Weekly Market Commentary By H.E.R.O. (2 to 6 Aug 2021)

U.S. markets were pushed higher by stronger-than-expected U.S. employment data that showed strong job gains, a sharp drop in the unemployment rate and a rise in wages last month, which could push the Fed closer to taper asset purchases and a less dovish tone, sending economically-sensitive Cyclicals, 10-year treasury yields and U.S. dollar higher, while bonds and REITS bled, gold price cratered -2.8%, and speculative assets such as Bitcoin and retail meme stocks went wild. The U.S. Labor Department reported on Friday that nonfarm payrolls rose by 943,000 jobs last month, beating the forecast of 870,000 jobs. Biden issued an executive order on Thursday to supplement the target to have 50% of the auto fleet on the road electric by 2030, continuing one of the largest government subsidized shifts to the auto industry ever forced upon manufacturers and customers, and also proposing new vehicle emission standards that would cut pollution through 2026, starting with a 10% stringency increase in the 2023 model year. With four-fifths of S&P 500 companies having reported second-quarter results, a record 86% have exceeded expectations on profits, though companies that topped earnings expectations have outperformed the market by only 10 basis points on a median basis, as evidence is mounting that companies are having a harder time passing off cost increases to their customers with dips in profit margins. Meanwhile, the Delta variant of Covid-19 is creating a frightening déjà vu in many countries that are the crucial to global supply chains like Vietnam, South Korea, Malaysia, and Thailand, posing another risk to global markets. Malaysia’s ringgit and the Philippine peso have slumped nearly 2% and 3% respectively against the greenback this quarter, while the Thai baht is among the worst-performing currencies in the world after weakening almost 4%. Business activity after “Freedom Day” in the U.K. has also been underwhelming, raising doubts over the narrative of a “Roaring Twenties” recovery and post-COVID boom in the U.K. and beyond. Market traders are increasingly nervous and signaling caution, as funds that use the buy-write options strategy -- owning shares while selling options on them to generate premium income -- attracted $1 billion of fresh money in July, the biggest inflow since 2012, a reversal from the first six months of the year when almost $2 billion was pulled out as traders been whipsawed in recent years as the equity rally sent calls into the money, reducing revenue from selling options. Worsening sentiment is impacting the ability of companies to tap credit markets at the terms they want, with multiple leveraged loans have had to up -- or “flex” -- their pricing wider in recent days. The next gathering of the policy-making FOMC starts on Sept 21, which is when the central bank will likely lay out when it will start tapering its bond purchases and by how much.

Meanwhile, China is dealing with virus outbreaks in multiple provinces with travel curbs, mass testing, cancelation of major events and movie showings, closure of tourism sites and entertainment centres used for playing cards and mahjong, and other strict measures, casting pall over the economy’s growth, prompting GDP downgrades and rattling the commodities market. China’s National Petroleum Corp estimates that this round of infections could wipe out 5% of short-term oil demand. Oil posted their steepest weekly decline in four months on worries that travel restrictions to curb the spread of the Delta variant of COVID-19 will derail the global recovery in energy demand. Iron-ore futures in Asia tumbled for the third consecutive week as demand fears and rising regulator controls in China become headwinds. A 30% hike in Hong Kong's stock trading transaction tax from Monday added to the gloom, alongside tightening U.S. regulations on investing in Chinese companies. Tencent and Netease led another stock rout after reports decried the “spiritual opium” and “electronic drugs” of online games, and TikTok’s rival Kuaishou plunged over 12% and Bilibili, dubbed “China’s Netflix”, was hammered, after an influential state-backed newspaper urged tighter regulation of internet video content amid spread of “vulgar content” and “bad fan culture”.  China’s top state propaganda organs, which decide what people can read and watch in the country, have jointly urged better “culture and art reviews” in China partly by limiting the role of algorithms in content distribution, a policy move that could translate into higher compliance costs for online content providers such as ByteDance and Tencent. A local procuratorate in Beijing has initiated a public interest lawsuit against Tencent, alleging that the youth mode of its massively popular WeChat social media platform fails to comply with China’s minor protection laws, marking the first time this kind of legal threat has been made against a Chinese social and gaming giant. Alibaba warned investors that years-long government tax breaks for the internet industry will start to dwindle, adding billions of dollars in costs for China’s largest corporations as Beijing extends its campaign to rein in the sector. State media also wrote that China should stop handing out tax breaks to gaming companies; in fact, they should assume more responsibility and give back to society via higher taxes. China’s antitrust regulator is preparing to impose a US$1 billion fine on food-delivery giant Meituan for allegedly abusing its dominant market position to the detriment of merchants and rivals. China's State Administration for Market Regulation is investigating auto chip distributors for driving up prices, and China's CSI All Shares Semiconductor & Semiconductor Equipment Index fell by 6% after the news. Makers of infant formula joined the growing list of stocks hurt by regulatory risk in China as policy makers show increasing interest in people’s health and lifestyles. China’s liquor and e-cigarette stocks also declined as skittish investors seized on a series of reports from state media that could foreshadow the next targets for stricter regulation. A Xinhua report about the harm from misuse of human growth hormone injections by parents who are anxious about their children’s height also resulted in biopharmaceuticals company Changchun High & New Technology Industry Group to slump by its 10% limit and Anhui Anke Biotechnology Group fell as much as 17%. Xi also wants cheaper weddings to eliminate costs and customs that are contributing to China’s declining marriage and birth rates. Engaged couples will soon be eligible for a government-sponsored group wedding, according to a three-year “wedding-customs reform” pilot announced, in which extravagances will be officially frowned upon. Authorities in Beijing have introduced rules to stop couples from faking their divorces to be able to buy more homes in China’s capital. Amid a broad effort by Xi to address widening social inequality, authorities are revisiting an idea long-discussed but never realized: imposing a property tax. If implemented, such a tax could have far-reaching implications for the country’s 300 million-strong middle class. Meanwhile, the average vacancy rate for office buildings in Shenzhen – China’s southern tech hub – reached 26.4%, and the vacancy rate surpassed 50% in Qianhai, a 15-sq-km (5.8-square-mile) strip of land in western Shenzhen being developed jointly by Hong Kong and Shenzhen as a “modern service industries cooperation zone” under a State Council plan.

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.