Category: Global Trends

US-China Trade War Effect on the EU

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.

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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.

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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.

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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.

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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.

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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.

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 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.

 

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Alternative investments will hit record $14 trillion AUM in 2023. What about PE?

Alternative investments will hit record $14 trillion AUM in 2023. What about PE?

Alternative investments will hit record $14 trillion AUM in 2023.

What about PE?

The popularity of the alternative investments space does not come as a novelty in a period in which investors increasingly seek to shy away from the less attractive returns of traditional asset classes. The news is however, that forecasts see the industry hitting a record $14tn AUM mark in 2023, growing by +59% (i.e. c.8% CAGR) from the $8.8tn recorded at the end of 2017. If we think that, merely ten years ago, assets managed by alternative investors stood just north of $3tn, growth has already been outstanding.

Key drivers for growth in alternative investments include investors’ need for yield, the long-term outperformance of private capital compared to public markets, the growing appetite for alternatives from institutional and private investors, and strong growth in emerging markets.

“Fourteen trillion dollars may sound like an overly ambitious prediction for the alternative assets industry, but it is lower than the average growth rate we’ve seen in the past decade, hence extremely likely to happen” comments Preqin’s CEO Mark O’Hare. According to the latter, other trends shaping the alternative’s industry besides the proven long-term performance, are the growing opportunities in private debt and the rise of emerging markets in which alternative funds are already entrenched.

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The asset class claiming the largest share within alternatives is obviously Private Equity, with an expected increase of +58% (i.e. c.12% CAGR) over the next five years from $3.1tn to $4.9tn AUM overtaking hedge funds that instead will grow by +31% (i.e. c.7% CAGR) from $3.6tn to $4.7tn. More interestingly, the rise of private debt will see the market for this asset double in size (e.g. expected at $1.8tn in FY2023) growing organically thanks to allocator interest no longer for traditional bank lending but for private capital. Real assets instead, although representing a smaller portion of the alternative investment universe at this moment (i.e. c.8% according of the total according to Preqin), are expected to be the fastest growing set of assets over the next five years.

Anna Gervasoni (Director General of AIFI – Italian Private Equity, Venture Capital and Private Debt Association and board member of Fondo Italiano d’Investimento) emphasizes this positive trend claiming that: “private capital and private equity will become more convincingly part of institutional investors’ asset allocations in the coming years”.

Performances have their say in this. According to Preqin, buyout funds have recorded performance of 5 ppts greater than those recorded by the S&P500 since 2000 and better than any other institutional asset class. Performance-based metrics remain a key driver in asset allocation towards alternatives says Michael Murphy (Managing Director and Private Equity Global Co-head at Credit Suisse):“I expect to see this trend rise even more leading to a more mature secondary market that will reduce the perception of illiquidity of these assets”.

But where does this growth come from? The most important sources of the incremental flows to alternative investments will be family offices, sovereign wealth funds and pension funds. These funds are starting to believe they can run their own money, rather than outsourcing to large asset management companies because they now “manage more capital, are more sophisticated and have greater expertise in-house than was the case prior to the global financial crisis” comments Michael Stirling, CEO of Stirling Infrastructure.

There are expected to be way more fund managers available for LPs to choose from in 2023, bringing the total number of alternative investment funds to a staggering 34,000! At that point, the ability of picking the right guy (fund) will be crucial, even more than today.

 

Sources:

Il Sole24Ore, https://www.ilsole24ore.com/art/finanza-e-mercati/2018-10-31/fondi-alternativi-l-industria-arrivera-14mila-miliardi-dollari-2023-131834_PRV.shtml?uuid=AEj7ojYG

Institutional Investor, https://www.institutionalinvestor.com/article/b1bg5lknj62d7l/Report-Alternative-Investment-Industry-Will-Hit-14-Trillion-By-2023

Preqin report “The Future of Alternatives”, https://www.preqin.com/insights/special-reports-and-factsheets/the-future-of-alternatives/23610

Bebeez, https://bebeez.it/files/2018/11/Alternative-Timeline.pdf

 

Our view on 2019

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

Figure 1

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

Figure 2

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:

  1. Monetary policy
  2. Inflation
  3. Trade war
  4. 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

Figure 3

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

Figure 4

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

Figure 5

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

Figure 6

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.

Figure 7

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

Figure 8

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 3rd 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 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.

 

 

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

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.

 

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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.

 

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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.

 

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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.

 

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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.

 

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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%.

 

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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.

 

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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.

 

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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.

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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

The return of megadeals: Blackstone buys Thomson Reuters’ data unit for $17bn

The return of megadeals: Blackstone buys Thomson Reuters’ data unit for $17bn

On 30.01.2018, Blackstone announced to buy a majority stake in the data business of Thomson Reuters, the world’s second largest financial information provider. It’s the private equity group’s biggest purchase since the financial crisis, pitting the firepower and network of Stephen Schwarzman, who oversees $387bn in Blackstone funds, against fellow billionaire and former New York mayor Michael Bloomberg, who dominates Wall Street’s financial information industry.

 

When Blackstone announced to buy a majority stake in Thomson Reuters’ data unit, there was a lot of excitement among investors, pushing Thomson Reuters’s share price to new highs at announcement date. The $17.3bn transaction is Blackstone’s largest deal by enterprise value since the firm’s $26bn buyout of Hilton Worldwide Holdings Inc, in 2007. Under the terms of the deal, Blackstone will acquire a 55% majority stake in Thomson Reuters’ financial and risk division, which will then be carved out into a new company, with Thomson Reuters owning the remainder. CPPIB(1) and GIC(2), will co-invest alongside Blackstone. According to the Financial Times, the deal will not include Thomson Reuters’ newsgathering operation or its businesses serving the legal, tax and accounting communities.

 

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The deal volume of $17bn consists of a $3bn equity investment from the Blackstone-led group and $14bn in debt and preferred equity. Bank of America Merrill Lynch, Citigroup and JPMorgan Chase will provide debt financing for the deal, most likely including leveraged loans and high-yield bonds. Canson Capital Partners, Bank of America, Citigroup and JPMorgan were financial advisers to the Blackstone-led consortium, whereas Guggenheim Securities, TD Securities and Centerview Partners advised the sell-side.

The deal will make the Blackstone-led entity the major competitor of the financial information industries’ global market leader, Bloomberg. Blackstone sees attractive growth in the Thomson Reuters unit’s data feed, its foreign exchange and treasury trading platforms, as well as its risk and compliance business, according to industry experts. In addition, the division would also be able to improve operations more quickly than a private company, highly critical in a turn-around.

The market for financial data and information is only weakly fragmented with Bloomberg and Thomson Reuters accounting for c. 56% of total revenues in 2016. In 2017, global spending on information/analysis increased by 3.6% to $28.5bn, for the largest YoY growth since 2011. When looking at the historic development of the market, Thomson Reuters has been the leading player ahead of Bloomberg until 2011 with regards to market share. Since then, Bloomberg has largely evolved as the dominant player in the financial information market and successfully defended its strong position. However, with increasing competition from new players such as Goldman Sachs-backed company Symphony, the market could undertake a major re-organization and threaten Bloomberg’s dominant position, which offers significant growth opportunities for the new company.

The market reacted with a 9.5% increase in Thomson Reuters’ stock price, immediately after the acquisition plans were published, whereas the share price of Blackstone fell by 2% due to increased uncertainty among investors. A carve-out by a private equity firm could lead to a turnaround that Thomson would have struggled to achieve on its own ague analysts in favor of the deal. However, there are also concerns with regard to the feasibility of the turnaround. According to Bloomberg, there is a plateau problem regarding the earnings of the unit. To achieve private equity-style returns, Blackstone will need to boost the unit’s average earnings, which are flat around $1.6bn since 2012, a task that has proved difficult for Thomson Reuters in the past. Finally, the question remains whether a deal of this size is an outlier, or the start of a new wave of megadeals in the private equity industry to deploy record sums of dry powder. “There is undoubtedly a lot of dry powder in the market at the moment,” said Andrew Adams, chief executive officer at Quayle Munro, a U.K.-based M&A advisory firm.

 

Thomson Reuters Corporation is a Canadian media and information firm with revenues of c. $11bn in 2016. As of 2018, they employ around 45,000 people across the four divisions, financial & risk, Reuters news, legal and tax & accounting. In 2018, the financial & risk division accounted for over half of the company’s revenue.

The Blackstone Group L.P. is an American multinational private equity, alternative asset management and financial services firm based in New York City. As the largest alternative investment firm in the world. Blackstone specializes in private equity, credit and hedge fund investment strategies. As of December 31, 2017, Blackstone had $434bn in assets under management.

 

Sources:

For Illustration 1: Thompson Reuters Revenue by Segment. Retrieved from: The Wallstreet Journal (2018): https://www.wsj.com/articles/thomson-reuters-chairman-criticized-its-17-billion-deal-with-blackstone-1518692400

Are We on the Verge of a Trade War?

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.

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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.

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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.

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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.

 

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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

Mifid II: what about the markets?

Mifid II: what about the markets?

3rd of January 2018, while the markets started well their year and were keeping a bullish direction before the recent increase in volatility, something else started. Yes, it’s the new European Union Markets in Financial Instruments Directive known also as MiFID II.

Most people talked a lot about it during the last quarter of 2017 and were trying to understand the possible opportunities and threatens related to this topic. But first, let’s see what it is about.

 

The Directive

The aim of this big EU directive (more than 7000 pages) is to protect investors and make sure they receive “fair” deals when dealing with Fund and Asset Managers and so try to make Financial Institutions more transparent. This happens thanks to reports filled within 15 minutes from the transaction so that the regulators can spot abuses in all existing asset classes (Bonds, Stocks and Derivatives) and consequently become more diligent.

A major related change is for Bonds and Derivatives as they will not be any more phones involved in those processes, but everything will be done electronically. In this way, the EU wants to push back a lot of trades to public exchanges so that they can be monitored.

On the Equity side, EU was pushing for stricter limits regarding dark trading but at the last minute it was set back, probably to broaden this aspect, making still possible to trade more than 600 stocks on dark pools. The dark pools are basically private exchanges or forums for trading securities not accessible by the investing public. In those exchanges there is no transparency at all and are mainly used by institutional investors who do not wish to impact the markets. This is confirmed by Trista Keller’s (Bloomberg) statement which says: “For a lot of people MiFID II has still not happened, at list on the equity market”.

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With this little, simple and effective table published by Bloomberg, we can have an overview of the rules that the European regulator introduced and the result that should therefore arise.

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The implications

Let’s now look at the implications of this directive. First, different studies showed a decrease for Research inside banks, both in budgets and in people. Therefore, many professionals of the sector decided to leave earlier to create their own firm. This because an increasingly large number of leading asset managers already announced they will internalise the cost of research in their P&L instead of charging it separately to investors via Research Payment Accounts which are accounts exclusively created for the clients to put funds in to pay for research and directly managed by the financial institutions and banks. A McKinsey report estimated a 10-30% reduction in buy side’s external payment for research over the next three years and a S&P survey indicates that, asset managers’ EBIT may decline by 15%/ 30% because of the shift to P&L accounting for external research expenses.

From the following chart, the first impression is that big banks need a lot of information and their demand seems very fragmented. However, 20 banks account for 64%. Therefore, according to 80:20 Pareto’s rule, one can dominate the market by providing reports of Equity Research to a small number of big players.

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Moreover, the impressive decrease in European Research budgets both in terms of advisory and brokers, could lead to a big change in banks demand.

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Another big effect is on Sales&Trading which last year has seen a declining number of traders together with an introduction of electronic trading engineers. Indeed, specific data compiled by McKinsey on the Equity segment of the top 9 investment banks show the overall Sales&Trading headcount declined three times faster than Research since 2011. For example, Goldman Sachs’ US cash equity business moved from 600 traders in year 2000 to only 2 traders in 2016.

In fact, with MiFID II will cause lot of job loosing but at the same time many have been, are and will be created. For example, the number of job adverts on LinkedIn for MiFID-related roles has more than quadrupled in the last year in a sign of how companies have been trying to be well prepared for the far-reaching European regulation. Banks, asset managers, consultancy and law firms have all embarked on a hiring spree ahead of the introduction of the second instalment of the Markets in Financial Instruments Directive.

This is quite a revolution happening in banking which is also related to Fintech and Robo-advisory recent success among investors. Indeed, this disruptive companies are recently receiving large funding from high-profile investors and hiring new talents to take advantage of growth momentum.

 

Winners

Until now, MiFID II has created some advantages that benefited some players such as:

  • Pension funds and family offices will be advantaged as they will be more aware of the fees payed for researches and so increase their bargaining power. Regarding the price, also big money managers such as BlackRock and Vanguard Group will benefit.
  • Platforms in general will benefit from this directive and particularly in hedge funds where they will ease compliance and reduce again costs.
  • Individual investors will be more aware of the fees and this might lead to a big shift from funds to ETFs due to their lower cost. Indeed, they are forecasted to surge from 725 billion dollars to more than $1 trillion in next 1 to 3 years.
  • Big Investment Banks will be able to compete on prices for research eventually building a new revenues stream.

Losers

As any other piece of legislation, MiFID also created some “losers”:

  • Smaller companies with lower budgets will encounter higher prices for obtaining information and may charge higher expenses to clients which could cause a negative impact on business. The same goes for smaller investment banks and boutiques that cannot afford a war price on their research products.
  • Hedge funds will have to insert reports within 1 minute for the equity side and 15 for the fixed income products. This will probably impact their transaction volumes and costs in terms of time and money.
  • Research teams will shrink and so their effort higher or the output poorer. Are unexperienced investors ready to independently search for stocks without being able to rely on recommendations? Will they take the risk or miss the opportunity? What would happen to the relatively unknown small cap? Would the capital run towards big firms leaving the small ones illiquid? As trades would not be any more done over the phone but via platforms, who will now loose his voice and go to the doctor? And what about the already declining fixed phone business?

 

 

Authors

Lorenzo Bracco