Weekly Market Commentary By H.E.R.O. (29 March to 2 April 2021)
Fear fades and greed rules in a dramatic quarter. The haloed promised end of the pandemic supposedly draws closer with every vaccine shot in the arm. So in the first three months of 2021, traders lunged to position themselves for a post-COVID world by girding for higher inflation and super-charged economically-sensitive cyclical growth poised to benefit from economic reopening. This reflation trade put Treasuries on course for their biggest lost and worst quarter since 1980, with the global bond plunge sending yields surging to pre-pandemic levels, sending the 15+ Year U.S. Treasury Index to post a loss of 13% for the quarter, and the 20+ Year Treasury Bond Index to drop 14%. Market fever dreams played out in the speculative cryptocurrencies, SPACs and retail meme-stocks mania such as GameStop, while traditional haven currencies and gold were battered. Margin lending has soared, increasing over 70% a year ago to more than US$813 billion, far outstripping the growth rate of the sharemarket. Notably, while benchmark stock indexes glide along, the subsurface churn has been extremely violent. A model from Bank of America that plots how much value is being created and destroyed each day in individual stocks shows that 2021 has generated more turbulence than virtually any other year. The volatility is just being masked because up-and-down moves in different companies over days and weeks have tended to offset each other.
Navigating the recovery trade got trickier as markets see-sawed back and forth towards a tech rebound during the holiday-shortened week of the quarter end as the aftermath of the Archegos’ US$80-billion margin-call forced-liquidation fallout eases, and skepticism creeped in towards Biden’s massive US$2.25-trillion “once-in-a-generation investment in America” infrastructure stimulus package unveiled on Wednesday, which faces challenges both from some moderate Democrats, who want the president to reinstate the state and local tax deduction, and Republicans, who oppose paying for the bill with tax increases. To pay for the bill, Biden wants to increase corporate taxes from 21% to 28% and require companies to pay at least a 15% tax on income. It would take 15 years for those tax increases to cover the proposed cost of the bill. While the White House is aiming to pass the legislation before the July 4 holiday, and lawmakers may write the bill in early May and completed before Memorial Day on 31 May, the scope of the bill combined with the need to appease all Democratic senators if it is passed through reconciliation means the time frame could slip into the fall in September. This uneasiness, and the growing view that the “short-and-hot” frothy overextended reflation trade rally and easy money in Cyclicals is almost done and that they are vulnerable to a sharp reversal, has eased the advance in Treasuries yield and the frenzied rotation into Cyclicals and questionable companies with weak balance sheets.
Stronger-than-expected jobs report on Good Friday, in which the U.S. added 916,000 jobs, reaffirmed the market’s great expectation for a strong economic recovery, which sent the 10-year Treasury note’s yield climbing back up as much as 6 basis points to 1.73% before retreating to end around 1.72%, sealing off the relief rebound in havens in gold and Swiss franc. U.S. dollar held near a multi-month high against other major currencies as investors bet fiscal stimulus and aggressive vaccinations will help the United States grow faster than other economies. As one single bitcoin is now worth one kilo of gold in a new milestone, there are some market chatters that the total market cap of gold and cryptocurrencies at around US$12 trillion – crypto approaching US$2 trillion vs gold US$10 trillion – could stay roughly the same in the near- to medium-term, albeit with crypto advancing further and eating into gold’s share to match it equally in market cap, as evident from gold’s trillion-plus decline by 16.7% from its August high to US$1,728/oz coinciding with bitcoin’s trillion-plus advance from under US$12K to nearly US$60K over the same period.
Still, the market narrative has increasingly shifted towards the view that an economic recovery based on stimulus won't be enough to set off a lasting return of inflationary price pressures. A proper inflationary shock would need pent-up consumer demand to boost economic output for many years to come. There is also that constant nagging feeling among doubters is that all the stimulus could lead to a painful retracing. The increasingly euphoric market sentiment, proxied by the BofA Sell Side Indicator, which tracks the average recommended equity allocation by Wall Street’s sell-side strategist, is at a 10-year high and less than a point away from a contrarian “sell” signal, its closest since May 2007, when the S&P 500 fell 7% over the subsequent 12-month period.
The Nordics made noticeable headway in repairing the damage from the coronavirus crisis, building on a year of remarkable resilience to global economic turmoil. In Sweden, robust business confidence and improving export prospects prompted Bloomberg, SEB and the Swedish National Institute of Economic Research to raise growth forecasts this week for the region’s biggest economy. The Nordics stood out for its impressive record in containing the fallout on economic expansion, aided by generous welfare systems, widespread digitalization and a relatively low reliance on tourism, showing noticeably similar economic trajectories despite divergent approaches to lockdown restrictions throughout the crisis. That legacy now looks likely to endure as vaccination programs pick up and global trade recovers. Upgrades to Sweden’s outlook have followed a spate of good news from businesses. In March, an index of manufacturing confidence rose to the highest since mid-2018, while Swedbank’s index of factory purchasing managers climbed more than economists expected.
Meanwhile in Asia, trading in more than 50 Hong Kong-listed companies was suspended on Thursday, after a record number of firms failed to report earnings ahead of the March 31 deadline. Notable firms include GCL-Poly Energy, one of the world’s leading makers of solar-grade polysilicon and defaulter of its debt, and “bad loan/distressed debt king” China Huarong. All structured products related to Huarong will also be suspended from trading; Huarong’s bonds slumped. The market narrative is that any rebound in the China market could prove fleeting, and market will be in a state of limbo, trapped in a horizontal range, in the wake of liquidity tightening and regulatory risks and frayed nerves of battle-weary investors. Notably, China’s total debt increased 29% points last year to 315% of GDP, driven by companies and provincial governments borrowing during the pandemic. Around 600 listed Chinese companies have leverage ratios 20 points above their sector averages. Their combined market valuation amounted to 11 trillion yuan (US$1.7 trillion), or 17% of the stock market. Assuming their debt is mostly financed by banks, every one percentage point rise in the lending rate would boost their interest payments by 152 billion yuan, equivalent to 30% of their profits. When the PBOC starts to exit its supportive monetary policy, markets would see the rising risk of default from those highly indebted enterprises. As the time it takes for indebted Chinese property developers to sell their growing inventory lengthens to over 15 months (provided no new projects enter the market), the latest gimmick pulled by them to skirt regulatory tightening is the pitch to buyers that a 5% deposit is all that it takes to buy a home instead of requiring a standard 30% downpayment, and the difference is made up by offering a two-year, interest-free loan funded by the project’s developer. This resulted in a proliferation of high-yielding 2-year structured notes and bond products promising double-digit interest yield that are marketed aggressively to investors.
The portfolio stocks remain well-anchored to very strong and powerful fundamentals with clear and visible growth prospects and positive corporate development progress and robust end markets, and are very likely to rebound resiliently from the speculative sentiment-led rotation and frenzied positioning once the 1Q2020 earnings reports start from mid-April onwards, and the current correction is a great opportunity to accumulate existing stocks and potential new companies.
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 who have remained resiliently positive throughout the most extreme ever market rotational change since November 2020, setting the roadmap this year and beyond in a post-pandemic future. 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.