Tuesday / November 12.
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Fed enables rally in global risk assets

global-investingnew|By Matein Khalid| The Federal Reserve did not disappoint the financial markets after Janet Yellen’s FOMC conference on Wednesday. The US central bank did not raise the overnight borrowing (or Fed Funds rate) to 0.5% on the eve of the November election. This triggered a wild rally in the US stock market with the Dow Jones up 163 points, gold up to $1342 and oil to $46 (aggressive monetary tightening and a stronger dollar is the kiss of death for the yellow metal and black gold!), a surge in the Euro and emerging market currencies. Interest rates will remain lower for longer but how much longer? The Fed noted that the case for a 25 basis point rate hike in December has “strengthened” now that it has reached the limits of its dual mandate to maximize employment consistent with 2% inflation.

However, all is not hunky dory in the citadel of US monetary policy on Constitution Avenue in Washington DC. Three FOMC members dissented and voted to hike rates immediately in September. On the other hand, the Federal Reserve has lowered its projections for the year end 2017 Fed Funds rate to 1% and yearend 2018 to 1.9%. This is the real reason the stock market surged, gold and oil rose, the US dollar fell and the Volatility Index plunged from 16 to 12. The shift in Bank of Japan’s monetary strategy also reassured Wall Street that the world’s top central banks do not want a sell-off in the stock and bond market while global economic growth is so fragile and world trade volumes are in a slump.
I usually avoid trying to handicap the hawk versus dove debate in the FOMC because it is impossible to predict the outcome of a monetary policy vote. Yet it is significant that Boston Fed Eric Rosengren dissented at and voted to raise rates in September. Rosengren has switched from dove to hawk, a camp that includes the presidents of the Kansas City, Cleveland and Dallas Federal Reserve banks. Money market futures in Chicago now predict a 52% probability of a rate hike in December.
Janet Yellen refused to answer a question at the press conference about whether the Fed did not raise rates due to the uncertainty created by the US President election in November even though she had specifically cited Brexit as a reason not to raise rates in June. While the Federal Reserve tries to maintain its aura of political independence, the fact remains that government spending and taxation plans (a political data point!) hugely influence the monetary policy debate. A financial markets economist I respect argues that Janet Yellen has been unnerved by the rise in the London Interbank Offered Rate (LIBOR) in 2016 and the Senate hearings on the Wells Fargo banking scandal. A panic in the global interbank market and threats to break up the California firm that was the world’s most valued megabank before the scandal broke are a clear recession threat to the US and global economy. Since a rise in LIBOR raises the borrowing rate on a home equity line of credits mortgages and business loans in the US, it acts as a de facto rate rise. This could easily be one reason why the Fed did not hike rates in September.
The Fed’s decision to guide “lower for longer” interest rates and the Bank of Japan’s new monetary stimulus is bullish for emerging market currencies and growth. European equities exposed to EM include Danone Airbus, LVMH and Daimler AG. High dividend US, European and Asian property trusts, telecoms and utilities will re-attract global investor flows. The US dollar will be pressured in October just as OPEC meets to discuss on output freeze. This means Brent crude could well rise above $50 and makes Total, BP and Shell irresistible to me – the Seven Sisters offer juicy dividends that will not be cut. At 18 times earnings, US equities are near Wall Street year end fair value targets near 2175. This means the hottest equities action in the global markets will be in emerging markets industrials, UK/French energy, Asian REIT’s. Above all, Bank Muscat still trades at 5 times forward earnings and 0.68 times book value for the sultanate’s ultimate “too big to fail” bank!
Stock Pick – The bullish case for Barclays and ING
The last $14 billion Justice Department hit for Deutsche Bank and the bailout of Italy’s Monte dei Pesci di Siena (founded in 1472 in the Italian high Renaissance and the world’s oldest bank proved that all is not hunky dory in European banking shares, despite their 30 – 50% falls in 2016. However, it is now evident that the capital markets are far too bearish on European banks now that Basel Four capital adequacy accords will be diluted at a time the EU is afraid to demand a significant increase in sector capital. There are two macro consequences in this context. One, banks will have the ability to boost dividends. Two, Bank CETI capital ratios can decline. True, I doubt if ECB monetary policy will change or Dottore Draghi’s quantitative easing magic wand will engineer either a steeper yield curve or generate more loan growth.
European banks now trade at a sector valuation of 0.7 times forward earnings. This mediocre valuation is entirely rational if the market expects a decline in net interest rate margins that is inevitable in 2017. Yet I now believe the worst sector performer in the Stoxx 600 in 2016 could well be a strategic buy sometime this winter.
HSBC analysts estimate that Barclays shares could rise 40% if noncore assets (eg Africa!) are sold, as Jes Staley has done at an accelerated pace. HSBC estimates this would mean a transfer of 8 billion sterling to core equity and a boost in the banks return on equity to 10%, something the bank has not achieved since CEO Bob Diamond was hounded from office after a public witch hunt in Westminster orchestrated by the mandarins of the Bank of England after the LIBOR rate manipulation scandals. Boys, alas, can no longer be boys in the City of London, unlike the Londonium of my youth! Barclays’s current share price does not incorporate any prospect of a valuation rerating due to a fall in non-core assets, excess capital generation and a rise in return on equity. This means Barclays shares can rise to 200 pence on the London Stock Exchange.
ING (INGA, Amsterdam) is Benlux’s leading retail and corporate bank while loan growth is mediocre at 2%, the bank generates a resilient 150 basis point net interest rate margin. The bank trades at 0.8 times net asset value, 9 times earnings, a 6.4% dividend yield and a Basel Three Tier One capital ratio of 13.6%. Unlike Deutsche Bank, I can sleep well at night owning ING as EPS growth and a fall in cost/income could well led to 15% upside for a 20% total return in the shares.
European equities were a loser’s bet in 2015-16 due to Black Death in bank shares and sixteen consecutive months of downgrades in Stoxx600 earnings estimates. Is there finally light at the end of the earnings growth estimate downgrade tunnel? True, slow growth, political risk (Article 50, the Italian referendum, the German AFD backlash, Syriza etc) and skepticism about additional ECB monetary stimulus does not warrant a valuation rerating or ignite any reversal in the 32 consecutive weeks of outflows from European equities funds.
I doubt if even an uptick in earnings growth will act as a catalyst for global institutional investors to accumulate European equities. The real strategy winner in 2016 was to only buy European companies with emerging markets exposure (Stan Chart, HSBC, BBVA, Banco Santander in the banking sector) but overall only 9% of Stoxx 600 earnings derive from emerging markets. Since I expect the Euro to fall to 1.05 after the December FOMC rate hike, I see no reason to go macro bullish on European equities. As Lady Gaga put it, a bad romance!
The next challenge for European equities is the US Presidential election. Citigroup’s political risk analyst has raised the odds of a Trump win to 40%. If Trump wins the White House in November, all bets in Europe and global risk assets are off. Que sera sera is not a viable investment strategy.
Market View – The world’s biggest bank IPO will be a winner
China’s economic malaise has led to a rise in non-performing loans (Beijing estimates 1.5% NPL, Wall Street estimates 12 – 15% NPL) in the Chinese banking system and a slowdown in financial sector profits. Despite this, I am convinced the $7 billion IPO of the Postal Savings Bank of China (PSBC) in Hong Kong will be a winner. Why?
PSBC is a state owned megabank with 500 million clients and 50,000 branches. This bank’s only comparables are ICBC, Bank of China, CCB and the Agricultural Bank of China. This fact alone means Beijing will ensure the deal is a success. Two, the deal is largely presold to strategic shareholders at $0.61. These shareholders include Alipay, Tencent, J.P. Morgan and China’s top state owned companies. Cornerstone investors own 60% of the PSBC IPO. Three, the euphoria that once made China’s Big Four banks the largest financial institutions on the planet is long gone. Chinese state banks now trade below book value. This does not mean the IPO will be a failure. Note China shipbuilding alone bought $2 billion of shares. Five, the bank has priced the IPO offer price at 4.76 Hong Kong dollars. I expect at least a 10% rise when the bank breaks syndicate and is listed on the stock exchange next week. This is the best money making opportunity in Chinese IPO since Jack Ma led Alibaba in New York all those years ago.
The ICICI Prudential IPO is India’s biggest new issue deal since Coal India in 2010 and has reportedly drawn $9 billion in bids. This makes it a waste of time to bid without a guaranteed allocation. This is a historic deal since ICICI Prudential is India’s largest private sector insurer and this is the first mature insurance deal on Dalal Street, after the Lok Sabha raised the permissible foreign stake from 26% to 49%. This is the reason the grey market price in Mumbai, is 350 rupees, above the 330 – 334 range. While the deal will be a large success upside for UAE investors is only 10% near a market top.
The Telxius IPO is interesting since its parent Telefonica will still generate 85% of its tower business while its growth potential will come from strategic alliance with other telecom service providers. Telefonica also generates 56% of Telxius’s cable business but the client roster is now as high as 200 operators. If Telefonica prices the shares at 12 euro, Telxius will be valued post listing at €3 billion, making it a compelling investment at 10 times earnings. Telxius will be the same size as its peers Cellnex and Inwit (Telecom Italia). The motivation for Telefonica to list its tower/cable businesses is to cut its colossal debt load and avert a credit rating downgrade. Telxius will own 16,000 towers and undersea cable connections in Spain, Germany, US and Latin America.
The tower business, pioneered by Crown Castle a decade ago, offers predictable revenues and high, reliable dividends. Telxius’s Achilles heel is the highly volatile undersea cable business, 60% of revenue and EBITDA since profit margins are lower and capex commitments higher than towers, with its stellar, recurrent and predictable dividends.
The real winner IPO last week was The Trade Desk (TTD) in New York, a 95% first day rise on its $15 IPO offer price. RBC and Citigroup priced this fabulously profitable ad tech firm IPO. How many UAE investors got an allocation in Trade Desk? Zero! An alternative strategy would be to accumulate the shares of rival adtech firm Criteo (CRTO). A put sale strategy could enable investors to accumulate shares in this critical, high growth online advertising infrastructure firm at 30 for a 42 – 45 target. Ad Tech could well be a $25 billion revenue market and this puppy is a market leader.
Twitter shares spiked 21% higher on Friday after CNBC reported that Salesforce and Google could launch a takeover bidding war for the embattled social media icon. I see no reason for Salesforce to buy twitter as it does not need to own it to use it as a customer service platform. Hence CRM’s 5% sell-off is a gift!