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The financial markets have finally cottoned on to the increasingly sordid political realities created by the Trump White House. Trump could well be impeached for obstruction of justice if he tried to pressure FBI Director James Comey to drop an investigation on disgraced General Michael Flynn’s contacts with Russian intelligence before the election. The appointment of a special prosecutor to investigate the scandal means Washington is now mired in a constitutional scandal that will make it impossible for the Trump administration to enact its tax reform/deregulation agenda. This was the reason the Dow Jones index plunged 372 points, the ten year US Treasury yield sank to 2.20%, the NASDAQ fell 158 points and safe havens like the Swiss franc, Japanese yen and gold surged against the US dollar on Wednesday. The political scandal in Brazil and the meltdown in the Bovespa and the real has only amplified the angst in risk assets. Is the Wall Street sell off just an ephemeral market or something more ominous, a trend change, requiem for the bull market?
The US stock markets’ ‘irrational exuberance’ since the election was based on sound macroeconomic logic. First quarter earnings were a beauty. Jobless claims are at a 28 year low. Housing, gasoline prices and wage growth still anchor consumer spending. Silicon Valley’s tech revolution once again has mesmerized the world. Yet Mr Market more than priced in all the good news at 18 times earnings and stratospheric valuations in Dr Schiller’s CAPE index. The stock market discounts the future, not extrapolates the recent past – and the future has darkened since Robert Mueller’s investigation could well lead to the political demise and possible impeachment of Donald Trump. This is Watergate 1974 all over again, not exactly a benign backdrop for the US or world economy at a time of epic geopolitical tensions in North Korea, Syria and Iran. Treasury Secretary Steve Mnuchin’s testimony to the Senate Banking Committee, while suave and optimistic as befits an ex Goldman Sachs partner, has not exactly reassured Wall Street. Thursday’s price action is a classic dead cat (actually kitten!) bounce though the Dow rose 140 points on Friday. Trump’s decision to renegotiate NAFTA creates yet more uncertainty in international relations and trade policy – and his decision to go to Israel, Saudi Arabia, the Vatican and Brussels on a state visit will not end the turmoil in Washington.
Financials were the quintessential Trumpflation sector since faster economic growth, a repeal of Dodd Frank, tax cuts and a steeper US Treasury bond yield curve fatten bank profits. So it was no coincidence that Bank of America and Goldman Sachs, the poster boys for the post-election money centre bank rally, both lost 5% in a single session on Wednesday. I believe financial stocks must not roll over or the bull market is toast. The fall in the US Dollar Index below 98 and the ten year US Treasury note at 2.20% tells me that the capital markets have scaled down their expectation of aggressive Federal Reserve monetary tightening this autumn. Will Janet Yellen raise the Fed Funds rate at the June FOMC? Yes, the logic of the Fed’s dual mandate has flashed green. Will a political crisis in Washington shape the time of the Fed’s balance sheet normalisation? Yes. This is the reason I am no longer willing to accept the risk reward calculus in most money centre bank shares and now await Citigroup’s fall to 56 or Goldman Sachs below 200.
Technology’s megacap darlings (FANG) and the Philly semiconductor index have also been fabulous money makers in 2016 and 2017. In fact, it is impossible to trade the S&P 500 index or NASDAQ without a continual real time grasp of the bull-bear debate in Facebook, Apple, Netflix, Google and Amazon. These are the megacap colossi who dominate the world’s biggest stock market indices. If the bull market dies, expect carnage in these Big Five shares as the sheer tsunami of leverage index selling hits Wall Street. Donald Trump’s fate is now in the hands of the 535 men and women in Capitol Hill who run American politics. The fate of the bull market on Wall Street also could be in the hands of the Congress – and the special prosecutor who will investigate whether Donald Trump colluded with the Russians, and then lied to the American people about it. The ghost of Richard Milhous Nixon now haunts Wall Street.
Macro Ideas: Pakistan’s financial fairytale continues!
Necklaced by the Margalla Hills, with its white marble mosques, heavily guarded diplomatic enclave, its geometric grid and lavish mansions, Pakistan’s capital is an unlikely host to one of the most exciting growth stocks I have ever encountered in the frontier markets. I have made no secret of my conviction, expressed ad infinitum in my column since 2012, that Pakistan (and Argentina) are a frontier market fairytale. Pakistani shares are up more than 400% for US dollar investors since 2012, making the Karachi stock exchange one of the world’s best performing stock exchanges. Of course, it was not money making ideas but my love for my darling father, my lifelong friend and mentor that took me to Islamabad.
I got an invaluable feel for the real time political and economic realities of Pakistan. In the past three months, I have been fortunate to talk to some of Pakistan’s top industrialists, diplomats, money managers, bankers and even a historian whose own father was Zulfiqar Ali Bhutto’s Intelligence Bureau chief. The spectacular bull market on the Karachi exchange (now 40% owned by Shanghai Shenzhen) reflates these new macro realities. Karachi was Asia’s best performing stock exchange last year, up 46% in 2016. Yet Pakistan still trades at only 10.8 times earnings, offers a 7.6% dividend yield and earnings growth of 15%. True, the Pakistani rupee is a tad overvalued and can well depreciate to 12 against the US dollar. Yet Morgan Stanley has upgraded to Pakistan to emerging market and the index will attract at least another $300 million in tracker funds. Conversations with friends tell me hundreds of new foreign fund managers have opened institutional new accounts in Pakistan. The megacity by the Arabian Sea, the city of my birth, is also the epicentre of the most frenzied property booms in Asia outside Hong Kong.
I have an emotional reason to be attracted to Shifa Hospital in Islamabad. After all, the world class cardiologists there saved my wonderful daddy’s life. However, Shifa is easily the most attractive health care proxy in this nation of 190 million people with a quantum increase in affluence, third party medical insurance, the planet’s highest fertility rates and a chronic shortage of hospital beds. I remember Shifa shares trading at 5 rupees in 2003, just after the trauma of 9/11 and the US invasion of Taliban ruled Afghanistan, at the start of Pakistan’s darkest decade in its history.
Shifa Hospital now trades at 265 rupees or 3 times book value. Shifa trades at 16 times forward earnings. The market cap is $140 million dollars. The hospital operator has a scalable model that can easily deliver 20% earnings growth (CAGR) in the next five years. With its major specialties, its diagnostics labs, I can well understand why a Dubai private equity colossus tried (and failed) to buy a controlling stake. I believe Shifa Hospital can rise to 400 rupees by end 2018.
My father was trained in the aristocratic Lloyds of London firm Willis Faber Dumas (the syndicate that insured the HMS Titanic!) in Britain and has used his contacts in the London reinsurance market to help government ministers on complex multi-billion dollar projects. Reinsurance is mission critical to the success of the $46 billion China Pakistan Economic Corridor, which will also transform the energy sector and add at least 2% to the structural growth rate. Thanks to Xi Jinping, Pakistan is South Asia’s new tiger economy, a vast hub that will link Sinkiang and Central Asia to the Arabia Sea.
I expect the Karachi stock index will trade between 45,000 and 65,000 in the next twelve months, with Fed rate hikes leading to a fall in both equities and the Pakistani rupee. My base case is that Nawaz Sharif will be reelected in the 2018 election, despite his progeny’s Panama offshore accounts and Mayfair apartments (hopefully, they hedged sterling risk!). Relations between the Prime Minister and Army House are fine since General Bajwa is a consummate professional solider who will vanquish the terrorist enclaves in North Waziristan. Pakistan is also the world’s only “geopolitical too big to fail” state for Beijing, Washington, Riyadh and Abu Dhabi. The Chinese commitment to Pakistan also makes a land war with India unthinkable, so it will hopefully lead to a rapprochement between Islamabad and New Delhi. After seventy years, Kashmir cannot be allowed to steal the future of 1.4 billion human beings on both sides of the Radcliffe Award. The doctors at Shifa saved my daddy’s life. I appeal to the military to save Commander Jadhav’s life. The hangman’s noose only debases all of human kind.
Stock Pick: UBS and Credit Suisse shares are overvalued
The Swiss brand in global private banking and offshore wealth management was severely damaged by the $57 billion in losses amassed by UBS in its proprietary trading and capital markets businesses under disgraced former chairman Marcel Ospel and CEO Peter Wuffli. UBS was no ordinary Wall Street investment banking gunslinger but the world’s largest wealth manager, the crown jewel of the Swiss Confederation’s $3 trillion offshore banking industry. UBS only survived due to a secret swap line arranged by the Federal Reserve with the Swiss National Bank. An entire generation of Swiss bankers were humiliated in the full glare of the world financial markets. UBS was later fined $750 million by the Justice Department for helping US clients evade income taxes, lost $2 billion in a rogue trader scandal and was ensnared in the LIBOR rigging scheme and chose to exit global investment banking, axing 10,000 jobs. UBS was forced to reinvent its business model under its new chairman Axel Weber, former head of the German Bundesbank and CEO Sergio Ermotti in 2012.
Five years later, the new UBS is rooted in its role as one of the world’s top private wealth managers, with more than $1 trillion in assets under management (AUM) in the United States (thank you, Paine Webber!) and 300 billion Swiss francs in Asia Pacific booked out of Hong Kong. I have no idea how much UBS manages in Dubai but the bank sure puts on some great Diwali parties. It is not often I see staid Swiss-German private bankers dancing to Bollywood hits in kurta pajama. Grutzi, Herr Private Bankerji!
UBS trades at 16.8 Swiss francs in Zurich as I write. This means UBS trades at 11 times earnings and 1.3 times tangible book value, a rich valuation at a time when the global asset gathering model faces myriad market, competitive and regulatory risk. I expect UBS shares to fall to 14 Swiss francs this summer. Why?
One, UBS return on tangible equity was only 9% in the first quarter, far below Ermotti’s 15% target. Two, UBS has provisioned 2.9 billion Swiss francs for litigation and regulatory compliance provisions, whose cycle has not peaked. Three, the oil crash, recession and banking cash crunches have gutted new money inflows from the GCC, West Africa and Russia, misnamed ‘growth markets’ for wealth management. Four, the US business experiences $3-4 billion in seasonal, tax related client outflows. Five, private clients are still risk averse in the eighth year of the US equities bull market. One third of UBS managed assets are in cash, laments Signore Ermotti.
Six, the G-20 common reporting standards will make tax evasion impossible even in offshore markets. Swiss banking secrecy no longer exists, at least not for Uncle Sam or the EU. Seven, cross-border tax ‘regularisation’ could well cost UBS 14 billion Swiss francs in client outflow. Eight, UBS is a ‘too big to fail’ global systemic risk bank. Hence it has to maintain a Basel Tier One capital ratio of 14%. Nine, negative forward rates will pressure margins in UBS’s Swiss personal/corporate bank. Ten, the flattening of the US Treasury debt/yield curve is negative for US profit growth. Eleven, UBS return on equity peaked in 2014 and has since plunged 30%, a bad omen. UBS shares are vulnerable to a valuation derating, the rationale for my 14 CHF target. Note that, after $5 billion in losses, Singapore sovereign wealth fund JIC slashed its strategic stake in UBS.
Credit Suisse shares were a no brainer buy at 10 Swiss francs last July. At 14.6 Swiss francs, the bank trades at 10 times earnings and 0.9 times tangible book value. The bank has announced a 4 billion capital raise that will dilute shareholders by at least 12%. While the capital raise removes the necessity of a Swiss Universal Bank IPO, the fundamental problem at Credit Suisse is a low profit product mix, bloated costs, an investment bank that needs to be downsized and suboptimal scale in international wealth management and two successive years of negative returns on equity. Credit Suisse cannot be a credible wealth manager with a Basel common equity Tier One ratio of 11.7%. The finest Swiss bank I ever dealt with was Bank Wegelin of St. Gallen, founded in 1746. Yet after the legal Gestapo of Washington targeted the bank, Wegelin was forced to liquidate. What a pity, what a world!
This article was originally published in the Khaleej Times.
