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Bull market’s trade-war strain

19 Oct 2018

Michael Power maps out October’s market selloff and what it means for the current bull market run.


 

Transcription

Lindsay Williams: 2018 has thus far been characterised by two fairly meaningful shots across the bow of the aging equity bull market in the United States of America. In February, it was led by tech stocks to the downside, of course, and also interest rate rises and the threat of future interest rate rises.

The very recent sell-off has been because of all sorts of reasons – maybe self-inflicted emerging market woes, maybe Trump-inflicted trade war concerns, maybe Italy-led European Union worries, also the Fed rate hikes, of course, as the US economy booms just like back in February and also, just like back in February, the tech stocks coming off very significantly.

I will throw in there the Saudi situation, which to me threatens the market for the short, medium and the long term but, anyway, if we go back to a chat that I had with Michael Power, Strategist at Investec Asset Management, a few months ago, he came up with a piece that we focussed on all those months ago when he said Trump does not understand or like global supply chains.

The article went on to say he breaks them, especially as they refer to big tech like Apple and Amazon plus the chip companies. He risks crashing the Dow and S&P as the FANGs have driven performance and much of their profits are founded on supply chains rooted in China.

Michael Power is on the telephone now with me. ‘I told you so’, Michael, you must be saying to yourself.

Michael Power: I am though I don’t revel in being right. I wish it wasn’t so. I think, obviously, there are other contributing factors but at the heart of what I think is playing out at the moment is that the profits-generating mechanism that ‘US Inc’, particularly US tech, has put in place is in danger of being ripped apart by Donald Trump when he says to the likes of Apple: bring your production back to the United States.

At the moment, I haven’t seen it for the latest iPhone but for the iPhone X they buy the unit for $370 from Foxconn and in the United States they sell it for $999 and the uplift is pretty much all profit. In Europe, the average price is $1,250 and the uplift is pretty much all profit because Apple has put in place, through the good graces of Ireland, a mechanism whereby they basically don’t pay tax in Europe so the entire uplift is ultimately reflected as profit in Apple’s books.

If Donald Trump chooses to upset the supply chain, which is exactly what he is talking about doing at the moment, the entire foundation upon which not just ‘US Inc.’ but the stock market, especially the recent bull run, has been founded is in danger of coming to an end.

Lindsay Williams: Yes, coming to an end is a fairly dramatic statement but we did see a 4.1% fall on that day this week that saw the second shot across the bow of the US equity market that I spoke about in my introduction. That seems like small potatoes compared to what might happen given the disruption or the dismantlement of the global supply chain that has built the foundation of this FANG stock phenomenon.

Michael Power: Absolutely right and I think, obviously, the likes of Apple must be shaking in their boots, facing the prospect that the wonderful little game that they have been playing – because, added to the fact that this is a wonderful way of generating profit, they have been storing the money offshore in large part, that which they have been able to generate offshore, mostly in Europe.

With that cash that strengthens their balance sheet, they have then been borrowing unbelievably heavily at home and using the proceeds of that borrowing at unbelievably low rates to buy back shares and this wonderful merry-go-round (if you will) hasn’t just allowed them to generate profit but, by using the balance sheet strength that results, they have been able to increase their EPS (what the Japanese would be calling zaitech) and drive up their stock price because net-net the only buyers of stock in the United States for the last 6 years or so have been the corporates. Institutions and individuals have been net sellers.

Lindsay Williams: The other factors that I also alluded to in my introduction are significant but it all comes together as a rather unpleasant concatenation of circumstances coming at the wrong time, particularly at the wrong time when it comes to the month of October, which has this sort of mystical quality about it when it comes to bear market sentiments.

Michael Power: Absolutely right and then, of course, there are all sorts of other cross-currents that are coming into play, not least of which is the impending elections in the United States. So Donald Trump has to be particularly hot in his commentary, anti-China rhetoric and the like, which just adds flames to the fire. I think it is fascinating that he has now decided to say that basically the Fed has stolen his stock market. I think that is a lovely little twist insofar as it was, of course, him who put the new Fed Governor in place.

Lindsay Williams: Precisely, Mr Powell was his appointment and I used to – in a galaxy far, far away, Michael Power, I used to have to speak to private clients in my capacity as a financial services salesperson (I suppose). People would call me a broker but I was just a salesperson and, when the market went up, the person that I would phone would say: goodness me, thank goodness I chose that stock, Mr Williams; I am really glad that my account is looking so good; but when things went badly, of course, it was my fault and everybody else’s fault. Mr Trump is the ultimate bad private client.

When it comes to Saudi Arabia, I looked at this over the last few days and I thought to myself this is actually quite serious and it is either going to be damped down quite dramatically and we will forget all about it or it is going to grow into something if the media has nothing else to talk about. Luckily, it has got hurricanes and bear stock market potential to talk about but this one looks quite dangerous to me. Would you agree that it could be the cherry on the top of a bear market cake?

Michael Power: I don’t think it would necessarily be the cherry but I do think the Saudis have something to answer for. I think that were it to have some impact on the oil price and say, for instance, the oil price spiked to 100, then, indeed, that could be the ultimate sort of nail in the coffin of this bull market but that Saudi story is, obviously, further bad news (if you will) that is feeding a grist into the mill at the moment and it is actually quite difficult, looking around at the moment, to find good news.

Lindsay Williams: Back in February I was hosting the Investec Asset Management “Taking Stock” roadshow and this first jolt (as you put it) was playing out before our very eyes as we sat down and presented to an adoring public all those months back. This time, do you think it might develop into something more unusual or again will it just be a blip on a long term chart to the upside?

Michael Power: Well, my sense is either Donald Trump or, if he loses control of the House of Representatives, the US political system will basically stop this madness within a month and reverse a lot of the rhetoric, the anti-Chinese rhetoric, the associated unravelling of supply chains that it entails. If Donald Trump loses the House of Reps, which looks like he will, I think that we could see a different tone developing in the second half of November.

My concern is the damage that can be done before then and I think the Chinese are not amused and, indeed, there are a lots of other people – the Europeans are not amused by what is going on at the moment; the Canadians have not been amused; even the Mexicans (although they have covered it fairly well) are not amused. So I think there is a sense that this is not just a one-off. This is part of the unpredictability of the office of the President in the United States at the moment and, while I think that there may be some attempt to put balm on markets after the midterms, I am not sure if it is going to work.

Lindsay Williams: Michael Power, thanks so much for your analysis. Michael Power is a Strategist at Investec Asset Management in Cape Town.

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