No Free Lunch: Valuation Determines Return

By John Mauldin

Angela Merkel, Donald Trump and a broken alliance
 
Weakening ties between US and Europe mainly benefit China and Russia
 
Philip Stephens
 


Here in the grand ballroom of Munich’s Bayerischer Hof was a moment for Europeans to feel good about themselves. Angela Merkel’s broadside against Donald Trump’s US administration in defence of the liberal international order unlocked a cascade of pent-up frustration. Mike Pence, who followed the German chancellor to the podium on Saturday, must have had his headphones turned off. America’s allies, the US vice-president intoned, should do as they were told.

That this exchange took place at the Munich Security Conference, for 50 years a spiritual home of Atlanticism, tells you something about the state of a relationship that not so long ago celebrated the victory over Soviet communism. Europeans have been inclined to downplay the impact of Mr Trump’s presidency on the Nato alliance. But enough is enough.

In this case, “enough” for Ms Merkel included Mr Trump’s unilateral decisions to pull American troops out Afghanistan and Syria, to withdraw from the treaty prohibiting the deployment of intermediate range nuclear weapons, and to threaten Europe for not falling into line with US sanctions against Iran. Each has a vital bearing on European security; all were taken by the White House without reference to, or discussion with, partners.

Add Mr Trump’s absurd threat to declare that European (he means German) auto exports are a danger to US national security and you can see why an energised, almost emotional, Ms Merkel received a standing ovation — and why a wooden Mr Pence was met with near silence.

The winners in Munich were Russia and China. Sergei Lavrov, the hard-bitten Russian foreign minister, rarely allows himself a smile. He struggled to suppress his satisfaction. If Russian president Vladimir Putin has one overarching strategic goal, it is to drive a wedge between Europeans and Americans. Let us Europeans run our common home, Mr Lavrov offers. What he means, of course, is that with the Americans gone Moscow can take charge.

Beijing also sees an opportunity. Yang Jiechi, the Communist party’s foreign affairs chief, put China firmly on Ms Merkel’s side, lauding the role of global rules and institutions in facing challenges such as nuclear proliferation and climate change. Mr Yang paid homage to multilateralism almost as often as Mr Pence praised Mr Trump.

Europeans have concerns about Beijing’s push westwards through its Belt and Road Initiative and about the lead China’s Huawei has taken in producing next generation communications technology. But does the continent, Mr Yang asked, really want to put itself at the mercy of US technological hegemony?

There are still those who believe that things can again be as they used to be. Mr Trump has, at most, six more years in the White House and, with a little luck, only two. The Democrats, newly in charge of the House of Representatives, sent a sizeable delegation to Munich carrying the message that Washington still has Atlanticists. Optimists point to a gap between Mr Trump’s rhetoric and US policy on the ground. He derides Nato; the Pentagon has sent more US troops to eastern Europe to counter the threat from Russian revisionism.

True enough. But the reality-is-not-as-bad-as-the-rhetoric school ignores the hollowing out of an alliance once grounded in shared principles and values as well as common defence. Nato’s founding charter starts with a commitment to democracy, freedom and the rule of law. These are not values that much interest Mr Trump. The US president has made plain his preference for authoritarian strong men over champions of a liberal international order. The rule of law scarcely looms large in his worldview.

The corrosive impact of this on European public opinion shows up in surveys showing the collapse of trust in American leadership. How can Germany make the case for Atlanticism, Berlin diplomats fret, when a sizeable proportion of the country’s voters would rather put their faith in Mr Putin than in the president of the US.

The weakening of the alliance predates Mr Trump. For all his grand rhetoric, former US president Barack Obama waited until the end of his second term to show much interest in refurbishing ties with Europe. The absence at this year’s gathering of the late senator John McCain spoke soberly to the passing of the generation of American politicians and policymakers for whom Atlanticism was mother’s milk. But take away the commonality of values and the very foundations crack.

The hard geopolitical truth is that both sides still need each other. Ms Merkel may talk about Europe taking on more responsibility for its own security affairs, but there is little evidence she is ready to persuade a pacifist Germany to turn that way. French president Emmanuel Macron has tried to force the pace. Ms Merkel has slowed it.

As for the US, Mr Trump may not understand this but the shifts in global power make Europe a more rather than a less important ally. This is not a continent that Washington can afford to cede to its rivals. What has been lost is the warmth that comes with the idea of a shared endeavour and the trust that allows space for valid disagreements. In a world destined to be shaped by coldly transactional alliances, Europeans and Americans are both losers.

Up and Down Wall Street 

The Federal Reserve Faces a Reckoning

By Randall W. Forsyth 


Federal Reserve Chairman Jerome Powell. Photograph by Andrew Harrer/Bloomberg


The Federal Open Market Committee won’t make any changes in its policy interest rates this coming week. It may disclose plans to wind down its program of reducing the size of its balance sheet. But these policy decisions will be made against the backdrop of a developing debate of the basic functions of monetary policy not seen in more than a generation.

As for the basic headlines, the Federal Reserve’s policy-setting panel is certain to leave its federal-funds target range unchanged at 2.25%-2.50% at the conclusion of its two-day meeting.

At the same time, the FOMC will also release its latest Summary of Economic Projections, which will include the members’ guesses on where the fed-funds rate will end 2019. Those are depicted in the “dot plot” graph, which gets the most market attention.

A lot has changed since the last set of FOMC forecasts released after the Dec. 18-19 meeting, when the Fed raised the funds target by one-quarter percentage point and the dot plot indicated a median forecast of three more hikes. Just days later, in early January, Fed Chairman Jerome Powell pivoted sharply to indicate that the monetary authorities would be “patient” in raising rates further and would be flexible in reducing its holdings of Treasury and agency mortgage-backed securities.

That reversal spurred the sharp rebound in equity and other risky assets that erased much of those markets’ fourth-quarter swoon, reflecting the new dovish tilt by the Fed. And by Friday, the fed-funds futures were pricing in nearly a 37% probability of a rate cut by next January, according to the CME FedWatch site.

Powell will be quizzed Wednesday afternoon on the FOMC statement and other decisions in the postmeeting press conference. His comments might provide more guidance on future rate moves, but his interview on 60 Minutes last Sunday shows that, after some earlier clear pronouncements on policy, he has mastered the ability of his predecessors to say little or nothing if it suits him.

What serious students of monetary policy are most interested to hear is how the Fed’s thinking on its aims and approaches might be evolving. Despite the U.S. central bank’s having virtually met its dual mandate of maximum employment with price stability—with February unemployment at 3.8% and its main inflation measure running just below its 2% annual target through January—there remains widespread dissatisfaction with the economy and how many are faring in it. And that’s a decade after the Great Financial Crisis and the extraordinary monetary measures enacted to stimulate a recovery.

Danielle DiMartino Booth, a former adviser to the Dallas Fed president and publisher of the Money Strong newsletter, wrote in a Bloomberg opinion piece this past week that while the loose policies of the Fed and other central banks have boosted asset prices, the inflation in prices of stocks and other assets have benefited their owners, primarily the well-off, and worsened wealth inequality.

“If the ‘wealth effect’ used to justify a generation of quantitative easing hasn’t kicked in yet, trickling down to those who need it most, it’s past time the Fed acknowledged its failings and opened the door to a new policy framework,” she concludes.

Martin Wolf, the Financial Times’ economics writer, contended this past week that “monetary policy has run its course,” having done all it can to fight secular stagnation, the state of persistent inadequate demand hypothesized by Lawrence Summers, the former head of the National Economic Council under President Barack Obama and Treasury secretary under President Bill Clinton.

Persistently low interest rates aren’t artificially depressed by central banks but by the low level of real rates needed by the economy, Wolf continues. But those low rates, even below zero, fail to boost the economy mired in a “balance sheet recession,” as Nomura economist Richard Koo hypothesizes, which leads companies and households to pare debt rather than borrow and spend. As Koo was quoted saying in this column in 2016, negative interest rates seem “an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results.”

Three years later, the total amount of negative-yielding bonds hit $10.2 trillion, JPMorgan reported this past week, the highest amount since December 2017. Others argue the expansion of debt encouraged by low interest rates now exerts a drag on the economy, as companies and households have to pay off those obligations rather than expand. General Electric(ticker: GE), an extreme example, has had to prioritize shoring up its balance sheet over growth.

With monetary policy having reached this apparent cul-de-sac, Wolf contends fiscal measures are needed to counter insufficient demand. Taken a step further, this argument extends to adopting Modern Monetary Theory, which essentially argues a nation that can borrow in its own currency isn’t limited by the size of the debt. If inflation heats up, fiscal policy can be tightened. Powell dismissed MMT as “just wrong” in recent congressional testimony, an opinion shared by the overwhelming majority of mainstream economists, even as it gains adherents on the left.  
Some critics on the right, meanwhile, argue the Fed simply has been too tight after its nine rate boosts since late 2015 and the contraction of its balance sheet from a peak of $4.4 trillion in October 2017 to $3.9 trillion currently. A Wall Street Journal op-ed this past week trotted out the idea of targeting commodities to guide monetary policy, a notion that goes back to early 20th century Swedish economist Knut Wicksell. The recent weakness of commodity prices suggests policy is too tight, the authors contend.

The Fed targets overall inflation rather than commodities, which play a small role in the 21st-century economy. The Fed’s problem has been that it has consistently undershot its 2% target, which is the opposite of central banks’ traditional inability to maintain stable prices. One change under consideration is for the Fed to make up past shortfalls by letting inflation catch up on the high side. Central bankers contend persistently too-low inflation makes it harder for them to fight recessions. Critics counter that 2% inflation means that a dollar loses half of its purchasing power over about 36 years, which is not price stability.


These and other policy ideas are under a review by the Fed under its vice chairman, Richard Clarida, which is supposed to scrutinize the central bank’s strategy, tools, and communications policies. The results, which are due later this year, will be of more than academic interest.

Forty years ago this October, the Fed embarked on a major, single-minded policy assault on double-digit inflation, even at the cost of severe, back-to-back recessions. Now, it would appear the focus of the debate under way is directed at maintaining the economic expansion that, despite being on the way to be the longest on record, has been more successful in boosting asset values than household income.

Will the Federal Reserve provide clarity on its bond holdings?

FT Reporters




Will the Federal Reserve provide clarity on its bond holdings?

Investors and economists are supremely confident that the US central bank will leave policy unchanged at this week’s monetary policy meeting, but there will still be plenty to digest — not least details of the Fed’s plans for its multitrillion-dollar balance sheet.

The Fed Funds market indicates that not only is there virtually zero chance of policymakers raising interest rates this week, it is now pointing to an extended pause from the central bank and a more than a 25 per cent chance that it cuts rates by the end of the year.

There will therefore be plenty of attention to the Fed’s revised economic forecasts. Although the central bank’s rate setters on the Federal Open Market Committee have sounded a cautious tone lately, several have stressed that they still plan to raise rates at least once more this year.



The greatest attention is likely to fall on any details offered on the Fed’s balance sheet which was swelled to a peak of $4.5tn through various quantitative easing programmes in the wake of the financial crisis.


But since 2017 the central bank has been shedding the bonds it acquired, deflating the size of its balance sheet to just under $4tn. However, the pace at which the Fed is offloading the debt it bought was one of the factors behind last year’s turbulence in financial markets, and Fed chair Jay Powell said last month that an announcement on its future balance sheet would come “fairly soon”.

That led economists to predict that a more detailed road map for “quantitative tightening” could come at this week’s meeting. But just how far it will trim has remained unclear, and whether it will slow its selling as it approaches the end point. On Wednesday, more clarity is likely to come. Robin Wigglesworth

Will UK government bonds wake up?

Their current snooze is certainly sparking curiosity. Gilts investors are clearly aware that the UK is trapped in a chaotic process of leaving the EU — an event with deep and broad implications for all UK markets, chiefly sterling but bonds and equities too. And yet the market is not really moving.

Robert Stheeman, who runs the UK’s Debt Management Office, noted to Reuters this week that “the market is currently quiet and relatively benign”. Ructions in the bond market have “rarely been noticeable”, he added.

In part, this reflects the same paralysis that is keeping sterling nervous but still within a tight range; without any certainty on how Brexit will pan out, investors are loath to jump in either direction.

In addition, the question ‘what would gilts do in a no-deal Brexit?’ is not straightforward.

For sterling, it is simple: the harder the Brexit, the larger the fall. For gilts, all things being equal, the “fear trade” from a deal-free divorce would almost certainly send bond prices flying and hammering yields down, particularly on the assumption that the Bank of England would respond with substantial stimulus.

But at the same time, the risk of inflation, fuelled by a plunge in the pound, would hurt gilts. In addition, some fund managers suspect that the government would find a way to smooth the blow with fiscal stimulus — another likely drag for the bond market.

Taken together, it is therefore hard to see how benchmark 10-year government bond yields can shift meaningfully from their current level of 1.19 per cent. A no-deal Brexit, which few in financial markets seriously expect, may be the only way to find out. Katie Martin

What is driving down the Hong Kong dollar?

A sliding Hong Kong dollar is again forcing the territory’s central bank to intervene in the currency markets, for the first time since August. The Hong Kong Monetary Authority has bought up $692m worth of Hong Kong dollars over the last week after the currency hit the lower limit of a trading band that dates back to 2005.

But this time it may also be China’s stock market rally — in addition to the US Federal Reserve — piling downward pressure on Hong Kong’s currency.

Even though the territory’s de facto central bank has raised its overnight lending rate in lockstep with the Fed, this has had little impact on the broader cost of borrowing thanks to the ample liquidity sloshing around in Hong Kong’s banking system. A gap of almost one percentage point between three-month Hibor, Hong Kong’s interbank lending rate, and US equivalent Libor, has prompted investors to sell lower-yielding Hong Kong dollars for the higher-yielding US dollars.

But now another seller of the Hong Kong dollar has entered the scene. Ronald Man, North Asia rates and foreign exchange strategist at BofA Merrill Lynch, said Hong Kong-based investors were selling Hong Kong dollars as they purchased renminbi to invest in China’s rocketing stock market.

Mr Man said the institutional investors who helped drive the weakness in the Hong Kong dollar last year “are probably very close to being at their limit, whereas more of the depreciation process here on in will be driven by the equities investors”.

Neither he nor any other analysts are worried about the viability of the Hong Kong dollar’s peg, though, as the latest interventions still left HKMA with HK$71bn to marshal in defence of Hong Kong’s currency if needed. Hudson Lockett

5G - The Future Is About To Arrive

Mark J. Grant



Summary


•The new 5G network promises blazing speeds, massive throughput capability, and ultra-low latencies and makes "the existing communication model obsolete."

•This is critically important to understand for investors.

•I still do not believe that many people and institutions know just how important this new technology is going to be in a wide variety of sectors.


Let me be explicitly clear. The new 5G network that is most assuredly beaming itself our way makes "the existing communication model obsolete." This is critically important to understand for investors.

The 5th generation of cellular connectivity promises blazing speeds, massive throughput capability, and ultra-low latencies. While I have written about subject before, I still do not believe that many people and institutions know just how important this new technology is going to be in a wide variety of sectors.

5G is going to have a huge positive impact on most major phone carriers, as the major carriers all plan to launch 5G this year. As they will become the provider of streaming services for everything from data, to TV content, to games, it is my opinion that they will eventually replace the cable and internet connections as there will be no need, any longer, to use those services. There will be a router in your house, or office, that will supply "everything." Also, virtually every phone will have to be replaced by the new 5G phones which will be a giant boon for the mobile telephone makers and their suppliers, in my opinion.

President Trump recently stated,

“I want 5G, and even 6G, technology in the United States as soon as possible. It is far more powerful, faster, and smarter than the current standard. American companies must step up their efforts, or get left behind… I want the United States to win through competition, not by blocking out currently more advanced technologies. We must always be the leader in everything we do, especially when it comes to the very exciting world of technology!

In a statement the CTIA, the trade association representing the U.S. wireless communications industry, appreciated the support from the President.


“We share the President's commitment to leading the world in next-generation 5G wireless.
Thanks to the innovation, hard work and investment of America's wireless industry, the first commercial 5G deployments are happening now, in communities across the country.

5G, and its connectivity to the "Internet of Things," has the capability to create more efficient industries such as connected cars, and smarter cities which are all components of the "Internet of Things" equation. The uses for the military are inestimable as military installations can be instantaneously controlled from hundreds of miles away. Cameras on military and commercial aircraft will be able to see and diagnose issues in "real-time," allowing for much safer experiences.

The global population is set to reach 9.6 billion people by 2050. In the "Internet of Things" 5G based smart farming, a new system will be built for monitoring the crop field with the help of sensors (light, humidity, temperature, soil moisture, etc.) and automating the irrigation system.

The farmers can monitor the field conditions from anywhere. The "Internet of Things" based smart farming is highly efficient when compared with what is available now.

One of the major telephone service providers has announced multiple partnerships focused on an enhanced 5G healthcare experience. Perhaps the biggest announcement was the partnership with Chicago based Rush University Medical Center. Together, they're working to bring the first standards-based, 5G-enabled hospital to the United States.

Incorporating 5G technology into the healthcare space will ultimately bring faster speeds and lower latency which are critical to the mission-critical nature of hospital care and they support the abundance of innovative technologies Rush is currently deploying throughout its system.

Dr. Shafiq Rab of Rush stated,

“High-speed, low-latency 5G technology will help enable care to be delivered virtually anywhere at any time. The technology will enhance access to care, even from long distances, while also helping to decrease costs and improve efficiency. Imagine sometime in the not too distant future, for example, a doctor performing a virtual visit with a patient while downloading an entire MRI scan within seconds. The cutting-edge applications we're implementing need a fast, reliable network to support them.

The numbers are staggering for growth of 5G. IDC forecasts 5G connections to rise at an annual average rate of 315.7% from 2019-2022. They also project 5G mobile subscriptions to expand by 322.2% during this same time period.

Next consider the car and truck companies. The vehicles will be able to communicate with each other in almost virtual time because the latency is so quick. A human being is unlikely to be part of this equation and the safety factor on the new 5G cars and trucks will make travelling much safer, which should speed up people and companies buying and leasing these new cars and trucks. The vehicles will be able to "sense" each other and avoid collusions and also avoid obstacles as the use of very detailed maps, constantly changing in "Real Time," will become available.

Then there will be the monitoring of devices. Water meters, electric meters, locks for your offices, garage door openers, inventory in a store and a whole host of the "internet of things" can be monitored in virtually "Real Time." The savings to many types of companies, such as utility companies, and retail stores, is likely to be substantial.

The 5G network, because of the speed, also requires more antennas at closer distances. That means that the tower companies, along with the chip makers, will benefit along with the makers of the antenna equipment. This will just be a huge boon for these companies, in my estimation.

The FCC estimates that there will be 4 trillion MHZ-Pops which is compared to the 230 billion that are in existence at this time. HIS forecasts that the 5G equipment market will grow 321.3% from 2018-2022.

You might think that the new 5G technologies are far off so that nothing needs to be done now.

I beg to differ. Keysight commissioned Dimensional Research to conduct the survey on which its state of 5G report is based, which included responses from more than 350 senior technology leaders and strategists from service providers and technology companies. Fifty-four percent of respondents said that they had already begun their 5G development, and 16% said they already had 5G partially deployed. Thirty-one percent of respondents said that they planned to deploy 5G within the next 12 months, with an additional 13% saying that deployment would come within the next 12-24 months.

The first mobile phone call took place on April 3, 1973. This was almost 46 years ago. The technology advanced slowly, slowly from one generation to the next. 5G is not an evolution, in my opinion, but a revolution, because of the huge increase in speed which allows for modern day miracles. "Real Time" has finally arrived.

I suggest investors take some "Real Time" now to size up both the opportunities and the pitfalls. If not, they will be making decisions in the past, as the future will have already materialized.

The Cold War in Tech Is Real and Investors Can’t Ignore It

By Reshma Kapadia


 

Cisco Systems, an early Silicon Valley success story, has become one of the nation’s top tech exporters. Today, roughly half of the networking giant’s sales come from outside the U.S. As foreign countries sought to catch up with U.S. connectivity, Cisco helped plug them in.

But a wave of nationalist thinking has put Cisco (ticker: CSCO)—and most of its peers—in an uncomfortable position. Earlier this month, Cisco CEO Chuck Robbins described the current climate as “one of the more complex macro, geopolitical environments that I think we’ve seen in quite a while with all the different moving parts.”

It’s likely to get worse.

While investors are cheering indications of progress being made toward a resolution of trade issues between China and the U.S., the battle for tech supremacy between the two global superpowers shows few signs of abating. Even as the White House was negotiating on trade with Beijing, it was also contemplating a U.S. ban of telecommunications equipment from Chinese companies like Huawei Technologies, essentially China’s version of Cisco. As President Donald Trump was tweeting about the importance of 5G on Thursday, Secretary of State Mike Pompeo was pushing U.S. allies to ditch Huawei.

This is a fight that is not going to end anytime soon. For years, U.S. officials have worried about Chinese equipment being used to infiltrate U.S. networks and businesses for possible espionage and theft of intellectual property. Even a resolution of the trade war won’t quell those fears.

“The perception is that too much of the information- and communication-technology supply chain is centered on China,” says Paul Triolo, who focuses on global technology policy issues for risk consulting firm Eurasia Group. “If we are in a conflict and using infrastructure built by China, they could theoretically hit a button and shut off everything.”

“After 30 years of saying companies should optimize supply chains and move some abroad, now we are saying it’s a security concern,” he says. “Adjusting to that is jarring.”

WELCOME TO THE NEW COLD WAR IN TECH.

For a short period last year, the Trump administration banned U.S. exports to Chinese telecom equipment maker ZTE(763.Hong Kong). Unable to get crucial components from U.S. suppliers, ZTE’s production was crippled, and its stock fell 40%.

The move had collateral damage, including U.S. optical networking company Acacia Communications(ACIA), whose own stock fell 35% in the days after the ban. Ultimately, President Trump reversed the ban and fined ZTE $1 billion instead.

Last August, Australia banned Huawei gear from its 5G networks. In January, the Australian wireless and internet company TPG Telecom(TPM.Australia) scrapped its plan to build a new mobile network, citing the ban. TPG shares are down 29% since late August.


For investors, these are early previews of the dangers to tech companies as their parent nations are pulled between the U.S. and China. Consider that Flex(FLEX), Broadcom(AVGO), Qualcomm(QCOM), Micron Technology(MU), Intel(INTC), and Qorvo(QRVO) each sold Huawei more than $90 million of equipment in 2017, the last full year of data, according to Gavekal Research analyst Dan Wang. All of those sales could be imperiled by a Huawei export ban that has been discussed by the Trump administration. For investors, a ban is a greater risk than the cyclical slowdown already weighing on the chip industry.

At the same time, China is no longer content to be the world’s factory for low-cost goods, pushing its own homegrown companies to challenge the global positions of established tech leaders. For China, technology is central to its ambitions to be a global power, a topic that goes well beyond trade agreements.

Western Europe is already caught in the middle. Ostensible U.S. allies are being pressured by the Trump administration to take a tough line with privately held Huawei. European telecom operators, however, have spent years buying Huawei gear. Vodafone, a top United Kingdom telecom provider, has temporarily banned Huawei from the most critical parts of its network. But both Germany and the U.K. are leaning against an outright ban, The Wall Street Journal has reported.

The U.S., meanwhile, has stepped up its crackdown. In December, at the request of the U.S., Canada arrested Huawei Chief Financial Officer Meng Wanzhou on charges of bank and wire fraud. The company has repeatedly denied those charges as well as spying allegations. Huawei did not respond to requests for comment.

Huawei has become a major player in the telecom space by undercutting rivals like Cisco and Nokia(NOK). The Shenzhen-based company’s revenue has risen to an estimated $109 billion last year from $18 billion in 2008.

“We have experienced price-focused competition from competitors in Asia, especially from China, and we anticipate this will continue,” Cisco warned in its latest annual report.

Congress has introduced bipartisan bills to ban the sale of U.S. chips and components to Huawei and other Chinese telecom companies breaking the law or violating sanctions. Lawmakers finding common ground on the issue illustrates the magnitude of the threat, which has been complicated by U.S. companies turning to China’s 1.4 billion consumers for growth.

Lately, however, U.S. companies have felt the pain of more-insular Chinese consumers, who have been encouraged to buy local goods. China weakness was the focus of Apple’s rare revenue warning earlier this year.

Mergers are another likely casualty, as the U.S. and China each add new reviews of cross-border deals. Last year, the Trump administration blocked chip maker Broadcom, then based in Singapore, from buying Qualcomm because of its Chinese connections. Qualcomm dropped its own bid for NXP Semiconductors (NXPI) of the Netherlands last year after China’s review board, the State Administration for Market Regulation, dragged its feet. In its latest annual report, Qualcomm warned that “future acquisitions may now be more difficult, complex, or expensive to the extent that our reputation for our ability to consummate acquisitions has been harmed.”

China’s investments in the U.S. fell to less than $5 billion last year from $46 billion in 2016, according to Rhodium Group.


Illustration by Edel Rodriguez


The shifting dynamic is a costly distraction, at best, as tech companies come up with contingencies and look to shift production out of China. But the real worry is that as the U.S. and China try to protect their own interests, they may take down the entire tech ecosystem along with all of the innovation it produces.

Wall Street’s tech analysts can’t model for an end to innovation. But that doesn’t mean investors should dismiss the risk.

“It’s absolutely something we have to think about in terms of the assumptions we are making about revenue and margins,” says Steve Smigie, senior investment analyst for GQG Partners, which oversees nearly $19 billion.

Take Huawei. If the company is hit with an export ban similar to the one imposed on ZTE, Wang of Gavekal Research says the company would be unlikely to survive. While a collapse might be seen by U.S. officials as a cold war victory, it would reverberate throughout the global economy. Huawei has six times the sales of ZTE, and its gear is used in 170 countries.

While the tech cold war remains largely theoretical, Barron’s spoke to policy watchers, fund managers, and industry analysts to come up with a basket of stocks already feeling effects from the tech battle.

THE HARDEST HIT: CHIP STOCKS

Semiconductor chips are the brains for just about anything with an on-and-off switch. Chips also happen to be the Achilles’ heel for China, making them a major battleground in a tech cold war. Despite several pushes in past decades to create its own semiconductor industry, China makes just 30% of the chips it needs, according to a report by Deloitte.

Chip stocks had a rough fourth quarter last year, hit by concerns about tariffs and a cyclical downturn. The PHLX Semiconductor Index has rebounded 17% to start the year.

The threat of export restrictions, however, still looms over the industry. “It has made it extremely hard to have conviction on a lot of these names,” says John Vinh, an analyst with KeyBanc Capital Markets, who has a Sector Weight on much of the industry he covers. “The ban on ZTE had a ripple effect through the chip industry. A ban against Huawei would have a much more significant impact. I would be cautious on any trade deal. China still has issues that we wouldn’t be out of the woods on, even if there is a resolution.”

Buttonwood

Why private equity appeals

It offers investors smoother returns, and a way around debt constraints



JOHN MCGAHERN’S novel, “That They May Face the Rising Sun”, is set in a remote corner of Ireland. There is a lake, a church, two bars and not much else. Gossip is prized but in short supply. Much of it is concerns John Quinn, a womaniser who has buried two wives and is looking for a third. His quest takes him to Knock, a shrine to the Virgin Mary, which has become a place to find a partner. Like many pilgrims, John Quinn is outwardly pious. But his mind is fixed on earthly matters.

The masking of intent may also be true of visitors to the temple of private equity. On the surface, investors in such funds might hope to harvest a reward—an “illiquidity premium”—for locking up their money for five to ten years. That allows private-equity funds time to turn sluggish businesses into world-beaters. The pitch is seductive. Capital has flooded in as readily as pilgrims flock to the shrine at Knock.

Perhaps, though, private equity’s pilgrims are really after something else. These institutional investors may face limitations on how much they can borrow. Private equity offers a way round such constraints: it is liberal in its use of debt to juice up returns. And that is not all. The value of privately held assets are not assessed all that often. That is a plus for those who, for ignoble reasons, would like not to be told how volatile their investments are.

This is a conclusion of a new paper from AQR Capital Management. Its authors look at the returns on private-equity purchases (“buy-outs”) of American businesses. They find that, after fees, private equity outperformed the S&P 500 index of large companies by an average of 2.3% a year between 1986 and 2017. That is quite the winning margin. But on closer examination, it looks less impressive. Buy-out targets tend to be small firms that are going cheap—that is, they have a low purchase price relative to their underlying earnings. An investor would have achieved higher returns from a basket of small-capitalisation “value” stocks than by putting his money in private equity.

The edge that private equity had over large listed stocks seems also to have dulled. In the past decade returns have been no better than the S&P 500. This may be because more capital is chasing buy-out targets. Private-equity funds once purchased businesses that were much cheaper than S&P 500 firms, says AQR. But the gap in valuations has closed.

Why are pension funds still so keen to push money into private equity? A tenet of textbook finance is that investors can build a portfolio that fits their preferences by choosing the right mix of equities, the risky asset, and cash, the risk-free asset. Nervous types might keep most of their assets in cash. At the other extreme, a risk-loving investor may wish to borrow (ie, have a negative cash holding) so that stockholdings exceed 100% of his capital. An investor with a limited ability to borrow can instead turn to private equity. Its funds take on $1-2 of debt for every $1 of equity.

The AQR authors point to another appeal. Illiquid assets, such as private-equity holdings, are not revalued in line with the price of publicly traded companies—“marked to market”—all that often. A common practice is to rely on self-appraisals. These tend not to reflect the day-to-day fluctuations in the price of listed firms. All this makes for artificially smooth returns.

Such smoothing has several advantages. When stock prices fall, the value of private-equity funds appears to fall less sharply. A mixed portfolio of public and private equity will look less volatile than a pure portfolio of listed stocks. The true riskiness of private equity would only become apparent in a prolonged bear market. Otherwise, it appears to offer diversification, albeit of a specious kind.

Some investors are forced to sell stocks (to “de-risk”) when prices fall, to comply with solvency rules. In such cases a bit of returns-smoothing is helpful, as a rigid marking to market would oblige investors to sell stocks at rock-bottom prices. That said, capital tends to flood into private equity when markets are booming. A lot of buy-outs will then be at peak prices.

The best private-equity funds are skilful investors. But the discretion they all have over how they report returns makes it hard for investors to judge who the best are. One study finds that half of funds claimed to be in the top quartile. Still, smoothed returns and leverage may be what investors are really after. Like lovelorn pilgrims to Knock, they will treat any other reward as a bonus.