Weekly Market Commentary By H.E.R.O. (6 to 10 Dec 2021)
Led by big tech, global markets rebounded after losing US$3.7 trillion in the week after omicron emerges (and world stocks had lost US$5 trillion since mid-November), though market volatility remain elevated, after Pfizer-BioNTech said initial lab studies show a third dose of their vaccine neutralizes omicron. Market sentiment has also recovered with other pieces of preliminary data suggesting omicron seems less severe than first feared, though offsetting that has been the imposition of tougher restrictions in UK and a growing list of countries to curb omicron's spread.
Epidemiologists and scientists remain cautious and warned that these initial studies from Pfizer-BioNTech and preliminary data do not mean that omicron will become less deadly in the process and should not be treated lightly until we have more information. One disturbing theory about how Omicron emerged in southern Africa has been advanced by William Haseltine, a virologist who has speculated that mutations could have been caused by Merck’s Covid-19 antiviral pill. He noted that South Africa was among the locations chosen for clinical trials of the drug molnupiravir, which began in October 2020. Some scientists, including Haseltine, have warned that its mutagenic properties could create more dangerous variants. The fear is that the omicron variant, with its far improved transmissibility that evades antigen tests, could first seem “milder” and lull public and policy responses but causes more infections, reinfections and breakthrough infections, before the second round of a potential cross-mutating again to a far more dangerous newer variant in causing more serious illness with stronger immune escape and far more fatalities.
The Fed's experiment with running a "hot" economy has edged into historically uncharted territory, with an unemployment rate never reached without associated central bank rate increases and now levels of inflation that in the past also prompted a policy response. The Consumer Price Index for November posted the biggest annual increase in 39 years, data on Friday showed, amid signs that price pressures are broadening and likely leading policymakers at their meeting next week to significantly raise inflation projections that have been running behind actual outcomes. That may prompt a policy shift, with officials accelerating plans to end their bond-buying and, many analysts expect, signaling that rate increases may begin sooner than anticipated. Notably, the Fed-funds futures’ probabilities of rate hikes in 2022 were hardly changed by the CPI report, which adds to the stock and bond markets’ lack of angst over the data. The unemployment rate is also flashing red, at least by past Fed standards. The 4.2% rate reached in November has only been hit or exceeded about 20% of the time since the late 1940s, covering four periods of low joblessness, including the late 2010s, with the Fed raising rates during each.
The newly hawkish Fed, the relentless supply chain disruptions, and the ever-evolving virus have made Wall Street forecasts for 2022 differ by the second-most in a decade. The yield curve steepened this week (for the first time in 5 weeks) by the most since January, but remains notably flatter since Omicron. Rate-hike odds shift lower (dovish) but a full rate-hike is still priced-in for June. BofA strategists pointed out that the real earnings yield for the S&P 500 Index has not been so deep into negative territory since 1947 and warned that this portends downside risks for stocks. There have been only four historical instances of negative real earnings yield, all of which resulted in bear markets.
Counterpoints to the pessimists have mainly centered around the heart of the global economic bounce back over the past year, and helping to underwrite strong financial markets were massive government stimulus payments to compensate for the expected drag from COVID. The OECD estimates governments around the world spent more than US$19 trillion combined on pandemic-related support programs. We would have to go back to World War II to find a comparable period of fiscal spending. Notably, according to Bank of America Merrill Lynch, rolling 12-month flows of money into equity funds topped more than US$1.5 trillion earlier this year, almost four times its previous peak, and the US$1.25 trillion invested in equities funds between January and November this year is more than the total amount over the same period for the previous 19 years combined. As a result, dip buyers have been rewarded virtually every time the market has pulled back, so much so that by one measure the strategy is having one of its best years on record.
Still, most investors who say that they are willing to bear more risk do not actually mean that. What they really mean is that they fear missing out on the higher returns experienced by other investors, especially when there is greater uniformity of portfolio positioning with more and more people sucked into similar overcrowded trades. However, the ability of governments to protect asset prices from another downturn has never been more constrained. The global US$30 trillion pile of stocks and bonds that have been purchased by central banks in order to drive up their prices has created a gigantic overhang. With inflation rising, policymakers are reaching the limits of their ability to support asset prices in a future downturn without further exacerbating inflationary pressures.
Most importantly, the bigger risk facing the global economy by late 2022 could be stagflation and even secular stagnation, not inflation, as cost-driven price pressures hurt still-weak domestic demand and tighter fiscal and monetary policies turn into a drag, This most probable scenario is yet to be priced in by the markets and would inflict heavy losses in the speculative economy-sensitive Cyclical/Re-opening trades.
Meanwhile, star money manager Nick Train said his listed investment fund Lindsell Train Investment Trust, which manages more than US$30.5 billion focusing on companies with robust brands, balance sheets and earnings streams, is experiencing its worst performance in the 20 years since it started business, as share price dropped 10% this year. Valiant Capital, one of the most famous Tiger Grandcub’s hedge funds, was reported to have extended its loss for the year to -35.29% as at end November, due to heavy losses in stocks such as Zillow. The US$17.8 billion ARK Innovation ETF has tumbled more than 20% this year and founder Cathie Wood says they are “going through soul-searching”.
Chinese leaders on Friday promised tax cuts and support for entrepreneurs to shore up slumping economic growth after a campaign to rein in surging corporate debt caused bankruptcies and defaults among real estate developers. China was the first major economy to rebound from the coronavirus pandemic, but that recovery quickly leveled off. Now, as China’s economy falters, the developed world looks resilient. China is preparing a blacklist that is expected to tightly restrict the main channel used by start-ups to attract international capital and list overseas, in a bid to limit the role of foreign shareholders in the country’s next generation of tech companies. The blacklist will target new companies in sensitive sectors that use variable interest entities (VIEs) to run their China businesses. China Evergrande Group has officially been labeled a defaulter for the first time, the latest milestone in months-long financial drama that’s likely to culminate in a massive restructuring of the world’s most indebted developer with over US$300 billion in debt liabilities. Fitch Ratings cut Evergrande to “restricted default” over its failure to make two coupon payments by the end of a grace period on Monday, a move that may trigger cross defaults on the developer’s US$19.2 billion of dollar debt. Before this week, Chinese borrowers had defaulted on $10.2 billion of offshore bonds in 2021, with real estate firms making up 36% of the total. The industry’s total interest-bearing debt more than doubled since 2014 to over 25 trillion yuan (US$3.9 trillion) in 2020, according to Goldman Sachs, and foreign investors are heavily involved. Meanwhile, the Chinese yuan currency tumbles after the central bank hikes FX reserve ratio.
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.