Podcasts

Absolute Return Podcast #21: The Trade War Truce


July 8, 2019–Donald Trump Halts Additional China Tariffs As Leaders Seek To De-Escalate Trade War. What Happened?

Group Mach Withdraws $14.00 Per Share Offer For Transat. Did Group Mach’s Bid Ever Have A Chance?

Canopy Growth Founder Bruce Linton Fired As CEO. Why Was He Ousted?

Loonie Hits 8-Month High As Canada Swings To Trade Surplus. Is The Loonie Rally Overdone?

Yields On European Bonds Hit New Lows As Christine Lagarde Nominated To Lead The ECB. Why Did The Market React So Favourably?

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Transcript

Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.com.

Julian Klymochko: Welcome investors to Episode 21 of The Absolute Return Podcast. Today is Friday July 5th 2019. I am your host Julian Klymochko.

Michael Kesslering:  And I am Michael Kesslering.

Julian Klymochko: A number of important topics to talk about on this week’s podcast off the top.

    • Donald Trump halts additional China tariffs as leaders seek to de-escalate the ongoing trade war. What happened just last week?
    • Group Mach withdraws its fourteen dollar per share proposal for Transat. Did Group Mach’s bid ever have a chance?
    • Big news in the cannabis space, with perhaps probably the biggest CEO in the space Bruce Linton. He actually got fired as a CEO of Canopy Growth. Why was he ousted from the company he founded?
    • Canadian dollar hit an eight-month high as Canada swung to a trade surplus last month. Is the loonie rally overdone?
    • Lastly, yields on European bonds hit fresh lows as Christine Lagarde nominated to lead the European Central Bank. Why did the market react so favourable favourably to this rumour?

We had important news on the trade war front just last weekend with Donald Trump tweeting on Saturday. He stated that he had a great meeting with China President Xi just the day before Saturday. One week ago, he said it was far better than expected. Trump agreed not to increase the already existing tariffs that they charge China, while they continue to negotiate. China has agreed that during the negotiation they will begin purchasing large amounts of U.S. agricultural products such as soybeans and other grains. At the request of U.S. high tech companies, President Xi has allowed Huawei to buy products from these U.S. entities. In addition they open up negotiations with China as the relationship continues to progress. They want to open up additional communication, as you know the parties have not spoken in quite a while. Each country’s trade representative wants to enter deeper discussions and so the market really liked this news. They liked what Trump had to say. The dynamic between the leaders of the U.S. and China, the two largest economies. What this did, the effect was to really ease investor’s tension and fears about an all-out trade war progressing and getting worse. Certainly, this provide the remedy to ultimately provide a truce to the escalations in the trade war. Not just that but investors were concerned that lingering frictions could gave away to another flare up, when trade tensions and market volatility as you saw Trump recently went after Mexico with potentially another trade war but they resolved that fairly quickly as Mexico kind of caved to their demands. Unfortunately, China is not as able to bend, as Trump would expect. However, they are indicating they are willing to be flexible here and things are looking up from a trade war perspective. What are your thoughts on these events?

Michael Kesslering: Yeah, so in particular with the agricultural purchases. I think that this does have some leverage for China on that issue as the purchase of these products that really works well politically for Trump with his base. That is something that resonates with his base, I do think there is some leverage there but as well the egg purchases on a on the whole although there is some leverage. It is unlikely to change some of the U.S. demands with regards to intellectual property and things of that nature. Currently the U.S. has allowed firms to continue doing business with Huawei, so they we have losing some of those demands but overall it will be interesting to follow this. By all measures, this is looking a bit more amicable. The only thing with the Trump administration is that can change very quickly; there could be a tweet tomorrow where Trump just completely derails things.

Julian Klymochko: Certainly, if he wakes up on the wrong side of the bed then markets could be in for another bout of volatility with any sort of signal of an escalation in the trade war. Wanted to recap on why Trump is pursuing this. The U.S. has experienced over the last number of decades a slowly and worsening trade deficit with China. Where month and a month out, it is just getting larger and larger where U.S. is purchasing more goods from China and becoming a larger and larger deficit. Now Trump wants to halt that and reverse that, so he is looking for China to be importing more goods from the U.S. and the U.S. ultimately importing fewer goods from China. You touched on the Huawei issue and I guess discussion is kind of thawing. What Trump previously indicated effectively banning Huawei from the U.S. economy was pretty harsh. He is indicating that he will give them some room, however as far as I understand it, Huawei will be prevented from selling 5G equipment into the U.S. where the bulk of the security concerns lie. It is ultimately that is what the U.S. and other developed nations are concerned about that. Huawei specifically their 5G equipment could offer the Chinese government a backdoor on spying or other sort of espionage activities on foreign countries. The U.S. really not bending on that perspective but with the thawing trade negotiations and this truce that we’re witnessing here the market certainly liked it.

We are notching new all-time highs especially yesterday on the S&P 500 and the Dow Jones industrial average. However small caps not really getting the love. They are still down 10 percent from their highs last summer as shown in the Russell 2000. Domestically focused companies not rallying as much as the large cap global entities that you find in the Dow Jones and the S&P 500.

Some news in the M&A, mergers and acquisitions, with a story that we have been covering quite regularly over the past number of weeks with respect to the potential bidding war for Transat. As you know, they entered into a friendly agreement with Air Canada to be bought for 13 dollars per share and then you had this potential interloper Group Mach floated a $14 cash bid per share publicly. But what happened a couple days ago is that shares and Transat fell 8 percent on the news that would be interloper Group Mach is actually withdrawing its fourteen dollars per share offer for the airline and travel company. Alfred Buscha a Mach executive, he stated that he was ultimately unhappy with the sale process adding that Transat would not even be open to discussions regarding the 14 dollar per share offer. He stated quote, “They completely ignored our proposal.”  Air Canada really did not get to talk about it at all, but we have been discussing on the podcast for the past number of weeks. As Group Mach proposal has been public. We really have been quite sceptical on it, we do not view it as a bonafide offer and this really proves out our thesis that look, they don’t really have any sort of reputation and they’re looking to buy a company for nearly six hundred million dollars. To raise that sort of capital when they don’t have it is quite difficult. To come out with what to be thought of as a competing proposal. If you don’t have the money then it’s tough for the board of directors of the target company to take that bid into consideration and it looks like that is exactly what happened here. Transat board likely quite sceptical of Group Mach ability to get the financing, the ability to actually close this deal. They went with the perceived lower risk Air Canada deal even though, number one. It is at a lower price, and number two it provides you know substantially more competition potentially anti-trust concerns from a regulatory perspective when it comes to close the deal. What are your thoughts on this M&A situation?

Michael Kesslering: Yeah I would definitely agree with you. Obviously if Transat viewed this bid as being at all, legitimate. They would take it to their board of directors are there would at least be negotiating with Group Mach. I think that as you mentioned this just kind of turn out that they weren’t taking it seriously, Investors were taking it a little bit more seriously.

Julian Klymochko: Right, It was trading above fourteen dollars at one point and you mentioned it is interesting that not only did the board seemingly ignore this but they didn’t even utilize it to try to get a higher price out of Air Canada.

Michael Kesslering: Yeah, I guess investors were hoping that a bidding war would ensue. That is not what happened. The other thing to note was that if the Group Mach, perhaps if they had come to the table and provided a higher bid than their 14-dollar initial bid there would be a 15 million dollar break fee payable by Transat to Air Canada in that case, but ultimately no bidding war.

Julian Klymochko: Right and I wanted to touch on a couple risks with the current friendly Air Canada deal that they did strike.

    • Number one, you are getting pushback from shareholders with respect to the price the thirteen-dollar offer per share. Not really happy with it, large shareholders have complained that Air Canada’s offer merely covers the cash on Transat balance sheet. It described no value for its operating business, which is a 40-plane airline and tour division.
    • Number two, as I stated the competition commissioner will likely try to extract major concessions from the combined company because they do have 40 to 60 percent market shares on certain routes. They can possibly force it to abandon routes and airport landing rights or even worse they could outright block the deal.

Those are the two major risks currently baked into the transaction. Some price action, Transat shares last time I checked were trading around twelve sixty which is a three percent discount to Air Canada’s 13 dollar offer. Market pricing and perhaps a double digit IRR so some risk there on closing the deal.

Shocking news in the cannabis space with Canopy Growth, which is perhaps the leading cannabis company worldwide. The founder and CEO Bruce Linton was actually fired and Bruce Linton he is perhaps the public face of the cannabis industry really an industry cheerleader. Started pretty much the first public Cannabis Company in the industry. He was terminated as CEO amidst increasing losses at the company. Bruce Linton, he started the company Canopy Growth in 2013. He was also removed as chairman of the company. Now the decision to fire him was driven by the controlling shareholder of Canopy, Constellation Brands. They invested five billion in canopy growth less than one year ago and with that 5 billion, Constellation now owns 38 percent of the company plus they control the board of directors and ironically it was Linton who brought in Constellation as the investor. So he effectively kind of wrote his own obituary there.

What was really interesting about this. This announcement it actually followed recent public criticism from Constellation CEO Bill Newlands who is also a Canopy Growth board member who just last week stated on a conference call that he was not pleased with Canopy Growth’s recent results. Now Constellation wanted to put the brakes on Canopy’s acquisition streak and focus more on operational efficiency and profitability. Canopy last month reported a quarterly loss of over 300 million dollars, which was way beyond analysts’ expectations, so they really had quite the poor fourth quarter. I mean this was compared to a loss of around 50 million a year ago to constellation. Clearly getting frustrated with losses of nearly six fold over 300 million dollars just in the quarter. Not just that but their stock price has fallen 26 percent since April.

A couple negative results there, Constellation stock also took a hit in June when the Brewer said it would book a quarterly lost of 78 million related to its share of Canopy results. What you have here is Constellation having to answer for their own frustrated shareholders on why this Canopy Growth investment is not turning out well. While they’re having to book losses on their investment with the stock going down, book losses on their income statements with the company notching much larger than expected, operating losses and that continue to expand in the future. Ultimately, Constellation saying enough is enough. We got to stem the bleeding here, we had to take this in a new direction and ultimately what happened to Linton was effectively foreshadowed on Constellations recent conference call where they indicated that they weren’t happy. I was really shocked, you never really hear a company make a very large multi-billion dollar investment and shortly thereafter and publicly rebuke the CEO. What are your thoughts on this interesting cannabis situation?

Michael Kesslering: Yeah, it is really interesting just with regards to the timing as there had been a couple of profiles in the media of Bruce Linton lately. He was getting some good press and then everything with Constellation a couple of weeks ago. Obviously how it is unfavourable for him, but really he is making out of this a very fine situation. He made over 200 million dollars I believe from his investment in Canopy and as well since he was fired all his invested stock options. They fully vested for him so he was able to keep those, so he is in a good situation what is interesting is where he will go from here. He does have a non-compete clause, which prevents him from working with any rival Canadian cannabis players, which is interesting because that might leave the door, open for any international players that he could be involved with. But the shares of a small software company that I believe he is the co-chairman and former CEO Marcelo Technologies. On the news when he was fired on Wednesday they actually increased about 89 percent, so there is obviously some speculation that he will become more involved with that company and that would really fit into his background. He has a technology background. It was really just with Canopy was his only forte outside of the technology sector.

Julian Klymochko: For sure and he certainly has made investors a lot of money here. I believe Canopy growth is trading around 50-dollar range, and when it came public, a number of years ago probably in 2013-2014, it was in the low single digit dollar range. Investors especially the early stage investors have done very well. Cannot really say the same about later stage investors such as Constellation perhaps booking some losses on their investment. Hoping and to turn that around, but Linton as you said was doing a lot of press over the past couple days really defending his management style, got a quote from him here. He stated, “The way the company operates is an aggressive entrepreneurial company not managing for profit at this point but managing for market share and growth.” So there you have it, that was ultimately his strategy and Constellation wanted to take the company in a different direction. Managing them more for profitability and doing less acquisitions. Got a quote from the Macquarie analyst Caroline Levy, she indicated that the departure of Mr. Linton is indicative of the fact that the losses Canopy is experienced are getting out of control.

Now Linton as you stated he owns about two and a million dollars of the stock. He had stated publicly that he plans on keeping the vast majority of it which I thought was interesting. He indicated his thesis was that the stock will do very well especially if or when the U.S. goes on to legally legalize cannabis. Ultimately, that is where he is sticking around obviously as really the industry cheerleader and the face of the cannabis industry. I think ultimately we will see more of him from the future as you state and not from a Canadian company but perhaps an International Cannabis producer.

Michael Kesslering: One thing that you mentioned is that he likes being the cheerleader and something that he mentioned in one of his interviews was that. He really likes the idea of being a CEO for having the microphones, the meetings, the business cards. I think were his exact words.

You will definitely see him with another company.

Julian Klymochko: Wanted to touch on some currency, some F/X action. The Loonie, the Canadian dollar recently hit an eight-month high as Canada swung to an unexpected trade surplus in May. Getting into the numbers here. Canada posted a 762-million-trade surplus for the month versus expectations of a deficit of one point five billion, so pretty massive beat of expectations on that figure. Now this surplus came from rising exports of motor vehicles, aircraft and energy products. We are starting to see a slow recovery in the energy industry. Now the Loonie, the Canadian dollar has benefited in recent weeks from data showing a recovery in the domestic economy, which could keep the bank Canada on hold over the coming months. Even if the Fed, The Federal Reserve cuts its interest rates as the market expects. I think the market is pricing in a nearly certain cut in July this month from the Fed. However, the market is pricing in only a 30 percent chance of a Bank of Canada interest rate cut this year. That is why you are seeing the Loonie rally versus the U.S. dollar. Some analysts and economists thinking that it could reach the 80 cent range up from 76 and change here. Ultimately, the Bank of Canada does not want to see the Loonie rally that much versus the U.S. dollar and ultimately its largest trading partner. They are sensitive to the Canadian economy and they don’t want the Loonie to rally too much. What are your thoughts on this price action and the economic action on the Canadian side?

Michael Kesslering: You had mentioned the rally. There was a slight pullback this morning after a surprise jobs decline. I believe they were down about 2000 jobs were lost in June. But when you look beyond the headline the news actually wasn’t that bad and even still that’s close to even on the month, but there was actually a gain of 24000 full time jobs. While Jobs or part time jobs actually decreased by 26000. You still did see some fairly strong growth on the full time side which is arguably you could make the argument that is more important than the part time jobs lost as well as unemployment. It was edged up slightly from five point four percent to 5.5 percent, but overall looking beyond just the headlines of those jobs numbers they are actually quite strong and wages I believe were increasing substantially as well. Overall, it is looking quite strong from the Canadian economic perspective at least in the short term here.

Julian Klymochko: Right and the Canadian dollar really has been range bound pretty much since 2015 after we had the large decline. At a big bear market in oil coming off 2014, ever since 2015 It has kind of been in the one point three USD per CAD range and you’re not still within that. We are not really seeing a breakout, Perhaps we could but ultimately analysts and economists are speculating that if we did see a breakout that the Bank of Canada would be pretty keen on halting that, as to not damage the domestic economy.

Getting into a bit more global macro with yields on European bonds absolutely plunging to pretty much, new all-time lows. As Christine Lagarde is nominated to lead the European Central Bank and Christine Lagarde, she has had a pretty storied career. She is currently the managing director of the IMF, The International Monetary Fund. She has been nominated to become the next president of the ECB, The European Central Bank. She has led the IMF since 2011 and she would seek to succeed Mario Draghi at the ECB. Now Draghi has been famously quite dovish and if you remember, back and I believe between 2013 and 2015 back when you had that big euro crisis yields skyrocketing. I believe Greek yields back in that Grexit talk days got close to 40 percent. Even Italian long-term bonds were in the 7 to 8 percent range. Portugal you had all these yield spreads really blowing out. So remember Draghi had that famous do whatever it takes to keep the euro together speech. Went on to implement quantitative easing and all sorts of very easy monetary policies throughout the Eurozone, which clearly has been successful.

However, the European economy has been struggling with sluggish growth basically ever since the 08-09 credit crisis. They are struggling with sluggish growth, low inflation for example growth in European manufacturing sector deteriorated for a fifth straight month in June. Last month Draghi said the ECB would announce further stimulus, if the region’s economic situation further deteriorated. Now one of Europe’s biggest problems is that weakness is driven by factors beyond the ECB control. Including a drop in demand and exports, driven by this big trade war between the U.S. and China, which is kind of affecting everyone globally.

Some price action on these rumours of Christine Legarde getting nominated. The FTSE 100, which is one of the big indices in the U.K. It closed up nearly a percent on the news, as the market expects that Legarde would implement fresh stimulus package to boost the European economy. There is speculation that she would perhaps implement QE2. She is widely regarded as being quite dovish perhaps even more so than Draghi and by dovish we mean someone who would be likely to ease monetary policy like to have easy money and see markets go up. Certainly not a hawkish central banker by any stretch of the imagination.

Getting into more shocking market action as we previously indicated and in the title, that we are seeing bond yields throughout Europe really plummeting to new all-time lows. Some numbers on European two year bond yields we look at Spain negative point for 6 percent, Portugal negative point 5 percent even Italy in the negative range, negative 5 basis points. Then we have France and Germany at negative point seven percent and negative points seven point seven percent respectively. Really just craziness in the European bond market for over two years, you expected to lose money to lend these governments your money. What are your thoughts on the price action here and all the speculation with respect to Christine Lagarde as the new president of ECB?

Michael Kesslering: Yeah. One other thing that I wanted to mention was you had talked about some of the issues in Europe are beyond their control. Another example of that was just recently the U.S. threats of four billion dollars’ worth of tariffs. That was just another thing that is stoking fears, of an economic slowdown. In terms of like how market participants are viewing things. Is you are seeing in most recently a really strong rally in German and French government assets as well. That is really just kind of a perceived move to safe haven assets as well. In terms of actual actions expected by the ECB, it is expected that they are likely to cut the deposit rate for banks by 10 basis points to a negative point 5 percent in September. As you had mentioned with Christine Lagarde coming in that there will likely be further asset purchases at least staying status quo if not going beyond that, so everything is well looking towards lower European bonds from here.

Julian Klymochko: Lower for longer. As has been the theme for pretty much the past 10 years, I find it ironic. You touched on this sort of migration to safe assets but if we go back, say six years in the depths of the euro crisis we have is absolutely skyrocketing yields. When we talk about yields plummeting right now that means a big rally in bond prices. Bond prices of course move opposite to bond yields but back then, half a dozen years ago you had skyrocketing bond yields, as investors really got spooked. They got spooked out of Greek bonds, they got spooked at a Portuguese bond and even Italian bonds as I indicated were I believe in the 7 to 8 percent range. Now all of those going to near zero or even negative which is just really shocking turn events especially when you consider that the Eurozone really has not turned around. You are still having incredibly sluggish growth. I did recently look at a graph of the European stock index EPS earnings per share and it actually has not even recovered to where it was pre credit crisis. Even back 10 years ago, I believe earnings per share of the equity index is quite below that. Contrast that to the U.S. where you had a big recovery in the market and earnings per share of American corporations, but ultimately does Lagarde have a lot of tools here if she is to become the new president of the ECB. Because we indicated a lot of this role caused by events outside of their control. Being majorly this trade war not just that but they’re kind of more structural issues such as massive deficits and in each country and you’re having political issues, you’re having demographic issues obviously European nations are getting older, less productive and really have seen multiple recessions in each individual country. Greece still really has not recovered since 08- 09 has had massive declines in GDP. Clearly, they are not in that depression that they were in a number of years ago, but really, I have not seen much recovery yet a big decline sort of flat line. You are seeing the same thing in Italy, which is one of Europe’s largest countries.

Had an interesting quote from the Evercore analyst. He indicated that Lagarde would be expected to lean broadly dovish on monetary policy while pressing fiscal authorities to play a more active role in promoting Eurozone growth. Specifically we think she would back what we expect will be one last big dovish play from Draghi in September which is an easing package that includes both a 10 to 15 basis point rate cut. That is point one to point 15 percent and a new QE program at around 30 billion euro per month of bond purchases.

What is interesting, the other thing that is causing European bond prices to rally yields to plummet. Is that you take Germany for example their two year bond is currently yielding negative point seventy five percent. Not only are you losing money on a normal basis but even more when you take inflation into account. Because I believe inflation is not zero in Europe, it is kind of in the 1 percent level not where they want it but certainly not deflationary but Germany they are actually quite fiscally prudent. Contrast this to the U.S., Germany actually runs surpluses, budget surpluses unlike the U.S. The US is running massive deficits and they are funding this by issuing Treasuries and so the Treasury market is very large and you have yields in the U.S. at around 2 percent. Then contrast that to Europe with Germany running not much for deficits. There is not very much German paper out there, there is not a lot of German bonds for the ECB to buy in their QE program, and I believe a large portion of German bonds have been bought by the central banks and there is really not much supply left. You know what happens when demand exceeds supply and then prices go up and that, is really the dynamic that we are seeing here. People are just running out of bonds to buy throw Europe. You are seeing prices increasing and then yields ultimately decreasing to what? In my opinion are ridiculous levels. There are two years all negative across the board and seemingly getting even more so negative.

So that wraps it up for Episode 21 of The Absolute Return Podcast. You can check out more on absolutereturnpodcast.com if you like it. Please leave us of review and we will chat with you next week, cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by accelerate financial technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.