The London Brief - October 31st, 2020

The London Brief

October 31st, 2020

In three days, the U.S. will finally hold its election. Markets are predicting a Biden victory, and a potential Blue Wave. Polls say Texas is in play with record voter turn-out. Other pollsters are suggesting evidence of a submerged Trump voter who is not being captured by the polls as was the case in 2016. There are unexpected signs of some black and Latino community support for Trump. My hope is that one way or another succession is smooth as the U.S. needs some sort of stimulus bill and if Democrats and Republicans are fighting about ‘hanging chads’, markets are sure to take a significant tumble. The election will also have implications for the China-U.S. relationship and the dollar.

This month’s brief describes some positive developments in Japan’s corporate governance reform journey; a summary of developments on the rise of the RMB as a reserve currency; a response to some fund manager predictions of a market crash; some datapoints on China’s quest for leadership in electric cars and semiconductors; a summary of the FT’s ‘Rise of the Multi-strategy Hedge Fund’ and a round-up of this month’s M&A activity.

Japan Rising

Japan’s new Prime Minister, Yoshihide Suga, gave an encouraging interview in the Nikkei, his first since taking office. "It is desirable to promote diversity, including by hiring more women, foreigners, midcareer workers. Further promoting reform is extremely important”. His reform comment refers to the continuation of the corporate governance developments undertaken by Abe. Additionally, colour from several Japan market participants I spoke to this month indicate that the LDP is fairly unified in continuing the governance reforms, although with a keen focus on making sure rural areas are looked after.

The Financial Services Agency and the Tokyo Stock Exchange are slated to begin discussions for revising the Corporate Governance Code in 2021, a process that occurs every three years. The governance code was implemented in 2015 to attract foreign investment and help make Japanese businesses more competitive. It helped reduce cross-shareholdings, something that use to hold back substantive changes in Japanese management practices. "As the coronavirus transforms the environment for industries as well as individual companies, new opinions should be reflected in order to realize growth," Suga said.

In preparation for the potential rise in deals, Nomura is hiring bankers for its M&A business in Japan. M&A head Shunichi Tsunoda said, “We’re recruiting people more eagerly than usual.” Consultations on local deals are up about 30% to 40% from a normal year with clients seeking advice on “every kind of transaction” even with the pandemic. “We’re at the start of an era. Be it post- or with- coronavirus era, things will change – there should be more industrial reorganization and cross-border transactions.”

These are encouraging comments and it should make Japan a strong area of corporate activity for a long time to come.

Potential Collapse of the Dollar and the Developments in RMB

Steven Roach wrote an op-ed in the Financial Times calling for a 35% collapse in the dollar by the end of 2021. He notes the U.S. reported a large drop in its savings rate to -1.2% in the 2Q or 4.1% below the 1Q (mostly due to COVID) and the current account deficit rose to 3.5% of GDP or 1.4% higher than 1Q. Going into the pandemic, the domestic savings rate was just 2.9% of GDP from 2011 to 2019 versus 7% from 1960 to 2005. Budget deficits will pile up in the years ahead leading to further downward pressure on domestic savings and the current account deficit will intensify. The latest Congressional Budget Office (CBO) forecast put the budget deficit at 16% of GDP in 2020 before receding to 8.6% in 2021. The U.S. net savings rate will be deeper in negative territory than the 2008 financial crisis. He believes this means the U.S. cannot invest in productive capacity; growth becomes impossible and the current account deficit will only deepen. The U.S. trade deficit widened in August to the largest since 2006 on a further increase in imports as companies responded to stronger domestic demand. This should theoretically lead to higher interest rates, but the Fed has closed off the interest rate channel for correction by continuing to keep rates low. This then leaves the currency. He further says the dollar has benefited from TINA (there is no alternative). But the July 21st agreement on a Next Generation EU Fund of €750 billion finally established a pan-European fiscal policy. The RMB, gold and cryptocurrencies are also alternatives to the dollar.

Although Roach is too Cassandra-like and he fails to discuss the U.S. superior relative growth rate, his view about the RMB alternative has legs longer term. The Financial Times reported that record foreign demand for Chinese assets will boost efforts to develop a more global role for the RMB. The relatively high yields and strong economic recovery from the coronavirus led to a surge of demand for China’s recent debt issuance. The People’s Bank of China (PBOC) has also not weakened the RMB after large rallies in the currency. The PBOC said in August, “the allocation of the RMB assets by foreign investors will be further facilitated” and it expected “more foreign central banks and monetary authorities to hold renminbi [assets] as reserve assets.”

Over the past few years, Chinese policymakers have been trying to reduce their reliance on the U.S. dollar by increasing the international use of renminbi for payments and investment. However, when Chinese policymakers engineered a decline in the currency in 2015, it dented investor appetite for renminbi assets. But China has had a good coronavirus crisis. It relied on fiscal support and kept its main rate relatively high, when other countries have lowered interest rates and relied more on the monetary mechanism. HSBC’s head of EM foreign exchange said, “In the last couple of years there was a lot of caution towards the renminbi by many investors, and this year there’s been a complete flip in that mindset.” Investors earn 2.7% on 10-year Chinese government debt versus 0.8% on an equivalent U.S. Treasury. Flows into China this year to August topped $90 billion and there was RMB 93 billion of inflow into equities. The past three months have shown a 7% gain in RMB versus the dollar. There were orders of more than 4x supply in a recent Chinese debt issuance; 15% were allocated to American investors. “This is the investor community showing confidence in China’s recovery,” said a banker on the deal. “US investors participation in Chinese paper is not reduced by any means.”[1]

A UBS survey showed that reserve managers have increased their 10-year renminbi allocation targets to 5% up from 1% last year and reserve managers currently have about a 2% allocation to RMB. Christy Tan of ANZ said, “The prospect of RMB appreciation is getting more structured – it’s no longer just cyclical. There’s a sense of confidence that the RMB is getting more internationalized.” But the survey also indicated that the lack of convertibility has hindered a larger allocation and the “global dominance of the dollar remains intact. The rise of the renminbi as a reserve currency is not a sprint, it’s a marathon.”

UBS is right to cite non-convertibility as an issue. But here too China is hinting at significant changes. Zhu Jun, director general of the PBOC international division, said, “As everybody knows in the past, the internationalization of the RMB sticks to the market principles. The role of the authorities was mainly focused on removing the policy obstacles for the free use of the currency.” The PBOC plans to be more proactive going forward. They may improve bilateral currency swap agreements to better promote trade and investments. They may also coordinate various means of yuan cross-border settlements and payments infrastructure. Over time they plan for a steady liberalization of the capital account and increasing exchange rate flexibility. They also plan to improve liquidity in the bond market. Central bank governor Yi Gang said, “The yuan internationalization should be market-oriented. The regulator’s main job is to reduce restrictions on the cross-border use of the currency, and let it take its own course.”

China also plans to roll out a digital currency by the 2022 winter Olympics in Beijing. Aditi Kumar of the Belfer Center for Science and International Affairs at Harvard said that if China develops a competitive digital currency, the U.S. will lose global influence. On October 12th, China ran a test in Shenzhen where 47,573 participants made $1.3m of transactions in the digital currency. Such trials are due to go ahead in 28 other cities. The PBOC has filed 80 patents. Belfer believes the yuan could form a new economic sphere primarily occupied by emerging market nations. Increasing this probability is China’s actions with regards to vaccines for the coronavirus. It has offered its future vaccine to developing countries, particularly the ones where it wants to build regional influence. The White House had declined participation through multilateral agencies that were looking to roll out vaccine cures to developing market countries. China’s methods have been deemed questionable with 100,000 Chinese people being enrolled in clinical trials with questionable controls on patient safety. Efficacy could also be debateable. But China has made inroads into Latin America. Sinovac, a producer of one of China’s vaccine candidates, signed a pledge with potential Presidential candidate Sao Paolo governor Joao Doria. Sinovac will transfer technology to facilities in Sao Paolo for the purpose of local contract production. Currently, President Jair Bolsonaro is attempting to procure vaccine supplies from AstraZeneca. However, with Britain and America focused on vaccinating its populations first, it may be a long time before Brazil gets the vaccine creating a political point scoring opportunity for Doria’s support from China (he is the most likely political opponent to Bolsonaro in the next election in 2022). Sinovac and Sinopharm have also been conducting clinical trials in Peru, Chile and Argentina and China has agreed to lend Latin America $1 billion for procuring vaccines. Poorer Caribbean nations have also become economically dependent on China during the crisis. Brazil sent 34% of its exports to China up from 28% last year, and China is now Argentina’s largest export partner.

Trust is the dollar’s edge in that pure cryptocurrencies lack government backing and countries like China are not considered responsible arbiters of the rule of law. Would you tie your reserve assets to the Chinese judicial system? An incident in Fiji illustrates this lack of trust as Taiwan accused two Chinese officials of beating up one of its diplomats in Fiji after they gate-crashed a reception for Taiwan’s national day. China is also engaging in ‘hostage diplomacy’ and may arrest Americans in response to American detention of Chinese scientists linked to the People’s Liberation Army (PLA). The State Department said, “We warn U.S. citizens that business disputes, court orders to pay a settlement, or government investigations into both criminal and civil issues may result in an exit ban which will prohibit your departure from China until the issue is resolved.” International creditors remained concerned about fair treatment versus domestic creditors according to a recent Goldman Sachs report.

That said, an interview with Mark Cuban illustrates how China’s economic power can often overcome this distrust. In a Megyn Kelly podcast she asked Mark Cuban, “Why would the NBA take $500 million dollars plus from a country that is engaging in ethnic cleansing?” to which Cuban ultimately replied, “Because they are a customer. They are a customer of ours. And guess what, Megyn? I’m Ok with doing business with China. And so we have to pick our battles. I wish we could solve all the world’s problems. But we can’t.”

Trust also extends to monetary and fiscal management, and if the U.S. decides not to abide by rules, then that can erode trust too even if the judicial system is sound. Stephen King, an HSBC Senior Economic Adviser had an interesting op-ed criticizing Modern Monetary Theory. Modern Monetary Theory says budget deficits are from a financing perspective irrelevant so long as increased borrowing does not lead to inflation. Taxes serve no useful macroeconomic role as government spending can be financed with cash. But taxes are crucial; the difference between government finances and those of companies and households are the coercive power to raise tax. This is why creditors accept lower returns on government bonds. But this is limited by the political capacity of government to raise revenues in difficult circumstances. Politicians primarily want to remain in power. King sees higher taxes, more austerity, rising inflation or eventual default.

Japan responded to China’s digital currency initiative by unveiling their own digital currency coordinating with the Federal Reserve to help set principles to guide the development of central bank digital currencies or CBDCs. The Bank of England is exploring a CBDC and the ECB is considering a digital euro. These could be alternative stores of value. While the €750 billion Eurobond issue is interesting, it doesn’t move the needle enough to fundamentally change reserve currency composition. Europe still has its own problems too with Italy, low growth and populism. So, I don’t see the initiatives proposed by Japan, the UK and Europe as real alternatives to disrupt the principle of TINA, but the rise and internationalization of China’s RMB is certainly something to watch. Ten years from now reserves balances may be very different.

The Crash

Morgan Creek’s CIO, Mark Yusko, made a provocative call to Bloomberg News that there would be a stock market crash, noting that only debt is supporting stocks right now. The M2 money supply growth is slowing and that’s the only thing holding up valuations. He noted the frenzy of the dotcom bubble and the Snowflake IPO at 227 times earnings. He sees the mounting corporate debt load as the catalyst to a crash.

While I don’t disagree that frenzied IPO trading means something is wrong, he is still looking at the world from a purely fundamental angle. The dotcom crash occurred because the Fed increased interest rates and deflated M2 after creating a lot of money due to a mis-forecasted Y2K panic in 2000. Today the Fed has singled an extended period of low interest rates and corporate debt can be rolled over. In some respects, its more similar to the Japan bubble period of the 1980s. This only corrected once the BOJ raised inter-bank lending rates in 1989, worried about speculative excess such as how frogs were being used to forecast which stocks to pick.

This leads to the unsatisfying position of not making a call and just being on stand-by mode, ready to act once policymakers and countries make key decisions.

I divide the scenarios into three:

· Status quo – Fed continues monetary easing; the rest of the world supports it; equity markets stay elevated or uptrend

· Dollar decline (see Steven Roach above) – Fed stays loose; China and the rest of the world doesn’t support it; equity markets stay elevated based on inflation

· Market crash – Fed raises interest rates to curb the monetary excess and we have a period like 2002, equity markets crash

If Biden wins, we may have a more status quo or the market crash scenario; whereas Trump would likely be more a dollar decline scenario.

Electric Cars and Memory Chips

The Nikkei reported that Tesla is already using Chinese-made batteries for its Model 3 and may be set to source engines from a Chinese supplier. China’s “dual circulation” policy where Beijing attempts to bolster domestic supply chains to counteract U.S. influence, is being played out rapidly in the EV (electric vehicle) market. Battery maker CATL already supplies Tesla. Zhejiang Sanhua Intelligent Controls supplies heat control parts for EVs. Xiamen Hongfa Electroacoustic, which manufactures electronic parts for EVs, is doing business with Tesla too. The upshot is that China is already EVs biggest market and it seems likely the country may become the global leader in EV technology.

In memory chips, a former Japan semiconductor executive was hired by Tsinghua Unigroup to oversee the launch of its DRAM memory-chip manufacturing business. He was impressed with Chinese business leaders. “[The Chinese CEO] told me that Chinese tech leaders are grateful to Mr. Trump for helping them become resolutely determined to develop technologies on our own.” A Tokyo professor Hideki Wakabayashi said becoming a leading chipmaking nation cannot be done quickly. But “there is a possibility for China to become a dominant country in the field in 10-20 years because of its abundance of talent in all science and engineering fields.” Toshiaki Ikoma, former president of Texas Instruments’ Japan subsidiary was SMIC’s CTO in the 2000s. “Their national strategy is to send many students to U.S. schools and companies and then repatriate them like sea turtles, which has been going on for decades, is bearing fruit.”

The Rise of the Multi-strategy Fund

The Financial Times noted the rise of ‘multi-strategy’ vehicles run by Citadel, Millennium, Balyasny and Point72. They have returned more than 10% on average to the end of August. The hedge fund industry as a whole is only up 2%. The article noted that institutional investors are also nervous about firms driven by the brilliance of a single founder or solitary investment chief. They care more about the wider support system. This makes the finely engineered, generally smoother returns of the multi-strategy fund more attractive.

Mergers

Speaking with two major prime broking desks who keep an active dialogue with their investment banking teams, M&A bankers are rejecting business and the next 6 to 9 months should account for significant activity. The last few weeks of October did not disappoint.

Semiconductor consolidation continued. AMD bought Xilinx for $35 billion in an all-stock deal. Intel sold its storage unit to SK Hynix for $9 billion. The deal will propel Hynix to the number two spot in NAND behind Samsung, and ahead of Japan’s Kioxia and Micron. Marvell made an offer for Inphi for $10 billion.

Hostile takeovers and bidding wars are often a sign of an ebullient M&A market and we saw two examples this month. Gardaworld made a hostile 190p offer for G4S PLC. G4S has had a troubled history with controversies over its detention centres, the inappropriate monitoring of prosthetic limbs, botched Olympic security, unlawful killings, human rights abuses, police telephone data manipulation amongst other things. As a result of these issues, G4S is understandably cheap. Another company Allied Universal Security Services made an approach with their own potential counterbid. Over in Japan, Nitori started a bidding war for furniture retailer Shimachu looking to outbid DCM.

Chinese deal activity remained steady. Huya agreed to buy DouYu International Holdings in an all-share deal to create a Chinese game-streaming giant with a market value of more than $11 billion. Alibaba acquired 70.94% of Sun Art Retail and make a bid for minorities. Sun Art is the second largest grocery chain in China and operates hyper-markets which includes amenities like restaurants, pharmacies and dry cleaners. Shandong Gold Mining made a privatization proposal to acquire all the shares in Hengxing Gold in a $450 million deal.

Japan’s subsidiary consolidation trend continued with JSR making an offer for its 50.82% owned subsidiary Medical & Biological Labs for $220 million. Japan’s NEC bought Switzerland’s largest software provider to banks for SFr 2.0 billion. Sony bought U.S. anime streaming service Crunchyroll for $950 million.

Financial services consolidation remains a mega-theme. In Spain, bank consolidation continued with talks announced between Sabadell and BBVA and talks between Liberbank and Unicaja. Generali confirmed a €300 million investment into Cattolica Assicurazione. It will manage a portion of the investment portfolio and health services. Nexi Spa merged with Sia in a deal worth over €4.2 billion deal consolidating the payment services space in Italy. Euronext acquired Borsa Italiana from the London Stock Exchange for €4.3 billion. Kotak Mahindra Bank Ltd. is exploring a takeover of smaller Indian rival IndusInd Bank Ltd to create the eighth largest bank by assets in India. IndusInd has suffered from concerns on worsening asset quality and the erosion of low-cost deposits. In the U.S. CIT Group bought First Citizens BancShares for $2.2 billion. Morgan Stanley acquired Eaton Vance for $7 billion in a cash and stock deal.

Private equity remained active. Lone Star bought McCarthy & Stone for £650 million signalling they believe the UK is still a good place to retire (they build retirement homes). Pretium and Ares Management Corp. purchased Front Yard Residential Corp for $2.4 billion to create the second largest single-family landlord in the U.S. Toscafund made a proposal to buy TalkTalk for £1.1 billion. TalkTalk provides fixed line communications services. AMP received an approach from Ares Capital Management for $5 billion. Carlyle and PEP approached the Link Administration in a potential A$3 billion deal. Link is considering a demerger of one of its divisions in response. Inspire Brands is close to a $9 billion deal to acquire Dunkin Brands home of Dunkin Donuts and Baskin Robbins. Carlyle is close to buying Siemens AG’s Flender mechanical drive unit for €2 billion. The unit makes gears and transmission for everything from cement production and shipbuilding to beermaking and offshore oil extraction.

Weaker oil prices, in part from the coronavirus but also perhaps as a structural trend as the world turns to EV, continues to generate consolidation. Conoco agreed to buy Concho in an all share deal valued at $9.7 billion to create one of the largest Permian players outside of Occidental and Chevron. Pioneer Natural acquired Parsley Energy for $4.5 billion in stock further consolidating the Permian. Cenovus and Husky Energy agreed to merge in an all-stock deal. TC Energy offered to acquire the shares of TC Pipelines in an exchange ratio valued at $1.5 billion. EQT bought Chevron’s upstream and midstream assets for $735 million. Chrysaor reversed merged into Premiere Oil in an oil takeover. Note all the deals were share for share as the industry preserves cash. Outside oil commodities, Saracen Mineral and Northern Star Resources merged in a $11 billion deal. The Chairman of KAZ Minerals made an offer for the minorities in a £3 billion deal.

Bridgebio Pharma acquired the remainder of Eidos Therapeutics in a $2.8 billion deal. Eidos develops novel oral therapies for the treatment of disease. Bristol Myers acquired MyoKardia for $13.1 billion, a precision cardiovascular medicine company. Endo Pharmaceuticals acquired BioSpecifics for $658 million.

Boral agreed to sell its stake in USG Boral for $1.015 billion.

Konecranes merged with Cargotec in a €2.2 billion deal. These are engineering groups focused on overhead lifting equipment and cranes. Cargotec does material handling in ports and terminals. The companies are expecting a long antitrust review.

Cellnex is in advanced talks to acquire CK Hutchison’s tower unit for €9 billion. Cogeco acquired DERYtelecom for C$405 million.

Avangrid will acquire PNM Resources for $8.3 billion. Avangrid is majority owned by Spain’s Iberdrola.

Coca Cola European Partners announced an agreement subject to due diligence with Coca-Cola Amatil for $6.6 billion in a deal designed to better withstand a slowdown in the industry and shift away from sugary drinks.

Vinci offer €5.2 billion for ACS Industrial Services, which holds eight concessions and PPPs related to energy projects as well as new projects in the renewables sector.

Brookfield made an agreement to buy the 43% of Genworth MI Canada it did not own.

After a long sales process, Walmart managed to offload a majority stake in UK supermarket chain Asda to TDR Capital and the owners of EG Group for £6.8 billion. Walmart had originally tried selling it to Sainsbury but was blocked by the competition commission. It remains to be seen whether EG Group can close on the deal given its weakening credit position.

End Note

Richard McGregor, the FT’s bureau chief in Beijing, says Donald Trump’s China trade policy is like a line from Macbeth: “It is a tale, told by an idiot, full of sound and fury, signifying nothing.” He predicts Trump 2.0 will drain America’s soft power reserves and embolden China around the world. That said, a Biden presidency could enable more alliances, but McGregor notes, “There is no magic bullet to reset America’s standing in Asia.”

However, there is still some soft power. For instance, on a positive note for dog lovers, the coronavirus could mark the end the sale of dog meat in Asia. Recent bans in Cambodia, China and India are helping prevent the spread of the disease. But Western images and movies of cute dogs doubtless also helped.

[1]“Beijing’s first bond offer to U.S. investors draws record demand”, Financial Times, October 15th, 2020