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The London Brief - November 30th, 2020

The London Brief November 30th, 2020 Between U.S. elections and vaccine trial results, November was an eventful month. Joe Biden is likely to disengage from ‘policy by Tweet’, which should lead to less frenetic trading in the years ahead. With vaccines from Pfizer and Moderna likely to get to people before the summertime, it seems that there is now a pathway to normality. That said, there is a large cohort of people who feel that everything said by a scientist or expert is a conspiracy theory. About 15% of people surveyed in the UK say they won’t get vaccinated even if it’s available right away. In the U.S., about 33% of Americans say they won’t take the vaccine. Anne Applebaum in her new book, The Twilight of Democracy says, “The emotional appeal of a conspiracy theory is in its simplicity. It explains away complex phenomena, accounts for chance and accidents, offers the believer the satisfying sense of having special, privileged access to the truth.” Airlines and other businesses may require vaccine cards, so people may have to give in and take the vaccine, but confidence in public health and science needs to be raised. This month’s brief will describe some views from Blackrock and Paul Krugman about the election and the global economy; some interesting insights from an industry conference on China including RMB internationalization and turmoil in the bond market; some predictions on hydrogen and electric cars; and a survey of this month’s M&A activity. Back to Normality? I won’t comment on the probability of Donald Trump pulling a Julius Caesar on the republic[1] and assume that President Biden will take over in January[2]. The thoughts below also assume the Democrats fall short in Georgia next month and that Republicans maintain control of the Senate. I listened to a Blackrock call on the election results and agree broadly with their predictions. Blackrock believes a Biden Presidency lowers risk premia because although China tensions will continue, policymaking will be less volatile. The lack of a Blue Wave makes stimulus more difficult, such that we should see a 15-basis point compression in Treasury yields. This also has some impact on emerging markets as there will be a quest for yield, which positions China attractively. China is a 2% weight for international investors and still offers a relatively good yield. About $16 trillion of government securities are negative yields and another $15 trillion are less than 50 basis points. Raymond James CIO thinks the election outcome is the best result possible. A Republican Senate will block tax hikes, but Biden would offer markets a steadier tone. “It takes some of the trade rhetoric away with Biden as president and that helps a lot of the multinationals… If you look back through history, Mitch McConnell and Biden have worked together. They’ve been able to negotiate a couple deals over their tenure down in Washington, especially when Biden was vice president with some of those issues like the fiscal cliff.”[3] Paul Krugman, a well-known economist, thinks the COVID crisis is not like 2008. He anticipates a quick recovery from an exogenous shock. The current weak economy was not due to a build-up of imbalances. During the summertime, when COVID ebbed, the economy had a sharp bounce. Major economies did better than expected in their policy responses. What is now needed is strong infrastructure programs. It’s tough to know what the limits of deficit spending are and it’s hard to come up with an example of someone borrowing in their own currency hitting a limit. “There has to be a limit somewhere, but it’s not clear where it is.”[4] Developed economies could have another 100% of GDP to run in terms of debt accumulation. It’s also a real debate about the effectiveness of quantitative easing (QE), something he is sceptical about. There is no evidence that it has given economies much traction. It may slightly lower the spread in rates, but it’s clearly not effective. The negative rate is small, and there are concerns from market participants about how it’s degrading the role of financial markets. “When the Fed intervened in March, it was appropriate but after that point, it’s really unclear.” He doesn’t think asset prices are high because of QE, but rather because we have low interest rates due to excess savings in the world. Any sustained yield producing asset is bid up. QE itself is not an inflation technique and unless economies get to full employment, he doesn’t see how you get inflation. There is no invisible transmission mechanism from the price of goods and services. It’s possible to have inflation from a massive fiscal stimulus where everyone is given money. He noted that GDP is close to trend whereas employment is not close to trend. This suggests that the economy is laying off people who weren’t making that much. Environmental regulation could be an investment driver, but unless there is fiscal spending alongside it, it won’t have an impact. He believes there will be some permanent structural changes in that we are more used to remote working. He’s not optimistic about commercial real estate like offices or cubicles. Another common refrain I heard through the month were that multi-lateral institutions have broken down. The U.S. is not as credible. The EU has lost credibility as well. Biden will have a long, hard road ahead of him to resuscitate world order, but for crises like COVID and peaceful cohabitation with China, these are important to bring back. China Wants to Still Play the Long Game At the same industry conference as Krugman, there was a panel on China, where Yu Yongding gave his thoughts. Yongding is currently an academic at the Chinese Academy of Social Sciences. He used to be a member of China’s Monetary Policy Committee within the PBOC (China’s central bank). He is on the advisory committee of the NDRC and the Ministry of Foreign Affairs. Although he is not close to the daily decision-making apparatus, he is well plugged in to the zeitgeist of the party at the moment, and he seemed particularly knowledgeable about RMB internationalization a topic I’ve written about quite a bit in the Brief. An outlook he agreed with is that the next five-year plan will prioritize per capita income growth such that the average GDP per head will be like Portugal ($25,000 per head). There is an awareness that deglobalization and anti-China sentiment is high in the U.S. This will likely impact growth and create a slower target of 5% or so. Innovation and technological self-reliance will be emphasized. He was most insightful on China’s financial sector and RMB internationalization. China’s strategy is focused around three principles: creating an open financial service sector, capital account liberalization and risk management. China has opened up to foreigners in terms of credit ratings, brokerage, insurance, fund management and interbank bonds. Capital account liberalization will still take more reform and time. On RMB internationalization he had pretty specific thoughts: (1) China will continue internationalization but it is not a policy priority shared by everyone; (2) the process will be market driven and not policy driven; (3) it will be a long-drawn process - in 2009 people were impatient and now they are patient; (4) it should be conditional on the progress of domestic reform such as property rights and financial account liberalization; (5) it is not the aim to replace the dollar as the reserve currency, but rather make it one of the major currencies alongside the dollar, yen, euro, and so on commensurate with its trading status[5]; (6) it is not high on the policy agenda; the government priority is financial sector reform including building infrastructure for cross-border flows; (7) the pace may accelerate if the US abuses its hegemonic position in international finance, which hopefully won’t happen with the new administration. One thing to note on this last point, is that a few months ago, Donald Trump had actively considered prohibiting dollar access to Hong Kong and Chinese banks. He was talked out of it, but if he had persisted, the pace of RMB internationalization could have accelerated. It is unlikely the Biden administration will consider such draconian actions and that the dollar’s reserve status in coming years should be secure. On the election, Yongding agreed with another panelist that the Chinese government was neutral. Chinese people think Trump is too unpredictable to negotiate agreements. But the Party does not think the overall policy will change. With the new President both countries can sit down and look to limit irrationality and uncertainty. He thinks they can reach some agreement. The panel felt that China would not achieve advanced technology goals anytime in the near-term. But in the longer-term, U.S. technology companies would likely lose a big market. Another interesting topic point was around China’s recent antitrust investigations into technology firms and its crack-down on Ant immediately before its IPO. Yongding felt the regulatory headwind was coming. As the tech companies grow, they challenge the existing players and destabilize the consumer sector. Fintech regulations will strengthen, but the government knows Alibaba and Tencent are great companies, so they have to protect investors. He believes they will strike a balance. Yongding was most worried about China’s growth; “we need to make [the] 5% growth rate. Otherwise, the Chinese economy will face challenges”. This year, the government assumes 5.4% growth. This is based on a 3.6% GDP deficit. But the real growth rate was only 2% and nominal growth was about 3%. This then leads to China’s state-owned enterprises and the recent activity seen in the bond market. In an effort to focus on the deleveraging of state-owned enterprises (SOEs), the central government seems to have adopted a stance of not bailing out local governments when their companies need to repay bond issues. Huachen Automotive Group, the state-owned parent of Brilliance China Automotive Holding, a partner to BMW in China, defaulted on a 1 billion RMB bond on October 23rd. This was after it transferred assets in its best unit (the BMW subsidiary) to another subsidiary and pledged those assets to another creditor. On November 10th, Yongcheng Coal and Electricity Holding Group, a state-owned miner in Henan, defaulted. Due to turmoil in the bond market, thirty-three SOEs had to call off bond issuances. Yongcheng was given a AAA rating by China Chengxin International Credit Rating agency. Only after the default did the agency reduce it to the lowest rating of BB. The miner is making its interest payments, but the payment of principal has been postponed. A division of the PBOC is now investigating credit agencies, financial institutions and accountants involved in the last Yongcheng bond. Haitong Securities was accused in a preliminary hearing of manipulation and illegally assisting on the selling of the original bond. Accounting firm Xigema, Industrial Bank, China Everbright Bank and Zhongyuan Bank are all under investigation along with the credit rating agency. The director of market research at the Rhodium Group said, “The problem for authorities is that the declining credibility of local governments is an entirely new form of financial risk, and the market is struggling to price it. Contagion is spreading, and more firms are having their creditworthiness questioned.” Hydrogen Versus Battery I listened to Daimler’s head of e-Mobility and other EV/hydrogen experts talk about electric and hydrogen vehicles. The overall view was that hydrogen would be utilized in long-haul trucks, but said it was unlikely to be the fuel of choice for passenger cars or short-haul trucks. Given that renewables are likely to not lead to free hydrogen, it will always be expensive. Industry participants were excited about Tesla’s short-haul initiatives and its fast-charging infrastructure. Delivery routes would have to be defined according to where fast-charging infrastructure was grounded, but it sounds like costs are rapidly coming down such that this may be deployed in the not-so-distant future. Some interesting summary points: · Daimler’s head of e-mobility does not think we will see hydrogen in passenger cars (a refrain articulated by most CEOs of hydrogen cars). The issue is that you need geometric flexibility in the hydrogen tanks to store the hydrogen adding tremendous cost to the car. · Tesla has a clever approach on trucks using high RPM electric motors and battery systems that can be fast charged at 400-volt architectures. Apparently, this can lead to a full charge in around 20 minutes. They also have short haul truck applications that define the routing. Trucks will need to stick to the routes with the fast-charging infrastructure. · Long-haul is more difficult for electric as the battery reduces the payload. Fast-charging will also stress the battery and age it faster. Meanwhile the energy scales linearly with the weight of the truck and electric long-haul requires 7 or 8 tons of battery weight. This brings down the affordable payload. Fuel cells, on the other hand, do not scale linearly which is an advantage for long-haul trucks. This sets up the potential for hydrogen, but there are challenges. For instance, in tank pressure, South Europe and North Europe have different standards. There has also been little development in the hydrogen supply chain. UBS projects 40% of new cars sold in 2030 will be electric cars and 60% in Europe. Daimler (who is usually wrong in most predictions on this) predicts 20% of cars in the world will be electric in 2030 and 30%-40% in Europe. UBS is more in the disruptive camp. M&A Roundup Dealmakers cited in the Financial Times say the combination of a Biden presidency and a Republican controlled Senate is the best possible combination for M&A. The Senate should control the worst tendencies of the Democrats, yet Biden should presage a less volatile and more predictable approach to governing, which businesses like. Additionally, the Financial Times highlighted that 40 deals were sent into a panic when the pandemic hit, but most have been resolved with none completing trial. This shows the resiliency of M&A strategies albeit returns are challenging. EU regulators are seeking new powers to look at foreign-subsidized companies operating in Europe that could distort the internal market. If non-EU governments are providing subsidies to such companies giving undue advantage, then the merger could be blocked. The measure is aimed at companies like Huawei and the CRRC (China’s railways), but it could also impact some UK companies. The UK passed similar national security legislation. In M&A, according to a UBS survey, ESG is another tool to assess the quality of a business. It’s a key non-financial metric and driven by real considerations. Most companies are revising their sustainability practices; they are now talking more about stakeholders and not just shareholders. I listened to several bank CEOs describe the prospect for more M&A in European banking. They see strong prospects for in-market consolidation. For instance, Spain has 60 branches per 100,000 people while Austria and Germany are 20 per 100,000. Synergies are far more than physical; it also has to do with IT investment. On cross-border deals, they noted that in Europe there is still a chance to be a global provider of retail customers, but every merger needs an equity story and it’s hard to get support from shareholders on these types of transactions. They believe we will likely only see in-country mergers unless Europe resolves its issues on tax and other key elements. This month saw validation of the in-market theme as Unicredit is in talks with Banca Monte dei Paschi di Siena (BMPS) on a merger. The Italian government is considering unusual measures to give life to the combination including potential €2.5 billion of fresh funds into BMPS, shielding the buyer from legal risks and integration costs and including a tax benefit in a draft budget law. Credit Agricole made a bid for Credito Valtellinese in Italy for €750 million. The deal has not yet been blessed. Sabadell and BBVA were not able to agree on an exchange ratio so that deal is on ice for now. Fintech consolidation also continued. Nexi IM bought Nets in an all-stock deal at €7.8 billion. The company was bought by Hellman and Friedman in 2017 for $5.3 billion showing the sharp uptick in the value of payments companies. Private equity remained active. Inspire Brands thought it was time to make the doughnuts and acquired Dunkin Brands for $11.3 billion in a tender offer. Dorel agreed to go private in a $360 million MBO led by Cerberus. Carlyle made an offer for Japan Asia Group in a $160 million bid. The bid faces an activist challenge. The Sioen family took Sioen Industries private for €455 million. American Securities will acquire Foundation Building Materials for $1.4 billion. The company was majority controlled by Lone Star. Waterfall made an offer for Alternative Credit Investments for £640 million. Macquarie Capital and GCM Grosvenor announced a $300 million deal to acquire Alaska Communications Systems Group. Apollo made a C$3.3 billion bid for Great Canadian Gaming. MBK spent $1 billion to buy CAR Inc., a rental car operator in China. Health and pharmaceutical transactions remained robust. Novo Nordisk is acquiring Emisphere for $1.35 billion. PerkinElmer offered to acquire Horizon Discovery Group for £296 million. Horizon is a UK gene editing and gene modulation company that designs and engineer cells for research and clinical applications. Sanofi offered to buy Kiadis Pharma for €308 million to try to restock its pipeline. Kiadis has a platform of ‘off the shelf’ cancer-seeking NK cells. It’s developing various therapies with that technology which could allow for a range of cheaper treatments across cancer types. The Nikkei reported that since June, Japan has seen a flurry of activist and hostile deal activity. Colowide successfully completed a hostile takeover of rival Ootoya in the fast-food industry. DCM successfully completed an unsolicited counterbid on Shimachu in the furniture space (see last month’s brief). Strategic Capital made a partial tender offer on Keihanshin Building. Strategic is led by former partners of the Murakami Fund, which was shut down in 2007 for insider trading, but more ostensibly for provoking the Japan corporate establishment. In the case of Keihanshin, there has not been any reporting on “abuse” by the press. Oasis Capital agitated against Tokyo Dome by calling a shareholder meeting to replace directors, which triggered Mitsui Fudosan to make a Y100 billion offer to take over the company. Granted these are small deals, but it marks progressive development. During the month, there was continued in-market consolidation. Yomiuri Shimbum announced a tender offer to acquire Yomiuri Land. Sumitomo Mitsui Finance and Leasing bought Kenedix, a real estate firm and asset manager, for $1.3 billion. Aso Corp. made a $170 million tender offer for Tohto Suisan. Resona made a tender offer for Kansai Mirai Financial consolidating a local bank subsidiary. Shinsei Bank agreed to make Aplus Financial a wholly owned subsidiary via a squeeze-out (they already own 95%). Mitsui made a $200 million bid for Honshu Chemical. Open House announced a partial tender offer on Pressance Inc. in a $354 million deal. In the technology space, Adobe acquired Workfront for $1.5 billion to add a collaboration tool to its marketing software. U-blox made a £259 million offer for Telit Communications. Telit operates as a global wireless technology and services company and manufactures short and long-range radio communication products. Take-Two made a £720 million offer for Codemasters Group. They focus on video games specialized in racing titles. Clearlake will acquire Endurance International for $3 billion. Endurance provides online web-hosting solutions. The company offers cloud technology, personalized engines, and application delivery such as website design, e-commerce and domains. In Hong Kong, TCL Industries made a privatization proposal on Tonly Electronics for $442 million. Tonly operates as a manufacturing services provider in the audio-visual space. Beijing Energy Holding made an offer for Beijing Jingneng Clean Energy for $2.9 billion. Telenav’s founder agreed to take Telenav private continuing the trend of Chinese company migration away from U.S. markets. There were several large deals across several industries. Home Depot acquired HD Supply for $8 billion. HD specializes in maintenance, repair and operations. SBB made an unsolicited offer for office property owner Entra in a potential $3 billion deal in Norway. Rival Castellum launched a counteroffer and the two are pairing off for the company. Intact Financial and Tryg made a £7 billion bid for RSA Insurance Group. Intact will take the UK and Canadian operations. Tryg would take Sweden and Norway. The two would split Denmark. Endeavour Mining acquired Teranga Gold in an all-stock transaction worth C$2.4 billion. End Note I’m a fan of Dan Carlin who does a podcast called Hardcore Histories. He has an usual speaking style that brings the history alive, and draws some profound insights from comparing and contrasting different sources of information from different angles in order to gain some semblance of truth or at least perspective. He has a five-part series called Supernova of the East that talks about the rise of Japan during the Meiji era and it’s collapse in World War II. When Matthew Perry entered Tokyo harbour with two steamers and two sailing vessels in 1853, he demanded a treaty to permit trade and the opening of Japanese ports to U.S. merchant ships. The Tokugawa shogunate in Japan had no navy and had to agree to his demands. Soon Russia, Britain, France and Holland all forced their way into Japan’s harbours and forced trade treaties too. This sudden trade forced an influx of foreign currency which disrupted Japan’s monetary system and led to the downfall of the Shogunate and start of the Meiji Restoration. The former Tokugawa shogunate built itself on a myth of images from the 1500s as a golden time of the samurai, when really this was more of a feudal kingdom. But the images allowed them to develop the masses in a conservative way and they stayed isolationist until Matthew Perry’s ships entered the port. The Meiji Restoration was opposed by the former beneficiaries of the Tokugawa shogunate, as can be seen in the Last Samurai. Although Tom Cruise’s acting raises serious questions, the story celebrates the concept of bushido or its image of benevolence, warrior spirit and self-sacrifice. But ultimately, the samurai were defeated by more progressive forces in the military determined to modernize Japan. Later, in the 1920s, progressives in Japan sought to overcome many rigidities inspired by the military including a move to democracy; this sent forth a conservative backlash modelled on the ways of the samurai (although the military had eviscerated the samurai only decades earlier). I bring this up, because currently our global society has gone through some big changes: globalization, free trade and technology (automation and AI). There are winners and losers, just like in the days of the Tokugawa Shogunate and the Meiji Restoration. And there is a constant battle between conservative and progressive, with the two sides swapping sides when it serves their needs. The question for leaders is how do we deal with this change? Japan ultimately went for a military dictatorship, but the West’s experience with the industrial revolution led to democracy. But history is based on leaders and events and random probabilities, and we shouldn’t take anything for granted. Cobham, Surrey, November 30th, 2020 [1] Julius Caesar became dictator for life in 44 BCE. Senators who were jealous of Caesar’s popularity and arrogance, but also who legitimately resented the end of the republic, murdered him at a meeting of the Senate. Today we can use more modern tools like tax audits. [2] Given the global economy and the lighting speeds of technology, why does it take two and a half months to transition presidents? In case you are wondering, originally it took four months to transition because there were no cars in the 1700s and it took a while to move everyone down to DC. In 1932, advancements made it much easier to move, and so they shrunk it to January 20th. Now we have airplanes, and Twitter; things move much faster, but it still takes 2.5 months to transition. The long time-lag is justified on the basis it allows the President-elect to select his cabinet and to get briefings from the former cabinet members. Except, when a President refuses to cooperate like we’re seeing today. It’s probably time to scrap this lag-time. [3] Businessinsider, “Raymond James investment chief details why Joe Biden and Mitch McConnell are the perfect pair”, November 7th, 2020 [4] This insights were made at a virtual industry conference but are not too different than some of Krugman’s views his collective Tweets. [5] The pound was not mentioned; sorry Brexiteers.

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