Inflation and RMB Update - August 31st, 2020

The London Brief

Inflation and RMB Update

August 31st, 2020

In case you missed it amongst the politico-virus news, SpaceX sent two astronauts up to the International Space Station (ISS) in late May using a reusable rocket. They are testing Starship, a launch vehicle that could enable larger payloads and settlement. The cost per kilogram of Starship for human transport could theoretically equal the cost per kilogram of a first-class ticket on a commercial plane.

Robert Zubrin, a space advocate, provides an anecdote about SpaceX’s start in 2002. When he first met Elon Musk that year, he felt that Musk knew nothing about space launch. By 2004, Musk had studied rocket science and Zubrin then felt he knew a lot. But he told Musk, your first few attempts at launching rockets will fail. Musk said, “how can you say that” and showed him his diagrams and plans and Zubrin said, “it doesn’t matter, everyone’s first rockets fail.” Musk then proceeded to fail twice and years later met up with Zubrin and said, “I’ll try once more, otherwise I’ll call it quits.” The third time SpaceX failed again. It wasn’t until the fourth time that Musk’s rocket worked.

We now have a launch vehicle. Moon colonization may occur as soon as 2024 and Mars could be 2030. Imagine being an early colonist on Mars; not only would you have amazing views, but you’d be too far away to get a Tweet. Fine wine may be a problem though.

This month’s brief will talk about the prospects for inflation, further ponderings on the RMB as a reserve currency and a summary of the major themes in M&A last month.

Inflation and the Crisis

CNBC had an interview with Ken Moelis. He is a deal guru and founded his own advisory firm many years ago. He made an interesting point about the differences between the fiscal response with COVID to that of the financial crisis in 2008. He noted that this time, there are eight million companies that are small and are not having a good run of it. But the S&P 500 and the strongest companies are benefitting from the weakness of these smaller companies and consolidating their position. There will therefore be more bad news to come in the real economy. Meanwhile, the U.S. printed $3 trillion dollars and sent out checks to people, something that has never happened. This is for the benefit of health. However, once checks are mailed to people, and the real economy is still struggling, it’s politically hard to stop. Moelis believes this has triggered a different way of thinking which we haven’t seen as much before. In the next six months, will the government let people suffer or will they mail checks?

This is a concept I’ve wrestled with myself. From January 2006 to July 2020, we have had steady monetary expansion, in recent years about 4% to 5%.

Yet the official inflation numbers (the bottom line) show anywhere from 0% to 2%[1] rather than the inflationary malaise that many buyers of gold and virtual currencies predict.

But our monetary system maybe more akin to the realm of physics. There the laws of the universe are split into the physical realm governed by the classical laws of physics and the quantum realm, which seems to follow no deterministic rules. Current inflation statistics are like classical physics. We measure baskets of goods and central bankers declare inflation or no inflation. The quantum realm is more the land of the wealthy. It is no secret that global wealth inequality has hit extreme levels. The wealth share of the top 1% in the U.S. rose from 22% in 1980 to 39% in 2014. The average wage in 2014 was no higher than 1979. Over the same period (from 1979 to today) the real wages of the least educated workers fell. For full-time male workers it fell 10% to 20% below their levels in 1980. In manufacturing almost 50% of sales were used to pay workers in 1982; it fell to 10% in 2012.[2] This concentration of wealth at the top has led to all sorts of inflation in the rich world that doesn’t correlate with the CPI basket: first growth Bordeaux retailing at £800 a bottle; West Palm Beach real estate breaking new property price highs; private school fees inflating at galloping rates; or even gold at $2,000 per ounce which tends to be the alternative store of value for mostly the wealthy.

So Moelis’ discomfort on the checks is understandable. As long as inflation exists in the quantum world, it does not show up in CPI statistics nor in the less expensive basket of goods. But if everyone is mailed a check, then inflation will hit the classical world and central bankers will need to act accordingly when setting interest rates. This is something to monitor as governments consider fiscal actions in the months ahead.

For the time being, the market is clearing looking for deflation. For instance, triple C rated bonds have done much better than the wider market as investors search for yield. Analysts at Bank of America noted that these lower tiers of the market are one of the few areas “with any air left to perpetuate the insatiable bid for risk.”

Reserve Currency Update

A reader sent me an interesting piece from American Express which talked about the IMF’s SDRs as an alternative reserve currency to the dollar[3]. In order for it to happen, the currency must be fungible so that overseas buyers can own onshore balances and there needs to be a ‘safe asset’ in which investors can invest. On this measure, SDRs would have a long way to go.

On RMB, a reader noted that if full fungibility was allowed, Chinese mainlanders would sell RMB and buy assets and currencies outside of China as there is concern about the long-term safety of onshore assets. Unless China takes steps to reduce this expatriation of capital, internationalization is very challenging.

On the creation of safe assets, foreign ownership in China’s bond market set new record levels this year as investors look for yield. By the end of June, according to Moody’s, overseas institutional investors held RMB-denominated holdings of $360 billion. However, this is only 2.4% of China’s bond market. Interest was primarily in government debt, but there was increased interest in the debt of China’s three policy banks. China is one of the few markets to offer a positive yield. Investors also feel confident in China’s handling of the coronavirus, which has reduced the need for wide-ranging stimulus programs. That said we are still a long way from a reserve currency switch to RMB.

Interestingly the euro has made some progress on safe assets as €750 billion of new bonds are being issued to help with the coronavirus crisis. This is backed by the whole EU rather than individual countries. “I think this will transform capital markets in Europe,” said Philip Brown, head of public sector debt capital markets at Citi. “You’ll have a shared safe asset that’s large enough to find its way into government bond indices and government bond portfolios.”[4]

M&A Activity

General Commentary

“The backlog is very busy, and I would expect things to continue, barring a major event that brings things to a halt,” said Alison Harding-Jones, head of M&A for Europe, the Middle East and Africa at Citigroup. “The kind of transactions we expect to see are big strategic takeovers, share-for-share deals among companies in the hardest-hit industries and an increasing number of private equity bids.” Nestor Paz-Galindo, global co-head of M&A at UBS said: “People are thinking about how to build scale and resilience, and that is a driver of M&A.”

Ken Moelis, in his CNBC interview, said that people are willing to overlook the immediacy of the virus. While he would not commit to the second half, he felt that it was just a matter of time before M&A would bounce back. Companies believe that there may be a ten year up-cycle. He made an interesting point that having a strong balance sheet allows opportunities in times of crisis, subtly criticizing the activist movement that emphasizes share buy-backs.

Japan also continues to generate transactions. The CEO of Mizuho said, “there is currently an enormous demand for M&A”. He noted consultations on succession issues had soared in recent months.

The Activity

In Japan, Sumitomo Bakelite acquired Kawasumi Laboratories for $370m continuing the trend of Japanese corporates dealing with publicly listed subsidiaries. Activism is also working with fund manager Effissimo extracting a 10% offer increase from Bain for NichiGakkan. The Nikkei Asian Review had an editorial from a Japan corporate lawyer about the “independence” of the independent committees that have been forming in Japan. In one example, Softbank and Naver made a joint bid for Line that was a 37% premium to the prevailing price before the COVID crisis. Along with that transaction, Naver would farm into the new company and receive Yahoo Japan shares for its stake while other shareholders received cash. At the time, the cash price was substantially north of the implied share transaction. But as Internet stocks appreciated and the strategic rationale of the offer was better appreciated, Yahoo Japan’s share price started to increase. The stock offer which only went to Naver was valued 35% higher than the cash price that minority shareholders would receive. The independent committee still recommended the offer, a condition of the Line tender offer, and did not push for an increase. The committee said the intrinsic value had not changed (implying the market’s derivation of value was flawed). However, the special committee should have noted that Naver was getting a special deal for their shares that was different than minority shareholders and fought for equal treatment. Several shareholders are now seeking appraisal rights. It will probably take over a year to figure out. One precedent case, JCom, shows that Japanese judges tend to be literalist (ie – if proper procedure was followed then the board’s judgement should stand), but there has been a change in sentiment from the political establishment about the fair treatment of minority shareholders so judges may take a different view this time[5].

In China, Haier Smarthome made an offer for Haier Electronics in a $10 billion deal. The parent will reverse list onto the Hong Kong Stock Exchange and have the opportunity to access its subsidiaries’ cash balances to deleverage and pursue overseas acquisitions. The market liked the terms and took Haier Electronics to new highs from before the coronavirus with both parent and subsidiary share prices liking the consolidation.

There was significant consolidation in the pharmaceutical and healthcare space. Cellular Biomedicine Group was taken private in a $348m deal. Johnson & Johnson acquired Momenta for $6.5 billion. Ligand bought Pfenex in a $438m deal. Sanofi bought Principia Biopharma for $3.4 billion. Teladoc Health acquired Livongo for $18 billion. Livongo is a biotechnology that applies health signals for the treatment of chronic diseases. Siemens Healthineers bought Varian Medical Systems for $16.4 billion.

Technology also continued its M&A pace. Microsoft looked to buy TikTok, although it was unclear whether Donald Trump would allow it versus just killing the app entirely. He’s still bitter about bring tricked in Tulsa it seems. Nvidia reached a deal to buy Softbank’s chip company, Arm. Aveva bought OsiSoft for $5 billion enterprise value. RWS Holdings, which offers patent and translation services, acquired SDL for £545 million, which offers computer software and services to corporations to maintain multilingual content. Continuing on the European telecom consolidation theme, Liberty Global made an all-cash offer for Sunrise in a CHF 6.8 billion deal.

Private equity continues to do deals when they can get the financing. Thoma Bravo is acquiring Majesco for $729m. CDR bought HD Supply for $2.9 billion. BGH group made an offer for Village Roadshow. Triton acquired HiQ, a Nordic digital transformation player, for $445m.

In other sectors, Montage Resources merged with Southwestern Energy in an all-stock transaction as the shale oil and gas sector seeks consolidation as a way of reducing costs to survive. Seven & I Holdings and Couche Tarde competed against each other to buy Speedway, an owner of gas stations across America, for $21 billion. This was after the Japanese firm had hit the pause button due to the coronavirus earlier in the year. In non-life insurance, Sampo and Rand Merchant Investments acquired non-life insurer Hastings Group, as the Nordic insurer looks to diversify its geographic exposure. Alfa Laval made an offer for Neles. Major shareholder, Valmet, increased its stake to 17% and is pushing for a higher price. Finally, Builders FirstSource and BMC Stock Holdings merged in a $2.2 billion deal consolidating the buildings materials space.

End Note

A thought-provoking movie I saw this month was Upgrade, a futuristic thriller representing AI gone wrong. The premise revolves around an AI chip that is inserted into a paraplegic’s spine and can connect to his brain. I won’t give away the plot, but it was interesting to see Elon Musk promoting a new company called Neurolink, whose goal is to implant a chip next to the brain and use its electrical signals to help alleviate spinal and neurological conditions like seizures, paralysis, brain damage and depression. My 10-year old son says this technology is very dangerous as articulated by the Bodyguard book series where some criminal uses a chip implanted in people’s heads to control their movements to commit dastardly deeds. At any rate, while it’s a long time before our bodies are being controlled by the joysticks, perhaps Elon Musk should watch the movie given how he’s opposed to AI.

Cobham, Surrey

August 31st, 2020

[1] In the 1990s, the government switched its CPI measures to a fixed basket of goods. In the past, CPI was measured by assessing the prices of goods to maintain a constant standard of living. This changed to a measurement which was based on a true cost of living concept based on the assumption, supported by many academic economists, that someone could substitute less expensive goods for more expensive goods. [2] Abhijit Banerjee and Esther Duflo, Good Economics for Hard Times [3] https://www.americanexpress.com/us/foreign-exchange/articles/could-dollar-be-replaced-as-world-reserve-currency/ [4] “Investors Hail Brussels as New Force in Bond Market”, Financial Times, July 22nd, 2020 [5] Shinzo Abe said last Friday that he plans to step down from office due to health reasons. The potential LDP members that are likely to replace him do not seem inspiring to push continued corporate reform. Hide message history

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