Vermont, Bernie Sanders. We all know how the Honourable Senator Sanders feels when it comes to budgets (and ensuring a steady supply of welfare to the American people).
\We will therefore likely see the requisite stimulus bill passed with potentially more to come. While Covid will continue to wreak havoc on large parts of the economy, the stimulus we expect should feed through into underlying Aggregate Demand and Expenditure within Q4 this year (given the lag time). With vaccine rollout underway we are likely to see a resurgence of pent up demand towards the backend of this year and first half of next year (in the absence of changes to Fed policy stances).
It was interesting to us that Biden’s pick for Treasury was Janet Yellen and much has been said about her subsequent wording when it came to USD and fiscal deficits. We see her interviews as validation of our view that not only will fiscal deficits continue to be blown out, but we are likely to continue to see policy makers prop up domestic demand at the expense of the US dollar. This is a trade off. To put it bluntly, this new focus on domestic demand will likely see a weakening of the USD in the medium to long term as well as new deficit spending, effectively being underwritten by the Fed. The trade off is effectively trashing the US dollar or the US economy.
What was rather telling was the fact that Ms. Yellen has clearly indicated that a focus will be placed on nations trying to manipulate their own currencies for commercial benefit, an eerily Trumpian policy stance. This seemingly innocuous statement was taken by the market to mean a bullish scenario for the USD. What I took away though was an awareness that more QE or movement toward YCC (Yield Curve Control) is likely to be required and the focus has to be on managing the pain when it comes to the inevitable pressures on the US currency.
For the Australian investor, this isn’t necessarily a bad thing given this nation’s reliance upon commodities which, all things equal, have an inverse correlation with the USD. For the currency traders amongst you, this presents the likely scenario that there is a bull case to be made for the AUD on a relative basis. A scenario that leaves our own policy makers some breathing space when it comes to managing inflation and the RBA’s often forgotten mandate of “stability of the currency.”
Infrastructure Spending
Within the whole context of stimulus, this is one area where there actually remains bipartisan support. And for good reason. According to even most optimistic estimates, according to the Council on Foreign Relations, the US infrastructure deficit is to the tune of close to $2tn by the year 2025. Here there are two important names to remember and they are the Secretary for Transport and the Secretary for Energy. The first nominee being Pete Buttigieg and the second being Jennifer Granholm.
Here again, the priorities given by the new administration were telling. Mr. Buttigieg is, again, a rather free-spending democrat but one with a gift for developing consensus. His rather breezy confirmation hearings and speech as pertaining to the ailing transportation infrastructure were taken well across the spectrum. We are likely to see him as a further catalyst for increased spending and given infrastructure is one with quite possibly the greatest fiscal multiplier (i.e. the amount of GDP added for every dollar spent) we will see this remain a focus. Ms. Granholm, previously the Governor for Michigan, has historically prioritised labour and providing jobs to her constituents. Her appointment yet again highlights that the second priority beyond infrastructure is labour. And, by the way, Janet Yellen is not a traditional central banker even when she was at the Fed, coming from a background of labour economics.
Within the context of infrastructure spending, we see continued emphasis on labour markets and green infrastructure in particular. This is especially the case given the pick for the EPA, Michael Regan who has been a career EPA official with brief stints working for the North Carolina Department of Environmental Quality and an NGO, the Environmental Defense Fund. A marked change from the previous administration which first nominated a lifelong critic of the EPA and second a coal lobbyist. This, combined with a nomination of the stature of John Kerry to the newly minted position of Climate Envoy, rejoining the Paris Accord and an Executive Order halting work on the Keystone pipeline, tells us that the life of the shale industry might have just got a little more complex.
This is a sign that is likely to see production and capex tick lower sequentially over the long run, especially given the reluctance of finance to play within the space. A situation likely to see continued upward pressure on the price of the Black Gold. For the Australian investor, Woodside or Horizon anyone? Similarly commodities such as Copper are likely to be further catalyzed with for example, wind turbines requiring 3.6 Tonnes of copper per megawatt generated.
Foreign Policy & Asia in Particular
Perhaps the most important relationship when it comes to foreign policy under the new administration will be the evolution of the Sino-US relationship, a relationship that is likely to determine the 21st Century. But before we go any further, let me tell you a little story. The year is 2008 and Wall Street, along with the rest of the world, is in the throes of the Global Financial Crisis, it was in this time that the Bush administration is preparing for one of the most audacious plans to bail out the financial services sector through the Troubled Asset Relief Program (TARP). However, there is a hurdle. The sheer scale of the project would entail the flooding of the Treasury market and new issuance to finance it. The answer was to send the ambassador in Beijing to ask the government of the day to silently buy up the new issuance. Within the space of a month, the PBOC had bought up close to $700bn in US treasuries.
What the above scenario illustrates is a relationship of mutual reliance (however uncomfortable), the Chinese could not afford to have their largest export market or the global financial system fall over and the US could use back-channels to save face. This scenario is however rapidly changing, initially under the Obama administration with the introduction of the now infamous TPP (Trans-Pacific Partnership) which, though a free trade agreement on face value, was a step in counterbalancing an expansionist China in the region. The tensions peeking under the Trump administration with his America First policy.
Though recent rhetoric by Xi Jinping in Davos placed emphasis upon multilateral cooperation, we somehow doubt that there is appetite in Washington to normalise relations any time soon. As we wrote about in our previous articles around Trump’s ‘trade war’, the question is not about current account surpluses but leadership, in particular leadership of the new industrial revolution (industry 4.0). China’s vision to no longer rely on labour arbitrage (labour is no longer cheap in China) and move up the value chain has created a scenario where American business, which has benefitted (in terms of the bottom-line) and historically erred on the side of caution when it comes to the hawkish policy or rhetoric, has endorsed a more confrontational policy. With Wall Street having close to three lobbyists for every congressman, we have no doubt that there will push for a more confrontational approach.
We will continue to see a disentanglement of supply chains, the building up of spheres of influence (through projects like the Belt and Road Initiative) as well as more aggressive security policy on both sides. Australia will unfortunately have to navigate this with great nuance given that China remains our largest export market and the US remains our largest source of investment. Australia, meet a rock and a hard place. In fact, the process has already begun with Lynas, for example, receiving $60m USD from the Pentagon to build a heavy rare-earths facility in Texas and Australia being seen as key to the US’ supply of commodities essential to the green economy. For the discerning investor however, this creates immense opportunities, creating artificial profits within companies that are seen as vital to the broader foreign and security policy. Think for example of the fact that Weibo has come to dominate the search market in China for the simple reason that Alphabet is unable to compete. Or the subsidies that Tesla continues to receive along with companies such as Boeing. This also happens to be one reason that we don’t see antitrust laws used against the tech giants even though there is probably an argument to be made there.
It is important as investors that we take advantage as the situation evolves, diversify geographically and not get caught up in the hype. Simply put, we do not see normalisation of policy. However, we do see the Biden administration as a reversion to the mean and likely to revive and continue on with the policies of the Obama administration (almost Obama 2.0 when one thinks about it). As for China, much has been said about Chinese expansionism and assertiveness, but my view is to look at it from the opposite perspective. Imagine if one were sitting in Beijing and looking out across the region, the below is what I would see. Military bases from Australia to Japan to South Korea to the Philippines. One would probably have reason to be cynical or at least uncomfortable…
Source: The Coming War on China, 2017, John Pilger
As with most things, there will be winners and there will be losers. It is up to us as investors to stay on top of the news and identify what these companies will be. In Australia, we will have to focus on walking the tightrope between China and the US and the opportunities it presents on both sides. As a materials heavy economy there may be a pivot to cater to the US’ green initiatives including rare-earths, energy (including nuclear). We make the call that given our commodities heavy investment landscape, we call an outperform for the ASX (excluding financials), we are the beginning of a secular commodities bull cycle as both superpowers look to build out their respective infrastructure and resource capacity. This also places us in the nice position of upward catalysts for the AUD and using this as a way to look to invest in sensitive sectors such as Technology outside of Australia and to back both horses (US and Asia).
