Tuesday, 8 January 2019

Outrageous predictions for 2019

Happy New Year everyone!

Life is good. Especially if you live in interesting times. And 2019 will be very interesting indeed. Here my outrageous predictions for the next 12 months:

1. The FED's quantitative tightening (QT) will intensify the global USD shortage. Bank shares will keep falling led by the ones with the largest USD short positions, i.e. the Europeans (Deutsche, BBVA,...)......until the FED announces the end of QT.

2. Donald Trump will keep up the pressure on FED's Chairman Jerome Powell for a more lax monetary policy. To send a clear signal of FED's independence to the markets, Jay Powell will keep QT in place for longer than the US economy fundamentals would justify and even increase interest rates by 25 bps one or two more times. The US yield curve inverts. The US enters a recession.

Donald Trump's 2020 re-election becomes a low probability event. The US institutional framework of checks and balances does work in mysterious ways.

Chairman Powell, high five!

3. Theresa May's Brexit deal is voted down in parliament. For weeks there is no majority in parliament for what Brexit-related path to follow. Newsnight (BBC 2, from Monday to Friday at 10:30pm UK time) becomes the world's greatest comedy show for quite a few weeks. 

Eventually, the UK parliament calls a second referendum and the EU agrees to extend the 29th of March Brexit deadline by 1 year. The referendum is held in September. Remain wins by a surprising large margin (55% vs. 45%).

The GBP goes through the roof. London's real estate prices start to go wild again. Brexiteers are angry. Boris resumes playing cricket with other Etonians in North London.

4. In May, populists parties across Europe secure less than 15% of the overall European Parliament's seats. Even if they formed a single parliamentary group, it would be smaller than that of the two leading parties.

The EU is perceived as having saved another set point by the British press. Brexiteers are angry. Boris is still playing cricket.

5. China launches a major stimulus programme. The Chinese aggregate debt levels keep rising and surpass 260% of GDP, 5% short of Italy's total debt to GDP ratio. This combined with Xi Jinping's aggressive anti-corruption campaign and the communist party's rising interference in China's large private companies, makes Chinese entrepreneurs increasingly nervous and looking for ways to transfer some of their wealth abroad.

China has strict capital controls in place. The capital account is closed. However, no capital controls system is 100% watertight. With the yuan denominated financial assets / foreign reserves ratio currently at 12x, a 4.2% leakage of financial assets abroad will cut Chinese foreign reserves in half. And force a devaluation of the currency.

The capital flight happens. The yuan devalues 15% vs. de USD (to USD/CNY of 8.0). Trump is not happy. 

6. An EU-wide recession is currently fully priced in by European stock markets. An US recession is currently priced in with a 50% probability by both European and US stock markets. In the European high-yield market, high single to mid-teen yields are available on names of strategic industrial companies benefiting from implicit core-EU government support.

2019 will be a good year to deploy capital. You just have to be patient. Contrarian. And long-term greedy.

7. Portugal will remain the European football champion in 2019. I'm 100% certain about this one. 

The next European Cup will only take place in 2020.

May 2019 be a FUNtastic year! 

Friday, 15 June 2018

The beautiful game: world cup 2018 forecast (with perfect foresight)

Today, for something completely different. The World Cup 2018. Spoiler: you will see the future.
I can feel your sense of anticipation. The excitement. And relate to the sleepless nights in search of answers to the supreme existential question: is there any meaning to life beyond seeing your team winning the football world cup?

Well, life is good. And today is your lucky day - here are all the existential answers you have been looking for (you're welcome):

1. Italy won't win the world cup. They have bigger plans for the summer: leave the Euro without anyone noticing.

2. Holland won't win either. They decided some months ago not to participate in this year's tournament. Despite not having any plans at all for the summer at the time. Now they are considering going to Italy on holiday and organise daily football matches with the locals. There is hope for the Euro's survival.

3. The US will contribute as much to raise football's quality standards as President Trump to make a rules-based world great again. It will be beautiful!

4. Putin is a man of vision. Why participate in a G7 +1 summit when you can host the world cup? Russia's football team will play with the same flair, diversity and success that characterises the Russian economy.

5. England won't win. Nothing new but at least England has an excuse this summer: there is no time for distractions - the nation has to focus all its energy in turning the Boris-Rees Mogg Brexit master plan into a major success by mid-July. 2018. No one really knows what the master plan looks like, starting with Boris and Rees-Mogg, but there is no reason to panic as the deadline is still a distant five weeks away. Well informed sources in Westminster say that Brexiteers have never been more confident about delivering a successful Brexit and destroy the Euro along the way. After Boris has been spotted ordering a Pizza Margherita in Islington yesterday, rumours are rampant that he plans to invade Italy to kick the Dutch out of the country.

6. Belgium is the secret favourite. So secret that no one will miss them when they head home after the quarter-finals. The Belgium chocolate pralines remain world class though. Then again, that's not a secret.

7. Portugal will start the world cup as European Champion. And finish the world cup as European champion. If anyone wants to bet against it, please call me.

8. Spain will play Portugal in its first match. It's an early final. What would be the point to have the same match in the final again? Right....

9. France has a fantastic team. It's true that Napoleon suffered an history changing defeat in Russia (calm down Boris and Jacob, we know: Waterloo was epic) and that it still weighs heavily on the Grand Nation's collective memory. However, France has now an Über-President who can turn the nation around: young, dynamic, competent, eloquent, an ex-investment banker, a broad thinker with attention to detail. From my generation. Just like me in fact. Ok, France won't win.

10. Germany. It was in Stalingrad in 1943 that the new cool Germany was born (sure Boris and Jacob, we know: Churchill was magnificent). Who said that a devastating defeat can't mark the dawn of a much brighter and happier era? Cheer up Neuer, Kroos, Özil & Co: Germany's football will become even better following your performance in Russia.

11. Argentina has Messi. Messi! Messi! Messi! The clinical magician. Cruyff on the bench and Messi on the pitch have been a generation's football heroes. The ones who radically reinvented the game and in the process took us to places no one ever thought could possibly exist. It's a pity that Messi has Argentina.

12. Brazil has nothing in common with Russia, except being an emerging market. Brazil is Southern hemisphere; Russia is Northern hemisphere. Brazil is hot; Russia is cold. Brazil is a chaotic, lively democracy; Russia is an organised, sombre authoritarian state. Russia meddles in other countries elections; Brazil can hardly keep track of what is happening in its own elections. Brazil has Neymar, Coutinho, William; Russia doesn’t. Opposites attract. Brazil is the top favourite.

Tuesday, 10 April 2018

What's up with Portugal?

Matthew Klein, from FT's creative department (FT Alphaville), did a very good analysis about Portugal's economic journey post-Euro adoption in 1999. Here the link to Matthew's article: FT Alphaville looks at Portugal
And a few remarks:
1. The increase in Portugal's household debt in the post-Euro period was to finance consumption. Not real estate acquisitions (mortgages). There was no real estate boom in Portugal over the period. The increase in household debt combined with the increase in government debt (part of it directed to infrastructure spending / construction) led to the massive increase in foreign debt pre-Eurozone crisis.
2. The phenomenal improvement in Portugal's current account balance since 2011 is a combination of three factors
a) luck: tourism picked up to a large extend due to competing destinations' troubles (North Africa, Turkey,...)
b) sheer need: PT's export companies had to expand into new geographies as demand from Spain & Co collapsed
c) FDI: reforms made PT more attractive. Some foreign companies established operations in the country (e.g. Rocket Internet); already present ones expanded their existing operations (e.g. Siemens, Bosch, Peugeot, BNPP...)
3. Reforms (read tax incentives) implemented post-2009 attracted many EU-citizens as permanent residents. Golden Visas attracted non-EU residents (Chinese, Brazilian, Angolan. And more recently Turks). These individuals are the main force behind the boom in the Lisbon / Porto real estate markets. The ECB has little to do with it.
Tourism boom and VIPs as permanent residents (Madonna, Michael Fassbender, Cantona, Monica Belucci, Philippe Starck....) doing high profile marketing of the country - for free - led to an international (re)discovery of Portugal. And have created a positive feedback loop for tourism and investment.
The main gap in the whole story: a much more aggressive FDI attraction strategy (a la Ireland) is needed. FDI is the only way for Portugal to massively broaden its export base, increase productivity and raise living standards sustainably over a reasonably short timeframe (10 years).
An Eurozone private sector transfer union based on a FDI core-periphery bridge is what the EU(rozone) authorities should focus on. It would be a win-win situation for core and periphery. And therefore a no-brainer:

Thursday, 21 September 2017

Tesla vs. BMW – all you need is imagination

Equity investors seem to regard Tesla as the future leader of the global affordable luxury car segment. The company’s current market capitalisation already roughly matches that of BMW - nothing that a giant dose of imagination and creativity can’t possibly justify.


We are in September 2027. The electric car revolution made Tesla the world’s leading affordable luxury carmaker – the new BMW. Tesla’s 2027 car sales are expected to reach USD 120 billion (matching BMW Group’s sales in 2017).

Tesla has a similar net profit margin (7.4%) and is trading at a similar PE multiple (7.4x) as BMW was 10 years ago. Its market capitalisation just hit USD 68 billion. It was USD 61 billion in September 2017. As no dividends were paid out over the past 10 years, Tesla shareholders earned a 1.2% annualised return in 2017-2027. They are disappointed.

When buying Tesla shares in September 2017, they had a vision: Tesla would become the new BMW in 10 years time. Accordingly, they expected to make a 10% annualised return on their investment. They would have made it – if they had bought Tesla shares 56% below the then prevailing market price.

That’s not a very realistic vision of Tesla’s future, some enthusiastic Tesla investors may now argue. BMW’s current PE multiple is depressed. In 2027, a very successful Tesla will trade at higher multiples.

Ok. Let’s think about an alternative future. In September 2027 the new BMW – aka Tesla – will trade at 10x earnings 2028 (post dotcom bubble BMW only traded, on average, higher in phases of depressed earnings during recessions). This would translate into a 2017-2027 annualised return of 4.3% - assuming that no further equity or quasi-equity financing will be needed over the coming years. Factor in a 10% capital increase (i.e. USD 6bn - Tesla’s cash burn rate in 1H2017 was USD 2.4billion, USD 3 billion of cash is left on the balance sheet) and the resulting dilution would lead to an annualised return of 3.3%.

But, hold on, Tesla is not only cars! What about the energy generation and storage business? Sure - currently it accounts for 10% of Tesla’s sales. Therefore, even if it was able to mirror the growth and profitability of the car business in the Tesla-is-the-new-BMW scenario over the next 10 years, it would hardly move investors’ return-on-investment needle.

Imagination and optimism are good things. They cannot change the big picture: even if Tesla turns out to be the new BMW, with a successful energy and storage business attached, it is doomed to be a poor investment. 

It’s what usually happens when a stock is priced for perfection.

Wednesday, 14 June 2017

Modigliani-Miller, Warren Buffett, gravity and US equity valuations

Given the high levels of debt, the world's main central banks can't afford to rise interest rates dramatically over the coming 10 years. Thus, 10-year government bond yields in the US, EU and Japan will reach maximum 2%. If we add a 2% equity risk premium - historically rather low but justified by the low equity market volatility that is supposedly here to stay - we end up with equities being fairly priced at an earnings yield of 4%. A P/E of 25x.

This is the standard explanation many give to justify that equity markets, starting with the US, are currently far from overvalued. Then again, what do we know about the relationship between debt levels and the cost of equity (i.e. the equity risk premium)?

We know, from the Modigliani-Miller theorem, that a firm's capital structure has no impact on its valuation. Contrary to what many argue, the increase in a company's level of (low cost) debt vs. (high cost) equity - an increase in leverage - doesn't lead to a meaningful reduction in the average cost of capital. The reason is straightforward: an increase in leverage by increasing the company's insolvency risk leads to an increase in the company's cost of equity (the equity risk premium goes up). The increase in the cost of equity in turn fully offsets the lower cost of debt, resulting in an unchanged average cost of capital. As changes in the capital structure don't have any impact in a company's operating free cash-flow generation potential, it follows that a change in a firm's capital structure doesn't have any impact on its fair value. There is only one minor caveat: given that interest payments are tax deductible, an increase in leverage leads to a minor change in the average cost of capital via the debt tax shield (e.g. if (i) 50% of the firm's capital structure is made up of debt, (ii) the corporate tax rate is 25% and (iii) the average cost of debt is 4%, the average cost of capital is.......0.5% lower vs. a capital structure with zero debt and 100% equity. Only 0.5% lower!). But even then there is a limit to the benefits of leverage: at some point (dependent on the cyclicality of the underlying business) further increases in leverage lead to an increase in the risk of insolvency and cost of equity that starts to offset the tax shield advantage. Keeping adding debt once that point is reached starts to increase the average cost of capital instead of slightly reducing it.

By the way, that the capital structure has no meaningful impact on a firm's average cost of capital and valuation is one of the few things on which Warren Buffett, Charlie Munger and financial academics agree on. So we better take it seriously.

With this is mind, where does the world economic system stands now? This is how the world's debt levels have evolved since the year 2000 (courtesy of MGI - McKinsey Global Institute):

The world economy is today more leveraged than it was in 2007. This must surely mean that the aggregate risk of insolvency is today greater than it was back then. And knowing what happened in 2008, it is reasonable to conclude that the resulting increase in the cost of equity more than offset any tax shield advantage from the additional debt the system accumulated in the meantime. So, the risk-adjusted average cost of capital should be higher today than it was in 2007.

What does this mean to valuations in the world's leading equity market, the US? Assuming, very optimistically, that (i) today's average cost of capital is only 10%, (ii) the US economy will grow at 5% nominally per annum in perpetuity (2.5% real growth + 2.5% inflation) and (iii) companies' average dividend pay-out is 75%, US equities would be fairly valued at a P/E of 15x (with a pay-out of 65% the fair value P/E would be 13x).

The S&P 500 is currently trading at a cyclical-adjusted P/E of 29.9x, trailing P/E of 24.1x and 1-year forward looking P/E of 19.0x. If this is fairly valued, what is overvalued?

And remember: gravity does exist. In financial markets too. It's just that it is not Newton's gravitational principles that rule financial markets - it's Wile E. Coyote's: markets can deviate from fair value for a long time, but eventually the power of gravity takes over.

Tuesday, 16 May 2017

Macron(omics) missing piece - a private sector-based Eurozone transfer union: the core-periphery FDI bridge

The Eurozone suffers from a structural economic problem. An imbalance: a centre traditionally running current account surpluses, a periphery traditionally running current account deficits. Admittedly, the peripheral countries' current accounts are now balanced but as unemployment keeps falling it is difficult to see how this won't translate into a rise in imports and current account deficits resurfacing again. The classic response to address such imbalances is via the creation of an EU transfer union. In theory, it would make sense.

But theory is not always very practical: it is almost impossible to gain political support at the EZ's national level to transfer taxpayers money from the centre to the periphery. However, doing nothing is not an option either. And this begs the question: what to do? The answer: create a centre-periphery FDI bridge. The idea's rational being reasonably straightforward:

Problem: Peripheral countries (Spain, Portugal, Greece) have traditionally (i.e. since WWII) run current account deficits - the resulting accumulation of foreign debt leading sooner or later to an inevitable “sudden stop”, financial and economic crisis. Just like in 2009/2010. 

Solution: These countries need to broaden substantially their export base and implement an export-driven growth strategy. The way to do it in an effective and reasonably timely manner (5-10 years) is by attracting massive amounts of foreign direct investment (FDI): that the Siemens, L'Oréals, Googles of the world set up production/service units in the countries (or expand the already existing ones) to serve (mostly) clients abroad. For it to happen structural reforms at the national level are needed – no doubt. But it will not be enough. The European Union has to create a mechanism that incentivises the flow of private capital (simply said “Germany’s excess savings”) from the centre to the periphery to finance the FDI projects. This should comprise:

- tax incentives, e.g. FDI projects not paying corporate tax for the first 10 years;

- a pan-EZ legal & institutional framework, e.g. FDI courts at EU level investors could resort to in case of legal issues arising with their projects. Thus overcoming the potential lack of trust in the national legal frameworks & judicial systems.

In short: create special economic zones in the EU periphery offering investors a highly attractive and reliable fiscal, legal and financial return framework

Result: A win-win situation - the periphery expands its export base and generates strong export-based sustainable growth; the centre can invest its surplus in economically sustainable projects at an attractive rate of return (instead of investing in US-subprime or Spanish overvalued, excessively supplied, real estate assets as in the pre-2008 period). 

Cutting a long story short, the centre-periphery FDI bridge is an incentive mechanisms at the EZ level to channel private sector monies from the surplus centre to the deficit periphery, to finance FDI projects in the latter. It is both politically more feasible and economically more efficient / sustainable than creating a classic transfer union.

Combined with (i) a limited common EZ budget (managed by an EZ finance minister) to finance investment projects across the EZ, (ii) evolving the ESM into a fully-fledged European Monetary Fund for crisis resolution situations, (iii) full implementation of bank bail-in mechanisms and completion of EZ's banking union, the FDI core-periphery bridge would complete Eurozone's required institutional framework and make it a sustainable and prosperous economic construct. The Euro would definitely become a success story.

Emmanuel, are you reading? Thanks to you, we - the Erasmus generation - are in charge now. Let's make Europe great. Again.

Monday, 20 February 2017

Hard-core Brexiteers' investor sentiment: Germany is stupid enough to let the Euro collapse...

Germany's current account surplus is estimated to have reached 8.6% of GDP in 2016 (Source: Ifo Institut).

The Deutsche Mark (DM) was Germany’s currency from 1948 to 1999. How often did Germany in the DM period have a current account surplus of 8.6% of GDP? Zero. How often a current account surplus of 5% of GDP? Zero. The highest current account surplus ever recorded during the DM period was approx. 4% in two years in the 1980s. During the rest of the time, Germany’s current account surplus always peaked in the range of 2%-2.5% of GDP. This includes the years of Germany’s economic miracle in the 1950s and 1960. Check it out for yourself:

Source: Bloomberg

[Please note: chart only depicts Germany's current account balance data from 1970 to 2015. Full data from 1950 to 2015 for Germany's trade balance can be found under German Trade Balance 1950-2015 and for Germany's GDP under German GDP 1950-2015 - data source for both links: German Statistisches Bundesamt. To calculate the German current account balance please take into account that 1%-2% of GDP have to be subtracted from the trade balance. Reason: Germany's current transfers are negative (EU net transfers accounting for approx. 0.6% of German GDP + monies transferred by migrants living in Germany to their countries of origin more than offsetting Germany's positive income balance)]
Is today’s German 8.6%-of-GDP current account surplus sustainable? No. During the DM period it would have been swiftly eliminated before it even came into existence via an appreciation of the DM (r-e-m-e-m-b-e-r: with the exception of two years in the 1980s, the German current account surplus never surpassed the 2%-2.5% mark during the over 50 years long DM-period). With the Euro, this market-based adjustment mechanism ceased to exit. What to do? There are two options:

  1. Break up the Euro and return to national currencies in today’s Eurozone
  2. Put in place a transfer mechanisms from Eurozone’s surplus to deficit countries via the public and/or private sector
What are advantages and disadvantages of option 1 for Germany?

The only advantage of Option 1 I can see is the lack of need for economic co-ordination among Eurozone member states, which can often be painful. A veritable pain-in-the-neck. I can see, however, many disadvantages both cyclical and structural.

Let’s start with the cyclical: Germany would undergo a recession - then again, who cares? Many young well educated citizens from EZ’s periphery would head back home - one of the best performing asset classes in Germany over the past 5-6 years has been real estate. A fall in real estate prices would be unavoidable. There is no asset class where the average investor is as leveraged as real estate. What would that mean for the German financial system? Bail-ins or bail-outs - do we start to care now?

On the structural side: how many decades would the resentment and lack of trust between Germany and France last following France’s crash-out of the Euro? Could the EU survive a break-up of the Euro? If not, what would the end of the EU's single market mean for the German economy? With 80 million inhabitants and a Eur 3.1tn GDP, Germany is Europe’s heavyweight. It accounts for roughly 1% of the world’s population and 4.5% of the global GDP - how much weight would stand-alone Germany have in the world (the US accounts for 24% of global GDP, China 15%, the EU 23%, the EU ex-UK 19.5%)? How much influence would stand-alone Germany have in forming and shaping international treaties and world trade agreements? Could NATO be a credible tightly knit military alliance with no underlying mutual trust among its core European members?

By choosing option (2) Germany would agree to transfer a large part of its current account surpluses to the Eurozone periphery. In return it would continue to have the full benefits of the existence of the Euro and a stable, sustainable and prosperous European Union. Given that Germany’s giant current account surpluses wouldn’t exist without the Euro, Germany would give up something it wouldn’t have anyway in return for having something extremely valuable and tangible. This is the closest you will ever get to a free lunch: get great value in return for giving up de facto nothing.

We can discuss if in the end Germany will push for an Eurozone-wide public sector based transfer mechanism between surplus and deficit countries (Eurobonds and an Eurozone finance ministry). Or a private sector based one, i.e., create incentives at the Eurozone level to incentivise massive amounts of foreign direct investment (FDI) in the periphery financed with German private sector surpluses – the periphery widens its export base and German investors obtain attractive returns for their savings (my favourite option). Or if Germany simply starts to spend more via a mix of public investments with a positive impact on the economy’s supply side (infrastructure, education…) and larger pay rises, which would increase German imports. Or if Germany will push for a combination of all these (the most likely option).

But saying that Germany, in the end, will let the Euro break up is saying that the country’s top-decision makers are economic and political illiterate. And absolutely stupid. Or that they are not intelligent enough to convey the message of the Euro’s and European Union’s importance and extremely high benefits for the country to German voters. Meaning: they are really stupid. Or that the vast majority of the German public wouldn’t understand the message. Meaning: the Germans overall are really stupid. Or that the German political system would not comply with article 23 of the country’s constitution. Meaning: German top decision-makers are not only stupid – they cannot even read. And on top of it, Germany’s political and judicial institutions are a fraud.

No, no, boys and girls. No, no, hard-core Brexiteers. I know that it is unpopular to say it these days, and I’m sorry to disappoint you, but the Euro will not collapse. In Germany’s wisdom and quality institutional framework you should trust. Even if you don't like it.