Market Thinking - a view from the equity market

Market Thinking - a view from the equity market

15 September 2017

Welcome to the G2...and the blockchain.

  • The CLSA conference has brought a huge number of companies, investors and specialist speakers to Hong Kong this last week. Discussions ranged from geopolitics, to genetics, populism, automation and artificial intelligence.
  • More stock and thematic discussions looked beyond crypto currencies to the blockchain itself, while more immediate economics discussed the dramatic rise of the digital consumer in China.
  • The key takeaway is that the US and China are negotiating everything and anything to their mutual advantage, removing the need for the post war global institutions. Meanwhile the blockchain will potentially remove the role of the middleman everywhere.

This is one of the busier weeks of the year for the Hong Kong investment community as the giant CLSA conference is in town, bringing in a wide range of companies, specialist speakers and of course visiting global fund managers. Last year most people were still in a state of shock after the Brexit vote and for many, if not quite all, the discussion was about how there was no way that Donald Trump could win the presidency. Twelve months on and while Brexit still rumbles on, almost everything else has been stood on its head. In the UK,  Mrs May has fought and almost lost an unnecessary election, while a virtual unknown, Emmanuel Macron, who had not even announced his intention to run this time a year ago became president of France. The Italian prime minister has gone, while the Brazilian and South Koreans leaders have been impeached. Much of the reaction to all this geopolitical upheaval has been played through currency markets. Sterling fell on Brexit and populism, as did the euro, making the US dollar strong by default. The US dollar has been weak in recent months largely because of the risks from last year that didn’t occur. France did not elect a leader who wanted out of the euro and the Chinese not only failed to devalue their economy (as recommended by US hedge funds) but cut back on overcapacity and continued to sustain a booming consumer. A year ago everyone appeared afraid of the renminbi  and a China hard landing, now the halls were packed with investors looking to ‘get more China’.

But to start with one of this year’s big underlying themes, the blockchain. Last week we discussed the actions by the Chinese regulators to limit Initial Coin Offerings or ICOs and the impact that was having on the feverish speculation in bitcoin itself. This triggered quite a response and in the last week there has been a lot of discussion on bubble and crypto currencies as many of them have crashed heavily. However, to be clear, in pointing out that there were parallels to the South Sea Bubble, which there undoubtedly are, this is in the areas of the ICOs themselves, not necessarily the transactional digital currency that is bitcoin. In my opinion, bitcoin is here to stay, but its bigger role is to highlight to us the emergence of the blockchain, the digital distributed ledger that not only enables bitcoin and other digital currencies to exist, but offers the ability to disrupt traditional markets for goods and services equal to if not exceeding that of the internet itself. Thus just as the dot com bubble was all about raising analogue money to invest in products designed to sit on top of the internet, so the feature that connects all of these ICOs are that they are raising digital money (mainly bitcoin) for products that are designed to sit on top of the blockchain. This is where we need to be looking.

The myriad of crypto currencies being offered are perhaps better thought of as being tokens for future products and services. In an analogue world it might be $10 today to give you a $25 voucher to be spent in the restaurant that your ‘investment’ is helping the start up to build. As that restaurant gets close to being finished, the value of your token may approach that $25 value, but equally it could be worthless. In the world of ICOs you are asking for digital currencies such as bitcoin rather than dollars in exchange for your tokens and these will enable your investors to purchase goods or services from you in the digital world. What we observe with these crypto currencies is nothing more than the bid offer spreads in the second hand market for these tokens. Obviously some if not all of the initial capital will need to be spent in the real world on servers, salaries etc. so some of the Bitcoin raised by the ICO gets turned into ‘real’ money, so that the coins/tokens are analogous to chips in a casino. The proliferation of offering has undoubtedly helped raise demand for bitcoin as a transactional currency, while the rise in price has also boosted it as a speculative ‘asset’, hence in many ways we can think of bitcoin as like a digital version of gold. (It has also long had an appeal to those that want to avoid ‘the system’ of fiat money).

This is also a useful analogy when thinking of markets for digital currency. Many emerging economies with concerns over property rights and banking security will be very attracted to the use of secure, encrypted digital transactions, not just for their anonymity (although that may also be a plus).  As we already know from products such as M-Pesa, where people in Africa effectively ‘text’ each other money from their mobile phones, the concept of ‘safe as cash’ means something rather different in a transactional rather than an investment world. Also countries with large remittances find that their workers spend one month a year working for the money transfer agents, who typically charge up to 8%. The world of fintech is seeking to arbitrage away much of these spreads while also helping make people’s savings more accessible and more secure. This thus gives us some insight into the true importance of digital currencies such as bitcoin – they are built on the platform known as the blockchain, which not only makes them extremely secure, but more importantly they reveal to us the true disruptive nature of the blockchain itself. The point of the distributed ledger is that it solves the dilemma of spending the same cash twice. Once someone has given you a bitcoin, the entire network can see that this has happened. They cannot spend it again. You don’t need to trust a third party like a bank. You don’t need a third party.

Regulators are concerned about protecting the public from risky ICO schemes, but governments and the establishment generally are concerned about the lack of visibility within ‘the casino’. They can control the on and off-ramps as people convert fiat currencies into the crypto-currencies and vice versa, but once inside ‘the casino’ they cannot control the flow of capital. There is much talk about security and protecting investors, but a major problem for governments is that once inside the ‘casino’, not only can they not monitor digital money flows, neither can they tax them. Put simply, the blockchain is here to stay and if you thought the internet was a force of creative disruption, wait till this gets going!

As well as talks on digital currencies and blockchain, there was much focus on geopolitics. CLSA always has some big name keynote speakers, but this year the big draw was undoubtedly the presentation by Steve Bannon of Breitbart. Curious to think that he was a virtual unknown a year ago but is now quite rightly regarded as one of the most influential political thinkers in the world.

Personally, I found his presentation extremely interesting, but I suspect that many in the audience, prepped over the last eight months or so to expect some extremist firebrand, may have been rather disappointed.  I have been reading Brietbart since they set up the London edition of their website in 2014, much in the way that as a buyer of a stock I also want to read the analyst with a sell note on the company and it was a major factor in my belief last year that both Brexit and Trump were far more likely to happen than was in the common belief system. As such I suspect I was more familiar than some with his economic worldview. The talk spent some time on the rise of populism (a factor touched on by a number of speakers at the conference) and Steve Bannon put the blame squarely on the shoulders of Wall Street and the response to the financial crisis - pointing out the timeline of the Tea Party being set up the following year and UKIP thereafter. He also noted that with the support for Trump and Bernie Saunders combined it meant that over 60% of the vote in the US was either left or right wing populism. He stressed that America first is protectionist, but not isolationist and expressed admiration for the mercantilist systems of Japan, South Korea and China, which he acknowledged worked very well for them, but not as he put it for the US. As such he confirmed what we have discussed here before, that the strategy is for bi-lateral rather than multilateral military and trade deals. In a comment that resonated with the points I raised earlier this summer he described the institutions and rules based post war order as a “fetish” in Washington that no longer applies for the citizen of the US and he is clearly the driver behind the Trump administration’s rejection of multi-lateral agreements like the Trans-Pacific Partnership (TPP) or the Paris Accord and the desire to renegotiate arrangements such as NAFTA (North American Free Trade Agreement).  There was further resonance with Market Thinking (I am sure he reads it J) when he described One Belt One Road (OBOR) as one of the “most audacious”  pieces of geopolitics in the last 40 years, pointing out that it incorporated most  of the key geopolitical theories (Mackinder, Spykman etc.) that we discussed only last week. 

Perhaps with respect to his hosts, but more I believe because the view on China is more nuanced than it appears in the headlines, he repeatedly stressed his and the Trump administration’s respect and admiration for President Xi and the leadership of China and again in line with things we have discussed here before, it appeared very much that the attitude of the Trump administration was that ultimately most of the big issues can and will be sorted out by the US and China getting together and working things through to their mutual advantage. This to me is the big takeaway for the rest of the world – if the mutual advantage of the US and China also suits you, then that is great, but if it doesn’t, well, tough luck. G7, G10 or G20, are talking shops that he sees as no longer relevant, while multi-lateral deals on trade or emissions caps that might suit the majority but disadvantage the US will be ‘re-negotiated’. The globalist establishment as he calls them and those that work in the post war Bretton Woods institutions can complain as much as the like, but it won’t make a difference.

Steve Bannon is clearly not a fan of the globalist establishment of the Bretton Woods institutions and neither was another of the keynote speakers, Yanis Varoufakis, the former finance minister of Greece. If Bannon was surprisingly measured compared to expectation, Varoufakis was the opposite, positively fizzing with insights and waspish comments about the Troika and the politics behind the Greek bond crisis. Beginning even earlier in history than Bannon, he explained how the Bretton Woods system worked for the US to recycle its savings surplus in an almost Soviet style but collapsed when the US trade surplus went into deficit in the 1970 and that the power of the US was sustained by recycling other people’s current account surpluses. Thus, post the closing of the gold window and the collapse of the various currency pegs, the US was not only absorbing the exports of the world, but the capital account surplus (to balance the current account deficit) reflected the fact that the profits associated with those exports largely went back to Wall Street. He went on to describe how the EU was modelled on the previous gold standard such that the burden of adjustment falls on ‘the weakest shoulders’, but without the advantage of adjusting currencies and thus the people of Greece were “locked in an iron cage of idiocy”. He also noted that currently Greece has an unofficial dual currency system for the euro. Because of the limits on withdrawing cash, anyone needing to sell any asset for a larger amount has to take a haircut of around 20%, assuming even then that there is liquidity. He talked of people having bought a property for 400 thousand having to sell it for 40 thousand. The important point for investors is that while Greece as an issue of extend and pretend has not gone away (his unwillingness to do this was why he resigned), the real problem for the eurozone is not Greece, which he admits is too small. It is Italy.

Interestingly, while he was very gloomy about the willingness, let alone ability of European politicians to change, Yanis did have some interesting possible solutions, essentially centred around the notion of simulating a fiscal union, without actually having one. Thus for example, the EU could allow debt up to the Maastricht limits as a percentage of GDP to be treated differently to any ‘surplus’ debt and effectively be bought by the European Central Bank (ECB) at close to zero rate, creating a form of European sovereign debt. The reduction in interest payments would be meaningful without appearing to give a blank cheque to deficit countries. Another idea was to turn Target 2 balances in the European financial systems around such that there were penalties for running too big a surplus as well as too big a deficit, forcing Germany in particular to recycle. Like Steve Bannon he was critical of the lack of investment going into real assets and real businesses. Unlike Bannon, however, he does not have a direct line to power, but he and his campaign group do have some very interesting insights and ideas and are very much worth keeping an eye on in my opinion.

In other news this week, it was interesting to see that the Chinese authorities have been unwinding some of the regulations they put in place to help protect the renminbi from speculative attack this time last year, perhaps not unconnected with the revelation that some of the China bears have finally capitulated. As reported last week on Bloomberg, US investor Mark Hart has finally closed out his losing bet against the Chinese currency. He was one of the more aggressive of the US hedge fund collective that was calling for a 50% drop in the renminbi this time a year ago, along with other high profile pundits such as Kyle Bass, David Tepper, Kevin Smith and the UK’s Crispin Odey. Most have quietly walked away, but uber bear Kevin Smith isn’t giving up and now believes that the yuan could fall 70% over the next 12 months! According to Bloomberg his fund lost 14% in the first seven months of this year on this trade so his investors have to be patient.  The high profile however is probably a function of the fact that, again according to Bloomberg, he only runs $79m so he is going to need to persuade a lot more people into his position.

This is not to gloat, but to remind investors that just because a big name investor made money in one market – most of them in the subprime market as bears – doesn’t necessarily translate to an expertise in others. Equally a lesson for traders is that even if you do get the economics right (and I am not saying that they did by the way) you make money by betting on what you think the authorities will do, rather than what you think they should do. China did not seek to deal with excess inventories by artificially boosting demand, nor by cutting export prices through a depreciation, they did it by cutting capacity.  Moreover, they prevented speculators from forcing their own agenda because they were not in the same position as a typical emerging economy (or the UK under ERM even). To paraphrase Sun Tzu (which many of them profess to read) - they knew themselves, but not the enemy, so for every victory gained they have suffered a defeat.

The rest of the week was packed and I will revisit some more of the themes and ideas next week, but to conclude, the Trump administration seemingly admire the Chinese government of President Xi and it looks like the two of them are likely to work together post the 19th Party Congress to resolve a number of differences including surrounding North Korea. President Trump’s November visit to Asia will thus be extremely important, not only for the Korean Peninsula, but for the rest of the world, as the two of them look likely to create a new set of rules. To put it bluntly, in my view China and the US will organise things to their mutual advantage, with little or no reference to what might be ‘fair’ for the rest of us. If Steve Bannon is to be believed this could mean protectionism, but not isolationism, the US is not going to retreat leaving China to take over the global institutions and multi-lateral agreements, those institutions are no longer relevant to the two largest economies in the world.  Meanwhile an increasingly digital Chinese consumer has already skipped a generation in terms of payments systems and is engaging with crypto-currencies to an extent that worries regulators. The concerns about the ICOs however are almost certainly overdone and ultimately miss the real story. The myriad crypto-currencies issued as ICOs are really just tokens to use a product that you are helping to build on the blockchain. The value of those tokens will vary depending on the perceived probability of ever being able to use them. The real story is the blockchain itself, which is perhaps best thought of as the next level of the internet. All the ICOs are for disruptive technologies that sit on the blockchain. Most will fail, but many will not and they will act as a massive disruptor to existing businesses since in essence they remove the need for third party intermediaries between buyers and sellers. With the G2 removing the need for all the post war global institutions and the blockchain destroying the profitability of many professional intermediaries, I think the globalist middle class professional and managerial classes are looking at some serious creative destruction. 

All data sourced by AXA IM as at Friday 15th September 2017.

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