Introduction - reasons for a US-China deal and for risk-on sentiment to develop outside of the US
With Europe intensifying tariffs on Chinese steel last week, and a drumbeat of weak economic news out of China, I think that China needs a deal. And politically, President Trump needs a deal; both sides need one soon. In addition, there are continued hopeful signs regarding North Korea. So I expect a deal within a few months, though not necessarily before some more angst, such as in relation to the upcoming deadline for intensified tariffs. I expect a deal would be risk-on for emerging and Asian markets, and that's a reason for the main thrust of this article.
Other reasons exist to think of a weaker USD as likely:
Financially, the US interest rate structure and current economic performance are so far ahead of its peers that a reversion toward the mean, i.e. toward a weaker USD, is, I think, reasonable to begin to bet on. That's especially so given that a long-USD posture is the most crowded long bet amongst global money managers according to a recent survey. The last time a long-USD trade was the most crowded one, in 2017, the dollar plunged. Also, US equity valuations are well above average, but those in several other parts of the world are at or below their usual levels. Today may be (far?) in advance of the optimal time to make such a commitment, but it may not be too soon to begin thinking of the topic, thus I'm contributing this article.
The "real" USD is stronger than the USDX
In contrast to the well-known USDX, which is dominated by the USD-Euro cross and other major economies pairs, the USD's strength is at multi-decade highs as judged by the broad trade weighted USD index:
As you can see from the chart below, Merrill Lynch surveyed fund managers believe the dollar is overvalued. This is the highest percentage that believe the dollar is overvalued since 2002.
Interestingly, while money managers are positioned heavily long the USD (see Introduction), which was their positioning in much of 2017 (when the trade failed), they also think it is overvalued. My inference: they are momentum traders, long the USD while believing their position is against the fundamentals.
I'll tend to invest against that sort of set-up.
Interim summary - setting the stage
Thus I am looking for plays on both US-Chine trade improvement and plays on relative weakness of the USD.
So I'm looking for new investment opportunities that meet three criteria:
- will benefit if the US and China come to a trade agreement rather than continuing the trade "war"
- are denominated outside of USD
- have cheaper valuations than the US stock market has.
Next are three very different opportunities I have starter positions in, totaling in aggregate about 1% of assets. If fundamentals and technicals start moving their way, more in the same or related investments will follow.
The following discussions are brief and introductory, beginning with the one closest to China:
Bulking up in South Korea
I look at North Korea's international threats and actions as largely controlled by China. So, when NK threatened the US with nuclear attack, it was China all along, and therefore potentially serious. And with US-NK relations thawing, it's a good sign for continued moves to peace in the Korean peninsula. If peace comes to Korea, and NK and SK develop normal relations or even reunify (that's not a prediction), there will be complex economic ramifications for the south and its companies. Not all of them will be positive, thinking of the reunification of Germany nearly 30 years ago as an example. But longer term, I think it will be good for the South and its stock market. Here are the metrics for the iShares MSCI SK ETF (EWY):
- P/E = 8.7X
- P/B = 1.0
- management fee = 0.59%.
The ETF's holdings are dominated by Samsung Electronics (OTC:SSNLF), at 21% of assets. This is roughly equal to the total weights of the next largest 8 names. Farther down the list are other Samsung companies. So that's one clear risk, especially with the continuing downbeat news out of much of the electronics industry. Another risk is the broader downtrend in the pace of export business in South Korea and economic weakness in China and much of the world.
I look at this ETF as a long term play that has substantial growth potential over the years, as current valuations appear to be discounting a significant recession at this point.
Other ways to play this type of investment exist beyond EWY, which are relevant given the Jan. 14 WSJ article,
Regional stock valuations are at their lowest levels in years.
So it's not only Korea. Broader Asian indices, and possibly those including or limited to China itself, may be considered as value plays. Again, global and regional economic trends may make the current period not ideal. But one never knows tomorrow's new, does one?
Moving much closer to home and less compelling on the value play are the Canadian rails, which are assets that boast reasonable but not cheap valuations but which I think will roll on virtually forever as earning assets.
Best railroading territory in the world?
In contrast to EWY as a play on good things happening between the Koreas and the US and China, this is a story where the US-China situation is secondary, but good news would be a kicker. These stocks are to a degree plays on the Canadian dollar rebounding. Here is the CAD versus the USD on a 6-year stack:
This chart shows a 25% drop in the CAD since 2013, a big move especially given sound finances of the Canadian national government. Canada never did QE and thus does not need to reverse it. A technically-encouraging aspect of the above chart is that the green line is positive, representing commercial hedgers accumulating long positions in the CAD. Going back to 2013, this set-up has always led to at least a modest rebound in the CAD. Especially for the smaller Canadian Pacific (CP), most of what the Canadian rails do is transport stuff from one part of Canada to end users within Canada. The larger Canadian National (CNI) has a significant part of its network around Chicago and down the Mississippi to the Gulf of Mexico. I am long CNI and may go long CP. Brief comments on each follow. Note, in looking at US data sources, many provide stock prices in USD, as the stocks trade widely on a US exchange, but then provide sales and earnings in CAD. This makes P/E's look lower than they really are. I have tried to get the numbers and translations correct; please let me know of any errors in the following commentary.
Canadian National Railway
CNI reports Feb. 1. Its 9-month data is expressed in CAD but CNI uses US GAAP. Diluted EPS were $4.31 versus $3.78 in the prior 9-month period. However, probably in this case it is more relevant to ignore gains from asset sales this year and make the comparison $4.01 versus $3.79. Revenues were up, partly from price and partly from ton-miles. Efficiency (operating) ratio rose (worsened) to 59.5% due primarily to numerous capital spending initiatives - at least that's the company's story at this point. Adjusted diluted EPS for Q4 2017 were $1.20. Thus the adjusted diluted TTM EPS were $5.21 CAD. Using the current $0.755 CAD/USD exchange rate gives TTM adjusted EPS of $3.93.
CNI's EPS guidance for 2018 is in the $5.40 CAD range, or about $4.00.
So, CNI is definitely not cheap on an EPS metric; it's above a 20X TTM P/E. While the company insists that its operating ratio will drop again to its more accustomed range (due to precision [scheduled] railroading or PSR), my view on this is that simply on fundamentals, it's an average blue chip. But I went long a starter position as I expect it will react well to the ultimate improvement in US-China (and therefore Canada-China) relations and to the potential snapback in the CAD-USD cross.
Consensus EPS in CAD for 2019 and 2020 are 6.25 and 7.00, which I calculate would translate to P/E's of 17.5X and 15.6X at the current exchange rate.
CNI may be the single best railroad property in the world. I expect its profit stream to grow in real terms and with some inflation essentially forever. CNI has very little exposure to coal. At $82.38 on the NYSE at Friday's close, it is down 10% from its high and boasts a strong long term chart.
I am also considering CP.
CP has joined the PSR push and under cover of a strong global economy in 2018 (at least, most of the year), has brought its operating ratio down substantially. Whether this decline to below 59% in Q3 is sustainable is to be determined, but the trend under new management is encouraging. CP has a lower P/E than CNI, both on trailing and consensus forward EPS, but that might be a permanent situation. CP trades at a 1.0% dividend yield versus about 1.6% for CNI.
Note, the proposed USMCA successor deal to NAFTA may affect CNI or CP in ways I cannot predict.
Moving to a very speculative situation, there is the country of the future that may always remain so.
Party in Brazil (stocks)?
This is on the highly speculative side, but sometimes speculating with 'mad money' makes a buck or two. In any case, after a punishing recession/depression, Brazil's small caps may rebound. Here is the 5-year chart for the larger of the two such ETFs I am taking a flyer in:
You can see that this Van Eck Brazil Small-Cap ETF (BRF) dropped about 70% in USD terms from 2014 to 2016, worse than the SPY in the Great Recession. Now it has rebounded partially, and might have some tailwinds if:
- a US-China deal revitalizes the global economy
- the USD weakens against the Brazilian real
- the election of Jair Bolsonaro as President reflects a tilt toward a more business-like state of affairs in the country.
There is a slightly smaller but more diversified ETF I also own some of, the iShares MSCI Brazil Small Cap ETF (EWZS). Both BRF and EWZS are under $100 MM in market cap. In contrast, EWY, the Korean ETF discussed above, has close to a $5 B market cap. So, beware or at least be careful with these little funds. If interested, check them out. I do consider EWY a serious investment, and clearly CNI and CP are mainstream investments, but small cap Brazil is another matter. Note, Brazil was trading down at mid-day Monday, so I expect these stocks to open down on Tuesday. My guess is that this down move reflects downbeat economic news out of China and perhaps elsewhere rather than specific news out of Brazil.
All investing has risks. Low P/E investing, as with EWY, has certain risks, and does high P/E investing with CNI or, less so, with CP. Leaving the well-trodden path to invest in secondary markets in Asia, or in South America, may be worth the risk, but permanent impairment of capital is indeed one of those risks.
Note, the great majority of my personal funds are in risk-off investments and are heavily US-centric. For now, the investments mentioned above are hedges, and may be increased, decreased or sold in full at any time.
The US economy and US dollar have outperformed their peers for some time. I'm good with that as a general pattern. But markets may have over-discounted this situation. Think back to September 2008 and how horrible the US system appeared then. Now my sense is that the pendulum has swung too far in the pro-US investment arena. Thus, I'm edging away from an almost all-US-based investment strategy to one that is more international. The above provide some opportunities I found interesting, and I hope you find them worthy of some consideration on your part.
Thanks for reading and sharing any comments you wish to contribute on this topic.
Submitted mid-day Monday.
Disclosure: I am/we are long CNI,EWY,BRF,EWZS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.