Weekly Market Commentary By H.E.R.O. (8 to 12 Nov 2021)

U.S. stocks retreated during the week as inflationary pressures continued to reverberate through markets, with MSCI ACWI All World index +0.05%, S&P 500 -0.3%, NASDAQ -0.7%, Russell -1%, and ARKK Innovation ETF -3.1%. Inflation-sensitive consumer discretionary stocks led declines after a Wednesday report showed October’s CPI accelerated at 6.2% yoy, the fastest pace in three decades since 1990 and the highest print since Volcker's fight with hyperinflation. UMich consumer sentiment plunged from 71.7 to 66.8 (way below the 72.5 expected), the lowest since 2011. Companies across industries have managed to navigate supply chain bottlenecks and climbing input costs by raising prices, which have been readily absorbed by consumers -- so far. Should inflation broaden and build, the worry for stock bulls is that demand drops off as price tags climb. The proportion of households who expected to be worse off financially stood at 24% in November, the last time a higher figure was recorded was in June 2008. Meanwhile, option trading volumes are now about 50% more active in nominal dollar terms than all actual stock trading. Most of the options being traded are “calls”, derivatives that allow investors to make aggressive bets that asset prices will rise. Globally, US$865bn of new money has been pumped into equity funds this year, according to EPFR. That is already almost three times the previous full-year record, and more than two decades’ worth of combined inflows. U.S. corporate buybacks were about to resume after the enforced blackout when quarterly earnings are reported, and fund inflows tended to be strong in the final stretch of the year. Combined. these factors could push markets even higher into 2022, though the frenzy is unsettling a lot of investors, who fret that the rebound from the shock of the coronavirus may now be verging into something more dangerous. Accelerating expectations for rate hikes soon after the Fed concludes tapering of its stimulative bond purchases is also translating to a stronger dollar. That risks triggering capital flows out of emerging-market assets, impacting stocks, bonds and other currencies.

Meanwhile in Asia, Chinese producer prices advanced 2.5%t in October for an annual growth rate of 13.5%, data released on Wednesday showed. It was the largest increase since 1995. With China’s PPI rising at the fastest pace in 26 years in October after increasing by 13.5% from 10.7% in September, firms may soon be forced pass on more of their increased costs to customers. Some food companies have announced price hikes of up to 15% for goods such as vinegar and soy sauce, while over the past week in China some isolated cases of panic buying emerged after a government notice advised households to stock up on daily necessities. The pass-through will likely become more visible in the coming months and push up the CPI. This may limit the room for monetary policy easing by the People’s Bank of China in 2022. After more than a decade of explosive growth, China's Singles' Day, the world's biggest online shopping fest, is losing its gloss and bracing for more modest growth in coming years, hurt by a slower economy and tighter regulatory scrutiny. Alibaba said on Friday its sales - or gross merchandise value - during the 11 day event grew just 8.5%, the slowest rate ever, underscoring the headwinds for China's tech firms. GMV had grown by at least double digits every year since Alibaba founded the festival in 2009 and built it into a global online shopping fest, dwarfing Cyber Monday in the U.S. State-backed Securities Daily newspaper criticised the focus on high turnover from sales for being unsustainable, chaotic and incompatible with China's new development path: "The 'worship of turnover' is not only unsustainable in terms of digital growth but is also inextricably linked to chaos”. Stocks linked to the metaverse slumped in mainland China after local newspaper Economic Daily warned against speculative trading in the “immature” concept and market regulators questioned their bold proclamations.

A bout of selling this week in junk bonds issued by riskier Chinese property developers has sent their borrowing costs soaring to the highest level in a decade and imperilled companies’ ability to access an important funding source. The wobble in the market for dollar-denominated debt of Chinese companies that carry a speculative-grade credit rating comes as concerns mount over a string of missed bond payments by large real estate developers such as Evergrande, Sinic and Fantasia. Importantly, China’s higher-quality dollar bonds are suffering their worst selloff in about seven months as property woes spill into the broader credit market from bonds issued by banks to Tencent. Spreads on the investment-grade notes -- which account for the bulk of offshore dollar securities from Chinese issuers -- widened about 8 to 10 basis points Tuesday, traders said. That would be the biggest daily expansion since April after a widening of 7 basis points Monday. Now that a bond selloff has spread to China’s entire real estate sector and beyond, concern is growing about the potential risk to the global financial system. The U.S. Fed made that link explicit in a report on Monday, warning that what happens in China’s property industry could impact financial markets and threaten world economic growth. Underscoring the risks of a potential spillover, HKMA asked banks to disclose their exposure to Chinese real estate. At the heart of the bond market rout is concern that developers may have far more debt than disclosed on their balance sheets. That’s after some companies struggled to pay public and hidden debt despite appearing to have sufficient capital. Making matters worse is developers’ inability to roll over maturing debt due to surging borrowing costs that effectively shut them out of the dollar bond market. Notably, China’s 10 largest developers by sales owe a combined US$1.65 trillion in liabilities. The outstanding value of banks’ high-yielding WMPs, used by developers and many China firms, stood at 27.95 trillion yuan (US$4.4 trillion) as of Sept. 30, 2021, official data showed. That’s equivalent to more than 27% of China’s GDP. Some WMPs have invested in each other, meaning one soured product could infect others.

Market sentiment and excessive optimism over Cyclicals may be punctuated by warnings from scientists that Merck's "revolutionary" COVID drug molnupiravir - which purportedly cut hospitalizations in half during a study that was cut short - could cause cancer or birth defects, according to a report published Thursday by Barron's. Molnupiravir works by incorporating itself into the genetic material of the virus, and then causing a huge number of mutations as the virus replicates, effectively killing it. In some lab tests, the drug has also shown the ability to integrate into the genetic material of mammalian cells, causing mutations as those cells replicate. If that were to happen in the cells of a patient being treated with molnupiravir, it could theoretically lead to cancer or birth defects.

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.