TheChek News Flow

Chinese leader favours faster pace towards reunification

Beijing’s daily dispatch of fighters, drones and warships towards Taiwan is stoking suspicion that Xi Jinping intends to seize the country by force.

So when China’s president kicks off the 20th Communist party congress on Sunday, nothing will be more closely scrutinised than what he says about the island.

Xi has tied his legacy to unification, describing it as integral to his plan to achieve a “great rejuvenation of the Chinese nation” by 2049 — a century after the party first set its sights on Taiwan.

As the congress prepares to make Xi the first party leader since Mao Zedong to stay at the helm beyond two terms, policy experts believe Beijing could hasten progress towards that goal.

“Beijing will not wait for Taiwan,” said Chao Chun-shan, one of Taiwan’s most senior China experts who has advised the last four presidents on cross-Strait policy. “Xi Jinping has said that the Taiwan question cannot be dragged out without resolution, so they are taking the things they can manipulate themselves and doing them first.”

There is ample evidence of that already. Over the past three years, Beijing has unleashed a flurry of initiatives that have the look of concrete planning for post-unification Taiwan and suggest to the public that this era is imminent.

They include a rail link between the coastal city of Fuzhou and Taipei in a plan for national transportation network projects to be completed by 2035. There is also advice being doled out on social media to Chinese citizens about buying property in Taiwan after unification, while internal lectures have been advising online opinion leaders that the country is moving towards unification.

The driver is Xi’s suggestion — first put forward in January 2019 — that “Chinese on both sides of the [Taiwan] Strait” should start looking in more concrete terms at the contents of the “one country, two systems” concept — originally developed for Taiwan but first applied in Hong Kong. He proposed that they “explore a Two Systems formula for Taiwan and enrich the practice of peaceful unification”.

The Chinese leader’s concept for that process is what he calls “integrated development”. According to research papers by Chinese scholars specialising in Taiwan policy, the approach envisions drawing the island more closely to China through a web of personal and business interests, and gradually winning the Taiwanese people over to Beijing’s vision of a unified great nation through educational exchanges and propaganda.

However, in Taiwan, that push is going nowhere. Since early 2020, pandemic travel and visa restrictions imposed by both Beijing and Taipei have severely impeded the Chinese Communist party’s efforts to woo Taiwanese students, businesspeople, religious communities, grassroots officials and gang leaders.

Even if cross-Strait travel opens up again, the prospects are dim. The Taiwanese government is pushing back against deeper integration with China, and even mainstream opposition politicians refuse to discuss unification because the vast majority of the population wants to retain the country’s de facto independence.

Xi is now shifting from the more patient approach pursued by his predecessor Hu Jintao to a policy stressing advances towards unification. “During Xi Jinping’s first term, our Chinese counterparts still remained focused on preventing moves towards formal Taiwan independence,” said Wen-Ti Sung, a lecturer in the Taiwan studies programme at Australian National University. “But now, their research and propaganda efforts have moved to the next step of promoting unification.”

An important reason is Beijing’s growing sense of urgency over what it perceives as attempts by the US to change the status quo in the Taiwan Strait — notably, Washington’s arms sales to Taiwan, visits by US politicians to the country and repeated statements by President Joe Biden that the US is committed to defend Taiwan if China were to attack.

“As the US and China are embroiled in [a] great power competition, Beijing is now more and more focused on pushing back against what it sees as external intervention in the Taiwan issue,” said Chang Wu-yueh, a professor at Tamkang University in Taipei.

In a white paper published in August, the Chinese government said external forces had tried to exploit Taiwan to contain China, prevent the Chinese nation from achieving complete reunification, and halt the process of national rejuvenation.

“External interference is certain to feature prominently in Xi’s remarks at the party congress as well,” Chang said.

Beijing is pushing back with military threats, such as the People’s Liberation Army’s unprecedented exercises around Taiwan following the visit of Nancy Pelosi, Speaker of the US House of Representatives, to Taipei in August.

But analysts believe warnings from US military and intelligence officials of a looming invasion are overdone. “Beijing still has strategic patience and that is a chance for Washington,” Colonel Zhou Bo, a former official in the Chinese defence ministry and a senior fellow at Tsinghua University, wrote in an article in the South China Morning Post.

Other experts argue that Beijing prefers using military force for intimidation, deterrence and coercion rather than war. “There are only very few scenarios under which Xi would seek unification at any cost,” said Taiwan’s senior China adviser Chao.

“Although for him, unification needs to be achieved together with China’s great rejuvenation, this is a dialectic relationship. He will not renounce the use of force to achieve unification, but achieving unification must not damage rejuvenation, the final goal.”

The relentless rise of the dollar has boosted the buying power of investors with funding in the US currency

Huge moves in currency markets look set to provide one group of hedge fund managers with a rich seam of trading opportunities again.

So-called merger arbitrage funds, which bet on the likelihood of corporate mergers and acquisitions closing, have had fewer deals to trade this year as global economic uncertainty and higher interest rates have weighed on dealmaking.

But the dollar’s relentless march higher against sterling, the yen and the euro could change all this. With dollar-based companies or funds now able to pick up foreign companies for a lot less than before, “everything in the UK is on sale”, as one US private equity executive put it this week. Merger arbs smell an opportunity.

“UK companies are a lot cheaper than a few weeks ago,” said Pierre di Maria, head of event-driven at Cheyne Capital in London. “We expect a pick-up in UK M&A to be triggered by weakness in the pound.”

Priced in sterling but with a high proportion of dollar earnings, FTSE companies are a natural target. Some managers, such as Kite Lake’s Jamie Sherman, believe the market is not pricing such stocks correctly.

Felix Lo, a former Millennium trader who now runs a merger arb fund at Trium Capital, has built a screening tool to monitor the effect that these currency moves are having on cross-border deals. He expects US firms to be active.

“Both the price paid and the target’s value can materially change in a very short period of time”, said Lo. “CEOs across the globe are generally cautious in this environment, but US CEOs are the most bullish and eager to do deals,” he added.

Any pick up in activity will be a welcome fillip to merger arbs, who have found their opportunities set constrained by a darkening economic outlook. After last year’s record M&A, global deal volumes were down 34 per cent year on year in the first nine months of this year, while US volumes were down 40 per cent, according to Refinitiv.

Deal activity has also been overshadowed by concerns that the Department of Justice and Federal Trade Commission will take a tougher approach to takeovers. The head of the DoJ’s antitrust unit, Jonathan Kanter, has said it will take a tougher stance on private equity deals, while FTC chair Lina Khan has said regulators should be “sceptical” when private equity firms try to buy businesses divested by companies that are merging.

While managers such as Kite Lake’s Sherman argue such regulatory risk is “more bark than bite”, it has nevertheless increased the uncertainty around deals.

Reflecting that uncertainty, average annualised deal spreads — the gap between the deal price and the share price — have risen from 8.1 per cent at the start of the year to 17.6 per cent, according to data from UBS Special Situations, which takes into account deals with a spread of between zero and 50 per cent.

The change in conditions is showing up in some funds’ performance numbers. While some funds such as Trium and Kite Lake’s KL Special Opportunities are up double-digits, merger arbs as a whole are up an underwhelming 0.7 per cent on average in the first nine months of this year, according to data group HFR.

That is a world away from the so-called “arb-ageddon” of March 2020, when deal spreads exploded during the onset of the coronavirus pandemic and merger arbitrage funds lost nearly 10 per cent on average in a month. But it is still a marked slowdown from last year’s buoyant 10.6 per cent gain.

But while a pick-up in cross border M&A will be welcomed, there will of course be hurdles. The UK’s financial chaos is likely to make US boards wary of committing to deals just yet.

Moreover, UK companies often seek to ensure they have enough dollar revenues to match the costs of their dollar debt. That can leave them in a “delicate” situation, according to Cheyne’s di Maria, as their debt rises in dollar terms while their revenues are hit by a slowing global economy. However, he believes this is a problem that can be “easily fixed” if the acquirer is a private equity that can then replace dollar debt with local currency paper.

While they wait for an upswing in M&A in the UK and elsewhere, there are at least some deals they can trade. Chief among these is Elon Musk’s extraordinary takeover battle for Twitter, which has been a profitable trade for many managers.

The vagaries of the deal, which is currently back on after Musk this month U-turned and offered to go ahead at the initially agreed price of $44bn, have provided plenty of media entertainment but have also given arbs the chance to trade in and out.

A number who have done their homework on Delaware law feel quietly confident that, whatever the two parties tweet at each other in the meantime, Musk will eventually be forced to follow through on the deal. That, for now, should be enough to keep the arbs busy.

Leader’s historic third term in sight amid traditional leadership reshuffle

President Xi Jinping’s expected reappointment for a third five-year term as head of the Chinese Communist party and the military is set to be a watershed moment in China’s modern history. As with Deng Xiaoping’s launch of economic reforms in 1979 and his decision a decade later to crush pro-democracy protests with force, it will — for better or worse — radically alter the country’s course.

The party’s 20th congress opens in Beijing on Sunday and will bring together more than 2,000 delegates from across the country. It will close a week later with the unveiling of the party’s new leadership, which is set to again be headed by Xi. In doing so, the congress will bring down the curtain on a two-decade period defined by predictable and orderly transitions from one party leader to another.

Besides reaffirming Xi as the party’s paramount leader and head of its powerful Central Military Commission, which controls China’s armed forces, the congress will unveil a new central committee comprised of about 200 full members and 170 alternates, a 25-member Politburo and a seven-person Politburo Standing Committee.

Will Xi be reappointed president?

Not yet. State positions, including president and premier, will not be made official until March, at the annual session of China’s parliament, the National People’s Congress. But the head of the party is typically appointed president. The party’s second-highest ranking member usually, but not always, serves as premier.

Xi is widely expected to be reappointed to a third term as the party’s top leader, or general secretary, although it is also possible he could resurrect and assume the title of party chair, which was discontinued in the early 1980s by Deng.

How is this year’s congress different from previous ones?

In taking a third term as party leader, Xi will formally scrap the system credited for the orderly leadership transitions of 2002 and 2012. In 2002, Hu Jintao succeeded Jiang Zemin as party general secretary. In 2012, Hu made way for Xi.

Xi set the stage for this month’s power grab at the 19th party congress in 2017, when he did not appoint a next-generation president to the Politburo Standing Committee. Both Jiang and Hu had done so five years before they relinquished power.

In March 2018, the NPC all but announced Xi’s intention to stay on for at least a third term, if not for life, when it scrapped the constitutional two-term limit on the presidency. There is no such term limit on the positions of party general secretary and military chief.

How many members of the Politburo Standing Committee will step down?

At least two. For everyone but the party leader, an unofficial retirement age applies to the Politburo Standing Committee. Anyone aged 68 or older cannot be reappointed to the body.

Four PSC members, including Premier Li Keqiang, will be 67 or younger, and therefore eligible for another five-year term. It is possible, however, that Xi could lower the age limit to 67 to replace Li — or simply orchestrate the removal of anyone he does not want in order to promote more allies to the committee.

Does that mean Li could serve a third term as premier?

No. Unlike the presidency, the premiership is still subject to a two-term limit.

If Li remains on the Politburo Standing Committee, he would probably retain his ranking as the party’s second most senior official, but would have to take on another government role, most likely to be head of the parliament.

So who will be China’s next premier?

This will not be known with certainty until he (it has never been a she) is formally appointed at the NPC in March. But if Li stays on the standing committee, its third-ranking member would be the most likely to succeed him as premier. If Li steps down, whomever replaces him as its second-highest ranking member will probably become China’s premier-in-waiting.

At present, Wang Yang, the party’s fourth highest ranking official, is considered the frontrunner to replace Li. Another contender is vice-premier Hu Chunhua, who currently sits on the politburo but not the standing committee.

Who are the others to watch?

With the exception of Xi, a Chinese leader’s official party rank is not an indicator of his real clout. Li, for example, has been a remarkably weak premier despite his number-two party rank.

During Xi’s first term as party leader from 2012 to 2017, the second most powerful man in China was clearly Wang Qishan, who managed Xi’s anti-corruption campaign but was ranked sixth in the party hierarchy.

One critical position to watch is who emerges as the head of the party’s Central Political and Legal Affairs Commission, which oversees China’s vast internal security apparatus.

Leading candidates for this post include two officials who worked closely with Xi two decades ago when he was climbing up the ranks in Fujian and Zhejiang provinces: Chen Yixin, who is currently the commission’s secretary-general, and Wang Xiaohong, who was appointed head of China’s public security ministry in July.

Water stress and floods place infrastructure at ‘significant risk’, World Meteorological Organization reports

The world’s energy infrastructure is at “significant” risk from climate change, as extreme weather events threaten dams, thermal power plants and nuclear stations, the World Meteorological Organization said this week.

In its latest report, the WMO said existing energy infrastructure was already “under stress” and climate change was likely to directly affect fuel supply, energy production and the physical resilience of existing and future energy projects.

Flood and drought risk was particularly highlighted. In 2020, 87 per cent of the global electricity generated from thermal, nuclear and hydroelectric systems directly depended on water availability, the WMO said, but some of the facilities are located in areas that were experiencing water stress.

The WMO said a third of thermal power plants that relied on freshwater availability for cooling were already in areas of water stress, as were 15 per cent of existing nuclear power plants and 11 per cent of hydroelectric capacity.

About a quarter of the world’s existing hydropower dams, and almost a quarter of projected dams, were situated within river basins that already have a “medium to very high risk” of water scarcity, the WMO said.

The results affirm a study published in the journal Water earlier this year, about flood and drought risk to hydropower dams globally. It found that by 2050, 61 per cent of all hydropower dams would be in river basins at risk of “very high or extreme risk for droughts, floods or both”.

While only 2 per cent of planned dams are in basins that now have the highest level of flood risk, the study forecast that almost 40 per cent of the same group of dams would be in river basins with the highest flood risk.

The report modelled three scenarios, with the pessimistic scenario assuming an increase of 3.5C by the end of the century, and the optimistic scenario assuming a temperature increase of 1.5C. Global temperatures have risen at least 1.1C since the 1840s.

Jeffrey Opperman, one of the authors of the study and the lead global freshwater scientist for the World Wildlife Fund, said even under an optimistic scenario for limiting global warming levels by 2050, there would be an increase in drought risk and flood risk.

“We need to adapt if we’re going to be successful,” he said. “There’s a big difference between the optimistic scenario versus the status quo, or the pessimistic.”

“That underscores that if we want to avoid disruptions to our water systems or energy systems, our safety, there is a really big difference between pursuing an ambitious lowering of greenhouse gases, and really hitting our targets versus not doing that,” Opperman said.

Countries with the highest existing hydropower capacity projected to experience the greatest increase in flood risk includes Canada, Uganda, Russia, Zambia, Egypt, Ghana, Venezuela, China and India.

Countries with highest existing hydropower capacity at risk of water scarcity also include China and India, as well as Turkey and Mexico, and the US states of Montana, Nevada, Texas, Arizona, California, Arkansas and Oklahoma.

The “megadrought” gripping the southwestern US provides a recent example. Water levels at the two largest reservoirs fell to record lows in May this year, forcing unprecedented government intervention to protect water and power supplies across seven states.

The sharp drop in levels on Lake Mead, which is the largest US reservoir, and is near Las Vegas, and Lake Powell upstream on the Colorado River, prompted federal officials to activate an emergency drought plan.

In the US, the Biden administration’s infrastructure bill earmarked $500mn over five years to fund dam safety projects, helping to shore up dams that may be subjected to increasing levels of flooding. US officials said the funding would help develop long-term resilience to drought and climate change.

In China, the severe summer drought and record temperatures led to power cuts as major hydropower-producing areas such as Sichuan province struggled to meet electricity demand.

Companies including Toyota and Apple supplier Foxconn suspended plant operations in the province after authorities said they would temporarily halt energy supplies to factories in a number of cities.

Frustration grows as share price of telecoms group continues to decline despite prospect of deals

Europe’s largest activist investor Cevian Capital has slashed its stake in Vodafone as scepticism grows that the UK-based telecoms group will be able to reverse its sluggish performance amid a challenging economic backdrop.

Cevian built a significant but undisclosed position in the FTSE 100 group last year through shares and derivatives, becoming one of the 10 largest shareholders according to people familiar with the matter. It was pushing for management to simplify the group’s sprawling international portfolio and sell poorly performing divisions.

However the activist investor sold the vast majority of its stake by the end of June, the people said, due to changes in the economic environment including indications that interest rates would rise, reducing the chances Vodafone would be able to secure favourable deals.

Vodafone has shed nearly 25 per cent of its value since then.

The group is looking at a series of deals across Europe but other investors have expressed impatience over the pace of change and prospects of its flagging share price being revived.

“Would management change be taken well? I think it would,” said one top 15 investor adding that chief executive Nick Read, who joined Vodafone in 2001 and took the top job in 2018, has “been there for a long time . . . and he has not transformed the business”.

Peter Schoenfeld, another shareholder and founder of New York-based hedge fund PSAM, said investors are “frustrated and fed up with Vodafone’s poor stock performance” and that “it’s very much a show me kind of situation now”.

“Read has committed to a strategy that he has so far failed to fulfil,” he added.

Short positions in the company — used by investors to bet that the share price will go down — peaked in May, with 10 per cent of the stock out on loan, according to S&P Global Market Intelligence. This has since dropped below 2 per cent.

But others are still betting the stock will rise. French telecoms billionaire Xavier Niel has built a 2.5 per cent stake in the group and is angling for a shake up.

Recent activity suggests Read is making good on his ambition to pursue deals. In August, Vodafone agreed to sell its Hungarian business for $1.8bn and earlier this month confirmed it was in advanced talks with CK Hutchison, owner of Three, to combine their UK businesses and create the biggest mobile operator in Britain. It also announced a deal to buy MasMovil’s telecoms assets in Portugal, and hired bankers to help look at selling its broadband business in Spain.

However Vodafone’s share price has fallen around 10 per cent over the past month, and 50 per cent over the past five years, to 100p.

Several investors have misgivings about whether the UK joint venture being proposed — with Vodafone as 51 per cent shareholder — would be given the green light by regulators, and if it is liable to create an even more convoluted business.

“We started off the year thinking regulators are more open to [deals], but that’s yet to be seen,” said the top 15 investor.

Some investors and analysts also expressed concern about the level of net debt on the UK group’s balance sheet — at £42bn — given rising interest rates.

“Vodafone tells us it’s all hedged and termed out but . . . hedges don’t always work as we think they will,” said the top 15 investor, who has also reduced their holding in recent months. “They’re trying to do some of the right things with consolidation but with that amount of debt . . . they can’t afford an [earnings] squeeze.”

Another source of frustration is a long-awaited decision over Vodafone’s 80 per cent stake in its Vantage Towers masts business, which would help reduce debt.

Read explored a merger with either Deutsche Telekom or Orange but is now reverting to the idea of selling a stake to private equity. The delay has angered some.

“It’s a statement of fact that they would have got a much better price for these assets a year or 18 months ago,” said the top 15 investor.

Vodafone said in a statement that “the macroeconomic backdrop is challenging for everyone. We continue to progress opportunities with Vantage Towers, strengthen our market positions in Europe, and prioritise the deleveraging of our balance sheet.” It declined to comment on Cevian reducing its stake.

Authorities tighten measures in Beijing and other major cities ahead of 20th Communist party congress

China has insisted it will stick to its strict zero-Covid policies, saying its extensive testing and quarantine apparatus is sufficient ahead of the 20th Communist party congress, which begins on Sunday.

Government measures, which also include lockdowns, are “the most cost effective and have worked the best for our country”, a spokesman for the Communist party said.

He pointed to the country’s large elderly population, its uneven development across regions and its insufficient medical resources, adding that the policies would continue to improve.

“We all wish for a swift end to the pandemic,” he said. “But as things stand, it is still lingering. That is the reality.”

The congress, which will lay out Communist party policy for the next five years, is widely expected to confirm an unprecedented third term in power for president Xi Jinping. The seven members of the politburo standing committee, China’s top political decision-making group, will also be unveiled.

China’s zero-Covid-19 strategy has been one of the dominant hallmarks of Xi’s administration and has mostly succeeded in suppressing the virus, in contrast to high death tolls in the US and Europe where healthcare systems have come under immense strain.

However its economic toll rose dramatically this year due to the two-month lockdown of Shanghai, its biggest city and financial hub, and the closure of dozens of other cities.

On Thursday, leading epidemiologist Liang Wannian said there was “no timeline” for an exit from zero-Covid rules and earlier in the week the state-run People’s Daily newspaper ran a prominent defence of the strategy.

Liang added that the country now had the capacity to test 1bn people in a single day. In Beijing and other major cities, including Shanghai, authorities have tightened measures ahead of the launch of the congress and residents need to test negative every few days to enter most buildings.

Zero-Covid, in combination with a worsening property crisis, has left Beijing struggling to meet its GDP growth target of 5.5 per cent over the course of this year — even though that is its lowest in decades.

According to World Bank forecasts, China’s economic output will grow by 2.8 per cent this year, lagging the rest of Asia for the first time since 1990. In the second quarter, GDP grew just 0.4 per cent year-on-year.

International concerns about China’s aggression towards Taiwan, the self-ruled democratic nation which China claims as its territory, have mounted ahead of the congress. The party spokesman reiterated that Xi’s administration reserves the right to use military force against Taiwan.

Heading into this past week, uranium miner Cameco CCO –4.06% was that rare stock in the market: It had posted a double-digit gain in 2022. One deal made those gains disappear—and created a buying opportunity.

At first glance, there didn’t seem to be all that much that was controversial about the joint venture Cameco (ticker: CCJ) announced this past Tuesday. Along with Brookfield Renewable Partners BEP –1.66% (BEP), Cameco agreed to buy Westinghouse Electric, a servicer to nuclear power plants, for $7.88 billion, including debt. Cameco will own 49% of the joint venture once the deal is completed.

Its stock dropped 20% this past week, after Cameco said it would issue $650 million in new shares at $21.95 apiece, a discount of 15% to where they had been trading. It was a steep price to pay to raise money for the deal, especially when the amount Cameco and Brookfield are paying is “skewing towards fully valued,” according to Cantor Fitzgerald analyst Mike Kozak.

But that was only part of the problem. Before the deal, Cameco had the benefit of being seen as an easy way to bet on rising uranium prices amid renewed interest in nuclear reactors. Investors who want pure uranium exposure might not stick around for what comes next.

They might want to. Westinghouse Electric services about half of the world’s nuclear reactors, according to Kozak, providing fuel design and fabrication, plant operation and maintenance, and refueling, while about 85% of its $3.3 billion in revenue comes from long-term contracts. “Cameco will undoubtedly be able to leverage Westinghouse’s downstream expertise with its dominance at the front end of the nuclear fuel cycle...in servicing existing customers and targeting new ones,” he writes.

The timing of the deal probably isn’t a coincidence. Countries in Eastern Europe have had their reactors serviced by Russia’s Rosatom, but with the war in Ukraine, there’s a good chance they will be looking for a new company to handle those duties. “They are aiming to fill a huge hole left by Rosatom and we like their chances,” writes the Bear Traps Report’s Larry McDonald.

The acquisition isn’t set to close until the second half of 2023, but there’s a lot to like about Cameco until then. Paradigm Capital’s Gordon Lawson notes that the company’s newest mine is almost at full production, and it has been approved to increase production at another mine. In addition, it has contracts in place that should help protect it from volatility in the price of uranium. He has a $48 price target on Cameco stock, more than double Friday’s close of $21.29.

Sometimes, a big drop is just a second chance to pick a winner.

Patience in a volatile market like this year’s is a tall order. But it is the recipe for long-term success espoused by institutional investors in Barron’s latest Big Money poll. Big Money respondents are relatively negative about the near-term trajectory for financial markets, but optimistic about opportunities over the longer term, given the most attractive entry points in years for both stocks and bonds.

Our latest survey finds 40% of money managers bullish about the outlook for stocks over the next 12 months, and 30% bearish. The bullish cohort has increased from 33% since the spring edition of the poll, which found a plurality of managers neutral, but the bearish contingent has also grown from 22%. The S&P 500SPX –2.37% index has fallen 14% since the spring poll was published in late April, and is down 23% for the year.

The bulls evince genuine enthusiasm for stocks and see a smart recovery in the offing. Based on their mean predictions, they expect the S&P 500 to gain 15% through June 30, 2023, and 22% by the end of next year. Bullish investors see the Dow Jones Industrial AverageDJIA –1.34% adding 19% through the end of 2023, and the Nasdaq CompositeCOMP –3.08% picking up 30% by then.

Even the bears think most of the pain is over. They predict that the S&P 500 will decline by 8% by the middle of next year, then rebound to finish 2023 just 4% below recent levels. Their average estimate calls for the Dow to end next year down 2%, and for the Nasdaq to be roughly where it is today.

“The longer your time horizon as an investor, the greater your competitive advantage,” says Ted Bridges, CEO and chief investment officer of Omaha, Neb.–based Bridges Trust.

In interviews, many Big Money managers sound more bullish than survey results suggest. Markets might stay volatile and challenging for the next year, but opportunities abound to scoop up quality stocks at cheap valuations. For investors whose time horizon extends well beyond a year, the current environment looks to be a gift.

If you’re too early or too late by six months to a year, you say, ‘Well, darn, I wish I could have done better,’ ” says John Guerard, director of quantitative research at McKinley Capital Management in Anchorage, Alaska. “But as an investor, you want to get the three- to five-year period right, because that’s when you’re going to make your money. And we’re confident that returns over the next three to five years will be substantial.”

Guerard and Dimitrios Thomakos of the University of Athens looked at every six-month period in the history of the Dow industrials going back to the Dow’s establishment in 1896. Given its loss of 15.3% in the first half of 2022, the period ranked in the top 10% of the worst six-month stretches ever. Guerard, whose firm manages $2.4 billion, found that after almost every six-month span with a loss of that magnitude, the Dow was meaningfully higher three years later—by an average of 23.3%.

he S&P 500 began 2022 trading at about 23 times forward earnings. Its valuation has dropped in the ensuing months to about 15 times projected profits, with price/earnings ratios contracting by even more for many companies. Still, about 40% of Big Money poll respondents still call the market overvalued, while 22% now think stocks are undervalued.

Stocks and bonds have traded in lockstep this year, declining for three consecutive quarters. Typically, the two asset classes trade inversely to each other, which means that bonds haven’t provided much ballast of late. “It has been a painful process, but this is the time you want to be an investor,” says Richard Alt, chief investment officer at Carnegie Investment Counsel, near Cleveland. “I’d much rather be putting money to work at 10 or 12 times earnings than 23 times earnings, and get the chance to earn something from bonds.”

The fall Big Money poll drew responses from 107 investors from across the U.S. The latest survey, conducted with the help of Beta Research in Woodbury, N.Y., closed in early October.

Investors blame the Federal Reserve and its fight against inflation for their recent wounds. The U.S. central bank has aggressively raised interest rates this year to curb inflation, while reducing its holdings of U.S. Treasuries and mortgage-backed securities. More than a quarter of poll respondents consider rising rates the biggest investment risk in the coming year, and only 14% expect the Fed to be able to pull off a “soft landing,” bringing inflation down without sparking an economic recession.

“They should have started tightening a long time ago, when consumer prices started going up so dramatically,” says Gloria Bohannon, president of Herbert R. Smith & Co. in Witchita Falls, Texas. “But they waited too long, and now they’re having to raise rates too quickly…. The market seems to expect that rates may come down next year, but we don’t think that’s going to happen.”

Poll respondents, on average, expect U.S. real gross domestic product to be about flat in 2022, and up only slightly in 2023. Most see the consumer price index, or CPI, increasing by 6% to 8% in 2022, before growth in prices eases to about 3% to 5% next year. That would still be well above the Fed’s 2% inflation target.

“I am fearful the Fed is pushing the brakes too hard,” says Alt. “If all they are looking at is inflation, then they’re going to keep hiking until something breaks. There is a limit to what the economy can handle when you lift interest rates too high, too fast.”

Big Money investors are sitting on more cash than usual, waiting for greater buying opportunities. Twenty-two percent of respondents called cash the most attractive asset class today, with 42% citing equities and 14% bonds. “We think we’re not quite at what will be the market bottom, so we’ve remained cautious and defensive,” says Erica Snyder, president and CEO of Hunter Associates in Pittsburgh. “The most important thing in this environment is quality and consistency of earnings, earnings growth, and free cash flow.”

Snyder’s firm, which manages about $2 billion, is overweight healthcare stocks due to their defensive attributes and steady businesses. People still need to access healthcare, regardless of what interest rates, inflation, or GDP are doing. Snyder is the favorite sector of 20% of Big Money poll investors.

Poll respondents predict that U.S. crude oil will trade for $89.36 a barrel a year from now, about where it’s changing hands today. That would continue to boost sales and earnings of energy companies—Big Money investors’ favorite sector, at about 26%. Bohannon owns the oil majors Exxon Mobil XOM –2.63% (ticker: XOM), Chevron (CVX), and ConocoPhillips (COP), while Bridges favors producer EOG Resources (EOG). The Energy Select Sector SPDRXLE –3.73% exchange-traded fund (XLE) includes all energy stocks in the S&P 500, while the iShares U.S. Oil & Gas Exploration & Production ETF (IEO) is focused on upstream oil-and-gas companies.

“We’re looking for those businesses that [Warren Buffett] likes to call ‘inevitables,’ ” says Bridges, whose third-generation family firm manages about $7.5 billion. “The stock market is going to mark their prices up and down, but their underlying business value is going to proceed at a pretty decent rate over time….So, the stock might be down 30%, but it’s unlikely that the true intrinsic value of the business is.”

Bridges points to several stocks that he believes fit that mold, including Alphabet (GOOGL), Old Dominion Freight Line (ODFL), PayPal Holdings (PYPL), Thermo Fisher Scientific (TMO), and SVB Financial Group (SIVB).

There are also investment opportunities in several long-term trends that will unfold beyond the current economic cycle. Peconic Partners’ President and CEO William Harnisch sees opportunities in infrastructure, namely in upgrading the aging U.S. electrical grid to support a clean energy future.

Completely decarbonizing the U.S. economy will cost as much as $4 trillion through 2050, according to an estimate by utility giant NextEra Energy (NEE). That will boost the fortunes of Quanta Services (PWR), which installs electricity infrastructure, and Wesco International (WCC), which distributes electrical and communications products, predicts Harnisch. Wesco and Dycom Industries (DY) also are benefitting from more investment by wireless companies in next-generation 5G networks.

Herbert R. Smith’s Bohannon likes the shares of hydrogen producer Plug Power (PLUG), as well as copper miners Freeport-McMoRan (FCX) and Southern Copper (SCCO). She sees a coming shortage of the conductive metal as the transition to electric vehicles and renewable energy sources significantly increases demand.

Carnegie’s Alt is looking to buy stocks trading at discounted valuations and offering attractive dividend yields. He points to JPMorgan Chase (JPM), which fetches nine times forward earnings and yields 3.7%; T. Rowe Price Group (TROW), at 13 times earnings and yielding 4.7%; and AbbVie (ABBV), at 12 times earnings and a 3.9% yield.

Nearly two-thirds of Big Money investors expect the U.S. to be the best-performing stock market in the next 12 months, while 13% favor emerging markets, and 11%, Europe. Emerging markets are getting interesting from a valuation standpoint, says Snyder, with many countries further down the path of normalizing rates than the Fed or European Central Bank.

But EM stocks might not work until the Fed pauses its rate hikes. Half of poll respondents expect the dollar to weaken over the coming year, which would be a tailwind for non-U.S. investments.

More rate increases seem assured after the government released September inflation data on Thursday. The U.S. consumer price index rose 0.4% in the month, and is up 8.2% for the year. The trend is unnerving for politicians, as well as consumers; this marks the last inflation report before Americans vote in the midterm elections on Nov. 8.

Some 86% of Big Money investors expect Republicans to win a majority in the U.S. House of Representatives next month; 52% predict the Democrats will win a majority in the Senate. Respondents aren’t worried about gridlock in Washington: More than half say that split control of Congress is the best outcome for the stock market. Inflation is the most urgent economic issue facing the next Congress, according to our poll, followed by immigration reform.

Big Money investors aren’t overthinking the fixed-income side of their portfolios. Some 39% called U.S. Treasuries their favorite category in the sector, followed by U.S. investment-grade corporate bonds at 20%. They’re keeping duration short, at nearly two-thirds of their combined allocation.

With a one-year U.S. Treasury bill yielding a risk-free 4.4% today, it’s a different world in fixed income than in most of the past 15 years. “We don’t need to be heroes and go for junk bonds just to put up some good numbers from fixed income again,” says Alt. “You don’t need to take much risk to put together a very good, quality income portfolio.”

As the Fed approaches the end of its rate-boost cycle, it will become appropriate to begin gradually extending duration, Big Money investors say, locking in some of the yields on offer for several years. We’re not there yet: Almost two-thirds of poll respondents expect a peak federal-funds rate of at least 4.5%, versus the current target range of 3.00% to 3.25%.

“One of the positives for investors is that, in a more normalized interest-rate climate, they can actually earn income on their fixed income again,” says Snyder. “When we look forward over the next decade, that may be one of the biggest opportunities.”

Russia is losing the war in Ukraine. If President Vladimir Putin’s initial goals were to decapitate the government in Kyiv, impose his own regime therein, demilitarize the country, and stop its Western orientation, then eight months in, the invasion has clearly failed.

Putin subsequently fell back on more-limited stated goals of securing Donbas and a southern land corridor to Crimea. In September, Putin seemed to try to cement his limited gains by announcing the annexation of four partially occupied regions of Ukraine. However, recent military defeats in Kharkhiv and now around Kherson raise doubts as to whether even these objectives can be sustained.

Indeed, a total collapse of Russian forces in Ukraine now seems possible. The limits of Russian conventional military power have been brutally exposed. President Xi Jinping of China and Prime Minister Narendra Modi of India are now appearing to distance themselves from the Russian leader. Within Russia, opposition and unease are growing at the poor performance of the Russian military and state.

Ukraine, on the other hand, has united and mobilized against the Russian threat. Ukraine now has a capable military force, arguably a much greater threat to Russia than on the day of the invasion. The West is also now united around the common purpose of standing up to Russian aggression.

From here on out, Putin is faced with three limited options. Each would affect markets.

First, the wise thing for Putin to do would be to quickly sue for peace. One could argue that the halfhearted Russian attempt to force an energy crisis in Europe and the annexation and linked threats therein of the use of nuclear arms, are all meant to force Ukraine and the West to the negotiating table this fall and to concede to peace terms on Putin’s terms—he keeps what he occupied. But with Ukraine on the front foot, Kyiv seems in no mood to negotiate until it at least pushes Russia back to positions as of Feb. 23, invasion day.

In fact, at this stage, a full reversal of Russian gains seems the most likely outcome, as Russian forces in Ukraine collapse over the winter. But waiting for this eventuality would leave Putin vulnerable to domestic political fallout from what would then clearly be a devastating military defeat. An early withdrawal amid some kind of peace process might enable Putin to save some face, by limiting Russian casualties, and perhaps he could negotiate some sanctions moderation on the Russian economy.

A Ukraine win and early end to the war would obviously be well received by the market. Risk assets would rally, and commodity prices probably fall or moderate their rises, although much would depend on the political setup remaining in Russia. But lower commodity prices would help counter the global cost of living crisis, and might allow the U.S. Federal Reserve to pivot in terms of interest rates, again helping to turn the global mood.

If Putin stays, clearly, relations with the West will remain strained, and sanctions moderation would be limited. Arguably, markets would be waiting for the next flare-up. Perhaps we would see a relatively short but significant market rally.

Second, a much more optimistic scenario involves Ukraine winning, and Putin losing power, most likely via an internal coup. Less likely would be a popular uprising, although this could happen over time, especially if Putin tries to grind out a longer war. Obviously, there are concerns about who would follow Putin. The next person is likely to be currently within the inner Kremlin circle, but one who wants to stabilize the relationship with the West. If this happens, and Putin leaves power, sanctions will be moderated. Markets are likely to rally hard on any such outcome, as the prospect will reopen investments into Russia.

The third and obviously worst-case scenario is that Putin could carry out his nuclear threat. He may use tactical nuclear weapons to try to halt any Ukrainian offensives and again force the Ukrainian side to the negotiating table. However, as military specialists have highlighted, the use of tactical nuclear weapons is difficult in practice. They might not bring clear-cut military wins, they risk contamination of Russia and occupied territory, and they bring huge political costs to Russia. China may abandon Putin. It would risk military intervention by the North Atlantic Treaty Organization, and the prospect that China and NATO might reach the same conclusions that Putin needs to be removed.

An outcome that involves nuclear war is unlikely, but obviously a nuclear attack by Russia would be a huge security event globally, making the world instantly more uncertain and risky. If Russia turns to nuclear action, the global markets would probably be sent into a tailspin, with flight to quality assets. Commodity prices would probably rise massively, global growth would crater, and risk assets would suffer. Risks would be of a global systemic event, adding on to already elevated concerns around the global cost of living crisis, Fed tightening, and existing war concerns.

Which of these three options comes to pass, regrettably, rests almost entirely with Vladimir Putin.

U.K. Chancellor of the Exchequer Kwasi Kwarteng has been fired over his handling of a recent economic crisis that saw bond markets crash.

He left an International Monetary Fund gathering in Washington earlier than planned and was promptly relieved of his position in a meeting with Prime Minister Liz Truss when he arrived back, making him the second-shortest serving Treasury chief in U.K. history. Truss named former Foreign Secretary Jeremy Hunt as his replacement on Friday.

Kwarteng’s dramatic departure leaves the government in dire straits. He and Truss came to power on the back of promises to cut taxes and shrink the size of the state. After just taking office at the beginning of September, the project has proved deeply unpopular with the public as well as investors, forcing humiliating climbdowns after only a few weeks.

The latest U-turn came Friday shortly after the chancellor’s dismissal when Truss announced the government’s plans to freeze corporation tax would be scrapped.

The pound fell on Friday, slipping about 1% to $1.12. Bonds yields, which were initially lower before the announcement rose, with the yield on the 30-year gilt 26 basis points up at 4.816%. The danger of more market disruption hasn’t gone away.

The Prime Minister’s latest steps “are arguably cosmetic and too late to repair the damage that has already been inflicted on investor confidence in the U.K.,” said Simon Harvey, head of FX Analysis at Monex Europe. “The near-term instability will only further deter foreign investment.”

Kwarteng faced fierce criticism over his execution of Truss’s plans for huge tax cuts, funded by new government borrowing. His Sept. 23 “mini budget” went down like a lead balloon and crashed the bond markets. The surge in yields pushed British pension funds to the brink of going bust.

The Bank of England was able to step in with emergency steps to buy long-dated bonds, but made it very clear that the brunt of support would end on Friday. Governor Andrew Bailey stuck to his promise and didn’t extend the program beyond Oct.14, though the BOE could revisit that if market turmoil returns. Bailey did introduce a new program to allow pension funds to use bonds as collateral for loans that will last longer.

The challenge for Truss is managing to roll back her budget plans without losing too much face. Truss staked her political future on reforms that are meant to unleash the productive capacity of the economy, and now it appears she is retreating at the first resistance.

“Part of our mini budget went further and faster than markets were expecting,” Truss said at a press conference on Friday. But she said she’s still on a mission to deliver a “low tax, high wage, high growth economy.”

Truss did indeed drop her plan to freeze corporation tax, saying it would rise to 25% as previously scheduled before she came into office. That reverses £18 billion ($20.1 billion) of the roughly £45 billion of the tax cuts announced on Sept. 23, which she said is a “down payment” on her medium-term plan.

Without giving any specific figures, she also promised that debt as a percentage of the economy will come down in the long term, and that spending will grow less rapidly than planned.

But that still leaves enormous tax cuts on the table to be funded by selling more government bonds. While yields appear to have stabilized for now, they remain elevated. Any further ructions will put pressure on the BOE to once gain come to the rescue. Chancellor Hunt is scheduled to give an update on the government’s budget plans on Oct. 31.

The turmoil in the U.K. matters in the U.S. For one thing, there’s always a risk of contagion that can emerge in unforeseen ways.

Second, it shows how delicate the financial system can be when interest rates rise. The last time the Federal Reserve started a serious hiking cycle in the mid-2000s, it killed the housing market and ultimately led to the financial crisis.

This round of hikes, in both the U.S. and the U.K., is much more aggressive. The lesson is to prepare for more surprises.