In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.
AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.
The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.
On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.
In the past few months, we have seen that despite the significant decrease in economic surprise indexes, US equities have constantly been reaching new all-time highs, with the SP500 index breaking above the 4,500 level this week. We previously saw that the US mega-cap growth stocks (i.e. FANGs) have been mainly driven by the dramatic surge in global liquidity, which we compute as the total assets of the major G10 central banks.
As the FANGs stocks represent a significant share of the SP500 index (over 25%), the strong momentum in tech stocks have pushed the whole index to new highs.
Interestingly, the chart below also shows the strong relationship between the Fed’s balance sheet assets and the SP500 in the past year. As a reminder, when the Fed halted its POMO operations in the end of October 2014 (following nearly a year of tapering), US equities remained flat for 18 months and experienced several drawdowns before starting to edge higher in H2 2016 with markets starting to price in further stimulus (Tax reform plan, higher spending). See the article entitled ‘Could we survive without QE?’ that we wrote in September 2014 for more details.
Even though this time is different, there is still a lot of uncertainty over the economic recovery, therefore normalizing policy too early could halt the momentum in US equities in 2022. This is a challenging time for US policymakers as inflationary pressures remain elevated in both DM and EM economies and the Fed needs to normalize its policy in order to leave more room for a potential new economic shock in the future.
We know that Sterling has historically traded like a risk-on currency that tends to appreciate in periods of trending markets and consolidate sharply in high-volatility regime.
Figure 1 shows the monthly average performance of the most liquid currencies relative to the dollar when the VIX rises above 20 in the past 30 years. As expected, the yen is the currency that benefits the most when price volatility rises, averaging 45bps in monthly returns. On the other hand, the pound has averaged -30bps in monthly returns when the VIX was high.
This was confirmed during the March 2020 panic as GBP was sold aggressively during that month with Cable reaching a low of 1.14 (down from 1.32 in early March) before starting to recover gradually (lowest level since 1985).
Figure 2 shows an interesting relationship between GBPUSD and mega-cap growth stocks since 2020 (FANG+ stocks); Sterling has significantly recovered in the past 17 months, up nearly 20% against the US Dollar. However, the momentum on Cable has halted in recent months as risky assets have shown some signs of ‘fatigue’ amid rising uncertainty over a range of risk factors (i.e. Delta variant, falling growth expectations…).
Nominal yields on long-term government bonds have been constantly trending lower in the past 35 years, mainly driven by the lower global economic growth and the convenience yield for safety and liquidity. In addition, policy responses from both governments and central banks following the Great Financial Crisis have also contributed to the downtrend in LT interest rates globally, driving the term premium (investors’ compensation for holding interest rate risk) to negative levels.
Figure 1 represents the history of interest rates since the beginning of the 12th century up to today. The data source comes from Homer and Sylla’s book A History of Interest Rates (2005), which reviews interest rate trends in the major economies over four millennia of economic history. For the last 150 years, we compute a GDP-weighted average interest rate times series using a sample of 17 countries (Global LT interest Rate), using data from Jorda et al. paper The Rate of Return on Everything (2017).
One interesting observation was that in the past millennium, nominal interest rates have mainly traded below 10 percent, with two exceptions:
· The first one is during the Spanish Netherlands period, which is the name for the Habsburg Netherlands ruled by the Spanish branch of the Habsburg. In the 16th century, Antwerp was one of the most important financial centres in the world, dominating international markets in sugar, spices and textiles. During a significant part of this century, the Exchange at Antwerp had dominated European transactions in bills of exchange and other credit instruments such as demand notes, deposit certificates and the bonds of states and towns (all short-term debts). Between 1508 and 1570 (when Antwerp defaulted on its debt), the interest rates were from loans by various bankers to the Spanish Netherlands government, Charles V and the city of Antwerp. We can notice that interest rates surged to 20% in the mid-1520s, and the bankers’ family, the Fuggers, made emergency loans to Charles V at annual rates as high as 24 to 52 per cent.
· The second period of high interest rates was during the Great Inflation of the 1970s, which was marked by a sustained trend in inflation in the US that affected the rest of the World as well. A number of factors were associated to the rise in inflation during that decade: oil price shock following the 1973 embargo, speculation, avaricious union leaders and bad monetary policy management. As a consequence, long-term interest rates started to surge around the world, reaching a high of 14 per cent on average in 1981.
Interest rates globally are sitting at their lowest level in history, with the aggregate currently trading at around 0.5 per cent (probably trading between 1%-1.5% if we include some major EM economies to our times series of LT interest rates). As uncertainty has been constantly reaching new all-time highs (especially in the past year following the Covid19 shock) and growth expectations have been lowered accordingly, global yields have decreased dramatically since the last quarter of 2018 and broke below the lows reached in the late 16th century during the Republic of Genoa. At that time, Genoa became the banker for the Spanish Crown, a role previously held by German and Dutch bankers. The Bank of St. George was issuing placements or perpetual bonds called luoghi, which paid deferred dividends on the amount of taxes collected, after subtracting payment of the expenses of the bank.
The explanation of the persistence of very low real interest rates in advanced economies is a contentious issue. While many studies, including those by central bank research departments, stress secular forces such as demographics, over-indebtedness and dispersed income distributions – factors that emerged before the Great Financial Crisis – others find an important role for monetary policy in the determination of interest rates. On the secular view, a potential mean-reversion in long-term real interest rates must be driven by a global economic force such as a sustained period of above-trend economic growth. On the latter view, the monetary policy regime is endogenous to the real interest rate and the unconventional policies of the past decade are part of the explanation for low rates.
In the past few months, we have seen that China Total Social Financing (TSF), a broader measure of credit and liquidity, has been falling sharply with the annual change in TSF 12-month sum down from over 10tr CNY in October 2020 to nearly 0 in May 2021. As a result, investors’ concern has been growing as they have been questioning if the rally we have observed in global asset prices can continue in the coming 6 to 12 months without Chinese help.
In the past cycle , periods of contraction in Chinese liquidity were usually associated with a fall in both domestic and international asset prices. This chart shows the striking co-movement between the annual change in China Tech stocks (CQQQ ETF) and the annual change in China TSF 12M sum. China Tech stocks are down over 25% since their mid-February highs; according to this chart, China tech stocks are expected to continue to consolidate in the short term.
Since the start of the year, we have seen that the annual change in China Total Social Financing (TSF) 12 Sum has been shrinking rapidly, which could eventually become a problem for risky assets. Previous periods of sharp contraction in China TSF (i.e. 2018) have been associated with a sudden rise in risk-off assets such as USD or US Treasuries. Figure 1 shows that the annual change in China TSF 12M Sum fell from over 10tr CNY in October to 3.1tr CNY April.
Interestingly, we can notice that that a contraction in Chinese ‘liquidity’ has usually been followed by a fall in US long-term bond yields. For instance, figure 2 shows the 6M change in US 10Y Treasury yield with the 6M change in China 12M sum (8M lead). According to this chart, the consolidation the US 10Y yield has just begun.
Copper was one of the major assets to benefit from the constant liquidity injections from central banks to prevent economies from falling into a deflationary depression. The front-month futures contract has more than doubled since its March low of 2.06 and is currently trading at 4.3, its highest level since August 2011.
However, we have also seen that copper prices (and other commodities heavily relying on Chinese economy) has been very sensitive to the annual change in China Total Social Financing (TSF). This chart shows that the annual change in China TSF 12M sum has been falling for the past 4 months, which has previously been associated with a correction in copper prices and other base metals. Can the momentum in copper continue without Chinese stimulus?
As we mentioned it in one of our previous posts, there has been a strong co-movement between the US Dollar and the 2Y10Y yield curve in the past 15 years, but the relationship was potentially going to break out as the US dollar was getting extremely oversold while inflation expectations have been constantly rising in the past few months (usually leading to yield curve steepening). This chart shows that while the the USD index has stabilized at around 90-91 since the start of the year, the 2Y10Y yield curve has steepened sharply by 45bps to 1.25%.
In the past year, central banks have been constantly injecting liquidity into the market in order to avoid the global economy from falling into a deflationary depression, which has generated a strong rebound in risky assets, especially mega-cap growth stocks. However, we previously discussed that the more liquidity reaches the market today, the harder the ‘COVID-19 exit’ will be. Equity markets have been diverging significantly from their ‘fundamental’ value in recent months and therefore a reversal in the stance of the Fed monetary policy could eventually result in a sharp selloff in US equities, which could have a significant impact on the real economy. This chart shows the strong co-movement between the 3-year change in the equity market (SP500) and the annual change in the US unemployment rate in the past 50 years; periods of equity weakness have been historically associated with a higher unemployment rate.
It the real economy robust enough to swallow a sustain period of equity weakness in the medium term?
In the past year, the constant liquidity injections from central banks to finance the high costs of lockdown policies implemented by the governments to fight the pandemic have generated a spectacular rebound in equities, and especially the mega-cap growth stocks. As it has been reflected in the stock price since the start of 2020, Tesla (TSLA) has been one of the big winners of the surge in excess liquidity; figure 1 (left frame) shows a strong co-movement between Tesla stock price and the annual change in global liquidity, which we compute as the total assets of the 5 major central banks (Fed, ECB, BoJ, PBoC, BoE).
With a forward P/E ratio of 192 and a market cap of over 800bn USD, analysts have been constantly stating that the stock was clearly overvalued, and a correction was due in the short run. However, as we know: ‘a stock can remain undervalued more than one can remain solvent’, especially in the current environment where the uncertainty over the ‘Covid19 exit’ remains very elevated. Do you really want to short Tesla now knowing that another 5tr USD of liquidity (at least) is expected to reach market in the coming 2 years?
Tesla performance re-adjusted
As skepticism over the future of monetary policy and therefore the future of money has been constantly growing in recent months, we think it will be more appropriate to normalize Tesla’s stock price by re-adjusting the price from the massive currency debasement that major economies have experienced since the start of the pandemic.
For instance, if you define Tesla as a futuristic tech company, and that bitcoin is the currency of this future tech world, then it makes sense to look at the performance of Tesla relative to a unit of bitcoin. As there are no ways of ‘diluting’ bitcoin, participants could look at bitcoin as a digital currency which is independent from central banks and monetary policies. Figure 2 (left frame) shows that bitcoin has also been very sensitive to the dynamics of global liquidity in recent years; its price would not have soared that significantly if we were not living in a world of ‘monetary experiment’.
Figure 2 (right frame) shows the dynamics of Tesla stock price per unit of bitcoin since January 2018; after it reached a high (of 4.3E-02) in September, the stock is down over 50% in the past 6 months. We think that both the stock price (in USD) and bitcoin will lose in value as confidence on the future of money comes back as participants start to price in a ‘Covid19 exit’ (therefore less QE), but for now we think that it will be interesting to follow the ratio (Tesla / bitcoin) in the coming months.
Tesla vs. the rest of the automakers: the chart that does not matter
In the past few months, one popular chart that has been making the headlines is the one that shows the current market capitalization of Tesla against the combined market cap of the 7 biggest automakers: Volkswagen, Toyota, GM, Hyundai, Ford, Honda and Fiat Chrysler. The combined market cap of this 7 automakers is currently of 630bn USD, which is far below Tesla’s 805bn USD (figure 3, left frame). Does this chart really make any sense? Tesla is an automaker, yes, but it also competes with companies from other sectors such as tech, which are generally very sensitive to global liquidity. Figure 4 shows the strong co-movement between Tesla and the FANGs stocks in the past year.
Hence, this could justify the massive difference in the market cap per car produced. With 500K cars produced in 2020, Tesla market cap per car produced currently stands at 1.6mil USD; on the other hand, figure 3 (right frame) shows that the market cap per car produced for other automakers stand between 10,000 and 20,000 USD.
Rising free cash flows and soaring sales
Despite the elevated uncertainty associated to Covid19, Tesla free cash flows have continued to improve in 2020, increasing from 1.1bn USD in 2019 to 2.8bn USD in 2020 (figure 5). Interestingly, Tesla had a solid second half of 2020, with FCF up +276% YoY in Q3 2020 and +84.4% in Q4 2020, respectively.
Profits were up 721mil USD in 2020 on about 31.5bn USD on sales, nearly completely erasing the 862mil USD loss (with sales of 24.9bn USD) in 2019. With the company expecting to increase production in the coming years amid surging demand for electric vehicles, sales are expected to continue to skyrocket to 49.5bn USD in 2021 and 67.4bn USD in 2022, respectively, with the highest estimates standing at 56.5bn USD and 88.6bn USD (figure 6, left frame).
Figure 6 (right frame) shows the exponential growth in the car deliveries in the past cycle; after delivering nearly 500 thousand cars in 2020, Elon Musk suggested a delivery target that could reach 1 million vehicles for this year (Wall Street analysts’ projections are currently more conservative with 796 thousand vehicles). With the strong popularity of the company’s founder and CEO (E. Musk has over 46mil followers on Twitter), it seems that participants are clearly more receptive on Musk’s tweets than Wall Street analysts, which is probably the reason why Elon’s 1-million target will be closely watched by investors in the following quarters.
Remember Apple and Amazon at 800bn USD
With Tesla crossing the 800bn USD market capitalization in 2021, we compared some of the company’s key fundamentals with two other main FANGs – Amazon and Apple – when their valuation crossed the 800bn USD threshold. Figure 7 shows the revenues, operating margin and net income of the three companies the year before the market capitalization surpassed 800bn USD (i.e. 2020 for Tesla, 2016 for Apple and 2018 for Amazon).
Amazon crossed the 800bn USD valuation in the middle of 2019, after reporting a 98% growth in profits of 11.2bn USD in 2018; the exponential rise in the stock price in the previous years brought Jeff Bezos to the top of the league of the world’s richest people. While Amazon revenues were over 7 times bigger and net income was over 10 times bigger than Tesla for the same market cap, operating margin was slightly lower at 5.3% and the 5-year average in revenues growth was already twice lower.
On the other hand, Apple had much stronger fundamentals in 2016 (Apple crossed the 800bn USD threshold in May 2017) with 215bn USD in revenues, 26.8% in operating margin and a net income of 48.3bn USD, which is probably one of the main reasons why the company is now part of the ‘2-trillion-dollar club’. However, revenues growth was even smaller than Amazon with a 5-year annual average of 16.1%.
Hence, it is difficult to use a comparable approach analysis in order to come up with a ‘rational’ valuation for Tesla when the dispersion between companies’ fundamentals are so elevated; however, one could look at the strong growth in revenues and car productions as key inputs to their valuation model.
Revenues and deliveries forecasts for the next 5 years
As we previously saw, Tesla’s deliveries grew by nearly 60% between 2015 and 2020 and revenues growth averaged 53% in the last 5 years; if we assume that the growth rates decelerate to 30% for the next 5 years, Tesla annual deliveries will reach 2.8 million cars by 2025 and revenues will grow to 128bn USD (figure 8). Even though some investors would argue that the projections are very aggressive, it is actually possible for Tesla to achieve this figures with the new factories (upcoming Berlin and Texas in 2021) and the new models (cheap-version, upcoming Cybertruck and Model Y).
In addition, Tesla also announced that battery costs could decline by over 50% in the coming 5 years, implying that the company is on track to achieve a battery cost of $55/kWh by 2025, which is significantly lower than the benchmark of $100/kWh at which EVs are thought to reach cost parity with internal combustion engine vehicles. Figure 9 shows the projections of the EV battery cost in the coming decades; with a current cost of $125/kWh, Tesla is already 20% below market average cost of $157/kWh and is expected to gain a significant share of the world EV market in the next 5 years (from nearly zero today).
Hence, the decline in battery costs and the improvement of self-driving capabilities should continue to drive software sales higher and therefore supporting margins.
Tesla’s sensitivity to US Treasury bonds
With more and more investors starting to get concerned that higher interest rates in the US will potentially start to negatively impact equities in the near to medium term, we look at the sensitivity of Tesla’s stock price to US 10Y yield in the past cycle. Figure 10 shows the 1-year rolling correlation between equity returns (Tesla, SP500 and Nasdaq) and changes in the 10Y yield, looking at daily data in the past 10 years. Interestingly, while equity indexes have shown a ‘strong’ positive correlation between price returns and changes in yields (i.e. negative correlation between equity and bond prices), the correlation between Tesla stock price returns and change in US 10Y has been much lower, averaging 0.1 in the past cycle. Does it imply that Tesla share price is ‘independent’ from movements in the Treasury bond market, and that higher yields in the short run may be irrelevant for Tesla stock price?
We know that given the current environment, the upside on the US 10Y remains limited and that the Fed will start to intervene at some point if rising yields start to significantly matter for equities. The 10Y yield has been rising in recent months amid the significant excess of Treasury net issuance over the Fed net purchases and is currently trading at 1.2%; we think that 2-percent is the ‘hidden threshold ’ and policymakers will prevent yields from rising to quickly from current levels.
Elon Musk: a transparent and reliable CEO?
Over the years, professional and retail investors have always been skeptical on how much effort and discipline a CEO was putting on a company that was not originally founded by him/her. This could be referred as the Principal-Agent problem in Corporate Finance Theory, where we do not know if the agent exercises the effort or not when managing the company. It is very rare to have an influential entrepreneur that communicates with the crowd through social network whose work-ethic is impressive. For most companies, participants feel very detached from the top executive board and therefore the lack of transparency may justify the lower premium that other competitors in the same industry currently offer.
For investors looking a major themes in market, we strongly believe that Tesla represents one of them as we could say that the company is actually ‘fighting climate change’; as Chamath Palihapitiya said in an recent interview, Tesla is a ‘distributed energy business’, which is trying to figure out ‘how to harness energy, how to store it and how to use it in a way to allow humans to be productive’.
In other words, even though some people would disagree with that statement, investing in Tesla could appear as one of the big ‘Climate Change’ trade; in the future, there will be many different ways to invest in climate change, but at the moment it could be seen as a big company that represents climate change.
Consumer Reports recently published a ranking of ‘The Most and Lease Liked Car Brands’ with car owners asked whether they would buy the same car again if they were given the chance. It was interesting to see that among the 27 brands that were included in the survey, Tesla came first with a 88% score (figure 11), implying that only 12 percent of the customers would have bought another (it was the only company with a score above 80%, the second brand was Lincoln with a 79% score). The only problem today is that the models are still expensive and represent a high barrier to entry for most of the customers; among Tesla’s cheapest models, we find the Model 3 at $38,000, which is in line with the average price of a new car purchased in the US (est. $37,000), but could gain much more popularity if the price was falling significantly below that level in the coming years.
A 25,000-dollar car for early 2022?
It has been a few years now when Elon Musk first mentioned the potential production of a low-cost Tesla model of approximately 25,000 USD.
Although some speculate that $25,000 is too low as a price, recent news from China hinted that Tesla was planning to produced a third EV model from its Shanghai Giga factory as early as 2022, with the price estimated between 160,000 CNY (24,800$) and 200,000 CNY (31,000$), which should be shipped around the world. Even though it will have less power or acceleration than other ‘regular’ models, its battery life will still be ranging between 350 km and 450 km.
Despite the company’s massive valuation, we still think that there are many better stocks to short in this environment than Tesla. The rising optimism amid the vaccination campaign and the reopening of the economy may halt the momentum in those mega-cap growth stocks in the near term, but social distancing norms combined with travel restrictions will certainly lead to more debt, higher liquidity and therefore higher equity markets.
After reaching a high of nearly 900 on January 25, the stock has been gradually consolidating in the past 3 weeks and seems on its way to retest its 762 support, which corresponds to the 23.6% Fibo retracement of the 328 – 896 range. We continue to think that further retracement could offer long-term investors an opportunity to buy the dip as we remain confident that the stock will break its 900 resistance in the coming weeks.
In this article, we highlight the fact that if people look at Tesla as one of the main companies of the future, then it would be also interesting to look at the stock performance relative to bitcoin, which could be seen as one of the currencies of the future, especially after the company has recently converted some of the cash in its balance sheet to bitcoin (1.5bn USD). In that case, Tesla stock price has been down (by over 50%) in the past 6 months.