War, Ukraine, Inflation

It’s been a pretty hectic 2 weeks in the markets, and I thought it was a good time to consolidate my thoughts and put them into writing.

1. What is going on right now:

A geopolitical shift is happening as we speak. Governments are now forced to re-think the transition to renewable energy. The past few years ever since the Paris Accord saw under-investment in fossil fuel production. Then COVID-19 hit, further exacerbating the issue with the supply chain shock that we now see. How can countries maintain energy security during the transition to renewables, which will take 10 – 20 years? We will see many countries think deeply about this issue in the years to come.

In the short term, the direct impact to markets are increased commodity prices. Oil, natural gas and grains are up as Russia and Ukraine are major exporters of oil, natural gas, and grains. Uranium is up as nuclear energy once again returns to the forefront. 10 years following Fukushima, we will probably see the EU reconsider it’s nuclear energy policy. With commodity prices so high, it makes the inflation problem even worse. Earlier this week, CPI numbers from the US came in at 7.9% yoy, a 40 year high. We will most likely see 8+% for march CPI, another 40 year high.

2. Risks to the markets:

The market is basically pricing in the possibility that Putin could pull the plug. Stop exports of natural gas and oil to Europe and cripple the EU economy. Of course some might consider this a low probability event, but this is a game of poker. As such, to take into account this risk, the market price of oil went up 25 – 30% this year. This in turn causes higher inflation. And which will in turn force the Fed to act. Whenever the Fed raises interest rates, economic activity slows down. The risk is that as economic activity slows down, but inflation remains high, the global economy moves into recession. Higher costs result in lower consumer spending, and increased business input costs, profit margins are squeezed, economic activity slows. In addition with the increase in interest rates, cost of funding increases. So if you need to pay more interest when you borrow from the bank, but your profit margins are declining at the same time, you are less likely to borrow to expand the business. Your focus will be on survival.

What this means is that we will most probably enter into a recession End 2022 and during 2023. How long this recession will last will depend on the Fed’s target inflation rate. As long as inflation stays high, they are unlikely to lower rates.

3. Market impact:

Stocks don’t tend to do well in rising interest rate + inflation + recessionary sort of environment. I think there might be further downside in the markets moving forward.

4. What I am doing:

Stocks: IMO, the signals to look out for are drop in oil prices + clear direction from the Fed on quantitative tightening and interest rate hikes. Once inflation expectations, both short and long begin to drop, and the Fed releases its target inflation rate, markets will price everything in, and the focus will be back to company earnings. Since the SNP 500 is pretty much held up by the bigh tech companies, as long as big tech earnings remain stable at ~10% yoy, the market can do decent.

Gold: My view is pretty contrarian. I think that once inflation expectations go away, Gold is going to see a dip in prices as real interest rates come up. Once that has occurred, I will consider adding on Gold to my portfolio.

Are Chinese shares still investable?

Hi. Today’s update is on the chinese equity market. As we all know, chinese equities span the entire range from being listed in the US, HK to SH and SZ. I have always been long term bullish on the chinese equity market, and if we just make extrapolations based on growth rates and GDP, there is a really good story for the chinese equity market. So, what are the rising industries in China that will most likely create new companies that will dominate in the next 10 years?

1. Tech, 5G, AI, Enterprise Software: Tencent, Alibaba, JD, Meituan, Huawei (not publicly listed), Xiaomi, China Mobile, and many many smaller companies which you need in depth research to discover. Many manufacturers are not even listed, so at this moment finding them is abit difficult.Yes the tech crackdown in 2021 was brutal, but this does not change the longterm trends for these companies.
2. Semiconductors. SMIC, Shanghai Micro Electronics Equipment
3. Pharmaceutical and Medical Devices: Mindray, Microport, Hengrui, Wuxi Apptec, Beigene etc. etc.
4. Chinese traditional medicine
5. Consumer Discretionary, especially Baijiu: Maotai, Wuliangye, Luzhou Laojiao, Shanxi Fenjiu
6. EV space: Nio, Xpeng, BYD, CATL

The problem here, and the biggest risk for these companies however is the US-China technology war. China wants to move up the supply chain into advanced manufacturing, and the US is pushing back. I previously thought that this was only limited to 5G (Huawei sanctions) and the semiconductor industry. But something this week however shows that those were only the beginning of things to come. Earlier this week, Wuxi Biologics was added to an export ban list. What does this mean? This means that the biggest risk, and biggest challenge for Chinese companies to advance technologically, is political risk from the US.

As an investor, if you are bullish on Chinese technologcial advancement in Tech, Semiconductors, and Healthcare, you are basically confident that China can become technologically independent in these areas. This means that China can produce its own 7nm chips by 2030. Chinese pharmaceuticals can begin to challenge the likes of Merck and Pfizer by 2030. Chinese EV makers can challenge the likes of Tesla in 2030. But as of today, the world is still largely dependent on the US and EU for IP in many of these advanced areas. And if we placed ourselves in the position of the US and EU, wouldn’t you want to protect US and EU company technologcial advantage? Imagine if Intel got replaced by a Chinese competitor, what impact would that have on the US economy and supply chain? It would be huge! Our laptops will no longer have the Intel i7 Sticker, Intel would probably go bankrupt, thousands of engineers from MIT and Stanford would be jobless. So you can’t really blame the US for trying to stop China advancing in this area. The same goes for pharmaceutcials.

As such, I choose to split the 6 industries above according to the graph below:

As such, for companies with high political risk and low probability of self sufficiency, we would want to adopt a VC approach and invest the way venture capital would. Which means, small allocation to many companies, expect large volatiltility and the possibility of losing 90% of your capital allocation. I mean, if SMIC really made it in 2030, you wouldn’t complain because you would be making so much money. Imagine if Xiaomi only uses SMIC chips in 2030, what would SMIC market cap be?

For companies with low political risk and high probability of self sufficiency, we can adopt a value investing approach. Which means find the best companies with stable cash flow, and buy in at the right time. Chinese equities are notoriously volatile, and some of the best consumer names right now are really expensive. Maotai is trading at around 45PE, way above historical average of around 40PE.

I guess the ones in the middle are Tech, Pharma, and EV’s. I always thought CQQQ would be OK moving forward, but the Alibaba cloud sanction just adds more uncertainty to the outlook.

For Pharma, I feel there is a higher probability of chinese companies becoming technologically self sufficient. And if the US does sanction these companies, they have the domestic market to support them anyway.

For EV’s, it is also a domestic market play. As long as the chips required by EV’s can be manufactured self sufficiently, then the EV space is a good long term investment.

In short, are chinese equities still investable? YES. But the approach, and the amount of money we put in, has to be different for the different industries.

Additional industries not mentioned above because they are traditional industries, but still have room for growth:

• Financials (ICBC, BOC, Merchants Bank etc.)
• Property (Wanke, SOE Developers)

Oil comes centre stage

As the Fed raises rates to normalise monetary policy, oil prices are still remaining extremely high due to supply and demand imbalances. This is a double whammy for the world economy which will face increased financing costs from rising rates, and increased operating costs from rising oil. What this means is that this is a perfect recipe for economic slowdown in the later half of 2022. The only way to get a good healthy economy with rising rates is to get rid of the high oil price. This has to come from a few sources:

1. Increased shale oil output and expansion. Unlikely in the short term.
2. OPEC+ increased output. Also highly unlikley in the short term.
3. Iran. This is probably the world’s only remaining hope to drag down oil prices, if the Iranian sanctions get lifted.

Otherwise, with all things being equal, 2022 is set to be a volatile year for the real economy as it faces increased financing and operating costs. For financial markets, Fed tightening has always increased volatility. Until high oil or hawkish fed goes away, we are in for a rough ride in the short term.

Yields, Just Wow

Here is a nice graph from the CME:

What do we see? The 2 year yield above 1.25%!!!!!!! This is crazy. The market is basically pricing in the equivalent of 4 rate hikes + balance sheet normalization by the end of the year. Even though this expectation is not crazy, but the RATE at which this is happening is insane.

The spread on nominal rates is now down to only 63bp. The last time it was this low was in 2017, just before the economic downturn in 2018.

This is reflected in the gold price as well.

What can save the situation?

IMO, oil price. Oil has to come down in a big way, which means Iran deal has to go through

What to monitor?

1. Rate of increase of the short end of the yield curve

If the rate slows, stock market volatility will decrease. And most likely focus will return back to earnings focus, and a balancing of value between stocks and bonds.

2.Iran

If Iran deal goes through, Oil prices comes down in a big way, long term yields most likely tick up slightly, Gold will be down in a big way, and stock market will be in a much healthier position, and 2s10s spread will increase.

FOMC Minutes Analysis

First Statement: on Longer Run goals and Monetary Policy

Some important highlights for me were:

1. Fed acknowledges that monetary policy is no longer the “go to”policy for maintaing employment

“The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. Owing in part to the proximity of interest rates to the effective lower bound, the Committee judges that downward risks to employment and inflation have increased.”

What does this mean? It means that when you hit zero, the Fed can’t do anymore and the fiscal side has to step in.

“The Committee is prepared to use its full range of tools“

When rates hit zero, the Fed is prepared to QE to support employment.

2. FOMC Statement:

Rates remain unchanged for now. Pandemic is still the main source of economic disruption, and one of the main sources behind supply bottlenecks and inflation.

“Progress on vaccinations and an easing of supply constraints are expected to support continued gains in economic activity and employment as well as a reduction in inflation.”

This was a good sign and not unexpected by the markets. Inflation expectations have come down, supply constraints easing will bring down inflation.

What does the Fed hope will happen? That as better economic conditions persist, they can raise rates and normalise the balance sheets without hurting the economy. So the bet is that the virus situation will improve. Either we vaccinate and medicate our way out, or a less fatal strain appears, which is highly likely. Which is why Powell goes on to say “Risks to the economic outlook remain, including from new variants of the virus.”

“The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March”

In line with expectations, but a little bit more accelerated.

3. On balance sheet normalization:

“reducing the size of the Federal Reserve’s balance sheet will commence after the process of increasing the target range for the federal funds rate has begun”

Best case scenario: Rates rise to 1%, then taper begins.

Most likely scenario: Rates rise once in March, and then the taper schedule begins together.

Summary:

Long term, the Fed knows that monetary policy is becoming increasingly ineffective in acheiving it’s goals.

Shorter term, the Fed will end asset purchases in March, albeit at a faster pace than was expected.

Regarding inflation, the Fed acknowledges both supply and demand imbalance. Even though the focus was on supply constraints easing.

The Fed gameplan is to hope that the virus becomes less of an impact on supply chains, inflation eases, and they can begin to raise rates.

Protected: Real yields and OIl

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Interesting forecasts for the past month

1. Fed Taper

Probably the hottest discussion roiling markets this year is on the topic of inflation. You can see the discussion between Summers and Krugman here. Everybody was talking about inflation causing the Fed to act to be ahead of the curve. My view however was that the Fed would simply continue with it’s plan, as priced in by the markets. They would only begin to raise interest rates IF inflation affected the 2022 mid term elections. If inflation only stayed for a couple of months, why risk the economy? But IF inflation begins to affect mid term election results, then the Fed will be forced to speed up its pace of cutting back asset purchases, and possibly two to three rate hikes in 2022. Sometime in 3Q21, it was pretty obvious that the american people were beginning to feel the inflation creeping in, and the costs it had on their wallets. At this point in time however, the hope by the Biden administration was for a quick resolution on trade tariffs with China, so that the Fed had more room to support the economy. But, China maintained their tough stance, and it was not so easy to remove the tariffs without incurring political backlash at home for Biden. In addition, the COP21 talks. US primarily relies on oil as its major source of energy. With oil prices at >80, and Biden not willing to allow shale oil expansion domestically, the US needed OPEC+ to increase output. But, COP21 was the perfect place for oil exporters to not increase oil production, and to transition to renewable energy themselves. As such, the two foreign policy initiatives to solve inflation, Tariffs + OPEC+ production increase, fell through. The only way to reign in inflation now was for the Fed to quickly cut back asset purchases, and move to rates increase. However, doing so with the SNP at around 4700 would be a big hit to the market, and would look bad on Biden as well. Then, Omicron hit. This was pretty much the nail in the coffin, and was not within my prediction. So, while I was pretty sure Biden had to act to save the mid terms, I didn’t really think about an indicator that would support this. Omicron has caused the Fed to speed up their actions, Yellen to talk about cutting back tariffs. I guess the question is why the sudden change? My guess is that they are preparing for the worst case scenario. If Omicron results in another lockdown, which is the black swan event, the Fed has to have additional space to further loosen monetary policy. So they have to show markets they are acting quicker, so that markets will price in actions quicker. And in the event Omicron results in a black swan event, the Fed has about 0.5 – 0.6% space to loosen, judging from US 2 year yields.

2. China

Many people were calling on the government in 3Q to loosen monetary policy and support the economy. My prediction however, was correct. That the government would not loosen monetary policy until the evergrande event gets resolved. This is to prevent moral hazard from happening. The CCP wants evergrande to hurt, for Xu Jia Yin to sell his assets, to make an example to show that the government will no longer bail out the property sector, and to kill property speculation once and for all. It is no coincidence that the Guangdong government talked to Evergrande, and Li Ke Qiang announcing that the RRR might be further lowered at a suitable time, no coincidence both events happened in the same day. Once moral hazard for the property sector is no longer a concern, the government will then be comfortable to loosen monetary policy to ensure that liquidity no longer flows into property speculation. Shenzhen was a bad example last year.

The most likely to thing to happen with Evergrande now is a controlled default. Which will cause contagion in offshore financing for the property developers. Onshore financing of course, is still healthy, but subject to the various restrictions. What does this mean? For struggling property developers, it will be even harder to raise offshore capital. The reforms of the property sector will accelerate.

3. Chinas capital markets

Today, the chinese securities regulatory talked about individual stock futures. Chinese capital markets are approaching maturity at an increased pace, and index investing will become the trend moving forward.

Market Update 14 Nov

1. US

As always, inflation makes good headlines, but we don’t need to listen to the economists or the experts. What we need to look out for is what the market is looking out for. Firstly, the Fed. The Fed does not seem to be worried about inflation. Why? Because inflation expectations for 2022 have not risen significantly. Remember, markets trade on expectations. And if the consensus at the moment, is that inflation is going to decrease in 2022, there is no need for the Fed to move. In addition, if inflation is mostly supply side driven, rising interest rates will not solve the supply chain issue, it will only kill demand and kill the economy, what bank of america strategists call the biggest market mistake of 2022. So the metric that we should be looking at right now, inflation expectations, what is the measure? A good measure is the energy market, namely oil, coal, and natural gas futures.

Coal: China has decided to once again, begin mining thermal coal. The physical increase in supply has brought down the price of thermal coal futures.

Natural Gas futures: Looks ok for now, but the Russia-EU tension is yet to be resolved.

Oil: The US is now the largest producer of oil in the entire world. With the Biden administration blocking further shale oil expansion, if oil futures are to go down, then increased supply has to come from somewhere else. At this point in time, it is unclear where the supply will come from.

Sum: Look out for oil and natural gas futures price movements in the coming month. These will determine inflation expectations, and subsequently market movements, and possibly influence how the Fed will react.

SNP 500 outlook for 2022: I”d be a happy man if the SNP500 gave a YTD return of 5% in 2022, because the past 2 years have not been normal at all.

2. China

The very first lawsuit by shareholders against a company was successful! Link here.

Why is this important? Because, for the longest time, Chinese markets have been plagued by no rule of law, and lack of proper accounting. Which means companies can fake accounts all they want and manipulate stock prices, which happened frequently in 2000 – 2012. Then Xi Jinping came into power and started tackling corruption, but the depth of corruption in the stock market only came to light during the market crisis of 2015 – 2016. 用中文说，水真的很深。But now for the first time, a company is being held accountable for shady accounting practices. This is the first time shareholders have successfully exercised their rights against a company, a hallmark of a mature capital market. If China wants to become a superpower, it will need a properly functioning capital market, proper rule of law, and transparent accounting practices. As chinese capital markets mature, the stock market will change from being casino-like to one that allows investors to uncover and price in true value. The next 5 years will see dramatic changes in the chinese stock market, and perhaps the beginning of index investing in China.

Action Point: I believe anytime from now until March next year is a good time window to consider how much chinese equities you want in your portfolio, and begin to load up on them. After march with more regulations, the stock market will change really really fast, for the better. How to invest in China? Major indices: SSE50, CSI300, MSCI China A50, Chinext 50, Star 50.

当前宏观形势

1. 中国

从房地产和基础设施带动经济的模式，转化为消费和科技带动的经济模式。即使现在经济不好，这个都在中央预料之中。我估计，恒大事件不解决，央行是不会放水的。要彻底打破房地产的信念。

行动：现在不是加仓中国股票的时候，等恒大解决好再看看。

2. 美国

美国已经是能源自给的国家，不再需要买中东的石油。需要中东石油的是欧盟和中国。所以，今年冬天美国不会有问题。欧洲问题可就大了。那么世界是否摆脱石油美元？No no no。 因为中东需要美元购买美国先进武器。

Fed 会不会因为通膨而提早收紧？我认为不会。因为这个是供给侧的压力，不是货币政策的问题。

2022 疫苗和新药会带动全球经济的复苏，宽松货币政策逐步退出。

中美重新谈判，重新定贸易协定对全球是利好。

全球Corporate Tax的步伐应该会加快的实现。拜登太需要一些政绩来赢得2022中期选举。

行动： Neutral Mood。不是加仓或减仓的时候。

Taper tantrum

Has the taper tantrum begun? I would believe so.

Yields are back up to ~1.5%, similar to what happened back in March. The difference now however is that the Fed is on the brink of scaling back its asset pruchases.

Dollar index is back up to 94, the highest it has ever been in 2021.

Taper process will take time to unfold, around 6 – 12 months. When and how will markets begin to price this in? Nobody knows. But my main conclusions are:

1. We will see higher real yields on the US 10s. This will cause global yields (other than China) to rise in tandem, which will cause pressures on EM economies financing.
2. Now is not the time to buy into equities outside of the US as capital flows back into the US (does not apply to China).
3. How will the US stock market fare? Don’t know.