Callum Turcan helps head up Valuentum’s research product and is co-editor of the company’s newsletters. We sat down with Callum to get his thoughts on new developments in the market and economy. Let’s kick things off with his thoughts on Brexit.
Callum Turcan: Looks like the Brexit debate is coming to a close with a large Tory majority coming into the UK Parliament (EWU) after the December 12 general election, a large enough majority to provide Prime Minister Boris Johnson with more than enough room to maneuver the likely political obstacles ahead (over the next couple of months). By early 2020, it seems the UK will no longer be a member of the EU given that the incoming Parliament, in theory, should easily be able to push through his “divorce bill.” PM Johnson will no longer need to rely on support from DUP (the Democratic Unionist Party in Northern Ireland) in order to govern, freeing his hand to leave the EU with relative ease.
We’ve covered this name in a past edition of the High Yield Dividend Newsletter through a Spotlight article, UK/USA utility company National Grid plc (NGG), which likely will be a major beneficiary of the latest UK general election outcome given how these results remove the chance of UK utilities getting nationalized (a more recent policy platform of the UK Labour Party). The leader of the UK Labour Party, Jeremy Corbyn, was one of the main backers of the utility nationalization push, however, he now intends on stepping down as leader of the party (after a transition period, where he will still play an influential role in who the next leader of the Labour Party ultimately ends up being).
It will be interesting to see how NGG reacts to this new information in the coming weeks, but if the favorable technicals in NGG heading into the UK general election were any indication, it seems that investors are factoring in a much more favorable outlook for the firm going forward. NGG traded up over 6% on December 13 during regular trading hours. The GBP (FXB) is strengthening against the USD (UUP, UDN, USDU), initially reaching as high as ~$1.35 (£1 GBP buys $1.35 USD) on the election news, keeping in mind there was a time just a few months ago that investors were expecting the GBP to fall below $1.20 (£1 GBP buys less than $1.20 USD). As of this interview, GBP has fallen back a bit relative to the USD and now trades at $1.33 (£1 GBP buys $1.33 USD).
As far as market movements are concerned, the pending near-term resolution of the longstanding Brexit debacle will make it easier for the Eurozone (VGK) and the UK to focus on other major developments going forward. Whether that be the ongoing slowdown in EU economic activity–including in Germany (EWG), where the economy is barely avoiding recession–or the possible UK-USA trade deal, it appears that the market will likely approve of the decisive result of the recent UK election as it will allow major global economies to move forward (uncertainty is unwelcome, generally speaking, regardless of the outcome).
Callum, what are your thoughts on recent data coming out of the US, the jobs report, for example.
Callum: The US economy (SPY, DIA) added 266,000 jobs in November, and due to favorable revisions for September and October (which added another 41,000 jobs combined to this picture), average monthly payroll gains this year have been ~180,000. While down from 2018 levels (which were around ~225,000), that’s still well above the level needed to absorb new entrants into the job market (roughly 110,000 jobs need to be created per month to keep up). Average hourly earnings growth just north of 3% on a year-over-year basis isn’t stellar, but that is enough to beat inflation.
While part of this strength was expected due to the labor strike at General Motors (GM) ending, which helped add over 41,000 jobs in the motor vehicles and parts industry in November, what stood out in this report was the 54,000 jobs created in the US manufacturing sector. Meaning that on top of the rebound from the GM labor strike ending, there was material growth in a space coming under serious pressure from exogenous forces (waning industrial activity overseas). It’s possible that part of this strength is due to expectations for strong US consumer spending during the year-end holiday season.
Interesting. What are your latest thoughts on the US-China trade deal?
Callum: When it comes to the nascent US-China trade truce, details given on Friday December 13 were quite limited. Effectively, China has agreed to purchase an unspecified amount of agricultural products from the US in return for modest tariff reductions and the scrapping of planned tariff increases. Information out of various White House officials conflicted at times, but that’s the general gist of the accord. However, very serious hurdles remain. China may reduce tariffs on US goods as part of this deal, but it’s clear the resumption of material agricultural purchases from US farmers remains President Trump’s number one priority.
The Congressional Research Service notes Chinese imports of US agricultural and food products dropped by 25% in fiscal 2018 from fiscal 2017 levels (according to USDA data). Furthermore, the public policy research institute commented that US agricultural exports to China would likely fall further in fiscal 2019. President Trump is clearly worried about the potentially backlash that dynamic may have at the ballot box or elsewhere and is maneuvering to better ensure farmer incomes start rebounding heading into the 2020 general election.
Recently, both chambers of the US Congress passed a law that effectively is a vote in favor of an independent Hong Kong (EWH), one that abides by the 1997 accord struck between the UK and China (FXI, MCHI). The law empowers the US Secretary of State to review every year if Hong Kong is sufficiently independent and if the city-state region should maintain its special trading status to the US. If this special status is lost, it’s unlikely Hong Kong would remain the global financial hub it is today considering the likelihood that Western finance activity transitions over to offices in New York, London, Paris, Berlin, Tokyo, Seoul, and elsewhere.
That isn’t to say Hong Kong wouldn’t still be a major financial hub, the city-state would continue to play a huge role in East Asia and Southeast Asia’s financial sector, but its ability to completely globally would be severely hampered if the US shuns Hong Kong–see what’s happening to banks and the financial sector at-large in Iran, Russia (RSX), and Venezuela right now as further examples. China could potentially provide tremendous financial backing to Hong Kong if needed, along with unconventional support as well (i.e. sending troops in to perform various functions), to keep the city-state’s economy afloat but Hong Kong’s banking sector would never be the same. Trade truce in mind, the US and China continue to jockey for global influence and power, a geopolitical dynamic that will likely lead to both superpowers often being at odds on the world stage (as has been the case in the more recent past, particularly starting in the 2010s decade).
Putting down the gauntlets and agreeing to any sort of truce is still a significant step in the right direction when it comes to diffusing US-China trade war tensions. Most importantly, the chance of the trade war escalating further has decreased materially over the medium-term. The “Phase One” accord will last indefinitely, providing a basis for the US and China to continue working together for their mutual benefit, but at this point, what a “Phase Two” deal could look like is still up in the air given ongoing tensions concerning other subjects (that relates to events unfolding in Hong Kong, Xinjiang, the South China Sea, and elsewhere).
Shifting gears a bit, what are your thoughts on some specific sectors, starting with the retail REITs and perhaps the telecoms? Both industries have a number of high yielders that garner a lot of interest.
Callum: We, at Valuentum, have largely shied away from retail REITs (VNQ), due to the strong correlation between nominal GDP growth and retail sales growth (~80% of US sales growth on an adjusted basis can be explained by nominal US GDP growth).
However, as the current business cycle is long in the tooth, retail REITs are likely to face a ton of stress in the event exogenous shocks tip the US into a recession, which would likely see total US retail sales shift significantly lower. Adding on to that, I think when viewed in this light, the rise of e-commerce and the downfall of various traditional brick-and-mortar retailers starts to stand out more given the high fixed costs and operating leverage (often financial leverage as well) of these firms. After removing items that generally wouldn’t be sold online in mass quantities (refined petroleum products and automobiles top this list), e-commerce market share in the US often approaches if not exceeds 20% in key categories.
As for the telecoms, other research shops tend to see Comcast (CMCSA) as marginally more attractive than AT&T (T) given its more promising dividend growth outlook. This, however, is entirely a function of Comcast’s much lower free cash flow payout ratio in terms of total dividend payouts, which is reflected in the relatively lower dividend yield of shares of CMCSA and the relatively higher dividend yield of shares of T.
Given AT&T’s more recent streaming strategy, however, in preparing for the launch of HBO Now and divesting its small stake in Hulu, coupled with targeted cost savings, expected adjusted EBITDA margin expansion, the potential boost 5G will provide, and AT&T’s ability to use “excess” free cash flow to seriously deleverage while also paying down debt and buying back stock (a product of the colossal size of AT&T’s free cash flows), I would contend AT&T’s outlook is better than Comcast’s.
Comcast’s ability to produce content is limited, NBCUniversal simply lacks the scale that purchasing Time Warner provided for AT&T, and AT&T has top quality content for streaming (having a base of HBO subs to build off of is great) while NBCUniversal’s upcoming Peacock offering doesn’t appear very competitive at this point. While Comcast intends on spending $2.0 billion over the next two years creating original content for Peacock and marketing the new service, AT&T has committed $1.5-$2.0 billion next year to creating original content for HBO Max, followed up by additional $1.0 billion investments in 2021 and 2022. This isn’t an arena Comcast is well-suited for, which is why Peacock intends on utilizing an ad-based business model as compared to a subscription-based business model. HBO Max is slated to launch in May 2020, while Peacock is set to launch in April 2020.
My two cents: AT&T still looks like a quality company, particularly well-suited for the High Yield Dividend Newsletter portfolio. On December 13, AT&T announced it was raising its quarterly payout by a penny per share on a sequential basis while also launching a $4.0 billion accelerated share repurchase agreement. Furthermore, the company remains on track to reduce its leverage ratio (net debt-to-adjusted EBITDA) to 2.5x by the end of 2019 and 2.0x-2.25x by the end of 2022 as its free cash flow profile is strong enough to allow for meaningful deleveraging activities and share buybacks, all while making good on its generous dividend.
As the holiday season is upon us, a few companies, including American Eagle (AEO), Children’s Place (PLCE), and Dave & Buster’s Entertainment (PLAY), have warned about higher mark-down activity.
Callum: Just imagine how poorly the space would perform if US consumer spending growth were to slow down significantly or even contract. Dumpster diving on the long side in this space seems like catching a falling knife, in my humble opinion, but there are potentially juicy short idea considerations. Tailored Brands (TLRD), one of our prior Exclusive short considerations a while back, is a prime example.
Thank you for your thoughts Callum!