Weekly Market Commentary By H.E.R.O. (5 to 9 July 2021)

U.S. stocks registered more fresh record highs, rebounding on Friday from the biggest one-day drop in about three weeks on Thursday fueled by concerns about global growth amid the spread of Covid-19 variants, even though Russell 2000 index retreated -1.1%. Thursday's mini rout started with one of the ugliest market opens in history in the form of the 4th lowest NYSE TICK print (which measures buying/positive vs selling/negative ticks, i.e., program buying and selling) in history and the worst market breadth since the dot-com bubble, as traders freaked out over fresh covid pandemic fears due to the soaring number of delta cases around the globe. Outside of the U.S., global stocks are generally down, with MSCI All World index flat, Hang Seng -3.4%, MSCI China -3.5%, Topix -2.3%, Stoxx -0.4%. China’s central bank cut the amount of cash most banks must hold in reserve, while the European Central Bank on Thursday indicated it will tolerate an inflation overshoot, implying an even longer period of loose policy. Asia is emerging as the epicenter for investor worries over global growth and the spread of coronavirus variants as China’s easing stokes concern. Investors took the cut in banks’ reserve ratio requirement as a signal that Chinese second-quarter GDP data due next week might fall short of market expectations, after a sudden plunge in June services PMI, the largest one-month drop outside of the catastrophic February 2020. Chinese ports and factory districts have been grappling with outbreaks of the Delta variant of coronavirus, as have an increasing number of countries around the world. In Japan, Tokyo has declared a renewed state of emergency to combat the resurgent virus, banning spectators from the Olympics and pushing the Nikkei 225 Stock Average toward a correction. South Korea is intensifying social distancing measures in Seoul while Indonesia is battling a virus resurgence that has crippled its health system. Sydney has had a strict stay-at-home order in force since late last month. The number of new cases in Spain has risen eightfold in two weeks, to a daily 100,000. Following the Delta and Lambda virus variants, researchers in California have also discovered during the week the “triple mutation” epsilon variant.

Just a couple of weeks ago, the market narrative was that not only was the economy recovering, it was recovering too fast and sparking fears of runaway inflation, but now the worry is that the recent economic surge is already waning and there’s increasing nervousness about growth. U.S. Treasuries rallied sharply this week on fears that economic growth may slow in the second half, pushing yields to plunge to levels not seen since February. The speculative market consensus that took months to build, namely that robust rapid broad-based economic growth and elevated inflation would bring about substantially higher interest rates, has been coming apart, and the pain for those caught in the reopening/reflation trade has heightened during the week. The speculative retail meme stocks are on the brink of a bear market as retail frenzy fades. Markets remain in flux and are at a major inflection point as traders flip-flopped to reposition against the backdrop of “peak in growth, a peak in inflation and a peak in policy stimulus” and are re-evaluating the prospects for future monetary tightening. Meanwhile, Biden signed an executive order late Friday that will establish a Federal Trade Commission policy to more closely scrutinize mergers by dominant internet platforms, especially those seeking to buy growing competitors, those offering free products, or accumulating large amounts of data, taking aim at the Big Tech in Google, Amazon, and Apple. Megacap tech stocks have been behaving like bond proxies, which not only undermines portfolio diversification efforts but increases the stock market’s vulnerability to a pickup in rates amidst corporate credit spreads at historic tights, raising the risk for complacent traders chasing Big Tech which could be locked into a generally downward correction trend over the next few months and quarters.

A fresh regulatory crackdown on Chinese tech stocks this week has also impacted investor sentiment in the region. The Hang Seng China Enterprises Index fell briefly into a technical bear market Friday. The market capitalization of shares in a gauge of China’s internet sector dropped by about US$200 billion this week alone, as Beijing vowed to increase scrutiny over data collection, as big data becomes big liability, and overseas listings, including the potential ban of the Variable Interest Entity (VIE) structure which could threaten more than US$2 trillion worth of Chinese shares traded in the U.S. China Tech has slumped by more than US$1.1 trillion since a Feb. 17 peak, with the index down 35%. Speculative traders blindly chasing the bargain-dips on price signals will hugely underestimate the mega risk in the new rules that would explicitly require Chinese firms using the VIE structure to seek and receive approval from Chinese regulators before they can go public in Hong Kong and the US, which also indicate that trillions of private equity investments in China unicorns are unable to exit for a prolonged period of time and should result in massive impairment writedown in value hitting the balance sheet of China Tech and investors in the months ahead. Corporate debt defaults in China have soared to record levels of 116 billion yuan (US$18 billion) in the first six months of 2021, the highest figure for any January-June period. The missed payments are alarming foreign investors and driving up the average yield on foreign currency-denominated Chinese corporate bonds with low credit ratings to above 10%. Meanwhile, tension between the U.S. and China continues to bubble as Biden added 34 Chinese entities to the economic blacklist over alleged human rights abuses and high-tech surveillance in Xinjiang, and global index providers removed more Chinese companies with alleged military ties from their global benchmarks under US executive orders.

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.