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Rumoured for a decade, the move to combine Germany’s two largest banks now has political backing

On an uncharacteristically bright early February day in London, German finance minister Olaf Scholz and his deputy Jörg Kukies spent the afternoon holed up in a series of discreet meetings at their embassy on the south-west corner of the city’s most exclusive square.

Amid the chandeliers, Teutonic tapestries and silver service of the 19th-century Belgrave Square townhouse, the duo quizzed a succession of investment bankers from the likes of Goldman Sachs and Bank of America on the issue consuming the German finance sector. Not the slowing economy. Not Brexit. But what can be done to revive Deutsche Bank? And could a merger with Commerzbank save them both?

Since the financial crisis, the condition of the two 149-year-old Frankfurt-based lenders has become parlous. Both have seen their share prices plunge more than 90 per cent in the past 11 years as they churned through eight chief executives — including the two incumbents, flip-flopping on strategy while raising more than €30bn in new equity.

Deutsche has become the symbol of pre-crisis hubris for European banks trying to mimic American-style “casino” finance. At one point it even ended up owning a $4.3bn Las Vegas casino by accident.

On almost any measure of financial performance, Deutsche will be at or near the bottom of the list. It makes the lowest return on equity, has the worst cost-income ratio and pays the most to raise funds of its continental peers. Between 2011 and 2018 it made a cumulative net loss of €6bn and was fined $14.5bn for everything from mis-selling mortgage securities to its role in the Libor scandal.

A combination with Commerzbank has long been floated as a way of reviving the fortunes of both banks, with rumours of a deal swirling around for more than a decade. But the match has never been consummated as both were busy removing toxic assets from their balance sheets, working through a series of post-crisis misconduct investigations and waiting for interest rates to rise again, to provide a boost to earnings.

Their self-help strategies have not worked. Deutsche’s stock has plunged to a record low and analysts openly question the viability of its business model.

And as Mr Scholz and Mr Kukies’ clandestine London meetings show, the idea is now gaining traction in Berlin. Policymakers and corporate bosses see a stable national banking champion as the backbone of their export-led industrial policy, vital if the country is to weather the next downturn that many economists warn looms large.

In turn, they hope a merger would help to re-establish Deutsche as a top-level capital markets player with the scale and reputation to hold back the encroachment of a revitalised Wall Street. Paul Achleitner, Deutsche’s chairman, has become the pivotal internal champion of a deal, according to people briefed on his thinking.

“It is important that we in Europe remain strong and independent,” says Simone Menne, former chief financial officer of German airline Lufthansa and drugs maker Boehringer Ingelheim. “It may make sense to join forces and, when it comes to financial policy, to pursue a more European approach.”

Yet, despite growing support for a merger in some business circles, there are many investors and executives arguing that combining the two banks would not remedy their problems.

“We think a deal only happens in the near term if Deutsche’s plan A is clearly failing and the share price is under [even more] severe pressure,” says Stuart Graham, founder of Autonomous Research. “A deal [would be] born out of desperation and hatched by a government seeking to prevent contagion.”

Politicians have been forced off the sidelines after a particularly turbulent 2018 that started with Mr Achleitner firing dour British chief executive John Cryan in favour of Deutsche “lifer” Christian Sewing, and ended with police raiding the bank’s headquarters in a money laundering investigation. Bank insiders suggest these raids added some urgency to Berlin’s merger discussions.

Deutsche is also embroiled in a scandal at Danske Bank, the Danish lender. And the US Congress continues to investigate its longstanding business relationship with President Donald Trump.

Leading the government’s Deutsche project is the softly-spoken, cerebral Mr Scholz, a business-friendly Social Democrat who Angela Merkel named vice-chancellor last year. Mr Kukies is his emissary to the financial world. The Harvard-educated, ex-Goldman Sachs derivatives trader is the opposite of his boss: confident, brash, ebullient.

The uber-bank they imagine would be the second-largest eurozone lender behind BNP Paribas, with about €2tn of assets. It would hold €845bn of deposits, almost the size of Citigroup, have more than 2,500 branches and employ 141,000 people — compared with Deutsche’s 92,000 today. As many as 20,000 of those jobs could be lost, analysts say.

The outcome of this saga has implications not only for the companies involved and Germany itself, but the continent’s banking industry as a whole.

Few European banks generate double-digit returns, considered the bare minimum by investors. That explains why many have repeatedly called for consolidation among the region’s 6,000 banks.

Speculation over any merger is being taken more seriously this time. Mr Scholz has adopted a far more activist stance than his predecessor, arguing that having strong and stable banks is a question of “national sovereignty”. He told a conference that the troubles of German banks had created problems for industrial policy because they “don’t have the scale and global footprint necessary to escort the corporate sector [overseas]”.

A person close to the politicians says their desire for a national flag-bearer stems from the 2008 crisis, when panicked banks restricted the supply of credit. “Foreign banks repatriate capital in times of distress,” he says. “One really has to be mindful of that.”

Another of the ministry’s concerns is that Deutsche alone may be incapable of escaping from what James von Moltke, its chief financial officer, has called a “vicious cycle of declining revenue, sticky expenses, lowered ratings and rising funding costs”.

Last year the bank generated a net profit of €341m — its first since 2014 — but it was forecast to be 20 per cent higher. The group made a return on tangible equity of only 0.5 per cent in 2018, a 20th of its target, and its struggling investment bank made a €303m loss last quarter as big institutional clients took their business elsewhere.

The government is even worried about the viability of Deutsche’s bread-and-butter corporate lending business in light of its escalating funding costs and deteriorating credit rating.

“Counterparties wanting to do a 10-year [interest rate] swap are starting to ask themselves how long the lender will be around,” says a senior European regulator, who asked not to be named.

Mr Achleitner, who has overseen Deutsche for almost seven years, has become the key figure in the saga. He knows Mr Kukies well; both went to Harvard and ran Goldman Sachs’ operations in Germany and Austria earlier in their careers. The wily, gregarious 62-year-old Austrian, who started his career at Bain & Co, is one of the best-connected power-brokers in German-speaking finance, also sitting on the boards of Daimler and drugs group Bayer.

However, his dealmaking record is chequered. As an executive at Allianz, Mr Achleitner oversaw the €24bn purchase of Germany’s Dresdner Bank in 2001. But within seven years Dresdner had lost half its value and the government was forced to broker a deal to sell it to Commerzbank.

He is said to believe Deutsche is well-positioned to take on the mantel of Europe’s champion because investors and corporates are wary of US capital markets hegemony in light of rising economic nationalism.

“There is a real demand for services that are not American,” a person close to Mr Achleitner says. “The American national interest might not be identical to the Europeans. To be that alternative, you just have to be the best of the rest.”

Internally Mr Achleitner has argued that the acquisition of a broader base of retail deposits could also reduce and stabilise Deutsche’s funding costs, which have been snowballing in the past year.

Yet many, inside both banks and investors, question the chairman’s arguments. “Economically, it does not make sense and it would be a total gift to our competitors,” says a Deutsche executive who asks not to be named. “People in Commerzbank don’t want the deal either. But I tell you who would love it — JPMorgan and BNP Paribas — because we would spend years distracted by it.”

Mr Sewing has already complained to colleagues that the merger speculation has overshadowed the fact that the bank beat its targets on costs, job cuts and capital last year.

Several of the bank’s top shareholders, contacted for this article, say Deutsche’s main problem is that it does not have a profitable core business to fall back on if it were to further overhaul its sprawling investment bank.

One executive at a rival likens the restructuring of big banks to repairing a jumbo jet mid-flight. As long as three of the four engines are still going, the plane stays aloft. “The problem is Deutsche only has one engine,” he says.

Swiss banks UBS and Credit Suisse have trillion-franc wealth management businesses. Barclays is supported by reliably profitable retail and credit card units. By contrast, Deutsche and Commerzbank operate in a fiercely competitive and structurally unprofitable domestic market, dominated by hundreds of municipality-owned savings banks, known as Sparkassen, and regional co-operative lenders with no obligation to maximise profits.

In February, Commerzbank chief executive Martin Zielke abandoned almost all of its 2020 revenue and profitability targets, blaming anaemic interest rates and local competition. However, its cheap valuation — 33 per cent of the book value of its assets — and market-leading position lending to Germany’s Mittelstand companies make Commerzbank a potentially attractive target for foreign buyers.

Mr Zielke favours a domestic merger over a foreign takeover “because he thinks that he would have more control in such a scenario”, a senior German policymaker says. The government still owns a 15 per cent stake in Commerzbank after its 2009 bailout.

Many observers argue, however, that a foreign takeover of one or other bank is preferable because there would be less overlap and fewer job losses. But few suitors have emerged.

“To buy the problems of the Germans would be absolutely mad,” says the chairman of one bank that has been linked with Deutsche. “All mergers need to be executed in a brutal way; ‘synergies’ is just another word for brutally slashing costs.”

In discussions with the government, Mr Achleitner has asked for guarantees he would be allowed to restructure without interference, arguing Germany’s low unemployment rate and social security net means it can cope with job losses. Whether he gets that assurance is another matter.

Cerberus, the US private equity fund, is one of the largest shareholders in both lenders. Despite sitting on paper losses from the share price fall of about €600m, the company backs the merger, sources familiar with its thinking say. However, Cerberus has few allies. Five other top 10 shareholders in Deutsche told the Financial Times they are highly sceptical about, or staunchly opposed to, a merger.

Their concerns are rooted in Germany’s terrible record of bank integrations, particularly the painful state-arranged 2008 merger of Commerzbank and Dresdner, as well as Deutsche’s own botched acquisition of retail lender Postbank the same year. “Combining two sick men does not create a healthy one,” warns one shareholder.

Verdi, Germany’s service sector union, is also in the no-deal camp. “We do not back such a scenario because we are concerned about another big loss in jobs,” says Jan Duscheck, head of its banking group and a member of Deutsche’s supervisory board.

Analysts are also unpersuaded about the numbers. JPMorgan’s Kian Abouhossein estimates a tie-up could generate €2bn in cost synergies within five years, but they would be offset by €4bn of integration costs. Moreover, due to client overlap the German superbank would lose close to €1bn in revenue, he adds.

Mr Graham of Autonomous Research says regulators would impose a higher “global systemically important bank” capital surcharge of 50 basis points, so the bank would have to hold more than 14 per cent of common tier one equity, to reflect the joint group’s larger balance sheet and complexity. That means the group might need to raise an additional €3bn in equity.

“From a financial market stability point of view, this would be an extremely bad idea”, because it would create a behemoth “even more difficult to wind down in a crisis”, says Isabel Schnabel, a member of the government’s Council of Economic Experts.

However, with an influential chairman campaigning for a deal — and a government prepared to take charge of Germany’s biggest systemic risk — politics could trump the pessimists.

Commissioner responds to Franco-German calls for overhaul of EU competition regime

The EU’s competition commissioner Margrethe Vestager has warned national capitals to be “aware of the consequences” of watering down merger rules, saying such a move would amount to a “strategic choice” to change Europe’s economic model.

“We have a lot of state intervention in our economy but basically it is a very strategic choice to have fair competition — and you can see that it bites,” said Ms Vestager in an interview with the Financial Times in Brussels.

The Dane, who has built a reputation as a formidable competition enforcer by taking on Apple and Google, enraged the French and German governments this year by blocking a plan to merge the rail businesses of Siemens and Alstom. The deal was supposed to create a rail equivalent of Airbus to counter competition from China’s state-backed CRRC, the world’s biggest trainmaker.

French finance minister Bruno Le Maire called Ms Vestager’s decision to veto the deal a mistake. Together with his German counterpart Peter Altmaier, he has proposed a potentially radical overhaul of the EU’s strict competition rules including the option of giving politicians the power to override commission decisions and ensuring regulators systematically base decisions on global rather than European or national market share.

Ms Vestager, one of the star performers of the commission and deemed a potential future president, agreed the time was right to have “a more nuanced and more pragmatic approach” to competition policy. Data were becoming increasingly important to the global economy, she said. Meanwhile, with the rise of Chinese state-capitalism and US protectionism, it was “more and more obvious” that the openness of European markets was “an asymmetrical thing”.

However, she argued the current regime to foster fair competition “has served us well” by creating markets that made European companies more efficient, innovative and better able to compete globally.

“I think it is important to discuss that very fundamental choice because if we want to change it [in Europe] we should be very well aware of the consequences,” she added.

Europe’s competitors had adopted different economic models, she added. The Chinese “have made a different strategic choice” for a market led by state-owned monopolies while in the US they have chosen to have “more concentrated markets”.

Ms Vestager defended her decision to block the Siemens-Alstom deal, saying had she allowed the merger go through, it would have cut competition and increased prices for very high speed trains, thereby pushing customers to look for a cheaper supplier — “de facto inviting” foreign competitors like CRRC into the market.

Critics see the blocked railway merger as proof that the EU rules need to change in order to compete with state-backed rivals such as CRRC. However, Ms Vestager said the deal could have been cleared if the companies had done more to reduce their dominance in markets for very high-speed trains and mainline-railway signalling systems.

To level the playing field with Chinese and other state-backed rivals, Ms Vestager said Europe needs to make better use of its trade instruments, the bloc’s public procurement rules and new EU procedures for screening foreign direct investment. EU governments also needed to accelerate stalled talks over procurement measures “that will allow us to ask for reciprocity [in rivals’ markets]”.

The commission urged EU capitals need to make better use of the programme to allow state aid for projects of common European interest. Established five years ago, the programme was first used in December to approve €1.75bn in government funding from France, Germany, Italy and the UK for a research and innovation project on sensors, chips and other so-called micro-electronics at the heart of household and industrial devices linked the internet.

Countries including France, Germany and Poland are considering funding a scheme to build next generation batteries for electric vehicles. Ms Vestager said the development of 5G networks “could be another candidate”.

One important reason for revising competition policy is that new antitrust tools are needed to deal with data, which is becoming increasingly important as more businesses and sectors digitalise.

“The creation of data and the pooling of data have been so much faster than expected — because now the internet of things is a thing,” Ms Vestager said.

An advisory panel she appointed to report on new antitrust tools to manage data will report in the coming weeks.

“This is all very, very inspiring because it is renewed interest in this field between competition law enforcement, regulation — coming from the fact that we are all digitalising — and the facts of life in the global marketplace,” she added.

Chief expects UPC deal to proceed despite one shareholder declining to participate in rights issue

The head of Sunrise Communications remains “very confident” that it will land its acquisition of cable rival UPC after pledging to launch one of Europe’s first 5G networks in Switzerland this month using Huawei equipment.

Sunrise has agreed to buy Liberty Global’s Swiss cable business for SFr6.3bn, which will be funded by a SFr4.1bn rights issue.

The structure of the funding has been designed so that Sunrise is not saddled with a large debt position but has created a problem for the company after Freenet, the German company that owns about a quarter of its shares, said it would not participate in the fundraising. Shares in Sunrise came under significant pressure last week as a result. 

Olaf Swantee, chief executive of Sunrise, said he expects shareholders to approve the deal despite the initial reaction. “We can create a really strong internet story for Switzerland. We are very confident this will go through,” he said. 

André Krause, chief financial officer of Sunrise, said the high levels of synergies — anticipated at SFr2.8bn — means the price it is paying Liberty is “fair” but that it has “heavy lifting” to do. “It will take time to narrow down some views,” he said of the reaction to the rights issue, which is larger than its market capitalisation. 

For Mr Swantee, the UPC acquisition is a critical step in Sunrise’s plan to create one of Europe’s largest “truly independent challengers” in telecoms. If cleared by regulators and shareholders, Sunrise will have a 24 per cent market share in mobile, 31 per cent in television and 29 per cent in broadband, according to the company.

Sunrise is launching 5G in Switzerland this month using equipment from Huawei. It expects to roll out 5G across 150 towns and villages in the country while investing in full fibre in more densely populated areas. 

Mr Swantee said that all telecoms companies in Switzerland use Huawei equipment. Moving into the 5G era, he has proposed developing a security operations centre that can test equipment from all equipment vendors. “We need to get an industry-wide approach to this topic,” he said.

Asian stocks rose with U.S. futures, and the yuan advanced after a report that the U.S. and China are close to a trade deal that may end American tariffs. The dollar fluctuated and Treasuries dipped.

Chinese and Hong Kong shares saw the biggest gains, though equities climbed across the region and European futures pointed higher. Beijing has made it clear in a series of recent talks with the U.S. that removing the tariffs on $200 billion of Chinese goods from day one was necessary to finalize any deal, according to people familiar. Meanwhile, weighing on the dollar was a warningagainst excessive strength in the greenback from U.S. President Donald Trump.

Nikkei +1.02% Hang Seng +0.59% CSI +0.91% Shanghai +0.84% Shenzen +1.85%

Eur$ 1.1365 CNY6.6934 CNH 6.6908 JPY 111.96 GBP 1.3228 CHF 0.9997 TRY 5.3760 RUB 65.7812 WTI$ 56.03

S&P +0.37% EuroStoxx +0.42% FTSE +0.40% Dax +0.42% SMI +0.46%

Macro :

- Italy’s League Gains Ground in Ipsos Poll as Five Star Slips

- Goldman, JPMorgan Still See Upside in China Assets After Rally

- May Gets Boost as She Seeks Approval for EU Deal: Brexit Update

- May Accused of Buying Brexit Votes With $2 Billion to Poor Towns

- Italy in the Danger Zone Alarms Rest of Europe a Year After Vote

Keep an eye on :

- AD NA : Watch Ahold on Report Amazon Planning More Grocery Stores

- ALPH SW : Alpiq Full Year Adjusted Ebitda CHF166 Mln

- AMEAS FH : Anta-Led Group Confirms Amer Sports Offer Won’t Be Extended

- BKIA SM : Bankia to Sell EU1B of Real Estate-Linked Loans: Confidencial

- BMW GY : BMW Group U.S. February Sales Climb 0.2% to 23,558 Vehicles

- BOKA NA : Boskalis Joint Venture to Sell Kotug Smit Towage; EV of EU300M

- BP/ LN : Bidders Said to Emerge In BP’s $7 Billion U.S. Shale Asset Sale

- BW NO : BW Offshore Considers Purchase of Maromba Field Offshore Brazil

- CA FP : Carrefour’s CEO Urges Equal Taxation for Amazon, Alibaba: JDD

- CLIMEB SS : Breakthrough Energy Invests $12.5m in Climeon Collaboration

- DAI GY : Mercedes-Benz U.S. Luxury Auto Sales Down 12.5% in February

- DAI GY : Daimler Chief Backs Higher Commercial Diesel-Truck Taxes: FT

- DFDS DC : DFDS CEO Smedegaard Steps Down as CFO Carlsen Takes Over

- DIA SM : DIA Board: LetterOne Capital Increase Doesn’t Solve Co’s Needs

- FB US : Facebook Sues China-Based Companies for Selling Fake Accounts

- FRE GY : Akorn Says to Still Defend Against Fresenius’s Remaining Claim

- GBB FP : China’s ICBC Ready to Buy Stake in Bourbon, Les Echos Reports

- III LN : 3i, Greene King, Takeaway.com to Be Added to Stoxx Europe 600

- ISAT LN :

- ITP FP : Interparfums Raises 2019 Rev. Target to EU480m vs EU470m

- BAER SW : Julius Baer Buys Majority Stake in NSC Asesores

- KARN SW : Kardex Full Year Revenue Meets Estimates

- LIN GY : Linde Delays 10-K Filing; Required Added Time Due to Merger

- LOK LN : Lok’nstore Chairman Sells Shares, Cites Investor Buying Interest

- NOVN SW : Novartis Psoriasis Drug Cosentyx Shows High Efficacy in China

- UG FP : EU Rules Must Not Stifle Battery Project, Tavares Tells Figaro

- RNO FP : Suga Denies FT Report That Abe Backed Opponents of Nissan Merger

- RR/ LN : Rolls-Royce Backs Out of Fighter Jet Project With Turkey: FT

- RR/ LN : Rolls-Royce Seeks Buyer for Nuclear-Equipment Unit: Sunday Times

- RDSA NA : Shell India May Sell 10% Stake in Mahanagar Gas After July: Mint

- RYA ID : Ryanair in Pact With German Pilot Union on Pay, Allowances

- SSC NO : *SCOTTISH SALMON CEO BOUGHT 27K SHARES OF COMPANY AT NOK 17 EACH

- SNBN SW : SNB Posts 14.9 Billion Franc Loss on Foreign Currency Holdings

- SLA LN : Standard Life’s Gilbert Says Job Cuts ‘Already Factored In’

- TIT IM : Telecom Italia Sparkle Names Mario Di Mauro New CEO

- UCB BB : Presented positive data from the Phase 2b BE ABLE extension study of bimekizumab in patients with moderate-to-severe chronic plaque psoriasis

- VAO GY : Vapiano to Slow Pace of Restaurant Openings: CEO to Focus

- VOw3 GY : Volkswagen of America Reports Feb. 2019 Sales Results Down 3.6%

- VOW3 GY : German Car Industry to Invest $45 Billion in Electric Vehicles

- VOW3 GY : Volkswagen Brand’s Profitability Falls in 2018: Spiegel

* Ageas Upgraded to Hold at HSBC; PT 42.20 Euros

* NYT (Saturday): Breaking with decades of practice, Mexican officials are carrying out the Trump administration’s immigration agenda along the border, undercutting earlier promises to defend migrants and support their search for a better life; Hundreds of U.S. commandos and other forces are leaving West Africa despite an onslaught of attacks from an increasingly deadly matrix of Islamist fighters, and the shift has unnerved African commanders in Burkina Faso and other sub-Saharan areas; Brands are giving lucrative endorsement deals to young children—known as “kidfluencers”—on YouTube and Instagram, raising questions about whether people in that age group should be seeing that kind of marketing; Canadian prime minister Justin Trudeau promised a fresh approach to politics based on openness, decency, and liberalism, but now finds himself embroiled in a scandal involving support for a Canadian company accused of bribing the Libyan government; +/- Huawei: Canada’s Department of Justice authorized an extradition hearing for chief financial officer Meng Wanzhou, who is wanted on fraud charges in the U.S., which accuses the company of stealing trade secrets and evading sanctions on Iran; (Sunday): Donald Trump presented North Korea what he considered a grand bargain: it would trade all its nuclear weapons, material, and facilities for an end to the American-led sanctions squeezing its economy—essentially the same deal previous presidents had offered, and which Pyongyang flatly rejected, undercutting Trump's vaunted “dealmaking” skills; “As battle lines harden between supporters and opponents of climate action, both are increasingly using bouts of extreme weather as a weapon to win people to their side,” raising the stakes for scientists who attempt to distinguish between short-term fluctuations and long-term shifts; Trump said he will issue an executive order that would help guarantee free speech at colleges and universities by putting their federal aid at risk if they do not protect the viewpoints of students of all political stripes; Sunday Business: Women make up only a small percentage of investing partners at the top 100 venture capital firms, and last year female founders received only 2.2 percent of $130B raised in VC money, a situation that has prompted the creation of women-only networking and entrepreneurial groups such as The Wing.

* WSJ (Weekend): Before Donald Trump’s meeting with North Korean Kim Jong Un, U.S. diplomats, sanctions officials, nuclear experts, and missile specialists taking part in working-level talks realized the country expected much more in sanctions relief than the U.S. was prepared to give; Lyft’s move to file for an initial public offering “fires the starting gun on what is expected to be one of the biggest years ever for initial public offerings” with a healthy stock market and the major indexes rallying; Technology is causing strains throughout the banking industry, especially among smaller rural banks that are struggling to fund the ballooning tab for digital services demanded by their customers—many of whom are moving their accounts to larger banks; Growth slowed at U.S. manufacturing firms in February, a sign the slowing global economy and uncertainty over trade could have clouded the outlook for factories; Democratic support for Medicare-for-all is slipping from the high levels seen around the November midterm elections as voters worry about its price tag and the toll it would take on both private and employer health coverage; Congress voted in February 2018 to suspend the borrowing limit for about a year and is set to reinstate it Saturday, but the Treasury won’t be able to borrow more money until lawmakers suspend the ceiling again; +T: Now that its acquisition of Time Warner is complete, the telecom giant plans to “officially break down the corporate walls and fiefdoms that have long been a way of life at the company's HBO, Turner, and Warner Bros. units”; West Virginia’s dependence on coal, which is fast losing ground as a desired source of energy, has left the state and its workforce poorly equipped to attract advanced jobs in technology and manufacturing that are key to prospering in today’s economy; Few economists predict a return to an age when manufacturing accounted for the top job in dozens of states, but many say the industry has stabilized, with much of the recent job growth coming from companies producing long-lasting goods, such as transportation equipment and machinery; Automated financial advisors—or “robo advisors”—are expanding into the cash-management market with higher rates, their latest move to capture clients from traditional, higher-cost banks and brokerages; Many investors say Chinese stocks are inexpensive despite this year’s surge, but the consumer and technology stocks many active fund managers prefer aren’t quite so appealing; H.O.T.S.: The age of gene therapy promises a wave of life-changing and life-saving medicines, but the high costs of such drugs raise a number of thorny questions; “MSCI is raising the portion of China A-shares in its EM index—but that doesn’t give investors carte blanche to snap them up”; Macau has seen gambling revenue growth stall, but that could change if it offered more casinos geared toward the mass market.

Entangled

"Do you understand quantum entanglement?” I asked the Aussie investment analyst, a recent engineering graduate. “No one understands it,” he replied. “You’re in good company, Einstein didn’t understand it either,” I said. “He called it spooky action at a distance,” said the analyst. Some subatomic quantum particles are entangled - when you separate them and change the spin of one, it reverses the spin of the other, instantaneously, impossibly, as they communicate faster than the speed of light. “I’m fascinated by this phenomenon,” I said.

“I look for things in markets that don’t quite make sense,” I told the analyst. “They provide a glimpse of a reality we do not yet understand. Just like quantum entanglement tells us we do not yet understand reality. The abrupt Q4 decline in US stocks didn’t quite make sense. QT and rate hikes were nothing new. So does it mean we’re entering recession despite so much fiscal stimulus? Or does it mean inflation is on the rise? Or might it mean that we’re on the cusp of an anti-capitalist political revolution? All three? I don’t know, but it means something."

China

“The US is our greatest ally,” said the CEO of one of Australia’s largest superannuation funds. “And China is our biggest customer,” he continued. “That’s an increasingly difficult line to walk.” 30% of Australian exports head to China. “And it’s particularly difficult to manage without adept politicians.” Japan is Australia’s next biggest buyer, a distant 2nd, accounting for 10% of total exports. “We’re a pimple to China, they’re an elephant to us.” Under pressure from America, the Australians joined other allies in banning Huawei 5G technology last month. Canberra cancelled the visa of billionaire Huang Xiangmo for links to the Chinese Communist Party, and for pursuing Chinese interests through political donations. Then China introduced coal import quotas and quality controls, and its largest port doubled custom clearance to 40-days for Australian shipments. In the power struggle unfolding between the US and China, Australia faces profound risks.

Not long after Beijing clamped down on capital outflows, Australia’s overpriced real estate market rolled over. Sydney prices are down 10%-20% from the highs. Melbourne a bit less. Yet the cranes still spin, completing boom-time projects, lifting supply, in an economy leveraged to assets price increases. The RBA responded by adopting a dovish stance, but like every global central bank, they have limited room to cut rates, having never found the opportunity to lift them from record +1.50% lows hit in August 2016. “There is so much focus today on what divides nations. But it’s vitally important to remember what connects us,” continued the CEO. “The Chinese buy our iron ore, our coal, our gold. They send their children to university here, earning world-class degrees, buying condos.” And 7,760km north, President Trump walked out on Beijing’s pawn, Kim Jong-Un. As America increasingly questions what connections it shares with a nation it increasingly sees as its principal adversary: China.

Trump Cards

“One common factor connects the fall of every Chinese Dynasty,” explained the CIO in Asia. “Their leadership ran short of food for the people.” Most of China’s land mass is naturally nonarable. Much of its fertile acreage has been degraded by erosion, salinization, acidification, industrial effluent, sewage, excessive farm chemicals and mining runoff. This leaves just 11% of Chinese land that can be farmed. 75% of rivers are severely polluted, one-third of those are too toxic to be used for irrigation. The remainder are drying up due to overuse.

The US has 6x more arable land per capita, and annual water resources are 9,400 cubic meters per capita. China’s annual equivalent is 2,200. Consequently, US industrial farms produce pork for $0.57 per pound versus $0.68 in China. The Chinese consume half the world’s pork. They prefer US pork to domestic production; our food safety laws are superior. US pork exports surged from 57k metric tons in 2003 to 2.3mm in 2016 ($5.7bln). As the Chinese grow more affluent, this demand rises. And no one know this better than Beijing.