US-China Trade War Effect on the EU

Back in March we introduced and briefly discussed Trump’s intention to impose tariffs on steel and aluminum goods. In less than a year those trade disputes escalated in a trade war, impacting not only the two involved countries but also other trading partners, including the EU. The disaffection versus international institutions has been driven by their inability to include the weakest parts of the population from feeling the benefits of the globalization process. While globalization has triggered economic growth and substantial real income growth in developing countries, the middle class of developed nations has not experienced the same benefits, leading to a decrease in purchasing power and a rise in protectionist sentiment.

The main idea behind Trump’s rhetoric was to reduce the large trade surplus China has with the United States. Trump previously described the widening deficit, which Washington has said is around $100 billion wider than Beijing reported, as “embarrassing” and “horrible”. China and the EU were among those expressing their concerns regarding steel and aluminum tariffs and have threatened the US with applying a number of countermeasures. Jean-Claude Juncker, President of the European Commission, announced that the union will engage in a collective response with other countries affected by American measures and expressed EU’s intention to draft a list of retaliation tariffs amounting to $3 billion.

Since then, Trump’s actions have shaken the very foundations of global trade, with billions of dollars worth of goods from the EU, China, Mexico and Canada. The protectionist measures imposed by the American president have escalated into a full-fledged trade war between China and the US. An economic showdown between world’s largest economies does not look great for anyone and the EU’s manufacturing and industrial sectors are largely affected. Clearly, those sectors are monumental for Germany – the world’s fourth largest industrial nation.

Potential Paradigm Shift?

As the US is escalating the trade war, it will be more difficult for China to accommodate American demands. There are few effective ways for China to retaliate without hurting its long-term development. An alternative would be to open up to the world’s largest economy to the EU. Thus, there is an expectation of a possible collaboration between China and the EU, given that China accepts the longstanding demands of the EU on better market access and give-and-take approach. Within this scenario we would observe a paradigm shift in terms of US-China economic relations. The EU Commission currently maintains a neutral stance towards Chinese exports. So, the result would largely depend on whether EU chooses to align with the US to protect its market from the Chinese market or maintain the neutral policies. By maintaining the neutral stance, EU could substitute the US and China in each other’s markets to an extent. Given that US does not hit the EU directly and EU maintains a neutral stance, potential gains for EU industries are relevant for the motor vehicles and aircraft sectors as well as other sectors combining over $200 billion altogether.

Germany’s GDP Growth

In the third quarter of 2018, German output contacted for the first time since 2015 and this helped push the euro zone growth down to just 0.2%. This weakness is expected to continue in 2019, with the German GDP Growth rate revised down from 1.8% to 1% due to the global economic slowdown. Furthermore, the euro zone does not have the economic backdrop to increase rates, since the ECB ended its net asset purchases in December. Therefore, the benchmark rate is likely to remain the same, making it harder for the EU to offset the effects brought about by the trade war.

The main factor contributing to this contraction is the German auto industry. German car production decreased by 7.4% quarterly and this subtracted 1% from expansion in the industrial production and 0.3% from Germany’s GDP growth. The reason for this decrease comes partially from the new environmental standards for passenger cars, as producers could not make the vehicles as quickly as they desired.

Another reason for the Germany’s GDP slump might be China’s economic slowdown as China is one of Germany’s largest trading partners. China is facing economic issues arising domestically due to financial instability and externally given the trade tensions with the US. In October, China’s financial team went into overdrive with ten meetings within two months and Vice-Premier Liu He’s team was under pressure to resolve problems caused by the trade war that slowed the country’s growth. China’s economy officially grew only 6.4% on YoY basis in the fourth quarter, its slowest rate since the global financial crisis. A lack of growth in investments and consumption is the main driver of this lackluster performance.

Weakness In The Car Industry

Back in June, Germany’s Daimler cut its 2018 profit forecast, while BMW stated it was looking at “strategic options” because of the trade war. Thus, the companies sparked fears of earnings downgrades in the auto industry. Daimler stated that import tariffs on cars exported from the United States to China would hurt sales of its Mercedes-Benz cars, resulting in slightly lower EBIT for the year. Morgan Stanley’s analysts added that Daimler will not likely be the only Original Equipment Manufacturer (OEM) to reduce its guidance. Other OEMs are exposed to similar trends in various degrees.

Daimler’s rival BMW, which also exports from the United States to China and Europe reaffirmed the profit forecasts, adding that these would largely depend on unchanged global political conditions.

“Within the context of the current discussion concerning additional tariffs on international trade, the company is evaluating various scenarios and possible strategic options”.

European Central Bank’s Hard Work

Mr. Draghi of the ECB and Mr. Weidmann of the Bundesbank seem to agree that the policy should be normalized without delay. This suggests that the ECB remains determined to end net asset purchases by the end of 2018. Still, German exporters are vulnerable to the slowdown in external demand and the risk of trade tensions between Europe and the United States.

So, what should the ECB focus on? The Quantitative Easing program launched in 2015 with the intention to reduce the risk of deflation has come to an end last December. The key EU Inflation Rate rose above the ECB’s target of close to but below 2% for 2018, making it harder to justify an extension of the QE program.

The ECB held its benchmark refinancing rate at 0 percent on October 25th and said it would stop to make net purchases under the asset purchase programme at the end December 2018.

This situation has changed in the past months as the effects of the Trade War have been felt on both the real economy and financial markets globally. The sharp slump in energy prices, a contraction in Exports and finally Consumer Sentiment drifting lower from high levels have consistently reduced Inflation and GDP Growth expectations for the EU Area. As a result, it is highly improbable that Mario Draghi will be able to follow through on ECB plans towards normalization in the short term. The continued reinvestment of the proceeds from bond redemptions will be necessary to provide stimulus to the European economy for the years to come. Moreover, ECB should use the forward guidance to thrust back market expectations over the key interest rate rise – something which would weaken the euro and further loosen the financial conditions. The ECB’s next moves largely depend on the upcoming levels of inflation and economic activity, which are linked to politicians’ ability to solve trade disputes and restore confidence.

Trade War Detente

China and the US have agreed to not impose new tariffs up until March, when a definitive agreement is expected to be reached. Furthermore, China’s Ministry of Finance removed the 25% tariffs on American-made cars and 5% on specific car parts for three months. This shows the willingness of both sides to cooperate and work towards a larger trade deal, but only time will tell whether this willingness will convert into a desirable outcome. As commentators pointed out, any positive cooperation including negotiation or even talking would help settle the markets, while continuing tensions will instigate investors to withhold their money.

Even if according to the United States Trade Representative several outstanding issues remain, the possibility of an expedited trade deal has helped stabilize the markets in the last weeks.

The Dow Jones Industrial Average gained 163.08 points (0.7% increase) to 24,370.24 – its highest level since December 13.

The upcoming elections of 2020 in the US oblige Trump to find an agreement in order to maintain his electoral base and increase his probability of reelection. According to reports from various sources, US officials are willing to grant China sizeable concessions in further negotiation rounds to reach an agreement before the deadline. It is unknown if this is enough to restore confidence in the system and the first test is expected in few months on the other side of the Atlantic Ocean. In May there will be the elections for the European Parliament, with Eurosceptic Parties gaining ground thanks to the widespread economic malaise exacerbated by the Trade War. The March meeting proves to be essential for all the parties involved, making extremely hard to forecast future upcoming events.

Authors: Nikita Borzunov, Mario Stopponi

The website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.

Our view on 2019

What’s up buddy?

At the beginning of 2018, the VIX, an instrument which tracks the volatility of the S&P500, surged dramatically showing a comeback of fear among investors (Figure 1) following a period of extreme calm started after the financial crisis.

Figure 1: Higher VIX since February 2018

Source: Bloomberg

February’s spike in volatility led to further speculations about a coming correction or bear market as the end of the bull market started in 2009. Through 2018, we saw an increasing number of headlines on the coming bear market but, on the contrary, the main US equity indices kept reaching new highs without giving any signal of a downturn. However, during the week starting on October 8, the main US equity indices fell raising concerns about the beginning of a correction. On October 10, the S&P 500 swept 4% from its all-time high with the 60% of the stocks composing the index down >10% from the 52-week high, therefore in correction’s territory. Over 130 components fell at least 20%, level at which a bear market is recognised. Why did that happen?

We believe that the main drivers of the market downturn were:

The tightening monetary policy in the US and expectations on the ECB’s interest rates hikes starting from mid-2019;
Rise in fixed income products’ yield shifting capital allocation from stocks to less-risky assets (e.g. bonds);
Slowing inflation around the globe giving signal of a slowdown of the global economy;
Emerging markets’ downturn due to political instability (e.g. Venezuela) and higher oil price (e.g. India);
A stronger dollar causing weaker currencies around the world, especially in emerging markets;
Concerns over the trade war between USA and China and other political crises fuelling uncertainty in financial markets (e.g. Italy, Venezuela, Turkey, Iran);
Higher oil price increasing companies’ expenditures hence lowering margins;

On top of these drivers, on October 9, the IMF lowered its guidance on 2018 global economy growth to 3.7%, down 0.2% from April estimates. We believe that the combination of these factors together with the negative sentiment fuelled by the newsflow, triggered last week investors’ sell-off which led the main US indices down, as observable in Figure 2.

Figure 2: S&P 500 (white), NASDAQ 100 (green) and Dow Jones (orange) LTM %change

Source : Bloomberg

So, given the current situation, what should you expect for 2019?

Main topics

We believe that 2019 will be a turning-point year for investors with the main focus being on the following topics:

Monetary policy
Inflation
Trade war
Oil price

Monetary policy

After the beginning of the latest financial crisis, central banks pumped liquidity into financial markets and lowered interest rates in order to sustain the real economy suffering from a troubled financial system. The Asset Purchase Program (APP), also known as Quantitative Easing, was first started by the Federal Reserve (FED) in November 2008 and officially ended in January 2014. However, the FED waited until the end of 2015 to hike interest rates when it brought the US FED Funds Rate from the historical low of 0.25% to 0.50%. In September 2018, Jerome Powell announced the third interest hike in 2018 bringing the US central bank’s benchmark rate to the range of 2.00-2.25% (Figure 3).

Figure 3: Increasing US Funds Rate starting from the end of 2015

Source : Federal Reserve

The comeback of higher interest rates was triggered by the concerns around rising inflation and a potential overheating of the American economy. However, apart from making financing more expensive, the tightening monetary policy impacted the bond market, particularly increasing the 2-year US treasury bill’s yield to 2.85% from the 1.92% at the beginning of 2018 (Figure 4).

Figure 4: 2-year US yield curve rose 48% YTD

Source : Bloomberg

As a rule of thumb, when the yield of government bonds surges, more risk-adverse investors shift their money from stocks to bonds as they can earn a decent return carrying the risk-free US Treasury bill. This shift of capitals from shares to fixed-income products generated a selling pressure on the stock market contributing to the above-shown downturn of the main US equity indices (S&P500, Dow Jones, NASDAQ). Looking ahead, we see the shift in capital allocation likely to continue as bonds’ yields increase due to the execution of the planned interest rates hikes announced by the FED. We see Powell’s schedule to be respected with 1 more hike in 2018, 2 in 2019 and 1 in 2020, leading the US FED Funds Rate to a potential 3.00-3.25% interest rate by the end of 2020 vs 40-year average of 5.72%. On top of that, the European Central Bank (ECB) announced the end of its APP to come in by the end of 2018 and consensus expects a first interest rates hike coming in in the second half of 2019. Albeit the political tension coming from Italy, we are aligned with consensus and believe that the ECB is set to hike the current -0.25% reference rate starting from mid-2019. An increase in European interest rates is likely to fuel the shift effect, leading to further sell-offs in the European stock market.

Inflation

US economy seems to be on the verge of the cool-off. Annual inflation showed a slowdown to 2.3% in September 2018, down from the 2.7% in August (Figure 5) and a miss vs expectations at 2.4%. It is the lowest rate since February and likely to be attributable to a sharp slowdown in gas prices. Since 1914, inflation averaged 3.27% reaching the high of 23.70% in June 1920 and the low of -15.80% in the same period one year later.

Figure 5: US inflation rate evolution since the beginning of 2018

Source : US Bureau of Labor Statistics

On October 15, US Commerce Department released data on US retail sales showing almost-flat growth with motor vehicle spending being offset by the biggest drop in spending at restaurants and bars in nearly two years. Retail sales rose 0.1% mom, 0.5% below expectations but up 4.7% yoy. Consumer spending accounts for more than two thirds of US economic activity. Despite historical low unemployment rate at 3.7% in September 2018 and 3Q18 expected 3.5% annualized growth in consumer spending, we see a slowdown in US macroeconomic data in 2019 and 3Q18 US GDP growth around 3.00%, down 1.2% from 2Q18. Adding to this, we see Trump’s rhetoric against the FED supported by investors’ that are losing confidence in Jerome Powell. JP Morgan recently published a report showing that the market reacted negatively to all the speeches given by Powell since the beginning of his mandate, quantifying the effect of his words in a US$1.5tn wiping away effect. This shows that investors are concerned about the speed at which the FED is executing its hiking plan as the expectations on US inflation are slowing down (Figure 6) putting investors on a wake-up call.

Figure 6: US annual inflation rate down in 2019-23E

Source : Statista.com

Trade War

On July 6 of this year, the US imposed 25% tariffs on US$34bn of imported Chinese goods in the beginning of what escalated to a proper trade war between China and US. On September 24, Trump’s administration imposed 10% more tariffs on US$200bn Chinese goods and China retaliated on US$60bn of US goods.

In this scenario, investors were scared of the potential effects that the neo-protectionist policies might have on their portfolio. In order to get a sense of how the trade war impacts companies, we looked at the luxury goods industry. Chinese authorities are implementing strict controls on travellers with the objective to look after imports over the duty-free allowance of CNY 5,000 (US$730). Chinese customers represent c.40% of the revenues for brands such as Louis Vuitton (LVMH) and Gucci (KERING) and a drop in purchases from Chinese customers would have a significant negative impact on the top-line of luxury brands. No wonder why on October 10, LVMH plunged 7.14% despite the company published strong results. We believe that investors reacted to the sentence of the head of Investors Relations at LVMH, Chris Holly, stating that the company is “subject to important risks and uncertainties that could cause actual results to differ materially” from previous forecasts. The entire luxury goods industry lost ground since the beginning of October, showing a more marked drop than other industries (Figure 7).

Figure 7: MSCI luxury good index (orange) down more than MSCI Technology (white) and MSCI Emerging Market (blue) since the beginning of October.

Source : Bloomberg

The example of the luxury industry gives a general understanding on how the trade war is already impacting equities and gives also a taste of the potential consequences that further escalations might have on the global stock market. We see the tensions between China and US to continue through 2019 leading to more industries being negatively impacted and a downward pressure on the global equity market.

Oil price

In October 2018, Brent oil – the main benchmark for oil price – was up 50% from the same period last year, reaching US$85.16 per barrel on October 9.

Figure 8: Brent spot price rose 50% since October 2017

Source : YCharts

The spike in oil price was mainly driven by the sanction imposed by the US government on Iran that lowered the OPEC’s member oil production to 3.4mbd (million barrels per day), down c.400,000 bpd from August 2018. Oil price is very sensitive to changes in supply/demand shifts and such a drop in supply makes oil scarcer hence increasing its value, therefore price, in the market. Higher oil price means rising energy costs for companies which will have to deal with increasing expenditures to keep the business going. This puts companies’ margins under pressure and translates into lower expected earnings per share (EPS). Therefore, investors see their expectations on dividends per share – computed as portion of EPS – decreasing and the equities’ bottom line shrinking. We see the oil price continue to rise in 4Q18 on the widening of supply/demand gap due to the uncertainty coming from Saudi capacity to cover the Iranian production wiped away by US sanction. Also, we think it is worth to keep an eye on the development of the latest scandal on the US-based journalist disappeared in the Saudi consulate in Turkey since potential sanctions on Saudi Arabia from western countries would put further upward pressure on the oil price.

Food for thought

The last two weeks were characterized by the sell-off, but also by the US investment banks’ 3Q earnings releases. In the 3^rd quarter of 2018, US banking sector’s results were overall positive with an improvement of the Net Interest Margin (NIM) – difference between interest income and interest expenses – thanks to the rising interest rates environment in the US. However, the IB – Global Markets divisions did not show much improvement. Indeed, results from the Sales & Trading departments of the biggest US investment banks (e.g. JP Morgan, Goldman Sachs and Morgan Stanley) delivered an overall performance below expectations. Therefore, one might draw the conclusion that investors are not exchanging their stocks for other financial products at higher frequency than last year, otherwise the level of fees should have been higher. Indeed, it seems that investors are selling their holdings without replacing those with other financial products, lowering the trade volumes hence commissions for the IB trading floors. From this perspective, one might argue that investors are taking out money from the market and building their cash piles in order to prepare for the worst-case scenario. As a corroborating factor of this thesis, BlackRock, the world biggest asset manager, had inflows below expectations in the last quarter showing a lowering investors’ appetite to put money in financial markets rather than under their mattress.

We believe that financial markets are impacted by a collection of reasons which go beyond the “Main topics” illustrated in this report. We are convinced that psychological, irrational and behavioral variables drive the market on daily basis together with financial, rational and economic factors. Therefore, we urge the reader to explore as many alternative explanations as possible when looking for reasons to justify markets’ moves.

Authors: Alessandro Sicilia, Lorenzo Bracco

The Retaliation of Tech

Long we have been used to tech stocks trading at price multiples (price/earnings) at more than the industry standard has been comfortable with for decades. Benjamin Graham’s ideal PE is between 10 and 15 dollars. The Dow Industrial is trading at 25 PE, the S&P 500 is trading at 25 PE. If you thought that the Dow and the S&P 500 are overvalued by Graham’s standards, here’s a look at the tech industry valuations. Amazons PE is trading at 316, Netflix is trading at 206 PE, Dropbox has a negative PE. However, what was evident this past two weeks is that these tech stocks are more correlated than initially thought. When one tech stock sneezes, the entire market catches a cold.

Facebook has fallen 14% since 16 March when the news of privacy breach by Cambridge Analytica has spread. This caused Apple to fall more than 5%, Alphabet and Amazon have fallen more than 8%, and last but not least Twitter fell more than 19%.

However, one knows that a cold eventually ends, and with these company’s being sugar-coated with net margins of more than 20%, and growth potential, innovation and barriers to entry, it is important to keep watch for those companies. They are more likely than not that they are trading at a discount. Most of these tech companies have very strong balance sheets. This means they are relatively low leveraged. A hawkish fed of increasing interest rates has lesser of an effect on their valuation extended to the end of 2018.

However, as a kid knows exactly when to catch an ice cream truck, a good trader knows when to enter a stock. Technical analysis 101 serves a good purpose. Many mistakes made by students these days are getting excited very fast, being scared to fast, and not admitting one’s own mistake like a toddler refusing to get out of a car.

As long as markets are trading above 50-day moving average, the trader should be thinking “buy the dip”, many do the mistake of directly entering the trade once the stock price has fallen, however the truth is to better forgo some profit for a safety margin to allow one’s self to be confident that the stock is actually reverting. The 100-day moving average, this line provides the support between the 50 days and 200 days. If it does not hold support, there is a high probability that the 200-day moving average is the next stop, this is the deeper pullback in bull markets. 200-day moving average, this is an indicator telling you which side a trader should be one, either a bull or a bear market.

It is important to know that moving averages are not the Holy Grail of trading they are tools to help the trader capture a trend in their own time frame.

The point is will tech stocks retaliate and gain back valuation and return to their highs? Or will they descend even further? Either way, liquidate and hold 100% cash and wait and watch for those moving averages, because at this level they have attractive risk/reward ratio.

Author:

Bassem Mneimne

2018 EU-US Outlook: Where do we come from? What are we? Where are we going?

As the first quarter of the year is headed to the end and new challenges lay ahead for international financial markets, frame the actual situation is necessary to adapt to future changes.

2017 has been a record year both in terms of returns and volatility. Looking at historic data, seems obvious the past year represents an outstanding exception, may have the markets gone too exuberant? Economic and business data do not suggest so, with results exceeding expectations consistently.

European Union: Renaissance

The year that just ended has proven the comeback of growth in the economies in Europe. The expansion in GDP and the steady decline in unemployment from the record level of 2011 has spread to Mediterranean countries and gathers speed. France, Spain and Italy have inverted their road joining Germany and northern countries in what can be compared to a renaissance of European Economy.

As over 62% of EU countries’ total trade is done with other EU countries, the interdependency across EU economies has risen to levels which make necessary a harmonized growth to attain lasting results. Moreover, the strong reliance on exports, as testified by the fall in imports between 2012 and 2016 while exports grew in that period, has proven to be beneficial given the harmonized global growth. The EU accounts for 15% of global imports and exports approximately, making it the second world player and a necessary participant to global expansion. Which comes first, global growth or European expansion? The answer is irrelevant, as they influence and reinforce each other in a benign loop. The high levels of unemployment from which Europe started the recovery in 2012 leave space for further expansion, accompanied by low inflation rates which are consistent with an early stage recovery.

Fiscal and monetary policies do not represent a threat, at least now. Governments around Europe share similar electoral programmes centred on the reduction of fiscal pressure and the enhancement of investments. The policy makers at ECB do not want to break the toy by acting too fast deleveraging their balance sheet, but the market is anticipating the end of QE and the beginning of the tightening cycle by end of 2018, beginning of 2019. Low interest rates are here to stay as Mario Draghi said, so the extremely favourable economic environment is going to support Equities through the year. The effects of improved stability can be seen inside Europe, with outstanding levels of consumer and business confidence, and outside Europe, with the Euro-Dollar Exchange Rate moving consistently with the strengthening of European Economies. The strengthening cycle of Euro started in 2017 will continue with the economic recovery, until Euro strength weights too much on exports. At least in the foreseeable future, this is not the case.

Attractive valuations in European Equity offer long term opportunity for investors looking to take advantage of the economic environment. On the other hand, the extreme intervention of ECB in the Bond Market has created distortions in prices with risks skewed to the downside. This means that investors will be exposed to volatility, both in Equity and Debt Markets, once the normalization of interest rates begins in the following years.

United Kingdom: Uncertainty

A big question mark is represented by the United Kingdom: after the Brexit the outlook for UK economy has darkened leaving big gaps of uncertainty. Those gaps will be filled only after the conclusion of the negotiations with EU representatives with the deadline to negotiations fixed in October 2018. The IMF has already cut economic growth forecast for UK, expecting 2018 growth of 1.6%, down from previously forecasted 1.7%, followed by a further slowdown next year to 1.5%. The effects of uncertainty cited by Christine Lagarde, IMF Chief, are the delay in investments and the loss in spending power, caused by rising inflation, falling pound and stagnant wages.

As a result, the UK will live the global expansion only vicariously losing relative strength and power in respect to other countries which offer better opportunities. On the other hand, the UK government will have to counterbalance the possible losses in the financial industry, approximately high net worth 100.000 jobs in the City with cascade effects on housing market, leisure industry and most importantly on tax revenue. The possibilities of actions range from a tax cut to a more generic business friendly environment, with Equities resulting as the most beneficiaries of the situation. Government bonds on the other hand are not as attractive, given the deficit that the UK government will incur to support fiscal policies. The uncertainty already weighting on the Pound will continue until businesses will have clear investment plans to adapt to the changing environment and markets will have enough information to take positions.

United States: Goldilocks

The expansionary cycle started in the US after the Great Financial Crisis does not seem to have stopped, as testified by the healthy 2.3% annual GDP growth for 2017, the steady decline in unemployment rate to 4.1% and the inflation rate of 2.1%.

These are numbers of a country which have abandoned early stages of recovery and has entered the late stage cycle of economic expansion. In this environment fiscal and monetary policies diverge. The Federal Reserve has started the unwind of monetary policies in Q4 2017, by deleveraging the balance sheet from the record level of $4.5 trillion at a rate of $50 billion per month targeting a drop below $3 trillion by 2020. Moreover, the FED plans three rate hikes for 2018 as the normalization process continues, but the threat of inflation picking up at wages level is creating questions whether the FED is already behind the curve. Given the 2% inflation rate target, the FED may be forced to accelerate the hikes before expected from the market, causing turbulence to the new chair Jerome Powell.

In this context, the Tax Plan approved at the beginning of the year by the Congress represents the fiscal lever to counterbalance the monetary contraction. Cutting the corporate tax rate to 15%, President Trump aims to stimulate the economy enhancing job creation, wage growth and investments. The slash of the repatriation tax rate on corporate cash held overseas, from 35% to 10%, is the second major incentive for investments in the country. With $2.5 trillion in cash held by US-owned corporations overseas, it is rational to expect a big portion of it to be reinvested in the US in the form of dividends, buybacks and M&A operations. As the economy is moving closer to full employment, the benefits of fiscal stimulus will likely be constrained because the economy is already operating at near full capacity. Nevertheless, GDP growth is expected to reach 2.5 percent in 2018 and then to moderate to an average of 2.1 percent in 2019-20. US listed companies will see the benefits of the Tax Plan on their balance sheets starting from 2018. According to the most recent estimates by UBS analysts, S&P500 companies will post an increase in earnings of 18% for 2018: nearly half of it, 8.5%, will come from pretax income growth, while the tax cuts for corporations, M&A and buybacks will provide a 9.7% growth.

How much of this positive outlook is already priced in by the market? The S&P500 delivered a 21.7% return in 2017, with no negative months across the year and extremely low levels of volatility, while the first quarter of 2018 has been characterized by spikes in volatility and dispersed returns.

Valuations look stretched here: the Price to Earnings Ratio is above 25 and the Cyclically Adjusted Price Earnings, which takes into account the adjustment for the average inflation from the previous 10 years, is around 32. This does not mean that the market is going to crash, but that returns in the future are expected to be lower as the market is already pricing them in the valuations. The US market has historically been more expensive than the global markets, as it offers both the biggest companies and the highest diversification by sectors. Moreover, the US are the first global superpower by GDP, GDP per capita and international influence, which means that they will always attract more investments and will sell at a higher premium than other countries.

Two major factors to further consider are the Dollar and the Government Bond yield. The 10 Year Bond yield is approaching 2.9%, the first time since 2014, as the market is pricing in the widening budget deficit coming from the Tax Reform and the $1.5 trillion spending of the Infrastructure Plan proposed by Trump in February 2018. The Yield curve, represented by the difference between 10Y and 2Y yields, is downward sloping and consistent with late stage cycle expansion, the Goldilocks period before the end of the expansionary cycle.

The last factor to take into account is the Dollar. Uncle Ben’s currency has started a weakening cycle from the highs of 2017, providing support both to overseas earnings of US stocks and to the FED in reaching the inflation target. As the global economy strengthens, risk-off currencies like the Dollar and the Yen should weaken as capitals flow to riskier countries which provide higher returns.

Author:

Mario Stopponi

Spotify goes public, not through an IPO

Spotify will go public before the end of the first half of 2018 and has already filed confidentially with U.S. regulators for an initial public offering. Morgan Stanley, Goldman Sachs and Allen & Co to advise on the listing, acting as commission brokers that will only help selling the shares.

Spotify, the privately held Swedish music company, last valued at $20 billion, will not be selling its shares and raise any capital through a standard IPO process but it will be the first large company to go public via an unusual direct listing on the NYSE.

Spotify is the biggest global music streaming service with 70 million paying subscribers as of January 2018 (compared with Apple Music’s 30 million), over 140 million active users worldwide and 30 million songs available to stream straight from the internet.

While Spotify’s losses are mounting – the company experienced net losses over the last 5 years and saw losses more than double in 2016 to 556.7 million euros – its revenues increased by 52.1 percent in 2016 and by 39% in 2017.

One of the reasons behind this unusual choice might be found in that the company had raised $1bn (£740m) in a debt deal with private equity companies in 2016. The deal provided that the debt interest rate would increase by 1% every half of a year until the company went public.

Moreover, Spotify’s listing would benefit not only its CEO Daniel Ek who controls 25% of the company and Martin Lorentzon, co-founder and director and former chairman, owning 13% of the company, but also Sony Music Entertainment International, Technology Crossover Ventures, Investor Tiger Global and Tencent which are the major investors of Spotify.

Company founders will retain control of the company by holding onto a separate class of shares, so-called dual-class, with enhanced voting power. The “dual-share” structure, employed previously also by Facebook and Alphabet, is not the only feature that sets this listing apart.

What is unusual about this

First, when a company decides to go public it does so by issuing new shares and increasing capital. However, Spotify decided not to go for the traditional route and thanks to the direct listing the private company will sell their shares on the market by bypassing the underwriting process by directly selling shares to investors at a price determined by the company without any help from investment banks.

Second, direct listings have occurred mostly in biotech and life sciences and have been limited to small-cap companies, Ovascience (market cap: $55 million) and BioLine Rx (market cap: $83 million) being two examples.

Third, when a company decides to go public it needs to register with exchanges, which are usually NASDAQ and the OTC market. However, Spotify has asked NYSE to change rules, and for the first time it will go public via a direct listing on the NYSE.

The Process

The process for going public is very similar to the IPO. In fact, the business presentation, due diligence, prospectus preparation, and forms required are the same as for an IPO but with an exception. What is different is that a direct listing does not require the 2 week roadshow.

You will ask, is a roadshow really needed? Usually it is carried out in order to setting up meetings and interviews, so that the investment bank will increase demand. However, being Spotify a large company, with an established brand and a knowledgeable customer base, a roadshow is not really needed.

Direct listings can be compared to the opening of a shop and hoping people will just drop by. The store is open, but you do not have anyone marketing or setting up meetings.” says Kathleen Smith. Private shares will become legally tradable and therefore whoever owns Spotify stock will have the chance to offer it on the public market and slowly Spotify’s stock will begin trading like any stock.

However, since there will be no agreed ‘starting’ price it is unclear what will happen at start of trading if the demand will be higher than the supply, hence we could see huge volatility (more than in an underwritten IPO) of Spotify’s share price.

Advantages of a direct listing

A direct listing will leave less money on the table as people will not sell their shares at a lower price. Moreover, since no new share will be issued there will be no dilution for existing shareholders.

In addition, investors can sell their shares more quickly as there is no lock-up period that prevents insiders from selling shares in the months following a listing. Finally, a direct listing requires no underwriters and therefore is cheaper because of no fees.

To sum up, in three words, direct listing is faster, easier, cheaper.

However, there are some disadvantages

Since there is theoretically no need for an investment bank, the company will not benefit from a professional support from investment banks (especially in terms of demand generation and liquidity support). Moreover, it will not have buffers against volatility (especially on the first day where volatility is usually high), and will not take advantage of presentation support from advisors (important for small to medium companies). In addition, its price will purely be determined by demand and supply and Spotify will not have any control over it.

Lastly, the company will be less likely to have long term investors, usually gained during the roadshow process.

Conclusion

Spotify’s unusual way of going public could change not only the way that large technology companies go public in the future especially those who do not need capital and would like to go public like Uber and Airbnb but could also impact investment banks’ business model as they would not be able to collect many underwriting fees. However, if Spotify, falls below the valued amount, it would probably not like a successful roadmap to follow.

Are We on the Verge of a Trade War?

Many of us have been asking ourselves this question after President Trump announced his intention to impose 25% and 10% tariffs on steel and aluminium imports, respectively. Trump’s announcement might be challenging the GATT (General Agreement on Tariffs and Trade) which despite evolving throughout time, have remained the WTO’s foundation since its establishment after World War II.

Globalisation has triggered global economic expansion and development, leading to substantial real income growth. However, developed countries’ middle class has not experienced such an increase on their real income. A decrease in their purchasing power has lead them to blame globalisation and free trade agreements for this.

This sentiment has triggered an increase in protectionism, being Brexit and Trump’s election two illustrations of this anti-globalisation movement. Trump’s potential tariff imposition is therefore another protectionist measure founding his campaign’s slogan: “Make America great again”. Previous protectionist tariffs, such as those imposed by George W. Bush in 2002, resulted in a loss of 200,000 jobs. Will it be any different this time?

Despite affecting other countries, such as Canada or Mexico, in a more devastating way, when Trump talks trade, he talks China. Decreasing China’s record high trade surplus with the US is one of Trump’s main targets, which he has emphasized throughout his mandate.

China, the EU and other countries have expressed their concern regarding steel and aluminium tariffs and have threatened to apply several countermeasures.

CHINA– China is one of the leading US export car markets as well as being one of the top tourist and technology-purchasing markets. Additionally, China holds over $1tn of US debt. Some likely countermeasures could be industry-specific, such as restricting automobile, semiconductor or agricultural imports from the US. Examples of firm-specific measures include restricting iPhone sales or substituting Boeing for Airbus aircrafts. Other counteractions might include discouraging travel to the US (more than 100 million Chinese people travel around the world every year) or limiting the number of Chinese students in the US. The Chinese Government, however, remains cautious in attempt to restrain a potential trade war.

CANADA– Canada would probably be Trump’s most sound victim if these tariffs are actually applied. Prime Minister Justin Trudeau classified them as “absolutely unacceptable” and expressed Canada’s intention to respond to them by targeting two symbolically-valuable industries: manufacturing and agriculture. Trump, however, announced that Canada and Mexico could be exempted from these tariffs if NAFTA were to be renegotiated.

EU– The European Commission president, Jean-Claude Juncker announced that the EU’s will engage in a collective response with other countries affected by these measures. Additionally, Juncker expressed EU’s intention to prepare a list of potential retaliation tariffs which would most likely add up to almost $3 billion. These tariffs would target a list of products including clothing, cosmetics, motorbikes, boats, agricultural products and industrial products.

UK– Despite being the US one of the UK’s most important trade partners and even though a possible US-UK post-Brexit free trade deal had been rumoured, Theresa May has expressed her “deep concerns” regarding new tariffs and confirmed that “while the UK remains part of the European Union, any action would come as part of an EU-wide response.” [1]

According to the WTO, Mexico, Japan, Australia, India and South Korea are also “very concerned” with Trump’s potential tariffs and have announced their intentions to apply countermeasures.

Despite easing trade war likelihood, the application of such tariffs would have a remarkable global impact if it escalated to a trade war. Some possible long-term consequences would include:

Global economic expansion slowdown triggered by decrease in global output
Gross job loss
Worldwide inflation driven by increase in product prices because of tariffs
Equity market sell-off driven by lower corporate earnings expectations
Decrease in risk appetite, increased demand for safe havens
FX fluctuations
US Tech sector decline

CONCLUSION –Imposing these tariffs on aluminium and steel may seem insignificant at first, however, this would most likely result in a series of retaliatory measures which would in the end lead to a trade war. “Protecting” these metals, mostly input goods, would have a negative impact on other aluminium and steel-consuming industries. Assuming no retaliatory measures are applied, negative consequences would still escalate to other countries, in a world where globalised supply-chain dependency is a reality. For a country that accounts for 13.9% of the world’s imports and 9.1% of the world’s exports a trade war definitely does not sound like the best solution.

Author

Carmen Álvarez Álvarez

Sources

Bidding War fires up the largest European deal of 2017

On May 15^th, 2017 Atlantia has announced its intention to acquire its Spanish competitor, Abertis.

Atlantia, Italian toll operator whose main asset is Autostrade per l’Italia, the largest concessionaire on the Italian highway network, is a holding company belonging to the Benetton family. Under the management of its CEO, Giovanni Castellucci, former partner at the Boston Consulting Group and manager at Barilla, the company has produced revenues for more than €4 billion and generated a net income of €1.12 billion in 2016. Its assets are strongly exposed to country risk, and an acquisition would be a way to enter new markets and diversify this exposure.

Abertis, headquartered in Barcelona and listed in Madrid, is a leading toll operator as well. Present in 13 countries, with a net profit of €897 million in 2017, a 13% increase from 2016, has appeared as an attractive target for Atlantia’s needs: the new conglomerate, in fact, would be in charge of the management of more than 14,000 km of highways and present in 19 countries.

The Italian company, advised by Mediobanca, Santander and Credit Suisse, has proposed a cash-offer, financed by Bnl-Bnp Paribas, Credit Suisse, Intesa San Paolo and Unicredit[1] valuing the Abertis at €16.50 per share and making up a €16.3 billion deal.

Alternatively, Atlantia has also offered stocks with the aim of making the offer attractive Criteria, unlisted investment bank holding of the Caixa foundation and majority shareholder in Abertis with a 22.3 percent stake, with important investments in the Industrial and the Real Estate sector.
The Italian company would offer unquoted, locked-in stocks, at a fixed conversion rate of 0.697 Atlantia’s share per Abertis share[2], for up to the 23.2 percent of the total offer. This would value the Spanish operator at €17.34 per share; considering the latest trading price at €16.38[3], it represents a generous upside for the shareholders with a premium of around 6%.

This share-swap offer is not appealing for all of Abertis’ stakeholders. Instead, it is a strategic move to win the favor of Criteria, a strategic investor with long-term objectives: in facts, not only the holding keeps its current claims on dividends, projected to increase, but also acquires the right to appoint up to three directors in the Atlantia’s Board, whose size therefore increases from 15 to 18 members[4].

Should this scenario concretize, Edizione, the investment vehicle of the Benetton Family, would suffer a 5 percent dilution in Atlantia, with its stake diminishing from 30 to 25 percent, while Criteria would earn a 15 percent stake. Castellucci has stressed that the combined groups’ strongly performing Latin American assets would be transferred to Abertis, which would maintain its headquarters in Barcelona and would keep trading in Madrid[5].

According to the Spanish Financial Authority, the CNMV, on October 19^th Abertis should have formally responded to Atlantia’s offer. Therefore, the bid carried forward by Hochtief, a German leading construction company operating worldwide, with important assets in the US and Australia and, controlled by the Spanish ACS[6], has been a surprise. Hochtief is offering €18.76 per share in cash, attributing to the target a value of €18,6 billion. Alternatively, Abertis investors may opt for a stock-swap option, the conversion rate being 0.1281 per newly issued Hochtief share. Should the Spanish constructor accept this offer, it would add more than 8000 km to the construction business of the German company and ACS, opening up the possibility to extend their operations in Brazil. Advised by J.P. Morgan, Lazard and Key Capital Partners, ACS and Hochtief are now tempting the investors with the promise of high dividends – the combined entity, whose stocks are intended to be traded in Frankfurt, is expected to generate revenues for €24.8 billion and has announced a retention ratio of 10 percent, meaning that roughly 90 percent of its profits would be paid out. Instead, some of the Abertis’ assets would be sold, among which shares in Cellnex Telecom SA and Hispasat SA.

The results of the takeover would be a decrease of ACS’s share in Hochtief, from 72 to less than 50 percent. This would cancel the leverage of the €12 billion net debt, contracted by its investment vehicle, to fund the cash payment, and would leave the company with a stronger position in the resulting entity8.

While Catellucci is considering raising its offer, that could be raised up to €19 per share according to some analysts5, and entering a bidding war, it also has to face a strong opposition by the Spanish government, which is concerned about the loss of the strategic assets owned by Abertis, and wants to prevent the company from falling under foreign ownership. In addition, in case of approval of the second offer by the CNMV, the Spanish Financial Authority, the government may still appeal to the administrative tribunal and cause severe delays in the execution process. The Hochtief offer, that would bring Abertis under the ownership and control of the ACS’ president, Florentino Perez, has encountered a much lower opposition, as the strategic assets owned by Abertis would remain under Spanish ownership. These governmental activities are not unusual: for example, in July 2017 the Macron government had decided to block the offer of Fincantieri and nationalize the building sites in Saint-Nazaire, considered of strategic importance for France, given the unique know-how of the employees, as reported by the French government’s spokesman Castaner[7]. Nevertheless, it is worth noting that such practices seriously harm free market competition and should be limited. Indeed, the issue of governmental interference in public utility companies has been long debated: a recurrent, and sometimes a bit abused, practice is the so-called Golden Share, which allows governments to acquire shares of capital and to appoint members in the Board of Directors of strategic companies and consequently to have a high influence on the decisions taken. This privilege has been, in some cases, sanctioned by the European Court of Justice as dangerous for the markets’ competitive functioning.

Financial markets have responded to the bids’ announcements. While Atlantia lost 1.2 percent, Abertis has been traded at a premium on the bid of the Italian company. The bullish trend has been followed also by ACS and Hochtief, which have gained 5.6 and 1 percent, respectively.[8]

In the end, Abertis seems to be the company benefiting the least from the deal: in fact, it is already well-diversified in terms of EBITDA sources. Additionally, the deal with ACS may be dangerous for Abertis’ creditors in terms of the exposure to the cash-flow volatility of the bidder.
Instead, Atlantia, whose main assets are located in the home market, could diversify its country risk away penetrating in Latin America. Furthermore, despite the poor synergies, it could benefit from an appealingly low acquisition premium embedded in its first offer and, in addition, may increase its cash-flows by building up scale. However, despite the higher acquisition premium of the eventual second offer these benefits would decrease, the Italian group would still enjoy substantial advantages.

With the recent approval of the second offer by the Spanish government, declared at the end of January, the two bidders are now free to compete. In the next 15 days the two companies will have to improve their bids, according to the Cnmv regulation, and then will submit their final offers.

What it is going to happen is still uncertain, but it is possible to see some general drivers in the wave of recent European deals. Low cost of financing, need of consolidation, low opportunities for organic growth are all factors that make M&A extremely attractive for European top players willing to compete in a global field. Just think about the deals between Johnson&Johnson and Actelion, Essilor and Luxottica, Mead Johnson Nutrition and Reckitt Benckiser, Toshiba and Consortium and Vodafone and Idea cellular. These are all examples of the cross-border trend of M&A in Europe, where external growth tends to be preferred more and more to internal expansion[9].

Author: Giacomo-Luigi Rossi

Notes:

[1] Source: Reuters

[2] The conversion rate indicates the number of Atlantia shares that can be exchanged with 1 Abertis share

[3] Abertis’ share price on May 15^th, 2017. Source: Yahoo Finance

[4] Source: Il Fatto Quotidiano

[5] Source: Financial Times

[6] Actividades de Construccion y Servicios SA – Spanish company whose President is Florentino Perez. ACS is headquartered in Madrid

[7] Source: Il Sole 24 Ore

[8] Source: Bloomberg

[9] Source: Factset

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