|By Matein Khalid| I was in a pensive-philosophic mood last week as I decompressed from a trip to a hauntingly beautiful post Soviet country in the Caucasus, the land that produced Koba from Gori and Prince Pyotr Bagration, the fallen hero of Tsar Alexander’s imperial guard at Borodino. Yet Georgia gave me time and perspective to think about the financial firestorms on Wall Street, Marounuchi, the Gulf and the emerging markets, the dark alleys of the planet. I am no Cassandra or pessimist though I am proud to call myself a lifelong student of Dr. Von Hayek and Ludwig von Mises. Yet I see madness in global equities now that the mother of all short covering rallies is over in October. So the S&P500 trades at 18 times earnings with 1% EPS growth. Wicked. The Russell 2000 is 22 times earnings even as high yield spreads widen and the Fed rate hike cycle tightens liquidity premia. I remember the words of Texan wildcatter T. Boone Pickens when he addressed us at Wharton. “Boy, I was born at night. Only just not last night”.
The US economy, while robust, has slowed to 2%. King Dollar will go on a rampage once Super Mario and Comrade Fu Manchu at the PBOC accelerate their printing presses. Emerging markets are up 12% in October but still compelling shorts as earnings tank and Brent/commodities fall to 2009 lows. China’s $10.4 trillion economic colossus has sent a big chill across world trade and even Singapore is on the brink of recession. Forty countries count China as their top export destination. Forty, no typo. A world in which crude oil falls 60% and the US Dollar Index rises 24% in twelve months is a world where deflation risk haunts the central banking gnomes. The Swiss franc debt yield curve is negative out to 10 years for good reason. Deutsche Bank, Credit Suisse, Barclays, Stan Chart, HSBC and even Citi trade well below tangible book value. At 14, the Chicago Volatility Index (VIX) underprices fear and overprices greed. So I say sayonara and whisper my requiem for Goldilocks. King Dollar had mauled and bloodied her and now the Chinese will kill her. That much, at least is certain. In any case, President Trump/Clinton will turn goldilocks into goldigridlocks.
I often read Voltaire’s Candide to make sense of the world in pre-revolutionary Bourbon France, in the ancient world of Diderot, de Ricaud, Mirabeau and the Comtesse du Barry. So is this the best of all possible Panglossian worlds in the stock market? Absolutely not. Late cycle economies goosed by seven years of easy money fall victim to the slightest shock. China is the biggest credit shock in human history, on a quantum scale higher than 2008 or even 1933. Seven years after Lehman/Creditanstalt, the wolf is here.
I see alarming ghosts of bubbles past in the money bazaars. The world has gorged on cheap debt even as Treasury TIP yields flash a deflation SOS. The ECB and the Bank of Japan wage the currency wars. Merger mania goes ballistic on Wall Street, as Michael Dell just proved. High yields spreads have widened as growth stalls. Amazon trades at 510 times earnings while the Kremlin trades at 5 times. Putin has resurrected the ghosts of the Tsars/Sovietski Soyuz apparatchiks in Syria’s Alawite heartland but forgotten the ghosts of Brezhnev’s Red Army, victors of Stalingrad and the Kursk, vanquished in Afghanistan. The post Ottoman Arab world is in epic ferment. The South China Sea could be the world’s next tragic Sarajevo.
The IMF has slashed global growth forecast once again. The Chinese Politburo is in a state of panic after last summer’s failed intervention in the Shanghai/Shenzhen meltdown. China’s GDP growth will now fall to the pre Deng, Mao and Zhou En Lai era, 3 or 4% as the shadow banking (Ponzi, Chow Mein!) chickens come home to roost. The Middle Kingdom will not hard land, it will belly crash. As after Tiananmen Square, the Asian flu or Lehman, China’s Confucian autocrats will flood the money markets with a tsunami of cash and the yuan will tank. The dollar will not just be king but it will be the world’s only King of Kings since the Shah of Iran jetted out of Tehran in 1979. So even while I hunt Indian e-commerce unicorns with my Saudi friends, I cringe at Uber’s private market valuation of $50 billion with no hope of an IPO window. Bubbles create bubble gum financiers. So will Heidi yodel in a Benares silk sari at Swiss private bank Diwali Nights? Or will I nurse my ursine nightmares alone at Boogie Nights while the lights go out in world finance all over again?
Macro Ideas – Pakistan is a frontier market fairy tale!
Fairy tales rarely happen in frontier markets but Pakistan since 2010 is an exception. The Karachi stock index generated a phenomenal 25% per annum return in US dollars for five years in a row. It is a pity that so few investors in the UAE trade Pakistani equities but the cognoscenti have made a fortune in Pakistani banks, current companies and leasing firms. Amid all the global hype of Modinomics, Zardarinomics proved far more profitable for international investors. The real catalyst for Pakistan’s spectacular bull market were the economic stabilization policies adopted by General Musharraf and ex PM Shaukat Aziz a decade ago.
Pakistan’s unique investment appeal to me lies in its “too big to fail” geopolitical significance for two superpowers (the US, China) and two Gulf oil exporters (Saudi Arabia, UAE). UAE’s financial lifeline prevented a Pakistani sovereign debt default in the late 1990’s after the US Congress imposed sanctions in the wake of the Baluchistan nuclear test. Saudi Arabia sold crude oil at below market rates to Pakistan since the reign of the late King Faisal, in whose memory a major city in Punjab was renamed. Washington was Pakistan’s Cold War ally and financial/security patron since September 2001. China has just promised $46 billion FDI in a new Silk Road economic corridor that straddles Sinkiang. This is the reason I believe Pakistani assets are grossly undervalued by a sovereign credit risk premium that is draconian, even though it is underwritten by Washington, Beijing, Riyadh and Abu Dhabi. No other emerging market in the world can boast such stellar geopolitical patronage.
This is the reason the IMF approved a $6.7 billion structural adjustment loan for Islamabad. This is the reason the Pakistani government was able to raise $2 billion in Eurobonds and $1 billion in sukuk in the international capital markets. The plunge in oil prices has been a windfall for Pakistan’s current account deficit and inflation rate. Inflation has plummeted from 8.4% in 2013 to only 3.8% now. This enabled the State Bank of Pakistan to reduce its policy rate to a 42 year low of 6%. The Pakistan Army is winning the war against the Taliban. Nawaz Sherif’s pro-business Cabinet has imposed fiscal discipline and earned the respect of the local financial elite on a scale impossible under the populist Sindhi feudal dominated PPP. Profit growth in Pakistani corporates has been as consistent as it has been spectacular, despite a chronic power crisis. Relations with India have improved under Modi, as has the domestic security milieu. Yet Pakistan still trades at only 7.8 times forward earnings, making it my favourite frontier market Cinderella in the world.
Wall Street folklore argues that “the big money is made when things go from Godawful to just plain awful”. This is what happened in Pakistan since 2008. The Philippines was rerated by the global markets after President Aquino widened the tax base, slashed the budget deficit, fought corruption and attracted global investors with a credible, consistent reform agenda. This macro valuation rerating has not yet happened in Pakistan. But it will, if the military high command finally defeats the Taliban and Nawaz Sharif accelerates his pro market reform agenda. Manila’s valuation soared from 8 to 19 times earnings when President Aquino changed the macro sovereign zeitgeist. This can also happen in Pakistan.
Pakistan has finally evolved into a mature parliamentary democracy with stable military-civilian relations, a vibrant free media and independent Supreme Court. Pakistan’s sovereign credit rating will rise and 200 million citizens finally hope for the social justice envisioned by its founder, the Lincoln’s Inn constitutional lawyer (and my ancestral kinsman) Mohammed Ali Jinnah. This is a wonderful dream that transcends mere criteria of money making for me. A stable, prosperous, democratic, moderate Pakistan at peace with India is an asset to a subcontinent whose time on the global stage has finally come.
The privatization of Habib Bank was a global success. Earnings growth will top 15% in 2016. Mutual funds have spawned an embryonic “equity culture” a MSCI upgrade is inevitable. Karachi’s first REIT was listed on the stock exchange. The oil crash is a financial bonanza. There is no shortage of potential triple bagger shares in Pakistan. I expect to travel to the city on the Arabian Sea where I was born but not visited since 1996 multiple times in the next twelve months.
Stock Pick – Microsoft was a winner idea but not Barclays PLC!
My recommendation to buy Microsoft at 43, published in a strategy column on September 21, 2015, proved a fabulous winner. Microsoft now trades at 54 or a stellar 26% profit above my buy price in only a month. This was my megacap software winner idea in 2015.
Satya Nadella has repositioned Microsoft for the new computer, cloud, mobile and consumer realities of the twenty first century after a decade of Windows/Office centric drift under Steve Ballmer. While the Nokia handset deal was a disaster, Nadella has done his best to mitigate the damage from Ballmer’s flawed hardware strategy. Unlike Ballmer, the new CEO has articulated a vision for Microsoft that moves beyond the PC server to the software centric cloud device model while using Windows/Office as a cash cow, with $85 billion now in the war chest.
As I expected, Microsoft’s earnings were goosed by the Windows10 adoption, while Azure revenues doubled, a testament to the cloud revolution that will remake Silicon Valley. The PC product cycle is a predictable train wreck but the installed base for Windows10 is now 110 million. Azure (like Amazon Web Service) are the real growth franchises in global cloud computing. The Achilles heel of the new Microsoft model are Xbox consoles, Surface tablets and Windows Phones since they hit operating margins now boosted by clouds/data software/services. This is an issue Nadella must address. Office 365 is a key product cycle inflection point.
The easy money in Microsoft has now been made since I recommended the shares at 43. I am nervous about the Evil Empire of Redmond at 19 times forward earnings and a $423 billion market cap despite Satyamania on Wall Street. Take profits. Let some other genius buy Mister Softy here at 54.
My bearish call on the Ferrari IPO was vindicated with a vengeance after the shares sank 11% (below the issue price) last Tuesday. A valuation of $11 billion or 35 times earnings for Ferrari makes no sense to me since even the world’s ritziest luxury brand companies trade barely above 20X earnings. The dual voting structure, production costs, plunge in GCC/Russian petrocurrency revenues, China’s hard landing a rise in asset volatility (correlated with a nervous IPO market). O sole mio, mamma mia, can the Ferrari IPO drop 20% below its IPO price? Molto dispiachi, amici! It can and it will. In fact, it already has. Danke schön, UBS.
I fell in love with Barclays PLC last year but Barclays did not love be back. The shares have drifted in the 230 – 280 pence range in London while incoming chairman John McFarlane sacked CEO Anthony Jenkins as profits sagged and a J.P. Morgan investment banking chief James Staley just took over as CEO. The New York ADR trades at 14.20 or 0.75 times book value. Jenkins, as a lifelong retail banker, “was a modest man with much to be modest about, to recycle Churchill’s view of Clem Attlee. Jes Staley is a right choice to lead Barclays Capital’s turnaround, now that the bank has finally exorcised the demons of the LIBOR manipulation scandal. Yet Barcap in 2015 is subscale on a global basis, unlike Goldman, Morgan Stanley or J.P. Morgan. A 12% composite return on equity (ROE) target is a pipe dream for now.
McFarlane tripled Aviva’s share price in his tenure. He will focus on UK High Street banking, mortgages, corporate banking and Barclaycard where 12-15% ROE is credible and happening. The commodities bust could mean bad loans in Absa, notably in South Africa and Nigeria. Management’s real challenge is to reinvent Barcap in the less leveraged, less profitable, overregulated investment banking and debt capital markets milieu of 2015. Barcap has shrunk from 50% to only 30% of risk weighted assets. The Fed rate hikes will fatten net interest rate margins. Sure, ring fencing will increase funding costs and Basel III will hit EPS growth. 3Q earnings were a lemon, with 3.1% ROE. The City speculates if Staley needs to raise capital. I doubt it, though a Basel Tier One capital at 11% is iffy. This puppy will be a long, hard slog and optimism is best expressed via high delta put option selling programs.
