Weekly Market Commentary By H.E.R.O. (27 Sep to 1 Oct 2021)
Yield spike during the week resulted in an extreme, violent rotation into the Reopening/Cyclicals trade in Energy & Financials, with the dollar index soaring to a roughly one-year high, and rates-sensitive bonds and REITS plunging in a bloodbath, and the S&P 500 suffered its biggest weekly slide since February: MSCI ACWI All World index -2.1%, NASDAQ/NASDAQ 100/S&P 500 Tech -3.2%/-3.5%/-3.3%, Stoxx -2.4%, while Euro Stoxx Tech crashed -8.5% and Cloud Software ETF WCLD -5.2%, and Topix -5%, Taiwan TWSE -4%, KOSPI/KOSDAQ -3.4%/-5.2%, Phillip SREITS -2.5%, Gold +0.6% (Gold -7.3% YTD). China markets were closed for a the Golden Week holidays and won’t reopen until next Friday. Stocks notched their steepest monthly losses in 18 months since the pandemic-fueled selloff of March 2020; NASDAQ was off -5.3%, its worst September in a decade. Stocks also suffered its first quarterly loss since the first three months of 2020. A $150 billion rout has turned Switzerland’s equity market, which is packed with defensive quality stocks from chocolates to pills, into one of the world’s worst performers this month. Some European long-term investors are reportedly using significant declines in stocks this week as a chance to build positions. Although active money sees the current environment as dangerous, longer-term investors wanted a pullback in the quality companies to deploy new capital.
The strengthening dollar, driven by a more hawkish Fed, is reducing the appeal of higher-yielding emerging-market carry trades, which handed investors their biggest monthly loss in 18 months. As well as the revival of the waning speculative Cyclicals/Reopening trade, the yield spike also prompted the most leveraged U.S. companies to have their best performance relative to healthy balance sheet names in six months. Promising results for Merck’s experimental Covid-19 antiviral pill triggered a bounce on late Friday (after European markets closed) for U.S. stocks that stand to benefit from an economic reopening. Investors pulled roughly $2 billion out of ETFs focused on U.S. stocks during the week through Thursday, extending outflows for a second week. Jittery investors were rattled by news of a short-term spending bill to avert a government shutdown while debt-limit wrangling was set to continue, and a planned vote in the U.S. House of Representatives on a $1 trillion bipartisan infrastructure bill was called off, as Democratic lawmakers failed to agree on other linked spending proposals.
Energy prices have been soaring, including in Europe as Friday marks the official start of winter, with shortages on the continent as well as in Asia, where China has been hit by power cuts and outages, with brent crude price pushing past $80/bbl for the first time in three years, natural gas for October delivery traded at the costliest in seven years and the Bloomberg Commodity Spot Index rose to the highest level in a decade. The U.K., which has been suffering petrol or gasoline shortages, saw three more smaller energy providers go out of business, leaving over 200,000 customers to find a new provider as wholesale natural gas prices have soared in the country. Just days after Goldman slashed its Q3 GDP estimate for China to 0% and commented that its hidden local government debt has swelled to more than half the size or 52% of the GDP at 53 trillion yuan (US$8.2 trillion), up from 16 trillion yuan in 2013, Beijing confirmed that the Chinese economy has indeed stalled, with the September Mfg PMI contracting in September for the first time since the COVID-19 outbreak, confirming that China is entering into a period of stagflation. Stagflation is unfolding worldwide, but becoming more severe in the U.S. which could prompt policy makers to tighten monetary policy more aggressively than expected at a time when output is weaker and risk asset prices may be volatile. Global manufacturing activity took a big hit from supply chain bottlenecks and escalating costs, exacerbated by pandemic-induced factory shutdowns in Asia and signs of slowing Chinese growth. A gauge by IHS Markit measuring business activity in Eurozone manufacturing fell last month by the biggest margin since April 2020 -- the beginning of the Covid-19 pandemic. Once seen as a driver of global growth, Asia’s emerging economies are lagging advanced economies in recovering from the pandemic’s pain as delays in vaccine rollouts and a spike in Delta variant cases hurt consumption and factory production. Between June and September, 224 S&P 500 companies mentioned inflation on their second-quarter earnings calls, according to FactSet. That is the highest number since FactSet began tracking the data in 2010. Historically, when a relatively high number of companies have mentioned inflation, profit margins have shrunk.
In terms of global central bank hikes exceeding cuts, we are now at the highest differential for a decade on a rolling 12-month basis. In other words, we are now entering the most aggressively global hiking cycle in a decade. Among the indicators investors are using to gauge stocks’ future trajectory is the spread between the yields on two-year and 10-year Treasuries. Some view this as a barometer of whether the economy is slowing or overheating. A spread of between zero and 150 basis points is a “sweet spot” for stocks, which has been consistent with an 11% annual return for the S&P 500, based on historical data. That spread has recently widened and stood at around 120 basis points on Friday. When the spread exceeds 150 basis points, that is when stocks tend to struggle, historically equating to an annual S&P 500 return of 6%.
As euphoric traders piled into the trendy Cyclicals/Value Traps, we believe that there is a high probability of downside risk in chasing and catching them at exactly the wrong time after their sharp run-up from being blinded by the fiscal stimulus hopes and vaccine euphoria — the light at the end of the tunnel — and things can turn very nasty suddenly, as markets tend to underestimate how long that tunnel is, and how dangerous that tunnel is. This situation is very vulnerable for cyclicals to degenerate or revert back into its true ugly colors as cheap-gets-cheaper Value Traps once the vaccine euphoria fades or something negative happen on the mass vaccination roll-out or the vaccine does not prevent people from carrying and spreading the virus to others or new mutated virus strains erupt to render the vaccines ineffective. Once the vaccines actually start being administered at scale and the pandemic recedes, a lot of investors are going to wake up to the fact that the global economy is still dogged by a host of thorny problems that both predate and have been exacerbated by the virus. The current unsustainable market euphoria over Cyclicals, Value Traps, Zombies (companies who cannot cover their interest expense with cash from operations) and Vampires (junk-rated corporations with negative EBITDA) has created opportunities for long-term investors in the inexorable rise of a selected group of fundamentals-based structural growth innovators. These winners solve high-value real-world problems to generate visible and vigorous quality earnings growth before and during the pandemic, as well as are poised to enjoy continued healthy demand and staying power in a post-pandemic future when the world recovers painfully and slowly to transition from the Pandemic Health Crisis to the next crisis – the PTSD Post-Pandemic Growth Crisis. Our portfolio companies have shown resilience and scalability during this tumultuous environment and the management continue to make key strategy decision to expand their market leadership in their respective fields. The quiet HE.R.O. innovators have invested wisely in innovations that sharpen their exponential competitive edge for long-term value creation, strengthened their market position in the value chain that supercharged their cashflow dynamics, developed new channels, new markets and new customer base for revenue growth while improving their profitability at a time when most businesses are struggling, and nurtured their human capital and corporate culture to foster innovation and ESG sustainability. While the short-term day-to-day price movement can be volatile, what continues to be crystal clear is that the quiet structural growth H.E.R.O. innovators remain the most visible and vibrant pathway in a foggy, volatile, whipsawing, uncertain market to deliver sustained outperformance with their healthy fundamentals results.