Economic and market themes: 2014-07-25 Ukraine, China, Japan, technology overvaluation

This week’s economic and market themes post has a lot of very different threads in it from all the previous parts of my life as a macro analyst: diplomacy and foreign affairs, technology, bonds, and the macro economy. So I am looking forward to writing it.

• Ukraine is at risk of becoming a failed state
• China’s growth is due to stimulus
• Japan’s macro figures worsen
• Microsoft’s strategy is weak
• Facebook is overvalued

Let’s start with the foreign affairs side and Ukraine.

Ukraine. The latest I am hearing, via a tweet from the U.S. State Department is that the U.S. claims to have new evidence that the Russians intend to deliver more powerful multiple rocket launchers to separatist forces in Ukraine. This, along with other tweets from U.S. Ambassador to Ukraine Geoffrey Pyatt hard on rhetoric about sanctions, makes it clear that the U.S. is putting a full court press on against Russia.

The angle that the U.S. government is taking is to make claims and try and present evidence that Russia is actively supporting the insurgents, and even engaging in warfare on Ukraine from just across the border. I see this as an escalation in rhetoric which we should take as a signal that the U.S. will seek new means to isolate Russia in the international community. 

The social media war is quite vocal and Pyatt is leading the charge on that front. Here is a good example of the propaganda war in the media at the New Republic which calls Ron Paul and anti-sanctions advocates at the Nation extremists and says one of their claims is a “lie”. The New Republic is a respected publication and terms like “lie” and “extremists” are almost never used in mainstream U.S. media against U.S. persons. So you know the stakes are ratcheting up.

The question here is how Russia will respond. One clue is that Russia has said that U.S. sanctions violate WTO guidelines, according to Reuters.

Countries enforcing trade sanctions do not have to justify them at the WTO unless they are challenged in a trade dispute. Justifications for restricting trade can range from environmental and health reasons to religious scruples.

But some diplomats fear that wide-ranging sanctions against Russia could only be explained by national security concerns. That would be a legitimate argument, but one that has never been invoked in a WTO dispute and could unravel mutual trust.

I don’t think Russia will cede any ground on this front. It will fight tooth and nail to undermine the legitimacy of sanctions. And if any of the U.S. claims about military support are correct, it also means that Russia will not cede ground on the military front either. So we have a situation here with no middle ground. And all appearances are that this crisis will escalate.

Meanwhile in Ukraine, the fighting is as intense as ever. Human Rights Watch says it has found a mass grave in Eastern Ukraine in Sloviansk, suggesting war crimes could be occurring in Ukraine. With the Ukrainian government collapsing due to its inability to get reforms and austerity through parliament upon which the I.M.F. loan is contingent, we have a failed state on our hands. We should start thinking of this as a potential Yugoslavia.

China. In China, the economy has regained its footing again on the back of more stimulus. Markit’s Flash China Manufacturing PMI hit an 18-month high of 52.0 in July, up from 50.7 in June. Earlier this year, I wrote that it wasn’t much longer before China stopped its rebalancing push because growth was slowing too much. There is a political limit here. Now, China is stimulating growth through with infrastructure spending and by trying to lift bank lending by having the PBoC inject RMB 1 trillion into the economy. If you want rebalancing, this is not it. Aggressive efforts to boost short-term growth are going to lead to worsening malinvestment high house prices and over-reliance on capital investment to drive growth. We have essentially partially returned to the old growth model in China. And China’s debt to GDP is believed to have passed 250% as a result.

And this is bullish for emerging markets and commodity prices. If China is reflating successfully, emerging markets will get a lift that keeps crisis at bay and gives them a window to make their own structural adjustments to be less vulnerable to crisis.

Japan. I am not particularly enamoured with Abenomics as a vehicle for sustainable growth. But it has been relatively successful thus far, more than I think people expected. My worry with Abenomics all along is that it needs to be a bridge to growth predicated on more jobs and wages and I am not sure it is. The latest out of Japan is that the trade deficit increased after exports dropped unexpectedly. One reason the shift in the Japanese trade balance has not been more pronounced is that Japan is a big importer of raw materials and the decline in the yen has not only decreased the cost of Japanese goods but also increased the cost of Japanese imports. It suggests to me that you can only get so far with policies designed to depreciate your currency.

The Japanese government has cut growth estimates. The economy is projected to grow 1.2% in the fiscal year ending March 2015, which is down from a previous forecast in January for a 1.4% increase. At the same time, wages are being squeezed by the uptick in inflation after the VAT increase. In May the number was 3.4%, a 30-year high. While this may have erased deflationary expectations for now, the impact on growth is unclear given the negative implications for spending power. And business sentiment worsened after the VAT hike.

Microsoft. Let’s take an abrupt shift into the tech world, where I worked in the 2000s. Microsoft is in the news for cutting 18,000 jobs, most of them at Nokia. And the company just reported mediocre earnings that were negatively affected by the Nokia acquisition. I don’t like Microsoft’s business strategy, frankly. In my view, Microsoft is where IBM was in the late 1980s, searching for a new business model now that their main line of business is stagnant or shrinking. And the transition to a coherent mobile strategy has been lacking.

Microsoft is trying to get people across form factors to use Windows and so it has been forced to change Windows toward a more mobile-centric interface since the world is moving toward mobile form factors and away from desktop systems. Execution here has been horrible. Windows 8 is a disaster for people using a desktop or laptop because it is such a fundamental change from previous Microsoft operating systems. And so as Microsoft transitions to a multiform factor OS it risks alienating its core customers in businesses and homes that use Microsoft for their desktop and laptop computers.

At the same time, Microsoft was late to the game in mobile. There is no traction for Windows Phone and I don’t see any being made unless Microsoft lowers the cost of its laptop-tablet hybrid, the Surface in order to build share. Microsoft is undoing its mistake with Windows 8. But if I were Microsoft, I would become much more aggressive about the Surface price point to better compete with iPads but be usable as a business laptop. And I would tie this into my cloud computing platform for business users.

Facebook. Yesterday, I tweeted an interesting statistic about Facebook in view of their earnings release.

Cisco’s P/E increased from 68x in October 1998 to 200x in April 2000. Facebook is about where Cisco was in 1999 https://t.co/12lncMYfj6

— Edward Harrison (@edwardnh) July 24, 2014

Facebook at about 100x earnings and $200bn is about where Cisco was in July 1999 $FB $CSCO

— Edward Harrison (@edwardnh) July 24, 2014

A company as large as Facebook (#14 or 15 in S&P500) really has to become massive to justify a multiple of 100x earnings $FB

— Edward Harrison (@edwardnh) July 24, 2014

If you look at Cisco Systems in July 1999, it had a market cap around Facebook’s level and it’s P/E ratio was also about where Facebook’s is today. Now, remembering what happened to Cisco, my basic argument here is that the growth, margin and macro assumptions built into Facebook’s share price at nearly 100x earnings are difficult to justify for a company of its size and maturity if one wants to make a decent return on the stock in the next seven to ten years.

First, on a purely macro perspective, when I worked at Yahoo in Corporate Development, I used to model out base, upside and downside macro economy discounted cash flow scenarios for my own unit at Yahoo and potential acquisition targets when presenting to the Yahoo board. The reason is that recessions have a huge impact on top line growth and therefore on valuation. We are in year five of a cyclical recovery. I find it hard to imagine a seven-to-ten year DCF for Facebook that won’t include one period of recession. So that’s number one.

Second, Facebook has a high degree of operating leverage as an internet company. That means that it can ramp revenue at a greater pace than costs. So, embedded in any model of Facebook’s cash flow is an increasing margin from operating leverage that falls to the bottom line as profit. The problem with this is that operating leverage is a two-edged sword. It magnifies top-line growth but it also magnifies top-line contractions. What I see happening – and I saw happen at Yahoo in the 2000s, which ultimately proved disastrous to its future as a leading Internet company – is that the next recession decimates ad revenue. Facebook is heavily dependent on ad revenue for profits. And if ad revenue shrinks due to a cyclical downturn, Facebook’s operating leverage will mean a huge and unexpected drop in profits.

Third, implicit in Facebook’s P/E is growth that I think is hard to come by given the maturity of the business and its reach to consumers. A business that has 100x revenue projections has to grow the top line a lot. And I question Facebook’s ability to do so.

The bottom line here is that Facebook is overvalued. It is emblematic of the market’s present obsession with growth that has caused the tech sector to be bifurcated into a set of companies with huge P/E multiples and a set of large established players with relatively normal multiples. I would bet on the latter over the former. In fact, I would overweight tech because of its countercyclical resilience due to the shift into mobile. But I would do that via large cap tech outside of Facebook and Amazon, which are not valued like the rest.

And remember that a market that values growth so much five years into an economic cycle is a market that is unusually vulnerable when a recession does occur.