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Manish Singh, CFA | Chief Investment Officer

Crossbridge Capital

January 2018: Market Viewpoints - economic data and trade wars

Summary

That was a very brief US Government shutdown this week. It lasted two days. Not that I am complaining. The agreement reached keeps the US Federal government funded through February 8, but it does little to resolve the contentious issues of immigration and government spending. The deal doesn’t preclude a similar shutdown next month. Markets care more about economic data than political “noise” and the data continues to be good. On the back of US tax reform, US growth is expected to accelerate and hopes have risen of wage increases. Global GDP growth is set to accelerate to over +3.5% from +3% in 2017. The global output gap is forecast to vanish in 2018 – the first time in a decade. The International Monetary Fund (IMF) estimates that, last year, 150 out of 176 countries managed to increase their exports. That is the highest share of nations on record and slightly higher than the peak reached in 2005.

So what could go wrong? The answer is: Trade wars. We got a taste of it on Monday when the US slapped steep tariffs on imports of solar panels and washing machines. President Donald Trump now seems ready to start implementing his “America First” trade policy. Be prepared to see more such trade-enforcements in the coming months. As top exporters, Europe, South Korea, Mexico, China, and Japan are all vulnerable to US trade tariffs and the “America first” policy. However, if trade wars become a global “thing,” with nations responding with tariffs and counter-tariffs of their own in a free for all, then the European Union (and Germany in particular), Korea and Mexico are most vulnerable, given their higher reliance on exports.

Macron the diplomatic Casanova

President Donald Trump got dinner in the Eiffel Tower, President Xi Jinping of China was handed a horse called Vesuvius (the eight-year-old gelding recruited from France’s elite presidential cavalry corps) and Prime Minister Teresa May received the “Bayeux Tapestry,” albeit on loan. President Emmanuel Macron of France is on a major charm offensive.

Despite its name, the Bayeux Tapestry is not actually a tapestry but an embroidery. It was embroidered in England in the 11th Century and somehow made it to Bayeux, France in the 14th Century. At the heart of the story depicted on the tapestry, are the events leading up to the Norman conquest of England concerning William, Duke of Normandy, and Harold, Earl of Wessex, later King of England, and culminating in the Battle of Hastings. The winners always get to write (or stitch) history and so did the victorious Normans. The fact that the tapestry has survived nearly a thousand years is a miracle. During the French Revolution, in 1792, the tapestry was used to cover military wagons. A local lawyer rescued it and stored it in his house. The historic artwork could have left France 70 years ago – under less friendly circumstances, if it hadn’t been for the code breakers at Bletchley Park who, in the nick of time, intercepted the coded German signal. The message read “Do not forget to bring the Bayeux Tapestry to a place of safety.” The code breakers tipped off the Allies and French Resistance fighters made it to The Louvre, with just 48 hours to spare, and saved the tapestry from falling into the hands of the enemy.

With the US retreating from the world stage, German Chancellor Angela Merkel weakened and struggling to form a government and PM May distracted by Brexit and domestic politics, Macron is strutting the world stage, enjoying the good fortune of an empty stage, all to himself. Even the worst critic of the Macron will have a grudging admiration for his energy and drive as he attempts to lead France out of economic morass. Macron is trying his best to project France in a good light and, more importantly as joint leader of the European Union (EU) after France has allowed Germany to dominate the proceedings for the past decade and more.

A large part of Macron’s election manifesto was to make France competitive again and increase French exports. A trip to China, therefore, to secure trade deals for French exporters, was of immense importance. Earlier this month, Macron pulled out all the stops for his three-day state visit to China. He flattered the Chinese with Chinese literature quotes and projected himself as the ‘‘Ambassador’’ of Europe. President Jinping, however, saw him as a leader of a country with a population equivalent to that of the seventh largest province in China. Unfortunately for Macron, despite his Gallic charm offensive and “horse diplomacy”, he didn’t achieve much success on the visit. Whereas Trump came back from his China trip last November with over $250 billion of deals, Macron managed less than a tenth of that. France simply doesn’t have the economic clout to dictate favorable trading terms with China. When queried on deals signed, as if to hide his embarrassment, Macron said – “Rather than figures, I prefer a follow-up.”

On the domestic front, Macron’s approval rating, having fallen to as low as 40% in August 2017, has rebounded to 52%. Since moving into The Elysee Palace last May, Macron has lowered taxes, labour laws have been loosened and the once fearsome trade unions have been outmaneuvered (for now). Yet, it would be foolish to assume that France has turned around to become a “free market.” The socialist thread runs deep and it’s not limited to the socialist parties alone. Of course, France has much less of a communist following than in the past. Recall, that in years after the Second World War, France had the second largest communist party in Europe and mass strikes broke out as the communists objected to the American Marshall Plan to rebuild post-war Europe. The very Marshall plan that was to be lifeblood of Europe in its reconstruction.

Markets & The Economy

That was a very brief US Government shutdown this week. It lasted two days. Not that I am complaining. The previous two US government shutdowns under President Barrack Obama in 2013 and President Bill Clinton in 1996 lasted for 16 and 27 days respectively. President Trump has been criticized for his use of Twitter, but it was his tweets that got the Democrats to cave in. Following the shutdown, Trump went on a Twitter offensive and painted Democrats as a party that “prioritized illegal immigrants over American citizens.” One of his tweets read – “The Democrats are turning down services and security for citizens in favour of services and security for non-citizens. Not good!” With the shutdown heading into its third day and, with one eye firmly on the mid-term elections, the Democrats panicked and decided to take a deal they had turned down only the night before. Count this as the second big win for Trump after his win on tax reform.

The agreement reached keeps the US federal government funded through February 8, but it does little to resolve the contentious issues of immigration and government spending. The deal doesn’t preclude a similar shutdown next month.

Meanwhile, in Germany, the political establishment is getting on with what looks like a “stitch-up. The Social Democrats (SPD) and Merkel’s Christian Democrats (CDU) formally entered into coalition talks. The two parties that got trounced in the recent elections, and had promised their supporters not to form another coalition with each other – are now likely to form a new government. Wunderbar! The grind to form a government is only just beginning. Once a formal deal is in place, the SPD’s full membership – more than 400,000 people around the country – will hold another vote on whether to actually enter into government. A No vote would most certainly lead to snap elections.

Come rain, snow, sunshine or shutdown, global financial markets continue to push higher, with the S&P 500 (SPX) up over +6.13% YTD. Mr. Market cares more about economic data than political “noise” and the data continues to be good. On the back of US tax reform, US growth is expected to accelerate and hopes have risen of wage increases. We have seen several large US companies grant one-time cash bonuses, announce wage increases and/or boost hourly pay. Some have even increased matching contributions to workers’ 401(k) pension plans.

Apple (Ticker: APPL) said last week that it would make a tax payment of $38 billion related to its offshore cash holdings. Reliable estimates of cash held offshore by US companies’ range between $1.4 trillion to $2.8 trillion. Taking the lower number of $1.4 trillion, Apple’s offshore cash holding of $252 billion represents 18% of the total. The $38 billion which Apple is paying in taxes is nearly half of the total amount of additional revenue the US Senate’s Joint Committee on Taxation (JCT) estimated would be generated in 2018 by the mandatory repatriation. Therefore, it now seems likely that the JCT’s estimate of $78.6 billion in additional revenue will turn out to be an underestimation. This means that the near-term revenue boost from tax reform will be higher, and budget deficits lower, than originally estimated.

The global output gap (an economic indicator of the difference between the actual output of an economy and the maximum potential output of the economy when it is most efficient—that is, at full capacity) is forecast to vanish in 2018 – the first time in a decade. The International Monetary Fund (IMF) estimates that, last year, 150 out of 176 countries (that’s 85%) managed to increase their exports. That is the highest share of nations on record since 1980 and slightly higher than the peak reached in 2005.

Those looking for a correction or slowdown may therefore be disappointed. Once economies get in sync, they tend to grow in tandem for few years as they feed off each other’s growth. According to World Bank data from 2012 to 2016 the global economy grew at the rate +2.5% per year. During 2017, growth rose to +3%. By comparison, the global economy grew at about +4% a year from 1984 to 1989 and again from 2004 to 2007. Will global growth get back to +4%? Of course, it can. Higher growth begets higher wages and consumption. This begets more growth until a spike in inflation activates central banks to raise rates to cool down the economy.

So, what could go wrong? The answer is: Trade wars. We got a taste of it on Monday when the US slapped steep tariffs on imports of solar panels (tariffs as high as 30%) and washing machines (tariffs of up to 50%). President Trump now seems ready to start implementing his “America First” trade policy. Be prepared to see more such trade-enforcements in the coming months.

As top exporters the EU, South Korea, Mexico, China and Japan are all vulnerable to US trade tariffs and the “America first” policy. However, if trade wars become a global “thing”, with nations responding with tariffs and counter-tariffs of their own in a free for all, then the EU (and Germany in particular), Korea and Mexico are most vulnerable, given their higher reliance on exports. In a recent interview with Master Investor magazine, I discussed China-US trade tariffs and their implications, Jeremy Corbyn, global mega-trends, Bitcoin and Chinese Tech shares. You may find it a useful read.

I continue to be fully invested in the equity markets with an overweight position in US equities and a sector bias to Technology (XLK), Financials (XLF), Healthcare (XLH) and Industrials (XLI). I increased my allocation to Emerging Markets in December and continue to hold the MSCI world index weight position in Japanese equities (DXJ). The Crossbridge Capital global equity portfolio notched a performance of +19.4% (net of fees) for 2017 and is up +7.0%YTD. This equity Bull Run will only come to an end when the US Federal Reserve starts raising rates aggressively, as was the case in 2006/07, and the yield curve inverts. I have very little immediate concern on the yield curve inversion front. Keep your equity positions longs.

I am more concerned however about the EU and particularly the Eurozone. In the Eurozone, deep structural problems persist:

  • We’ve discussed Germany. In Italy, the self-styled “demolition man” Matteo Renzi’s sinking popularity, increasingly points to the March 4 election producing a hung parliament, which is not a positive outcome if attempting to reboot Italy’s economy. Joblessness remains a scourge in Italy, where a third of young Italians are out of work.
  • The Wall Street Journal reports that the retirement funds of grandparents are now the last hope for impoverished Greeks – even young ones. Pensions in Greece currently account for 17.4% of GDP. Italy and Portugal also spend more than 15% of GDP on pensions, compared with less than 12% in Germany, the Netherlands and Sweden
  • In Italy and Greece, new retirees outnumber new entrants into the workplace. Greece now counts 2.7 million retirees against a working population of 3.5 million. In 2016, Greece paid out €30 billion ($35.7 billion) in pensions but less than €1 billion in unemployment benefits. In Spain, nearly half of those 65 or older provide financial help to friends or families
  • Then there is Brexit. Poland and Hungary are in open rebellion against Brussels and Spain is divided over Catalonia.

There’s some good news on the Brexit front however. It seems France and Germany are coming around to understanding the importance of a bespoke deal for the UK and therefore the GBP/USD has hit the 1.40 level. Regular readers of this newsletter will recall I have always maintained that there will be a bespoke deal, because it is in the best interest of both the UK and the EU. If the EU had more sense it would use the deal with the UK, as a blueprint for deals it may have to strike when more countries leave the EU or even the Eurozone. President Macron was on the Andrew Marr show on the BBC this weekend and he showed some honesty in admitting France would have voted for Frexit, if they had a referendum on membership in the EU.

My concerns about the Eurozone are not immediate but are for later in the year, when the European Central Bank (ECB) starts unwinding its Quantitative Easing (QE) program. Will they unwind it rapidly or, indeed, will they be able to unwind it fully without causing another scare? This remains unclear at this time. The recent strength of EUR/USD is based on the anticipation that the ECB will not extend the QE beyond its September expiry date. I don’t see EUR/USD staying above the 1.25 level in the long term. Yesterday at the World Economic Forum in Davos, US Treasury Secretary Steven Mnuchin said – “A weaker dollar is good for us as it relates to trade and opportunities.” President Trump wants US equity markets higher and the US Dollar lower, but these alone are not going to push the GBP and EUR higher. I see GBP/USD in the 1.35 to 1.40 range over the next quarter and EUR/USD in the 1.20 to 1.25 range.

I continue to remain underweight the Eurozone and overweight the US because of the relative strength of the US economy. In the Eurozone, I choose to invest in individual stocks in the Financial and Industrial sectors.

In terms of stocks I like: JP Morgan (JPMUS), Bank of America (BAC US), Citi (C US), , VISA (V US), Blackrock (BLK), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRMUS), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN UN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Pioneer Natural Resources (PXD), Schlumberger (SLB US), Danaher Corp (DHR US), WallGreenBoots (WBAUS), CVS Health Corp (CVS US), Delta Airlines (DAL US), YUM Brands Inc. (YUM US), BNP Paribas (BNP FP), Barclays (BARC LN), Intesa Sanpaolo (ISP IM), Vinci (DG FP), Eiffage (FGR FP)

Best wishes,

Manish