The U.S. capital markets have been undergoing rapid changes. Interest rates which had been low for so many years are rising: the fed funds rate is up by 150 basis points (bps) from its cycle trough and the 10-year treasury is up 140bps. Equities, after being in a seemingly unstoppable bull market for almost 9 years, have stalled since late January and volatility has surged with the CBOE Volatility Index (VIX) jumping from a low of 9 to 25 in just a few months. It is indeed possible that the great bull market will not be able to endure in the face of rising rates and growing uncertainty.
Only time will tell.
In the meantime, professional investors would be well-served to focus on themes. It is the identification of change-driven themes that is our mission at MRP. So, in the face of the recent market turmoil, a review is in order. Since October we have added 3 new themes and also eliminated 3. Currently, we have a total of 19 themes that are active. A review of them follows.
THEMES FOCUSED ON COUNTRIES OR REGIONS
ASEAN – Long:
Launched March 28, 2018.
The Association of Southeast Asian Nations (“ASEAN” bloc) has emerged into an important economic bloc thanks to its strong growth, rising urban population, favorable demographics, growing middle class, and geographic proximity to China and India. Although ASEAN produces more than 7% of the world’s exports, it accounts for just 3.3% of global GDP. However, that is likely to change in the future, as the bloc now has four key elements that should pave the way for ASEAN to become Asia’s new low-cost manufacturing hub.
New and disruptive technologies are impacting almost every industry and creating the sort of dynamic business environment that is conducive to an economic boom.
ASEAN market valuations are still relatively low and earnings have lagged the underlying macro momentum.
FRANCE – Long:
Launched June 14, 2017.
France has finally emerged from a decade of low growth and weak job creation that left nearly 3.5 million people out of work. The country is experiencing its strongest pace of job growth since the 2008 financial crisis, and President Macron’s pro-business agenda is already having a positive effect on GDP. Last year, the economy expanded at a rate of 1.9% versus growth of 1.1% in 2016. It is projected to grow 2.5% in 2018.
Macron’s efforts to revamp France’s labor laws last summer went better than expected. He has now taken on a greater challenge which could define his legacy as president. Macron’s proposals to abolish jobs-for-life at the state-owned SNCF railway company have set his administration on a collision course with France’s powerful labor unions which have organized nationwide strikes.
The strikes affect rail and air transportation and could last for months, disrupting the economy. We will be monitoring this development closely.
GREECE – Long:
Launched January 19, 2018.
Greece is on track to finally exit its bailout program this year. Kalin Anev Janse, a board member of the euro zone’s bailout fund, noted: “They have pushed through unprecedented levels of structural reforms and are one of the few countries in the euro zone to run a fiscal surplus along with Netherlands and Germany”.
The European Commission sees the economy expanding by 2.5% in 2018 and 2019, up from 1.6% growth in 2017 and negative growth in 2016. An EU-sponsored investment of 8 billion euros into the recovering economy should help spur further growth as restrictions on banks are also eased.
Greece’s stock index is still 40% below its previous high, but should get a boost as earnings improve.
THEMES FOCUSED ON SECTORS
AUTOS – Short:
Launched October 12, 2017.
Auto sales have slipped in the first two months of 2018. February saw a YoY decline in sales of 2% and this pace could begin accelerating from here on out. Auto loan interest rates are now at levels not seen since 2010 – an average of 5.2% in February, compared with 4.4% in February 2013. That means higher monthly payments regardless of whether one is buying or leasing. The average new-vehicle retail transaction price to date in February is $32,237, a record for the month, surpassing the previous high of $31,302 set in February 2017.
The consumer price index for used cars and trucks had been ticking up for the past few months, likely bolstered by the 1 million vehicles destroyed in Hurricanes Irma and Harvey this past year. However, February broke that trend with an 0.3% decline MoM.
Inventories of new vehicles are still taking very long to clear, currently an average of 70 days before a dealer is able to sell a new vehicle – just off the highest level since 2009 of 75 days.
Outstanding motor vehicle loans are also at an all-time high. Auto loan debt has climbed 14% since the beginning of 2016. Delinquencies on auto loans also threaten to bring down the car market as the percentage of 90+ Days Delinquencies have increased by 15% over that same span. Auto loans are the second fastest growing loan delinquency category, trailing only student loans.
DEFENSE – Long:
Launched November 27, 2013.
The recently passed $1.3 trillion spending bill includes $650 billion for the U.S. Defense Department, dramatically increasing funding for the military by almost 10%.
The Missile Defense Agency will get $393 million to speed up Boeing’s modernization of the “kill vehicle”, an integral part of 20 Ground-Based Midcourse Defense System interceptors. There are also funds for three more Boeing KC-46 tankers, on top of the 15 the Air Force requested. The Army will recieve $577 million for 17 Boeing AH-64E Apache helicopters, and the Navy $501 million for three more Boeing P-8 maritime surveillance aircraft.
The proposed budget also includes $165 million for more Lockheed Terminal High Altitude Area Defense interceptors along with $178 million for Raytheon (RTN) SM -3 interceptors and $137 million for another test of Raytheon’s SM-3 Block IIA missile. Both interceptors are for use in Lockheed’s Aegis Ashore system. Along with an increase in F-35s, Congress approved $84 million for six more Northrop MQ-8 Fire Scout unmanned helicopters.
ELECTRIC UTILITIES – Long:
Launched November 20, 2017.
Electric utilities are on the cusp of a renaissance powered by four major forces: the electrification of transportation, the proliferation of digital data from IoT and cloud computing, the digitization of money, and advances in energy industry technologies. These shifts are heavily influencing how money is being deployed on infrastructure, which will transform the electric grid from traditional to “smart”.
A U.S. household with an electric car could see a significant increase in its electricity usage. Meanwhile electricity consumption from data centers and IoT should rise, because wireless technologies consume more energy than wired technologies such as fiber, cable or DSL. Also, the mining of cryptocurrencies, whether privately-issue or government-issued, will still need to be mined which requires a lot of power.
These seismic shifts will result in higher electricity demand and a more dynamic business model not yet fully priced into the stocks of electric utility companies.
U.S. FINANCIALS & REGIONAL BANKS – Long:
Launched December 23, 2016.
While interest rates are rising, a good sign for the financials sector, an impending trade war between the US and China is creating shaky footing. The consensus view, as of now, is that long-term growth expectations are not keeping pace with short-term growth, flattening the yield curve.
However, as Trump has already granted tariff exemptions to multiple countries and is preparing to negotiate with Chinese officials, it remains to be seen if GDP growth will actually be negatively impacted in the long term.
Outside of international tensions, things are looking up for banks. Overall net-interest income for U.S. banks rose 8.5% in the fourth quarter from a year earlier – a jump from the 7.6% increase in Q4 2017. Along with this, the average rate on a one-year certificate of deposit, or CD, rose to 0.49% last week, the highest level in more than seven years. MRP sees higher rates on the way, spurring more deposits and saving.
On the regulatory front, midsize banks are set to benefit from new legislation that rolls back Dodd-Frank, raising the threshold at which banks face tighter oversight to $250 billion in assets from the current $50 billion. For a long time, banks have purposely restricted their assets to remain below the $50 billion mark to avoid enhanced oversight. With the new legislation in place, a wave of M&A could pave the way for expanding regional banks.
US HEALTHCARE PROVIDERS– Short:
Launched October 16, 2017.
Lines are being redrawn in U.S. healthcare as the $3.3 trillion industry undergoes an unprecedented transformation. Hospitals are wading into drug manufacturing, pharmacies are merging with insurers, and corporate America is experimenting with customized solutions that bypass traditional stakeholders.
Reimbursement cuts, lower patient volumes, and pressure to provide more care in outpatient settings are forcing health systems, such as hospitals, to rethink traditional barriers and business models.
This is just the beginning of a restructuring of America’s healthcare industry which is also under significant regulatory strain. MRP believes that as these forces unfold, share prices of healthcare services companies will likely underperform under these conditions.
U.S. HOMEBUILDERS & HOME CONSTRUCTION – Long:
Launched November 3, 2011 / Reaffirmed in the Spring 2012 / Updated August 5, 2016.
In February, MRP reaffirmed our Homebuilders and Home Construction theme in Beyond the HOUISNG HEADWINDS. Although total housing starts slipped again in February, it was largely dragged down by a decline in multi-family units. Single-family housing starts increased 2.9% from 877,000 in January to 902,000 in February. New home sales slowed while existing home sales increased in the month.
The data initially seems neutral, however homebuilder sentiment still remains high with the National Association of Home Builders/Wells Fargo Housing Market Index at 70, well above 50, considered to be the baseline for a positive reading. Although home prices continue to rise, the estimate of new houses for sale at the end of February was 305,000, the highest since March 2009. However, the current 5.9 months of supply is still more than 40% lower than what it was in ‘09 since today’s rate of sales is much higher.
The pressure of rising mortgage rates should continue pushing prospective home buyers to lock in purchases before rates increase even more in the long run. According to a recent survey by Redfin, 94% of respondents would not cancel their search for a home altogether because of rising rates, and 21% of that cohort said rates passing 5% would increase their urgency to buy a home.
INDUSTRIALS & MATERIALS – Long:
Launched December 23, 2016.
The basis of this theme was our expectation that President Trump’s policies would unleash a national infrastructure rebuilding program and improved corporate cash flows, both of which would spur a boom in private sector and non-residential construction outlays. This in turn would lead to substantial increases in demand for industrial materials and machinery. The country is still waiting on the President’s supposed $1 trillion infrastructure project; thus far, he has only signed an executive order to speed up approval of projects.
Despite this, capital expenditures in general have exhibited strong year-on-year growth, with the industrial side recovering from largely negative figures in 2015 and 2016. The industrials XLI has kept pace with the S&P in 2017, returning about 14% since the theme launch. The Materials XLB has done slight better, returning almost 17% over the same period.
ROBOTICS & AUTOMATION – Long:
Launched July 20, 2017.
As with many technologies, China is taking a leading role in automation. Their growing dominance in AI research is leading the charge as the number of industrial robots put to work in China reached record levels in 2016, with installations projected to swell at an annualized pace of between 15% and 20% through 2020. The pace is unlikely to slow as fears of steep unemployment and growing poverty in China have proven unmerited. Humans aren’t displaced for very long. They’re retrained, even if informally, to oversee more and more output, with much of that output growth the result of automation.
In the US, automation is continually growing. Low unemployment rates are leaving a lot of manufacturing firms without human labor to staff factories, accelerating the pace of automation. Only about 12.4 million factory workers were employed nationwide last year, a decline of almost 2 million industrial jobs in a decade and 5 million since 1997. However, output as a share of GDP continues to hold steady, indicating that robotic technologies are picking up the slack.
Last year 27,294 robots worth $1.47 billion were ordered in the first nine months for installation throughout Canada, Mexico and the United States. This was a record sales mark for any three-quarters period in any year. The average price was $54,000 per unit, affordable for most manufacturers.
VIDEO GAMING – Long:
Launched October 19, 2017.
Gaming is experiencing a large-scale shift to the cloud. Microsoft, one of the longtime hardware producers of the industry and manufacturer of the Xbox, has recently broken new ground in the industry by introducing a “Netflix for Gaming” based on its cloud service. Further, more than 90% of the world’s largest game companies are now utilizing Amazon Web Services, the megacorporation’s cloud computing arm, which offloads online gaming infrastructure tasks to Amazon’s giant cloud computing resources. Amazon has said that top games from Activision’s Destiny 2 to Supercell’s Clash Royale rely on its cloud infrastructure to handle the ebbs and flows of demand on cloud-connected data centers.
Steam, the world’s largest gaming platform, had a record year in 2017 with $800 million in growth from 2016. Consumer spending worldwide on game consoles and hardware related services last year reached its highest point since 2011, recording an 18% YoY increase – the first YoY increase since 2014.
THEMES FOCUSED ON COMMODITIES
GOLD & GOLD MINERS – Long:
Launched October 21, 2015.
Gold has been stronger in 2018 as a result of a consistently weak dollar and volatility creeping back into the market. Inflation is also trending back up, threatening to push gold even higher. While the Fed is still treading their path to higher interest rates, a 50 basis point increase for the rest of the year is still dovishly cautious and does not pose a huge threat to gold.
Rising instability is always a catalyst to watch and with some of President Trump’s latest moves, tariffs on Chinese tech products, and the appointment of the aggressive John Bolton to the position of National Security Advisor, gold could continue an upward trend.
Further, the S&P 500 is still overvalued and has been in a bull market for more than 8 years. MRP highlighted the extended market valuations in our market viewpoint report The Gathering Storm and believes that the price of gold will move significantly higher.
LITHIUM – Long:
Launched October 2, 2017.
Lithium has been the central catalyst of the battery revolution this past decade. It already plays a large part in our daily lives through our smartphones, laptops, and almost all other rechargeable electronics. The market for lithium-ion batteries alone was $31 billion in 2016 and is expected to reach $67 billion by end of 2022. A lot of that growth will come from the electric vehicle and utilities sectors. All the major auto makers have frontloaded their electric car plans, and lithium-ion batteries are the fuel source of choice for most of them. Electric power generation companies are also increasingly using batteries to store solar energy during daylight hours, and these energy-storage sites feature large lithium-ion batteries.
Lithium has faced some headwinds, chief among them, a Morgan Stanley report that forecast rising supply to decrease prices by 45% over the next 3 years, a prediction that contrasts with most analyst expectations. Industry executives also dissent from this opinion, stating that Morgan Stanley underestimates strong demand and how complicated lithium is to process and mine.
Further, the effect of the demand from automakers has not yet become a significant part of the pricing equation. Real lithium supply and demand—producers selling to cathode manufacturers—is what is currently driving the price. The auto majors are yet to enter this “real” market”.
OIL, US ENERGY, OIL SERVICES – Long:
Launched April 8, 2016.
The OPEC-Russia cartel, whose output cuts have become deeper than planned, with total compliance reaching 149% in February, may now extend the restrictions into 2019, according to Saudi Arabia’s Energy Minister Khalid al-Falih. This, while instability and the resulting decrease in production is still plaguing some key producers like Libya, Angola, and Venezuela. In the US, inventories are now below the 5-year average, following months of net declines in crude stockpiles.
Oncoming US tariffs on steel and aluminum – crucial components of energy infrastructure – could create a significant effect on oil markets. US oil and gas executives are skeptical that the US steel industry has enough capacity on its own to supply future infrastructure expansions, especially since some projects require specialized steel that is not produced by American companies and must be imported. Steel needed for 26-inch pipelines, for instance, is manufactured in only three countries, none of which are the U.S. A study by the Association of Oil Pipe Lines last year showed that a 25% increase in pipeline costs could increase the budget for a typical project by $76 million.
If the cost to build pipelines increases, the price of crude must be higher to incentivize oil companies to invest in their construction and expansion. If US pipelines are not expanded, thereby eroding American export capacity and upstream investment in new projects, importers would simply have to find oil elsewhere. OPEC would be the most likely candidate to fill that demand, guaranteeing they maintain reasonable power over prices.
PALLADIUM – Long:
Launched October 9, 2017.
Shortages sent prices to a record $1,139.68 an ounce in January. While the price has slipped a bit lately, the rest of 2018 is expected to see production continue to trail.
Palladium is a key emission-controlling component of catalytic converters in gasoline engines, whereas platinum is used for that purpose in diesel engines. Along with restrictions and outright bans on diesel-powered vehicles throughout Europe decreasing the market for platinum, palladium is benefitting from the shift to cleaner, but still gasoline-based, hybrid engines.
STEEL – Long:
Launched December 23, 2016.
Enthusiasm for US steel and aluminum companies was very high when President Trump announced sweeping 24% tariffs on all foreign steel. However, as seems to be Trump’s negotiating style, he begins slamming an issue with a sledgehammer and then, later, dialing it back. In this case Trump has already granted the European Union, Brazil, Mexico, Argentina, Australia, Canada and South Korea temporary exemptions from duties on steel.
It is important to note, though, that US steel producers will still benefit from tariffs on countries like Russia, Turkey, and China. These specific exemptions will even further bolster other parts of the US steel industry. For example, companies like California Steel Industries Inc. don’t produce the raw steel used for their sheets and pipes, but rather buy whole slabs from Mexico and Brazil.
China, the world’s biggest steelmaker, is now expected to continue production cuts beyond the winter heating season as the nation presses ahead with a campaign to reduce air pollution, and simultaneously reducing a supply glut. Hebei Province, together with several other areas of northern China, ordered cuts of as much as 50% on steel production during the winter heating season, and the country as a whole plans to eliminate 30 million tonnes per year of production capacity in 2018. A goal that should be reached comfortably, opening the door to further cuts later in the year.
THEMES FOCUSED MARKET CYCLES
TIPS (Long) / LONG-DATED UST (Short):
Launched October 26, 2016.
In November’s Market Viewpoint report, Beyond the BOND BUBBLE, MRP highlighted four major disruptions that would depress bond prices in 2018. These included the Fed’s balance sheet shrinkage, rising interest rates, the acceleration in global growth leading to higher inflation, and a changing of the guard at the Federal Reserve, and possibly, a more hawkish central bank. Indeed, Jerome Powell’s Fed is already projecting three rate hikes in 2019, up from the previous projection of two.
Now, there are external headwinds in the form of waning demand from Japan and China’s possible scaling back of its US treasuries purchases.
Moreover, MRP believes bond yields may soon start moving in the direction of the US’s nominal growth rate, which itself may be about to accelerate. If the administration hits its real GDP growth goals and the Fed were to hit its inflation target, nominal GDP growth of 5-7% would suggest a more than doubling in the level of the 10-year yield.
As we’ve noted before, longer-term bonds perform poorly in rising interest rate environments, so now would be as good a time as any to short long-dated U.S. treasuries.
VALUE OVER GROWTH – Long:
Launched August 28, 2015.
The FAANGs have lately been hit with a load of “techlash”, largely stemming from external idiosyncrasies. Chief among them has been the renewed push for data privacy measures in the wake of Facebook’s Cambridge Analytica scandal and subsequent FTC probe. Facebook’s share price has declined more than 13% since March 16th. Europe’s incoming General Data Protection Regulation legislation is also rattling shareholders of social media corporations that make large sums of revenue from selling user data. The GDPR requires explicit consent from users for their data to be stored for later use. Amazon has also tumbled 8% in the two days after taking shots from President Trump, sparking fears of a possible antitrust investigations.
Further complicating things for growth stocks, two more interest rate hikes are on tap following this month’s FOMC decision to hike the fed funds rate from 1.5% to 1.75%, already the highest level since the Great Recession began. On top of this, they have also increased the pace at which they’d like to continue raising rates, plotting a path to 3 rate increases in 2019 instead of the previously forecasted 2. This is significant for high growth stocks as the present value calculation of its expected future stream of earnings wil be discounted.
During the past ten years of near-zero interest rates, growth stocks have have dramatically outperformed value. Now that the Fed is squarely focused on tightening, the market landscape will undoubtedly shift. If history is any indication, the initiation of higher rates will be followed by a reversal of the earlier trend, and value will prevail.