|By Matein Khalid| The US Dollar Index has now fallen 3.5% since it peaked on January 3. Donald Trump and his White House aides broke the 20 year taboo against speaking out against the “strong dollar” policy platitudes. The Federal Reserve did not raise interest rates and signaled no rate hike is imminent at the March FOMC. It is significant that the US dollar has fallen against every G-10 currency for four successive weeks. The Yellen Fed obviously wants to assess the scale and timing of President Trump’s fiscal stimulus. However, the US labour market is white hot as the 225,000 January payroll growth data attests. The Yellen Fed will have to respond with interest rate hikes this summer.
The Japanese yen, as usual, rose to 112 as it is hyper-sensitive to any narrowing of the yield differentials in US Treasury debt and Japanese government bonds. Trump’s “yen bashing” on Japanese current account surplus is yet another factor that will compel Shinzo Abe and Governor Kuroda to expand the Bank of Japan’s quantitative easing program to target zero ten year JGB yields. This means the yen is headed to 125 against the US dollar once the Fed rate hikes begin in the June FOMC.
Donald Trump’s sidekick Peter Navorro, China basher extraordinaire, has accused Germany of “exploiting” the US and EU with a “grossly undervalued” Euro. Frau Merkel felt compelled to refute Navarro’s accusation and reiterated that Berlin did not influence the ECB (Yeah right – or ja richtig, achtung baby!). Is the Euro undervalued on criteria as diverse as the Big Mac index, PPP or forward rate parity? Yes, thank to Mario Draghi’s money printing. The Euro, far cheaper than a stand alone Deutsche Mark, helped Germany accumulate $1 trillion export windfall. Now German inflation has risen to 1.9%. Political resistance to ECB easy money and negative German bank deposit rates will become fierce. The Euro parity trade is now verboten!
Trump’s NAFTA threat and dismal 0.4% GDP growth cap the Canadian dollar’s upside, despite the greenback swoon and $56 Brent. Stephen Poloz has no choice but to talk down the loonie and threaten an interest rate cut. Ontario factories, like Alberta oilfields, have suffered a growth shock and Ottawa’s central bank governor is a Mercantilist. This means a lower loonie in 2017.
The Aussie dollar is headed to 0.78, thanks to Canberra’s trade surplus, macro hedge fund buying and strength in industrial commodities. The latest dairy cattle epidemic in New Zealand is also a signal to buy the Aussie/Kiwi pair. If the Chinese Politburo reflates the economy of the PRC this summer. Copper and iron ore prices will soar again – and so will the Aussie dollar.
India’s 2017 Union Budget is both fiscally prudent (3.2% budget deficit target) and pro-growth at a time when Modi’s rupee reforms boost the banking system’s liquidity and widen the tax payer base. Offshore funds will accumulate Indian long duration G-Secs (and bank shares?) on Dalal Street on hopes of a RBI policy rate cut. This means the Indian rupee appreciates to 66 against the US dollar. My preferred carry trade de jour? Long rupee-yen!
While the Russian rouble was a compelling buy last February at 74, when Brent bottomed at $28, it is now fully valued at 59. The Kremlin plans to use its crude oil windfall to boost its foreign exchange reserves. This mean the next trend move in the Russian rouble is lower possibly to as low as 64 to the US dollar. However, any correction in the rouble will be limited by the Bank Rossiya 200 basis point rate cuts that will stimulate offshore investor interest in rouble debt. The OPEC oil deal, Iraqi noncompliance, Ukraine geopolitics and US shale oil supplies are also threats to the rouble.
While US dollar wobbliness on Trump’s “its killing us” comment and the FOMC’s non-commitment to a March rate hike has led to sterling’s rise to 1.2670, Article 50 and the politics of a hard Brexit put a ceiling on sterling strength next month. Sterling sank to its lowest level since the 1985 Plaza Accords before macro hedge funds accumulated cable at 1.20, when the US Dollar Index peaked at 103.8. It is tough to be a complacent long on sterling given Britain’s shocking current account deficit, the rise in inflation, Chancellor Hammond’s slashed growth forecast and rise in the HM Treasury borrowing target. Sterling volatility has fallen to 10. Time to accumulate a long cable straddle!
Macro Ideas – Country selection in emerging markets in 2017
Emerging markets have been an underperforming asset class since 2011, apart from a few spectacular country bull markets like Pakistan, Vietnam and India. In 2016, after an awful 2015, Brazil returned 56% for US dollar investor after the resignation of President Dilma Rousseff raised hopes for a reformist economic regime change. Russia was also a spectacular winner in 2016, thanks to the rise in Brent crude from $28 to $56 while inflation plummeted, even though the Kremlin still remains under sanctions for its military intervention in the Crimea and Ukraine’s Donbass.
Three major risks cloud the outlook for emerging markets in 2017. One, Donald Trump’s protectionist policies could well cause a trade war in China and Mexico. Two, fiscal stimulus in the US could ignite aggressive Federal Reserve monetary tightening and a surge in the US dollar. Three, China’s yuan has been undermined by accelerating capital flight from the Middle Kingdom. The geopolitical and financial meltdown of Turkey could also spark contagion. 2017, like 2016, will be a year where country selection and tactical timing will be essential to make serious money in this embattled asset class.
India’s Nifty has been one of my favourite emerging markets since the November rupee demonatisation shock. My recent idea to buy HDFC Bank’s New York ADR at 59 was highly profitable as the bank stock price has rebounded back to 71 in only three weeks. The 2017 Union Budget makes me even more bullish on Indian banks. Finance Minister Jaitley both lowered bank taxes and increased allowable provisioning for non performing loans to 8.5%. The new 3.2% of GDP budget deficit target is also bullish for the rupee and Indian G-Secs, ballast for banking bottom lines. Apart from banks, the BJP led NDA coalition’s plans to increase spending on rural areas by 24% is hugely bullish for Indian fertilizer shares. Indian IT services companies may well struggle as the Trump White House targets the H1-B visa program, 70% issued to Indian citizens. This is not the time to bottom fish in TCS, Infosys, Wipro or Tech Mahindra.
Russian equities are up 20% since Trump’s election, sovereign Eurobond yields have plunged from 11% to 8.25% and the Russian rouble has surged from 76 to 60 against the US dollar. My strategy recommendation to buy Sberbank, Russia’s oldest, biggest “too big to fail” retail bank was a money gusher as the bank’s shares surged 125% since the recommendation. The big macro theme de jour in Russia will be a cumulative 200 basis points in central bank rate cuts, a ballast for economic the growth rate relative to consensus and consumer shares. Russia boasts a current account surplus and has historically been resilient to Fed rate hikes.
Even though Russian equities have surged 72% since their cyclical lows, Russia still trades at a mere 6.5 times earnings, a 48% valuation discount to the MSCI emerging markets index. While my favourite Russian stocks are still Sberbank, X5 Retail, Sistema, Mail.ru and Lukoil, investors can also attain exposure via the VanEck Vectors Russia ETF (RSX), up 60% since early 2016 for UAE dirham/US dollar investors. Russia demonstrates once again that the biggest risk in Moscow is sometimes not taking any risk in its stock market. Spasiba, Sberbank!
I am skeptical about China’s prospects in the Year of the Fire Rooster, thanks to Trump risk, currency risk and the Communist Party’s political transition risk. It is entirely possible that the yuan will fall below 7 against the greenback and the Chinese GDP growth rate will disappoint below 6.5%. After four years in power, President Xi Jinping has not reformed China’s 143,000 state owned corporate dinosaurs even if he has consolidated more personal political power since any successor to Chairman Mao and Deng. China has also accumulated history’s biggest public debt load since 2008, a credit bubble that whose end game could devastate its banking system and financial markets.
Pakistan was up 45% for US dollar investors and was Asia’s top performing stock market in 2016. The Karachi stock index has now risen 400% since 2010, one of the world’s great investment fairy tales. 6% GDP growth, 3.8% inflation, Shanghai Electric Power’s KESC bid, the MSCI upgrade, the 6.7 billion IMF loan, military success against the Taliban and $3.5 billion in sovereign Eurobond new issues were all catalysts for Asia’s hottest bull markets. Karachi is still not expensive at 10.8 times earnings but the easy money has now been made in Pakistan.
Stock Pick – Money center bank shares and the allure of Citigroup
Donald Trump may have turned “market villain” with his immigration order/Mexican wall but his election win was a fabulous money making opportunity to accumulate US money center bank shares. The Keefe Bruyette BKX index is up 23% since November 8. Trump’s promise to “do a number” on Dodd Frank is hugely bullish for bank shares, as is the steepening of the US Treasury yield curve, deficit financed infrastructure spending, light touch regulation, global growth, higher trading, underwriting and corporate finance fees. It is no coincidence that Wall street bank analysts have begun to raise their 2018 earnings estimates on Bank of America, the world’s most interest rate sensitive US money center bank, Wells Fargo (banking scandal victim) and Citigroup, beneficiary of a regulatory rollback and accelerating loan growth in global consumer/corporate banking despite its Mexican exposure.
The reflation theme has even gone international European composite PMI was 54.4 in December. This could mean an opportunity to invest in selected European banks, the third cheapest sector at 12 times earnings in a Euro Stoxx 600 index that itself trades at a 15 times forward earnings, a 200 basis point discount to Wall Street. The ECB is still accommodative, German inflation and Bund yields has begun to rise and banks such as Barclays PLC and Societe Generale still trade below tangible book value. Excess capital return is another theme that will become very evident as the Federal Reserve’s CCAR stress test season begins. It is highly probable that the payout ratios of State Street, Key Corp and Fifth Third Bankcorp will rise. Bank of New York Mellon, with $30 trillion in assets under custody and $1.6 trillion AUM, is another undervalued banking colossus on Wall Street leveraged to higher interest rates and trading volumes.
I had flagged Citigroup at 45 in October as America’s most undervalued money center bank. However, not in my wildest dreams did I imagine that its shares would rise 25% in the next two months, thanks to Trumpmania on Wall Street. Citigroup has corrected to 56 as I write as Trump’s dark side on trade/immigration spooks the stock market. Since Citi’s tangible book value was $64 at year end 2016, New York’s most fabled money center bank trades at 0.86 times tangible book value, a discount to Goldman Sachs and J.P. Morgan at 1.2 – 1.3 times tangible book. Is Citi’s valuation discount justified? Yes. Citigroup has systemic exposure to the emerging markets and owns a major subsidiary Banamex in Mexico while its returns on equity lag both the Houses of Dimon and Blankfein.
However, Citi also benefits more than any other bank from Trump’s pledge to “do a number” on Dodd Frank (or Dodd Frankenstein, as some call Obama’s punitive post crisis banking regulation) Citi has traded at an average multiple of 10.3 times earnings in the past five years so its valuation metrics are in the “fair value” range at 54 – 56. However, financial markets discount the future, not just extrapolate the recent past. Citi’s fourth quarter EPS of 1.14 beat consensus. Fixed income and foreign exchange trading revenues surged by 35%, while equity derivatives rose by 20%. Citigroup now ranks third in the global M&A league tables and improved its market share in investment banking. The wind down of Citi Holdings continues to generate excess capital. True, Global Consumer Banking net profit growth has been mediocre but North American consumer banking is on a roll, thanks to the vibrant credit cards and mortgage businesses. The Costco card deal has begun to create value.
Citi will increase its share buybacks after the 2017 Fed stress tests to 5% of the share count, a scenario not priced into current prices. I see no reason why Citigroup 2017 earnings cannot beat the current 5.20 EPS consensus. In fact, if the ten year US Treasury note yield rises to 2.80% and the Republican Congress green lights fiscal stimulus/Dodd Frank moratorium, I see no reason why Citigroup should not trade above tangible book value for the first time since its spectacular near failure and Uncle Sam TARP bailout in November 2008. This is not wishful thinking as these multiple catalysts could mean analyst EPS estimates for Citi could rise at least 10% this summer and autumn. Mexico is a drag, but not a deal breaker for a valuation rerating. This is not the time to abandon Citi as its shares rise to their natural level – tangible book value at 64.