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China: market bulls beat the short sellers — for now

Big bets on the collapse of the country’s indebted economy have largely failed. Did the hedge funds misread the signs or were they just too early?

Soon after the global financial crisis began to recede in 2009, an analyst at Kynikos Associates gave a presentation on China to the hedge fund’s management, led by James Chanos. What he said made their jaws drop.

The analyst estimated that at the time there were 5.6bn sq m of high-rise buildings under construction in China, a number so high — the office space alone equalled a small cubicle for every man, woman and child in the country — that Mr Chanos assumed the analyst must have mixed up square feet and metres.

But when the analyst said he had double-checked the numbers, the hedge fund manager was shocked. “We realised, wow, this is a once in a lifetime kind of thing,” he later recalled.

The silver-haired iconoclast rose to fame for being among the first to realise that Enron was a fraudulent house of cards, betting against — or going “short” in Wall Street parlance — the energy company. And in China, Mr Chanos thought he had found Kynikos’s next big short. He started betting against companies that would suffer if China crashed back to earth, and talked loudly about the dangers lurking in its massively indebted economy.

“Bubbles are best identified by credit excesses, not valuations . . . there is no bigger credit excess right now than China,” he told CNBC in December 2009. A horde of fellow hedge fund managers — many of them with high profiles in the media — soon piled in as well, including Eclectica Asset Management’s Hugh Hendry, Hayman Capital’s Kyle Bass, John Burbank at Passport Capital and Crispin Odey of Odey Asset Management.

Fast-forward to 2018, and the bears have mostly been forced to eat cold porridge. Although the Chinese economy has slowed from its double-digit growth rate of a decade ago and there have been bouts of turbulence in 2015 and 2016, the turmoil dissipated each time. The debt implosion and currency collapse that many predicted have failed to materialise. Chinese gross domestic product grew 6.9 per cent in 2017, its fastest pace in two years.

“There was a great deal of momentum built up in the [short China] trade. But they missed the fact that China both had the will and the wallet to deal with these issues,” says Michael Gomez, a Pimco fund manager. “That turned the tide.”

As a result, many sceptics have thrown in the towel. Mr Hendry turned positive on China in 2016, but had to shut his hedge fund last year; Corriente Advisors’ Mark Hart gave up on his own Chinese short in September. Mr Burbank closed his flagship fund in December. Even Mr Chanos says he is now the least short on China he has been since he implemented the trade.

Betting against China was particularly painful last year. Investors that shorted Chinese companies listed in Hong Kong or the mainland suffered losses of more than $35bn in 2017, almost half their stakes, according to New York-based data provider S3 Partners.

Why were the China bears so wrong? Did they fail to understand the way the Chinese economy works or were they just too early? In markets there is often little difference. But for the global economy this is one of the most important questions to answer in 2018.

Even with strong headline growth, some analysts and investors are once again worried that Beijing’s stop-start attempts to tackle its alarming credit boom could cause problems this year.

Indeed, some of the biggest bears remain undeterred by China’s thus-far graceful slowdown in growth. Kynikos’s bets against China largely paid off, Mr Chanos says. And the hedge fund manager — as well as a handful of other prominent investors and economists — remain convinced that China’s economy is still on the road to ruin.

“Nothing has changed,” Mr Chanos says. “They’re just doing what all governments do, kick the can down the road. And in China’s case it’s a giant, borrowed can . . . I don’t know when it will end, I just know it’s unsustainable.”

Xi Jinping, China’s president, announced a “new era” for the country at the Communist party congress in October, where he exhorted colleagues to “work tirelessly to realise the Chinese dream of national rejuvenation”. A large part of that dream has already been fulfilled. Three decades ago, China’s gross domestic product was about $250bn, roughly the equivalent of Finland or Chile’s current economic heft. Today, just the economy of Shenzhen — the mainland city north of Hong Kong — is a third bigger at current prices. The country’s overall GDP has grown to nearly $12tn.

However, China’s post-crisis growth was juiced by a borrowing binge. Its overall debt-to-GDP ratio — including the government, households and local companies — has risen sharply over the past decade to 256 per cent, according to the Bank for International Settlements. The Chinese banking sector’s assets have swelled to 310 per cent of GDP, up from 240 per cent five years ago.

This was the central concern of hedge funds gunning for China, such as Hayman’s Mr Bass. In early 2016 he laid out his case for why “China’s back is completely up against the wall”.

“The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline,” he wrote.

Mr Bass argued that China would have to burn through its foreign currency reserves to rescue its financial sector, which was bloated with bad debts. This would force it to devalue its currency, the renminbi. At the time China had already rattled markets by letting the renminbi depreciate against the dollar, and betting on a deeper devaluation became the popular trade for hedge fund managers.

For a period it looked smart. About $1tn of China’s reserves evaporated in 2015-16, and by the end of 2016 the renminbi had slipped by over 12 per cent to an eight-year low versus the dollar. Yet China held the line. The renminbi bounced back in 2017, reserves are again on the increase and the shorts have been remorselessly flushed out.

“The government is very sensitive to having the renminbi shorted and considers it some kind of national disgrace to have foreign funds be able to outflank them,” notes Anne Stevenson-Yang, director of research at J Capital Research. “The Chinese government sees itself as master of the house — the house being the Chinese economy.”

Some China bears — such as Mr Chanos — still made money by eschewing the currency trade and focusing instead on companies that were indirectly exposed to its slowdown and rebalancing, such as Brazil’s Vale, Australia’s BHP Billiton and other commodity groups. But for many investors the big China short became what traders ruefully call a “widow-maker”.

Mark Kingdon, a veteran hedge fund manager who has been investing in China since the early 1980s, says many bears simply misunderstood the country. “With all the noise, it’s sometimes easy to forget that China is a managed economy, that they owe all the debts to themselves, and they have trillions of dollars in reserves,” says the head of Kingdon Capital Management. “I’ve been following China for a long time, so maybe I’m drinking the Kool-Aid. But it is astonishing what they have achieved.”

There are signs the authorities are getting a handle on the credit boom. Morgan Stanley estimates that China’s overall debt-to-GDP ratio rose by only 4 percentage points in the first nine months of 2017, a “significant improvement” compared to the 42 percentage point increase in the ratio from 2015-16. JPMorgan estimates that the debt-to-GDP ratio fell in the second quarter last year, the first outright decline since 2011. 

Beijing’s success is underscored by the diverging performance of two exchange traded funds appropriately called Yinn and Yang that are managed by Direxion. Yinn, which is a three-times leveraged “China Bull” ETF, returned nearly 130 per cent in 2017: the Yang “China Bear” ETF lost two-thirds of its value.

However, the factors that unnerved the pessimists remain in place. In its latest outlook on the global economy, the IMF warned that “the size, complexity and pace of growth in China’s financial system point to elevated financial stability risks”.

Even Zhou Xiaochuan, the central bank governor, has warned that China faced a possible “Minsky moment” — referring to US economist Hyman Minsky’s theory that stability breeds a complacency that ultimately disintegrates into panic. Last week Guo Shuqing, the chief banking regulator, also warned that a “black swan” event could threaten China’s financial stability.

In the lead-up to last year’s party congress, Beijing unveiled a “regulatory windstorm” that was aimed at taming the shadow banking system. The possibility that this might escalate into a clampdown that could imperil growth even triggered some unease in Chinese markets last month.

Cracking down on the unrulier corners of finance is overdue, argues Arjun Divecha, head of emerging market equities and chairman at GMO, the Boston-based investment group. He compares the Chinese economy to a forest where the undergrowth — the shadow banking system — has grown too quickly.

“It needs to burn that away without burning down the trees. There’s a risk that happens, but they have the tools to deal with it,” he argues. Mr Bass did not respond to requests for comments on Hayman’s short position, but he appears determined to hold his ground. On December 29, he tweeted a Reuters article about China’s shadow banking sector, calling it a “total financial disaster”.

Mr Chanos says Beijing is unwilling to take action that would risk a sharp slowdown and imperil the Communist party’s grip on power. “The treadmill to hell hasn’t ended, they just keep investing,” Mr Chanos says. “Whenever they tap the brakes the economy wobbles and they reverse course.”

At the moment, investors are basking in the broadest spell of global growth in years, helping spark a global market rally. China’s rebound has played a significant role in this, and most investors expect it to continue.

Mr Gomez says Pimco spends “an extraordinary amount of time” assessing China, visiting every month to assess its health. And while there are still some dangers, he believes the authorities have largely handled the challenges well. “We have not let down our guard. But at the moment our assessment is that the issues are contained,” he says. “They’re driving with one foot on the gas and one foot on the brake.”

Nonetheless, long-term bears argue that there is little reason to relax.

Patrick Chovanec, chief strategist at Silvercrest Asset Management and a former professor at Tsinghua University in Beijing, says “they’ve kept the show going for a lot longer” than he expected at the cost of “unimaginable” debt levels.

He adds: “If you have cancer and the doctor gives you three months to live, and you live much longer than that, you still have cancer. You wouldn’t stop by your doctor and laugh at how wrong he was.”

Engineering group lifts forecasts in fast-growing electric driveline business

GKN sought to underline its potential as an independent company in the face of a hostile, largely share-based £7bn offer from Melrose Industries by significantly lifting its forecast for growth in the electric driveline business.

The FTSE engineering group said it expected sales in 2020 from the unit, which turns out the parts that send battery power to car wheels, to be £275m by 2020, 36 per cent better than the £200m previously forecast and up from £33m in 2017, the company said in a statement on Sunday. Turnover would hit £500m by 2022, thanks to recent big contract wins.

GKN also announced that the order book for electric driveline — a small part of its business that is rapidly growing — hit a record £2bn at the end of 2017. This reflects a series of significant programme wins for the unit, otherwise known as eDrive, with major global automakers.

GKN last reported its divisional breakdown of sales and orders in August. Sunday’s uplift was possible due to a series of important contract wins since then, a person close to the company said.

The boost in sales targets comes as GKN attempts to convince investors to reject the hostile cash-and-shares offer from Melrose.

The bid has come at a difficult time for GKN, left without a successor to former chief executive Nigel Stein and in the wake of two profit warnings.

However, the company has argued that Melrose’s offer, 80 per cent in shares and 20 per cent in cash, significantly undervalues the group.

Melrose said in a statement: “Research and development is a key part of the Melrose equation and today’s [GKN] announcement is part of the justification of the premium that we are offering to GKN shareholders as we seek to create a £11bn value powerhouse by merging our two businesses.”

The GKN team — led by Anne Stevens, the former non-executive who has been promoted to chief executive in the face of the Melrose bid — argues that accepting the offer would hand a significant share in the future benefits of growth to the bidders’ shareholders.

Ms Stevens has said she intends to reverse the company’s poor record on cash and margins with a restructuring plan and by better supporting growing businesses such as eDrive.

GKN makes parts and systems for roughly half the world’s passenger cars. However, the shift to hybrid electric vehicles could threaten that position. GKN has been investing heavily for years in electric technology.

In 2017, the research and development hit to profits was £36m, with total investment of more than £123m over the past six years, GKN said.

But the company said this was now paying off. “Whilst impacting near-term financial performance, this investment is now delivering strong sales and order book growth,” the group said in a statement.

Among the recent major wins that have contributed to the £2bn order book, GKN cited: a multimode etransmission system due to launch on a Chinese manufacturing platform across a number of vehicle models from 2018; a semi-integrated electric driveline unit from 2019 for a new vehicle launched by a premium European automaker; and an integrated edrive system for a European global manufacturing programme that is expected to be first launched in China from next year.

Deal would combine two of the world’s four largest grain merchants

US agribusiness Archer Daniels Midland has approached its rival Bunge about a potential takeover that would combine two of the world’s four largest grain trading houses, three people briefed on the matter said.

ADM’s approach comes eight months after Swiss commodities trader Glencore proposed a tie-up with Bunge, setting the scene for a potential bidding war.

Glencore and Bunge had signed a standstill agreement that prevented any further talks between the two companies until February. It was unclear whether Bunge, which had a market capitalisation of about almost $11bn on Friday evening, is interested in pursuing a deal with ADM, said one person briefed about the situation.

Along with Cargill and Louis Dreyfus, ADM and Bunge constitute the so-called ‘ABCD’ of global grain traders, buying millions of tonnes of corn, soyabeans and wheat from farmers for processing into food or export to booming markets such as China.

In the summer Bunge chief executive Soren Schroder left a door open to a possible transaction, saying that the suburban New York-based company would seriously evaluate any offer that would generate shareholder value. However, he has emphasised partnerships and joint ventures as a means of consolidating an industry suffering from too much capacity.

A combination of Bunge and ADM would face serious pressure from antitrust authorities to divest assets especially in the US and Canada, an industry executive said. This could offer an opportunity for Glencore or another company to acquire those assets without engaging in a bidding war for the whole of Bunge.

It is unclear whether Glencore would renew its interest in a deal after the standstill agreement ends as the commodities group is concerned about a recent decline in profitability at Bunge, said people familiar with its thinking.

Bunge, which is incorporated in Bermuda, has no poison pill or bylaws that would allow it to fend off an unsolicited approach, making it vulnerable to a hostile takeover.

Its shares spiked in the last minutes of trading on Friday to end 11.3 per cent higher, and gained another 1 per cent in after-hours trading after the Wall Street Journal first reported the talks. ADM’s stock rose a little over 1 per cent in after-hours trading, giving the Chicago-based company a market value of nearly $23bn.

ADM and Glencore declined to comment, while Bunge did not respond to a request for comment.

While demand for grains continues to grow, agricultural traders have struggled as a succession of bumper crops has depressed prices and curtailed trading opportunities.

Farmers have built up their own storage bins, allowing them to wait for more favourable prices before selling harvests to traders. Consumer food companies, recognising the state of plenty, have been reluctant to pay traders a premium for firm supplies.

In some locations, grain merchants have overbuilt ports and silos needed to handle flows of grain and oilseeds, whittling down profit margins. In November, Mr Schroder cited “a growing understanding within the industry that something has to change, particularly in the US”.

ADM dates to 1902. It is the most US-weighted of the ABCD companies, with more than half its processing plants and nearly three-quarters of its procurement facilities located in the country. It has sought to expand its global reach, including through an attempt to take over Graincorp of Australia that was blocked by local authorities.

Bunge was founded in 1818 in Amsterdam, moved its headquarters to South America in the early 20th century and resettled in New York before its public listing in 2001. Reflecting its history, it has an important presence in South American soyabeans, corn and sugarcane, in addition to assets elsewhere.

Executives of Franco-Dutch group met Italian commissioners to discuss joining auction

Air France-KLM has held talks with Alitalia about entering the race to acquire the ailing Italian flag carrier, a decade after its efforts to purchase its peer were scuppered by political opposition. 

According to people familiar with the matter, Alitalia’s government-appointed commissioners met AF-KLM executives in Paris last week to discuss the Franco-Dutch airline’s interest in joining the auction, possibly through a joint bid with easyJet, the British low-cost carrier. 

AF-KLM’s arrival on the scene marks a new twist in the long-running saga surrounding the fate of Alitalia, turning control of Italy’s skies into a key battleground in the European airline sector.

The Italian airline collapsed into bankruptcy last year, after employees rejected a deal on salary and benefits proposed by the company, in which Etihad, the UAE-based carrier, had a big investment.

Now under government control, the airline has been trying to draw out potential buyers, but struggled to find a palatable option. A potential joint offer from AF-KLM and easyJet would join Lufthansa, the German airline, and Cerberus Capital Management, the private equity group, as the most likely contenders to buy Alitalia. 

This month, AF-KLM denied that it had already made a bid for Alitalia, but it did not rule out any interest in doing so in the future. People familiar with the situation say that AF-KLM may be feeling squeezed between Lufthansa and IAG, which owns British Airways and has a foothold in Italy through Vueling, the Spanish low-cost airline, so it may not want to sit out the Italian contest. 

However, AF has already been scorched by a previous attempt to buy Alitalia in 2008, which was scuppered by political opposition as the centre-right government led by Silvio Berlusconi at the time pushed for an all-Italian rescue of the airline instead.

“I don’t think the past experience of either KLM or Air France in their relations with Alitalia encourages us to repeat the experience of a direct presence in Italy,” Jean-Marc Janaillac, AF-KLM chief executive, said last year.

However, he left himself some room for manoeuvre when he said AF-KLM would “watch what happens” with the commissioners, and “adjust our position accordingly”. 

Alitalia — and the Italian government — had hoped to get the sale wrapped up by the end of last year, but the offers that came in late 2017 were not considered sufficiently strong to merit any kind of exclusive negotiation, let alone a formal deal. 

This prompted the commissioners to engage in a new set of talks with potential buyers, including AF-KLM, which was granted access to Alitalia’s data room after last week’s meeting, but also Delta Air Lines, the US airline, which acquired a 10 per cent stake in the French airline last year.

Lufthansa has already said its bid was contingent on assurances that Alitalia would implement deep cuts under the commissioner’s leadership. According to Reuters, Carsten Spohr, Lufthansa chief executive, said there was still “a considerable amount of work” to do on the restructuring front before a takeover by the German airline could be viable in a letter to Carlo Calenda, Italy’s economic development minister, this month.

The entry of AF-KLM into the picture means that it could still take weeks — if not months — for Alitalia’s commissioners and the government to settle on the best offer, entering into exclusive talks with a single buyer. Most likely, this means the fate of Alitalia will be decided after the general election in Italy, set for March 4. 

Alitalia and AF-KLM declined to comment.

He is to join the French house on Feb. 1 and show his first collection next September.

PARIS — One of fashion’s preeminent image-makers and trendsetters, Hedi Slimane is to lead Céline into men’s wear, couture and fragrance as its new artistic, creative and image director, WWD has learned.

He is to join the LVMH brand on Feb. 1 and unveil his first fashion proposition for men and women next September during Paris Fashion Week.

“I am enchanted, what a great choice,” said Karl Lagerfeld, one of Slimane’s most enthusiastic fans, who famously shed 90 pounds in order to shimmy into his slim tailoring. “It will be great.”

It marks a major homecoming for Slimane, who cemented his reputation — and influenced men’s tailoring for more than a decade — as the designer of Dior Homme between 2000 and 2007. He went on to reinvent and ignite the Kering-owned house of Yves Saint Laurent, which he rechristened Saint Laurent, between 2012 and 2016 — all the while maintaining a close rapport with the Arnault family, which controls LVMH and Dior.

In a curious twist of fate, Slimane will be reunited with Sidney Toledano, the legendary chief executive officer of Dior, who recruited the designer to propel the storied couture house into men’s fashion.

Toledano is to relinquish his role to Pietro Beccari, who joins the management helm of Dior from Fendi, and become chairman and ceo of LVMH Fashion Group, which includes Céline along with the brands Givenchy, Kenzo, Loewe, Marc Jacobs, Pucci, Rossi Moda and Nicholas Kirkwood.

“I am particularly happy that Hedi is back within the LVMH Group and taking the creative reins of our Céline maison,” said Bernard Arnault, chairman and ceo of LVMH Moët Hennessy Louis Vuitton, calling Slimane “one of the most talented designers of our time.

“I have been a great admirer of his work since we collaborated on Dior Homme, which he launched to global acclaim in the 2000s. His arrival at Céline reinforces the great ambitions that LVMH has for this maison. Hedi will oversee all creativity for both women’s and men’s fashion, but also for leather goods, accessories and fragrances. He will leverage his global vision and unique esthetic virtuosity in further building an iconic French maison.”

It is understood Céline, prized for its sumptuous leather goods and modernist clothing, is already approaching 1 billion euros in revenues.

Sources indicate LVMH has ambitions to double that figure as it leverages Slimane’s global following, his design chops, and a widening of the product universe.

It is understood the first freestanding Céline men’s boutiques are to open as early as 2019. Slimane’s designs for men are sure to attract keen interest from retailers and fashion fans alike — while perhaps sparking anxiety among some of his designer colleagues in men’s.

In a statement, Slimane said he is “delighted to join Bernard Arnault in this all-embracing and fascinating mission for Céline. I greatly look forward to returning to the exciting world of fashion and the dynamism of the ateliers.”

The Frenchman takes over Céline from Phoebe Philo, who announced her resignation from the brand last December after an electrifying 10-year tenure, during which she reinvented the brand in her image and made it a watchword for sleek designs crackling with currency.

It is understood Philo will not work for another label in the near future and the fall 2018 collection, to be unveiled in March, will be the last collection crafted by her.

Given his close rapport with the music scene, Slimane is sure to bring a blast of cool and youth to Céline, which enjoyed more of a high-minded, adult allure under Philo.

According to sources, Slimane is to maintain his home base of Los Angeles and lead creation there, while shuttling to Paris, where Céline is based. Its Rue Vivienne headquarters boasts extensive ateliers.

The designer is expected to eventually offer made-to-measure designs — in the manner of couture but without big fashion shows — as he did while at Saint Laurent.

It is understood his first fragrance for the brand could be ready before the end of the year. While Slimane did not have purview over beauty during his Saint Laurent tenure, much to his chagrin — that business is controlled by licensing partner L’Oréal — he had a good deal of influence at Dior Homme, introducing several fragrances and a complete skin care range.

The exacting designer will also have input into Céline’s store fleet, which counts 150 locations and echo his taste for luxurious materials like marble and modernist design references.

Slimane’s career path in some ways echoes Philo’s. Slimane took a sabbatical from fashion after exiting Dior Homme and focused on his photography and artmaking sidelines. Philo, who forged her reputation at Chloé, made her fashion comeback at Céline in 2009 after a three-year sabbatical.

“Hedi Slimane is an exceptional designer, complete artist and passionate about his work,” Toledano commented in a statement. “I am certain that he will bring his renowned creative energy and discipline to lead Céline to even greater success.”

Last year, LVMH recruited Berluti’s Séverine Merle to take the management helm of Céline and lead it into online selling.

Merle, who worked under Berluti chairman Antoine Arnault, is a veteran of LVMH, having worked at its flagship Vuitton brand as its general manager for France and women’s wear merchandising director.

Hennes & Mauritz shareholders just endured another tough stretch, with H&M’s stock unraveling by some 20% since mid-December. Bears are growling that the fast-fashion powerhouse’s days as a growth story are over.

In the weeks ahead, the Swedish retailer might win back some investors as it gives its annual results on Jan. 31 and holds its first-ever capital markets day, a meeting for institutional investors, on Feb. 14.

But there is also a chance that the pessimists are right, and a big rally isn’t in the cards at this point.

“The company may continue to aspire to 10% to 15% annual sales growth, but with actual performance so weak and future store openings now set to be scaled back significantly, we think the days of consensus assuming that a ‘return to growth’ is just around the corner are coming to an end,” wrote Morgan Stanley analysts in a recent note. They have an Underweight rating on H&M’s stock (ticker: HMB.Sweden) and a price target of 120 Swedish kronor ($15), implying a drop of more than 20% from the recent print near SEK157.

After sales gains of 18% and 19% in the fiscal years that ended November 2014 and November 2015, H&M delivered a 6% rise in 2016 and looks set for 4% growth in the just-concluded fiscal year, hampered by a decline in fourth-quarter revenue that H&M revealed last month. In the 2018 and 2019 fiscal years, sales growth is expected to range between 5% and 6%, according to consensus estimates from FactSet.

H&M has been “an international rollout story,” but lately there have been twists in that tale, Morgan Stanley’s Geoff Ruddell and Amy Curry say. H&M has more than 4,000 stores around the world, after clearing the 3,000-locations mark five years ago and topping 2,000 roughly a decade ago. Yet these days, H&M is closing stores in mature markets, as shoppers increasingly buy its $7 T-shirts online. Accelerating internet sales haven’t fully offset reduced foot traffic.

Moreover, the main challenge for H&M isn’t just adjusting to a web-centric world, but that its value proposition is fading for customers “who can now shop considerably more cheaply elsewhere,” write Ruddell and Curry. One rival with budget offerings: British clothing retailer Primark, owned by Associated British Foods (ABF.UK).

H&M Stock Has Fallen, But It’s Not a Bargain Yet

Smaller sales gains will lead to weaker profit growth, and H&M’s price/earnings multiple ought to continue to drop to reflect that it has been “several years since H&M has really been a ‘growth stock,’ ” the Morgan Stanley team wrote. Shares trade at 16 times forward-year estimated earnings, on par with U.S. clothing retailer Gap (GPS) P/E, and much cheaper than its Spanish rival Industria de Diseño Textil’s (ITX.Spain), or Inditex, with its 26 multiple.

Inditex, the parent of Zara, may deserve to be significantly pricier. H&M and Inditex are “a world apart” in their prospects, Barclays analysts offer in a recent note. Barclays puts an Underweight rating on the Swedish company and an Overweight rating on the Spanish retailer. H&M has grown mainly through opening new stores as sales deteriorated in key regions, and its profit margins could keep falling, wrote the bank’s Boris Vilidnitsky and Alvira Rao. Meanwhile, Inditex’s margins look defensible, and the market hasn’t given that retailer enough credit for its ability to boost sales per store, they wrote.

H&M does boast a pretty fat dividend yield of 6%, though management could reduce the payout.

“We would not rule out a dividend cut, perhaps even later this month,” warn Morgan Stanley’s Ruddell and Curry, though they say that’s not the most likely scenario. “Cutting it would give the company much more freedom to reinvent its customer proposition.” An H&M spokeswoman says executives weren’t available for an interview, citing a quiet period before results hit on Jan. 31.

This month, H&M’s stock slid to nine-year lows, and it now has been sliced in half after climbing above SEK360 in 2015. Some shareholders still sound upbeat.

“H&M has invested heavily in its online presence in recent years, and we believe it is better positioned than many in the market appreciate,” wrote David Herro and Michael Manelli, portfolio managers for Oakmark International Fund, which holds H&M shares, in their fourth-quarter letter. The Stockholm-based company’s disappointing fourth-quarter sales were due in part to weakness in its sector, as well as “a fashion miss in H&M’s collection and a failure to get the right product to the right stores.” The retailer has made changes, they note, with a new H&M brand head tackling “fashion and product-allocation issues.”

Even so, investors may want to wait and see if management offers reassurances in the next few weeks that beaten-up H&M is a bargain.

IN EUROPEAN MARKETS last week, the main indexes were a mixed bag as earnings season helped drive the action. Burberry Group (BRBY: UK) was among the big losers after the British fashion house posted weaker-than-expected quarterly sales. The Stoxx Europe 600 has gained about 3% so far in 2018.

VICTOR REKLAITIS is a London-based writer for MarketWatch.

What is the U.S. getting for its corporate tax cut? A boost in investment in U.S. manufacturing is possible, but far from assured. More tangibly, especially for tech companies, tax cuts will boost dividends, buybacks, and mergers and acquisitions, all of which may boost stock prices.

Tech, more than other industries, has a hard time putting vast amounts of cash to work. That’s because it requires relatively little R&D to produce huge amounts of revenue. For example, Apple (ticker: AAPL), which may have the most to gain from tax cuts, with $252 billion in cash overseas, doesn’t have many places to invest that will demonstrably boost its financial results.

Last week, after Apple said it will pay $38 billion in taxes on its overseas holdings, the conclusion of many on Wall Street was that the two biggest investments Apple might make—in plant and equipment, and in manufacturing—aren’t really meaningful.

For example, regarding Apple’s pledge to spend $30 billion in the U.S. on capital expenditures over the next five years, “this annualized $6 billion U.S. capex is largely already built into Apple’s $18 billion capex guidance for fiscal 2018, and does not result in a meaningful increase,” wrote Amit Daryanani of RBC Capital Markets.

And Apple’s plan to expand its Advanced Manufacturing Fund, that is, money for U.S.-based production of key components, from $1 billion to $5 billion, is also pretty much business as usual. Apple already “has long used its large cash position as a strategic supply-chain lever,” wrote Robert Cihra of Guggenheim Securities. “Most were likely to happen regardless,” added Piper Jaffray’s Michael Olson last week.

Many last week concluded, as William Power of R.W. Baird noted, that “the primary use of [Apple’s] repatriated proceeds will go toward significantly increasing the size of its buyback.”

No one knows how much bigger Apple’s capital returns, already the largest in corporate history, will get. The focus for now is on Apple’s Feb. 1 conference call, when CEO Tim Cook and CFO Luca Maestri may signal their intentions.

At this point, the most surprising development for Apple would be a very large acquisition. The conventional wisdom is that it won’t happen, that Apple will stick to its practice of buying only small companies that directly contribute technologies for the iPhone and other products.

That may be naïve. With Apple still generating more than $1 per share in cash per quarter, on top of what will be $24 per share in net cash after paying the repatriation tax, and after subtracting $116 billion in long-term debt, even an increase in the dividend and buybacks will leave plenty of cash. Without the constant excuse that the cash is stuck overseas, pressure may grow for Apple to do something big.

The most likely candidate for an Apple purchase seems like Netflix (NFLX). The deal would be a distraction from the company’s business of making and selling devices, but it would immediately add extra luster to Apple’s services and content business. Not that Barron’s is recommending it, but at $95 billion in market capitalization, Netflix is certainly not out of reach for Apple.

With Apple’s cash unleashed, we find ourselves in uncharted territory, and the unprecedented must be seriously considered.

TAX CUTS COULD BRING special dividends back into favor. Credit Suisse’s Michael Nemeroff last week opined that Microsoft (MSFT) could use some of its $112 billion held overseas to declare a one-time special dividend of $14 per share. However, last time that happened, in December 2004, its shares rose just 3% in the ensuing 12 months.

For many techs, the immediate benefit of lower rates is more money that can be plowed into M&A. In software, Jefferies’ John DiFucci wrote last week that “more cash in large tech companies’ coffers will likely drive M&A and capital returns and executive pay,” and he cited Microsoft, Oracle (ORCL) with $49 billion, and VMware (VMW) with $7 billion, as the biggest among those that could repatriate. And there are plenty of small- and mid-cap software targets, including Red Hat (RHT), Veeva Systems (VEEV), Citrix Systems (CTXS), Talend (TLND), Okta (OKTA), and Twilio (TWLO). The rush of new cash may also further fuel semiconductor M&A, which was at a risk of cooling thanks to rising interest rates.

A nice example of how tax cuts are unhinged from anything having to do with the business itself is cable giant Comcast (CMCSA). Alongside the cut in the statutory tax rate to 21%, capital investments are deductible under the new rules, and Comcast is in a capital-intensive business. A lower rate and deductions could produce $14.4 billion in additional cash for Comcast through 2021, reckons Craig Moffett, who helps run boutique research house MoffettNathanson. With that extra cash, he expects the company “will have no choice but to buy back stock, and lots of it.”

That’s because, he wrote, telecom investors will expect as much. “Comcast’s fortunes will hinge on what it does with that cash,” wrote Moffett, precisely because its fundamentals aren’t likely to get “dramatically better.” Instead, “Comcast is now almost ideally suited to become a financial engineering story.”

Moffett expects the extra cash will let Comcast retire 7% of its free-floating shares through 2021, on top of what was already expected to be a 12% repurchase program.

To be sure, no one can rule out increased investment in the U.S., precisely because no one knows how all tech’s newfound cash will be spent—probably not even the tech companies themselves. What Wall Street cares most about, though, is what it’s always cared about: paying shareholders and doing M&A deals that drive banking fees.

Small-company stocks have begun the year with the wind at their backs. They’ve risen 3.4% through the first half of January, a strong kickoff by historical standards. There is some evidence that a strong January points toward a strong year.

Many people are making the bull case for small-caps as an asset class, and it’s an appealing one. The U.S. economy is still getting better, and earnings are rising. The new administration has been mostly friendly to business. Away from the soap opera, it has been cutting back federal regulations, and the new corporate tax cut should boost net earnings.

Meanwhile, the bull market for small-caps is less than two years old. The Russell 2000 tumbled 25% between July 2015 and February 2016. Such bear markets are usually followed by longer uptrends in stocks.

Jeff James, manager of the Driehaus Small Cap Growth Fund (ticker: DVSMX), expects many companies to raise their guidance when they report earnings in the next few weeks. That should keep the party going for a while longer.

But there are more risks out there than many investors realize. Small-caps today are expensive by historical standards. Worse, they are almost certainly more expensive than the headline numbers suggest. They are also, as a group, less profitable, more heavily in debt, and more exposed to the threat of rising interest rates than many investors may realize.

None of this may pose an immediate danger to a segment of the stock market that is enjoying momentum. As the old Wall Street saw has it, don’t fight the tape. But these factors pose longer-term concerns.

CONSIDER VALUATIONS. Wall Street values the Russell 2000 index at about 28 times forecast earnings. But this number, while still high, flatters to deceive. That multiple excludes all the companies that are losing money. Yes, that’s true for most stock indexes. But among small-caps it really matters. Some 34% of the companies in the Russell 2000 are currently losing money.

Factor those back in and, according to a Barron’s analysis and FactSet Research data, the Russell 2000 trades at 56 times 2017 earnings, and 36 times those forecast for the next 12 months. Those are lofty multiples. You need a lot of things to go right to justify owning or buying stocks trading at 56 times trailing earnings.

Yes, there are arguments for excluding these companies from the valuation multiples. FTSE Russell says they tend to distort the overall picture. Other analysts note that many loss-makers in the index are high-risk, long-term ventures such as biotechnology companies—lottery-ticket stocks for which current earnings aren’t particularly relevant. They will either cure cancer or go bust, and it’ll take about 10 years to find out which. What’s the right price/earnings ratio for that?

Yet this is still a little misleading. If investors in the index profit from earnings, they must also shoulder the losses.

Among the consequences: We don’t really know how big the overall effect of the corporate tax cut will be. Companies that are losing money will receive little benefit, for the obvious reason that they pay no income tax anyway.

Possibly more ominous is the matter of debt. According to Bloomberg data, small-caps in the Russell 2000 have more than doubled their overall net debts in the past five years. Everyone knows why: low interest rates, low inflation, and the Federal Reserve have allowed them to leverage themselves up cheaply.

Many companies have borrowed to expand, take over competitors, or simply buy back their own shares. It’s done wonders for their stock prices. But it hasn’t always helped their underlying business. Average returns on assets for small-cap stocks have tumbled by a third since 2012, to a little over 2%.

DOES THIS MATTER? Maybe not—if you’ve issued long-term bonds and locked in low interest rates for many years. But what if you haven’t?

Goldman Sachs analyst Jessica Binder Graham found that 42% of the debt owed by companies in the Russell 2000 carries floating interest rates. (That’s compared with just 9% for the big companies in the Standard & Poor’s 500 index). That leaves these small-caps vulnerable to an uptick in inflation, higher short-term rates, or both. Ominously, according to data from S&P and FactSet, in the last 12 months small companies were already spending a third of their earnings before interest and taxes on interest payments. That’s as high a proportion as it was at the worst point in the financial crisis. Indeed.

These things worry Francis Gannon, co-chief investment officer of The Royce Funds, the investment firm which specializes in smaller company stocks. Net debt in the Russell 2000 is higher than it was in 2007, just before the crash, he warns. “There’s a lot of financial leverage that people aren’t thinking about,” he says.

In the short term, the momentum remains with smaller companies. Even the cautious Gannon thinks the economy is better than the consensus realizes. That should, logically, keep the party going, at least for a while. But watch out for interest rates.