Weekly Market Commentary By H.E.R.O. (11 to 15 Oct 2021)

U.S. stocks began the week with losses, but turned higher after companies delivered robust results for the latest quarter. Each earnings season has provided the definitive antidote to the stock market’s ills, with the S&P 500 climbing six straight times each quarter since March 2020, advancing 4% on average over the six-week stretch. Retail sales also unexpectedly rose in September, despite economists’ worries about the Delta variant of Covid-19 and the end of enhanced unemployment benefits, though U.S. consumer sentiment printed at its 2nd lowest level in a decade. MSCI ACWI All World index +2.1%, S&P 500 +1.8%, NASDAQ +2.2%, Russell +1.5%, while China CSI 300 flat, Shanghai -0.6%. Energy markets extended a run-up Friday that has pushed oil and gas prices to multiyear highs and strained already snarled supply chains. Brent-crude futures, the benchmark in global oil markets, notched its eighth consecutive week of gains—its longest such streak since a 10-week period through April 30, 1999. The worst appears to be over for the supply-chain snarls that have plagued shipments of everything from Coca-Cola ingredients to paint, toys and industrial fasteners. Average ocean freight rates have declined for three straight weeks. A composite index of global container prices has fallen back under $10,000 for a 40-foot box for the first time since Labor Day. While the cost relief is modest - the freight rate benchmark remains almost 300% higher than it was at this time last year - the feverish climb in shipping costs at least appears to be waning. The shipping crunch may have been exaggerated in recent months as companies over-ordered to ensure they had enough product and wouldn’t miss out on sales. While global orders for semiconductors keep rolling in, the latest data from the world’s biggest chipmaker hint that this strong demand is beginning to look like industry inventory stockpiling. That could be a massive indigestion problem when supply chain bottlenecks ease. The heightened fear that forced option traders to load up on hedges during the summer months has dissipated; in fact, prices for calls slowly perked up, indicating demand for upside. MSCI commented that the risks from cryptocurrencies could be steadily “creeping” into your portfolio, noting that at least 52 companies representing US$7.1 trillion in market capitalization have some exposure to cryptocurrencies as bitcoin jumps back above $60k for the first time since April on optimism for approval of the first ETFs and futures ETFs debut in the U.S.

Meanwhile in Asia, China’s factory-gate prices grew at the fastest pace in almost 26 years in September since Nov 1995, climbing to 10.7% from a year earlier, adding to global inflation risks and putting pressure on local businesses to start passing on higher costs to consumers. While coal prices were relatively contained one month ago, they have since then exploded. And if the historical correlation between Coal prices and PPI holds, we may be soon looking at a tripling of China's PPI, which is about to soar to 30% or more. If Chinese PPI does hit 30%+, even if CPI somehow stay in the single digits, the results would be catastrophic: profit margins would collapse, the plunge in already thin cash flows would lead to even more defaults and supply chain bottlenecks, even as the scramble to obtain commodities "at any price" keeps pushing costs - and PPI - even higher. International bond sales by Chinese developers have all but halted as the crisis at China Evergrande stokes fears of defaults across the country’s property sector, throttling a crucial driver of Asia’s high-yield debt market. Just one developer has managed to tap overseas bond investors since Evergrande, the world’s most indebted real estate group, missed an $83.5m interest payment last month and missed its third round of bond payments in three weeks, rattling global markets. Having already suffered the fastest drop on record, Chinese junk bond markets - where property developer issuers dominate - were routed once again as fears about fast-spreading contagion in the $5 trillion sector, which drives a sizable chunk of the Chinese economy, continued to savage sentiment. Housing prices have fallen in 16 out of China's 31 provinces for the first time in more than six years since March 2015 as the government tries to tame a real estate bubble, sending debt-laden local authorities rushing to put a floor under the declines to defend key source of revenue. One-fifth of the homes in China - at least 65 million units - are empty, which is enough to house the population of France.

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.