Weekly Market Commentary By H.E.R.O. (28 June to 2 July 2021)

U.S. stocks closed at new all-time highs during the week ahead of the July 4th Independence Day, after Friday’s “Goldilocks” jobs data for June came in better than expected, with S&P 500 rising +1.7% to produce its second-best first-half of a year since 1998, but Russell retreating -1.2%, with fewer stocks participating in the latest rally led by Big Tech. U.S. dollar index also posted monthly gains of almost 3% in June. The US labour market added 850,000 positions last month, its largest gains in 10 months, beating economists’ expectations for 720,000 new jobs and substantially above the 583,000 revised figure for May, while the unemployment rate edged up to 5.9%. The report helped bolster views that the Federal Reserve won’t rush to tighten monetary policy any time soon and risk stifling the economic recovery from the pandemic. The S&P 500 also marked a seventh straight session of records, a feat not seen since 1997. The rally came amid unprecedented investor appetite. In the first half of 2021, almost US$600 billion poured into global equity funds, a pace that if annualized would surpass the total inflows from all the precious 20 years. However, ETFs focusing on U.S. stocks lost almost US$6 billion in the week through Thursday, a departure from the first few months of the year, when they lured more than US$200 billion of fresh money. Meanwhile, money-losing companies are flooding the market with new shares: Over the past 12 months, about ,000 companies issued secondary or add-on shares in the U.S., and nearly 750 of them weren’t making a profit. The money losers raised $27 billion more than the moneymakers since last June—something that hasn’t been seen in at least 40 years, surpassing even the gap during the dot-com bubble.

There’s a growing sense of defensiveness in the markets over peaking earnings growth and the spread of the Delta variant as the threats to stocks. Earnings growth for the average S&P 500 company is expected slow down to 11% in 2022 from 36% in 2021. More than 540 U.S. listed companies have restated their financial accounts in the past three months, higher than every full year since 2013. Investors are also taking risk off the table as the fast-spreading delta variant of the coronavirus causes fresh outbreaks in many parts of the world. Airline and cruise stocks are being dumped and the reopening/reflation trade in Cyclicals has quietened down. A Goldman basket of stocks poised to benefit from a return to normal economic activity just suffered its worst month since last July relative to the stay-at-home basket. The recent reflation/reopening trade unwind has also wrongfooted several big-name hedge funds who suffered losses in the month of June. In addition, the Skew index — which measures the difference between the cost of derivatives that protect against big market drops on one side, and the right to benefit from a rally on the other — has hit record heights. The Skew gauge rises when fear outpaces greed, so the widening divergence indicates how worries are bubbling up beneath the seemingly exuberant surface of the stock market as financial speculation pervades the society. Biden has also seen an erosion in support since April, mainly from fellow Democrats, as his administration wrestles with Congress to make good on campaign promises and more Americans worry about an uneven economic recovery. The eroding support for Biden coincides with Democrats struggling to pass major parts of his agenda in Congress.

Outside of U.S., Europe and Asia markets languished as summer season starts in Europe, as investors balked at risks from the highly infectious Delta coronavirus strain which is causing renewed restrictions in parts of Europe and lockdowns across Asia and Australia, and exited Cyclical assets that benefit the most from economic reopenings. During the week, Stoxx -0.9%, FTSE -0.2%, DAX +0.3%, and Japan Topix -0.3%. The MSCI Asean Index of equities headed for its weakest close in seven months, while Indonesia’s rupiah and the Thai baht slid to multi-month lows.

China and Hong Kong stocks had their worst week in nearly four months since Feb, with Hang Seng -3.3%, China CSI 300 -3%, MSCI China -3%, amid weaker economic data in China and after the celebration of the great centennial anniversary of the Communist Party in which Xi issued a blistering "warning" to the West, vowing that any outside "bullying" powers will inevitably "get their heads bashed". To a large crowd cheering as Xi lauded his party’s accomplishments from the podium of the Gate of Heavenly Peace at the entrance of the Forbidden City, the supreme leader added that: “Anyone who tries to do so will be crushed to death before the Great Wall of steel built with the flesh and blood of over 1.4 billion Chinese people". Investors had expected more supportive rhetoric from Xi’s keynote address. The speech made little mention of measures to support the economy or markets and instead focused on the party’s role in fostering the “great rejuvenation of the Chinese nation”. Meanwhile, rising investor concerns over shaky finances in China’s most economically fragile provinces have prompted a sell-off in state-run groups’ bonds, as analysts warn of a surge in defaults in the country’s US$17tn credit market. The median yield on bonds issued by state-owned enterprises in six large provinces and municipalities that suffer from weak finances jumped to more than 5% in the second quarter, up from less than 3.5% a year ago. Across China, S&P calculates that Rmb4.2tn (US$650bn) of bonds are due this year as well as Rmb1tn in put options that give bondholders the right to early repayment.

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.