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Absolute Return Podcast #26: Currency Wars: A Race To The Bottom

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August 12, 2019—U.S. Labels China a Currency Manipulator as the Renminbi Hits 11-Year Low. Why Did China’s Currency Depreciate?

Crude Oil Hits Seven-Month Low as Trade War Slows Economic Activity. What’s Driving the Price Action?

Disney Bundles Disney+, Hulu and ESPN+ at $12.99 in a Challenge to Netflix. Will it Work?

A Conversation About July Factor Performance. Which Factors Produced Alpha?

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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 26 of the Absolute Return Podcast, I am your host Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is Thursday, August 8th, 2019. Going to keep this podcast relatively brief. Just a few key topics to discuss this week, of the top.

    • U.S. labels China a currency manipulator as the Chinese currency hit an eleven-year low. Why did China’s currency depreciate?
    • Crude oil. Big news in the oil market. It hit a seven-month low and a bear market. About 25 percent down since its peak in April. What is driving the price action? We are going to chat about what is happening in the oil market.
    • On the micro side, Disney bundles Disney+, Hulu and ESPN at twelve ninety-nine, which is a shot across the bow to Netflix. Big challenge there, matching Netflix’s price, but with a much more expanded suite of coverage on the streaming side, will this work? And what are the potential effects on Netflix?
    • Lastly, we will talk about July factor performance.

Biggest news in the market this week, we have a potential currency war breaking out. What happened was the U.S. Treasury officially labelled China a currency manipulator as the PBOC, the People’s Bank of China, allowed the Chinese currency, the Renminbi, also known as the Yuan or RMB. They allowed it to fall past RMB 7 per U.S. dollar for the first time since May 2008. Now the Yuan devaluation was only one point six percent. However, it crossed a key level being this seven per U.S. dollar. This really spooked global markets. I mean, the S&P 500 dropped 3 percent just that day on the news. This was the U.S. index’s largest one-day decline of the year. That designation by the Treasury was seen by analysts as largely symbolic move that would serve as a political justification for more tariffs, and I should note that when Trump was campaigning to be president back a number of years ago, one of his campaign promises was to indicate or deem China as a currency manipulator. This was kind of way back in his mind, but three or four years ago, and so he’s finally following through with one of his campaign promises. And what’s really unique is the way that the Chinese currency depreciated. Now, what the PBOC, the People’s Bank of China does is they engage in open market operations to keep the Yuan or the Chinese currency is relatively stable, plus or minus around a band compared to the U.S. dollar, roughly a peg that moves around over time. What they have been doing lately is buying up the Chinese currency in the market to support the price. So all this devaluation was less support in the market for the currency. They are doing less buying of the Yuan, and so, you know, a sceptic like myself would consider that less manipulation of the currency. But now the U.S. Treasury deems that coming back on buying or decrease buying, they deem that being manipulated, which is somewhat counterintuitive. But that’s how Trump and the political process tends to work.

Nonetheless, The Treasury Department said China had a long history of facilitating an undervalued currency by intervening in the markets. In recent days, China has taken concrete steps to devalue its currency while maintaining substantial effects reserves. Despite active use of such tools in the past. Allowing the Chinese currency or the Yuan to crack seven is a carefully crafted gamble by the Chinese government that it can use the currency to soften or cushion some of the worst effects of this ongoing trade war with the U.S. without triggering capital flight. Now, this is a very delicate balance because if China allows a currency to depreciate too much with respect to the U.S. dollar, then local Chinese people see that. They see their currency losing purchasing power and they immediately want to get their assets out of the country before it loses more and more value. The government does not want to see that, however, as we indicated, this currency does provide quite a good cushion to the tariffs that Trump is implementing on Chinese goods. But the main crux of the issue here is the two countries seemed near to a deal just a number of weeks ago, but Beijing steered the Yuan towards a stronger exchange rate against the dollar as talks were going well. However, when there are relapses, when Trump has a Twitter tantrum implementing more, punitive actions on China, this is when the PBOC allows the currency to depreciate, so they are really using it somewhat as a pressure valve in the market to reduce Trump’s punitive trade actions against China. The bottom line is the Chinese currencies move through seven is a sign that Beijing now sees little hope of reaching a near term trade settlement with the US, and markets took it as such as stated that S&P down 3 percent on the news, getting hit hard on that. What are your thoughts on this kind of ongoing trade war now morphing into a currency war?

Michael Kesslering: And so The U.S. Treasury designating them as a currency manipulator. That actually technically triggers a process where the U.S. can ask the IMF to evaluate China’s currency policies, which is another interesting matter, although likely, the IMF really wouldn’t have much for teeth in any sort of judgment they made on China, as China in the past has ignored what the IMF has said. I don’t really think that has a lot of bearing there, but what I really wanted to point out is, just as you mentioned, this is not really an action from China. It is just a lack of action, and it is very ironic that the U.S. is accusing China effectively. Not allowing free market forces to dictate the value of their currency, which the U.S. is supposed to be the most free market country in the world. The fact that they are vilifying another country for not allowing their country to roll with the free market valuation is just, I find a little ironic and a little bit comical.

Julian Klymochko: Oh, certainly. And what you’re seeing is each country and the way that a currency war comes into play is, you know, each country tries to get their currency to depreciate such that local businesses are more competitive in the international market. But Trump sees another country allow its currency to depreciate, and he believes, you know, it’s kind of a win lose situation, a zero sum game. He believes that the U.S. dollar needs to depreciate in order to make U.S. businesses more competitive on an international scale, and you have this competitive devaluation of each country’s currency as they try to keep up with that game.

Got an interesting tweet from Trump here on the news. He indicated “China dropped the price of their currency to an almost historic low. It is called currency manipulation. Are you listening, Federal Reserve? This is a major violation, which will likely weaken China over time”. Trump taking the opportunity to not only bash China, but also the Fed, as he usually does. He also tweeted China had used currency manipulation to steal our businesses and factories. Hurt jobs, depress our workers’ wages and harm our farmer’s prices, not anymore. Got an economist from Commerce quoted here stating, “the market implications of breaching seven point are tremendous.” And he’s indicating this key threshold of RMB 7 per U.S. dollar. “We will see a new wave of depreciation among Asian currencies in the foreseeable future and there could be further risk off movements in global markets. It looks like a tsunami is coming, and so what this economy is indicating is that in the global currency markets, there tend to be knock on effects”.

As China allows its currency to depreciate while you are seeing, other Asian currencies depreciate as well, and if we go back 20 years, in late 90s, there was an Asian currency crisis where you had big devaluations of several Asian currencies, and it really led to panic throughout many markets and wild moves even in equity markets. And it just shows you how interlinked all global markets are. Currencies, commodities, equities, fixed income.

Michael Kesslering: The other interesting aspect is that Trump has alluded to in the past in his tweets, although not directly saying it, but that there is the option for the U.S. to take moves to devalue their own currency, which I mean, one of those moves is just the Federal Reserve decreasing rates. That is just a common way to devalue their currency, although it is not explicitly stated.

Julian Klymochko: Right and I believe we saw comments out of Powell stating that managing the currency is not part of their mandate. They have this dual mandate for stable prices and maximum employment. I believe the job of managing currency value falls to the Treasury.  That would be Steven Mnuchin one of Trump’s key advisers who runs the Treasury. That would more so fall on their shoulders. However, Trump does not seem to acknowledge that.

Michael Kesslering: It is very clear that he does not acknowledge any form of the Fed being independent, so that is not surprising.

Julian Klymochko: Right, he pretty much just takes any opportunity he can to bash the Fed and tried to pressure implement maximum pressure on the Fed to consistently lower rates. Touching back on this Chinese currency devaluation, we actually do have a precedent here. We had something similar in 2015. China di depreciate or devalue their currency in 2015 and actually August of 2015 in order to provide a short-term boost to the Chinese economy. However, it did prompt major capital outflows at the time, and it drew the ire of critics in Washington who accused Beijing of currency manipulation and ensured regular scrutiny from the U.S. Treasury. However, back then, they were not deemed a currency manipulator. Back then, in 2015, the PBOC see actually let the RMB fall 3 percent on August 11th, 2015. Now, compared to this week’s drop, which was only one point six percent back in 2015, it was actually nearly twice as large, and looking at market action on that precedent, four years ago, the TSX index actually went on to lose nearly 18 percent over the next five months. From August 11th, 2015, it didn’t actually bottom until January 2016. You had quite the extended risk off period from that.

Nonetheless, some market action on this current devaluation, S&P 500 down 3 percent lower, its biggest one-day drop since December 4th, six consecutive session of decline. Longest losing streak in 10 months. Then you had some interesting action on the fixed income side. Treasury yields down 12 basis points to one point 735 percent. Government bonds rallying on that risk off move in the currency markets.

We are seeing interesting knock on effects of this ongoing trade war in the crude oil market.

Now, what happened there was oil actually declined into a bear market as prices decline nearly 5 percent on Wednesday, taking the peak to trough decline this year, to negative twenty four point five percent from their peak price in April. Now, what happened here was crude oil futures came under selling pressure declined pretty remarkably from, number one, an unexpected build in stockpiles. So a big inventory build there on the supply side, combined with slowing demand due to economic concerns from this ongoing global trade war. Some price action – Brent crude oil, which is the European benchmark, now settled around 57 bucks. It is down 14 percent since Trump announced new tariffs last week. So pretty large decline after Trump escalated the U.S. China Trade War. WTI, the North American benchmark crude oil price around fifty-two and change, still a pretty significant discount compared to the European benchmark oil price.

On the supply side now. Government data showed a build or stockpile of two point four million barrels of U.S. crude stockpiles last week, this was compared to 2.8 million draw down. Analysts had expected less crude coming out of stockpiled than expected. This is about 2 percent above the five-year average for this time of year.

Interesting comments out of Saudi Arabia, and so Saudi Arabia is one of the largest producers in the world, typically second or third in top three with U.S. and Russia. But Saudi Arabia is highly reliant on the oil price to run their economy, and the de facto leader of OPEC, the International oil cartel. What Saudi Arabia is trying to do is they are trying to combat this price decline. They like to see oil typically in the 60 to 80 dollar range. Traders said there were reports that Saudi officials were considering all options to stop the drop in oil prices and that they believe the fall has been caused by fears of an economic slowdown, not an oversupply of crude. But one of the mechanisms that Saudi Arabia does have is to basically reduce their production and take supply out of the market. What are thoughts on the interest in price action in the oil markets?

Michael Kesslering: Well, there was actually some good news coming out of oil markets this week as well. We did see that Chinese imports were up 14 percent over July, so that is a key market for and end products as well as just crude oil in general. I would agree with some of your comments just regarding the cause of those price action being there is just a lot of fear about the potential economic slowdown. There is as well on the other side, some oversupply issues, but I think it has really been being driven by the fear on the economic side. And that’s just if you look at the price of oil around some of Trump’s comments over the last month or two months, you do see some spikes down whenever he does start tweeting about the trade war.

Julian Klymochko: Right, and so it is interesting for investors to know just how interconnected global capital markets are. You have a Trump tweet; The Dow Jones tanks 550 points on that. But it’s not just equity markets, You’re saying international effects on currencies. You are seeing effects on commodities, with a big decline in the price of oil. You should really take into account all of the news that does not affect just domestic equities, U.S. equities. But, you know, it affects everything, prices at the pump, interest rates, currencies, exchange rates. it’s something to keep in mind how interconnected global markets really are these days.

Michael Kesslering: I would also you just mentioned speaking domestically in Canada. Is that the Canadian oil gas market has a number of headwinds on the domestic front.  To do with pipeline capacity, other issues like that and discounts and this is just another headwind facing a sector that has really low sentiment, has struggled to raise capital, and their results have been getting hammered over the last, five or six years.

Julian Klymochko: It certainly has been a five-year bear market for energy. I believe the Canadian energy index is actually significantly lower than its peak in 2007. So tough time for energy investors, but I mean, I don’t really see any sun on their horizon for them. It seems like more cloudy skies, more tough market, and so, you know, they are in a tough spot.

Interesting news on the stock specific side now, Disney came out with a really interesting press release this week indicating that they’re going to bundle their three streaming platforms, Disney+, Hulu and ESPN Plus, a twelve ninety nine per month, which is a direct challenge to Netflix because Netflix is main offering cost the same price. Now, our thoughts here is that consumers may not go right and cancel their Netflix. However, what it does is it really limits Netflix as pricing power as we previously discussed. Like Netflix, it is highly reliant on future price hikes. They are burning a ton of cash producing content, negative free cash flow to the tune of about three billion dollars per year. I believe they are going to spend 15 billion on content this year. And so at some point, they need to at least get to break even, and what was shown last quarter when they did increase price is that their core business really suffered. I mean, the shares fell 10 percent after subscriber growth was actually negative in North America and significantly below. Not just consensus, but their own guidance internationally. I should note that price increase, it came without significant competition because this Disney service, I mean, they have not even really launched it yet. Not to mention this killer package that I view, Disney+, Hulu and ESPN at twelve ninety nine. I mean that seems a tremendous value. And if we talk about Netflix having to raise their price to say over time to 20 bucks a month, unless Disney is leading those price increases, it’s going to be tremendously difficult, if not impossible for Netflix to get their price that high when Disney is sort of anchoring it around this 13 bucks level. Not only is Netflix reliant to make their business at least break, even if not profitable over time. In addition to that, they have a tremendous multiple in the market, you know, a huge valuation, which is really reliant on future price increases to justify it. So what are your thoughts on this? What I think genius move by Disney to really take that competition to Netflix.

Michael Kesslering: Yeah, and first. I would mention that speaking directly to Disney is that they have a unique advantage over Netflix with regards to their content costs as most of their content is evergreen. I believe it was either Charlie Munger or Warren Buffett described Disney as oil wells that just continually keep pumping and pumping, and you can repurpose the characters that Disney already has. You can repurpose their content and build other content on top of that, so it is in a really unique situation, and as you mentioned, Netflix spending 15 billion this next year in Capex costs for content. It’s a really interesting in terms of who’ is going to be the low cost producer is most certainly going to be Disney. The other aspect is when you discuss the pricing power and with the pricing power for Netflix. If you are just increasing it a dollar or two and you are just comparing that to the traditional cable bundle, which is in the 80 to 100 dollar range, one or two-dollar increase, really is not that significant from that consumers price value perspective. But when you have another competitor that’s around the same amount, the same price point. That completely changes that dynamic, then what the question really becomes is what percentage of the consumer’s wallet share are streaming services going to have moving forward? How much can they command from that consumer’s wallet? You know, is that 50 dollars is 100 dollars. That really matters for the overall thesis on Netflix.

Julian Klymochko: Right, because one of the main value ads or appeals of streaming where it is significantly lower prices than cable. However, once you have Disney, Netflix, and all these other services. HBO, at what point is that negated? You know, next thing you know, you add up all your streaming services while you are paying a hundred bucks a month. How is that any different than cable?

I would also like to note that there is a really interesting shareholder dynamic between Netflix and Disney. We really saw that in action this week when Disney came out with their quarterly results because their stock was down 5 percent as their earnings per share came quite a bit below analyst expectations. So their margins were lower, expenses were higher, which shows that their investors are quite sensitive on profitability, and so they’ve really got to be careful here in how they operate their streaming services because Netflix, historically, their shareholders have not cared whatsoever about profitability. All they care is spend, spend, spend, grow, grow, and grow as quickly as you can. Disney shareholders are not like that at all. They are highly reliant on steadily increases in earnings per share. They are highly sensitive to margins, profitability, etc. So that’s another core thing to watch as Disney dips its toes into the streaming service in competition with Netflix, whose shareholders have really never cared about profitability.

Michael Kesslering: Absolutely, and in terms of another thing that I thought was quite ironic is that cord cutting originally with these media companies was a way for consumers to fight back against the bundle. Now media companies are just re-bundling their content in a different way. It is really quite analogous to what robo advisers are doing in the financial services space, as part of the goal was to unbundle all the financial services. Now what you are seeing from some of these top providers is they are just re-bundling through the use of their robo advisor app as a customer acquisition tool and then up sell products across to their customers. I just thought it was a kind of unique and interesting analogy to what is going on in the financial services space.

Julian Klymochko: Yes, certainly and I agree with that because one of the main criticisms of cable is, you know, very high price and a lot of wasted channels that you don’t utilize. Robo advisors are kind of indicating the same thing about financial advisors saying, oh, you know, we can cut out a lot of the stuff people don’t need and offer it on an automated basis at a significantly lower price point in years. You are seeing that action in both these industries.

We released our monthly Alpha Factor performance this week, which measures the performance of various factors, including value, quality, price momentum, operating momentum and trend. This was really just a kick ass month for multi-factor investing. I mean, we had net alpha or outperformance on all 12 different factors we measure, and so there is the aggregate multi-factor outperformance. The long minus short portfolio was up eight and a half percent in Canada and up eight point nine percent in the U.S., which is tremendous performance in our month of July where the TSX was nearly flat up slightly and the S&P 500 was up about 1 percent and change.

In Canada, great long multi factor performance north of 5 percent. This was largely driven by price momentum operating the momentum and trend. Same thing on the short side, those offering exceptional divergence on the price, operating momentum and trend. Then we look at the value and quality side. Really, no performance out of quality and value, which is kind of the story as it has been this year. Value has sucked for a long time and quality not doing too well, but nonetheless price momentum, operating momentum and trend really making up for it. We see something similar in the U.S. However, you had tremendous net alpha from multi-factor in the U.S. but all of it was driven by the short side. I mean, long only was pretty much flat. However, the short side generated nearly 9 percent return, which is really the case on all five other factors value, quality, price momentum, operating momentum and trend where the short portfolio’s dropped anywhere between 4 percent and nine point four percent.

The main point being here is that in a multi factor investing can be really value-added. Where a lot of people don’t get it right is say on the smart beta side, they’re trying to capitalize on these factor premiums. However, as the numbers show here, smart beta is long only and where we have seen the bulk of the alpha or performance generated has been on the short side. That is one of the main value ads of multi-factor long-short investing is that you are harvesting significant amount of alpha on the short side. When you look at net alpha generation, a large chunk of that comes from the short portfolio, and you are just not getting that in smart beta, which is a long only strategy. I implore investors to really take a look at really consider multi factor long, short investing, which goes far beyond smart beta in terms of sophistication where you’re really, really capitalizing on those risk premia on the short side to generate not just additional alpha, but to hedge your long portfolio, manage risk, manage volatility. In my opinion, a significantly better strategy than looking to harvest factor premia on the long only side. You can argue that, you know, the long only factors are getting crowded with a bunch of factor-based ETFs, but you are really not seeing that in my opinion on the short side. As I indicated, more and more long, short net alpha being generated on the short side of multi factor investing.

And that’s all for us this week of the Absolute Return Podcast, episode 26. We hope you enjoyed it. If you did, feel free to check out more episodes at absolutereturnpodcast.com. You can check out all our older episodes there or any of the major podcast providers. That is it for us this week. Leave us rating. Send us a 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.