Weekly Market Commentary By H.E.R.O. (24 to 28 May 2021)
Markets advanced during the week ahead of the Memorial Day holiday weekend, with MSCI World Index up +1.4% and S&P 500 +1.2%, with sentiments lifted by Biden’s unveiling of a massive stimulus plan. Biden sent Congress a $6 trillion budget plan that would ramp up spending on infrastructure, education and combating climate change, which includes a retroactive capital gains tax hike that would have started in April, meaning that it would already be too late for high-income investors to realize gains at the lower tax rates if Congress agrees. Notably, the stimulus includes the $753 billion national defense budget, shifting billions in spending from old systems to help pay to modernize the U.S. nuclear triad of land-launched nuclear missiles, nuclear missile-armed submarines and aircraft with nuclear bombs and missiles to deter China. The Pentagon sees space as a major warfighting domain in the future and funding for the U.S. Space Force increased by $2 billion to $17.4 billion. Senate Majority Leader Mitch McConnell heaped scorn on the plan, and warned Democrats to "move beyond the socialist daydream and the go-it-alone partisanship." "President Biden’s proposal would drown American families in debt, deficits, and inflation," McConnell said in a tweet. The euphoric gains during the week, led by short-squeezed stocks and speculative retail meme stocks, masked how the underlying overall markets remained choppy and on edge, as traders are whipsawed by the rotational blade oscillating back-and-forth at an increasingly unpredictably faster speed between Cyclicals/reopening bets and “growth”. Meanwhile, convertible debt sold by high-flying US groups such as Airbnb, Twitter, Peloton etc falls back to Earth recently, once again highlighting the risks of being seduced by bankers into buying attractive high-yielding instruments with limited downside risks, as the “best of both worlds” angel can suddenly morphed into a “worst of both worlds” monster.
The big question in the market is this: What happens when torrid monetary and fiscal reflation in the U.S. and the West meets tighter credit and evaporating liquidity in China? The market narrative has shifted its attention to assessing the collision impact of this situation, whether these two colliding forces moderate each other, or set off a new sort of wild ructions in the currency, commodity, bond and stock markets in a looming crisis, especially as fiscal stimulus in the US is likely to fade later this year just as China hits the bottom of its deleveraging cycle, which would be a rude awakening for speculators.
Chinese stocks rose the most since July on Tuesday, buoyed by unprecedented buying of China’s second-largest ETF via exchange links in Hong Kong, as traders are betting Beijing wants to see a strong market leading up to the 100th anniversary of the Chinese Communist Party on July 1 in a posturing of strength by Xi. The equity bounce boosted the allure of the yuan, which is at its strongest against the dollar in almost three years. The rebound on Tuesday followed from Beijing’s one-sentence statement on May 23 that warned of “zero tolerance” for “abnormal transactions and malicious speculation” in commodities markets. The powerful National Development and Reform Commission (NDRC) has told key players in the metal industry that it is cracking down on illegal activity. Notably, commodities and even commodities futures contracts have been used as loan collateral multiple times for leverage, worrying regulators. The local price of iron ore and steel promptly tanked by 7%. China's top banking regulator has also directed banks to stop selling commodity-linked investments to mom-and-pop retail buyer to curb future investment losses. The China Banking and Insurance Regulatory Commission (CBIRC) also instructed banks to unwind existing books of commodity-linked products. Like whack-a-mole, however, crackdowns in some parts of China’s financial markets lead to other assets rising. Rampant speculation is also seen in frightening boom-bust crashes, with Hong Kong stock Perennial Energy that had soared nearly 450% the past year plunging 69% on Friday to an eight-month low in its first trading day as a member of an MSCI China index.
Traders chasing the bounce in China after Tuesday were caught with generally volatile losses that ensued, which refocused the attention back to China’s “credit impulse” which has turned negative. This tracks the ups and downs in “total social financing”, Beijing’s key mechanism for regulating the economy. It is an early warning indicator of China’s compulsive stop-go cycles, which in turn drive everything from commodity prices to Korean industry and German machine tool output. In addition, China’s factories are absorbing significant cost pressures from rising commodity prices, damping the inflationary impact for the rest of the world. Notably, the combination of higher input prices, uncertainty about export prospects and a weak recovery in domestic consumer demand meant Chinese manufacturing investment from January to April was 0.4% below the same period in 2019 (comparing to 2019 strips out the distortion of last year’s pandemic data).
There are widespread reports of manufacturing industry production shutdowns and job losses in China because surging prices of raw materials means margins are compressed and factory owners say it is too risky to take new orders and that 2021 may be worse than 2020. China’s attempt to crack down on commodities speculation, cryptocurrencies, grain purchases and property bubbles and its efforts to slow capital inflows and the appreciation of its currency are indicators of stresses and conflicting challenges within its economy. It has been notable in recent weeks that Beijing has been very active on a wide range of issues and there is a sense of urgency in their response to the surge in commodity prices, a flood of capital inflows and financial and currency markets risks. Markets will take a dangerous turn from euphoria to bust when there is the painful realization that Xi is seen to have only limited control over its economic levers in navigating the increasingly conflicting complex challenges with fragile financial foundations.
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.