Market Thinking September
September 6, 2021
The back-to-school-trade in markets is not to look at the short term forecasting uncertainties around the Delta Variant of Covid, but rather to consider the medium and longer term implications of the latest twists in the New Cold War and the implications for capital flows. Investors in Greater China and other Asia (emerging or otherwise) are beginning to realise that they are now going to have to operate on China’s terms. No more ADRs and VIE structures, participating in Asian growth increasingly means buying Asian equities on Asian Markets. Meanwhile, the reality of the US retreat from Kabul is that not only is the Shanghai Cooperation Organisation (SCO) now a meaningful economic and political bloc, but that Europe now faces the choice of whether the new multi-polar world is bi-polar or tri-polar. Europe has the opportunity to get the best of both worlds, or the worst. Either way the implications for investors are profound.
Short Term Uncertainties
The broad equity markets still seem to be buying dips rather than selling rallies, although having said that they are undoubtedly due at least a modest setback, having rallied over 100% since the original Covid lows. While valuations based on our Internal Rate of Return models are not that stretched – indeed are returning to ‘normal’ – the risk signals coming from our Satellite, Thematic Equity, Model Portfolios remain elevated compared to our Core, Factor based, Model Portfolios, suggesting an enhanced degree of short term risk premium in global equities. This is the equivalent of bond portfolios ‘shortening duration’ at times of uncertainty since while the Thematic portfolios tend to have greater expected return, they also have greater uncertainty around those payoffs.
Risk levels are rising, but not really because of the Delta variant
The noise traders (and their in-house economists) are still pushing the narrative that markets are all about Covid and the Delta variant, but while this may well be what is driving the traders’ in-house models of economic growth, the reality is that longer term investors and markets rarely care about these and we believe that currently they are actually taking a rather longer term perspective, in particular around medium term shifts in the Eurasian growth story and how to invest in it.
The biggest spike in risk premium came, not surprisingly perhaps, with the changes announced at the end of July to the allowable profitability of the Chinese education sector. This triggered a rush for the exits not just in Education but in all the Variable Interest Entity (VIE) structures underpinning the Chinese portion of the ADR market in the US, as risk managers belatedly acknowledged the inherent governance risk embedded in structures that played regulatory arbitrage by pretending to be simultaneously 100% owned by Chinese and 100% owned by foreigners. This showed up most powerfully in one of our sub themes, Emerging Market Consumers, where the benchmarks (and hence the ETFs) have a meaningful weight to the two mega-cap Chinese Tech/consumer plays of AliBaba and Tencent. As an interesting aside, this also impacted the whole Emerging Market ESG trade, where there was an even greater bias to these stocks on the basis that much of the ESG space is, almost by design, short energy and overweight tech. Together with the rise in risk premium that has had us ‘out’ of the Clean Energy sub-theme for much of the year, this has the makings of a tricky year for the Zero Carbon investment crowd.
Elsewhere, the noise traders have struggled to catalyse much movement in FX and commodities over the summer. The dollar index remains in its range, as does Oil – albeit biased to the upside – while Gold (another subtheme) remains largely on the sidelines.
Medium Term Risks
The asset allocators coming back from their staycations will be more concerned, however, with the medium term implications of the two major market ‘shocks’ that took place over the low volume summer period. (Or at least they should be). The first shock to markets in low volume July was the sell-off in many of the Chinese ADR listed stocks noted above, while the equivalent shock in August was the all-too-predictable, but yet somehow ‘unexpected’, US withdrawal from Afghanistan. While markets appear to have largely recovered – certainly in the US – we believe both have meaningful implications for medium and long term investments, something we look at in the long term trends section below.
Elsewhere the reflation/inflation debate continued. Evidence of short term price pressure is certainly abundant, reflecting a combination of (recovering) demand and restricted supply (see economics by anecdote). Perhaps most obviously this is appearing in shipping costs as demonstrated by the graph of the Baltic Dry Index, which has squeezed to levels not seen since 2010. Great for shipping companies, less great for their customers. And their customers’ customers.
Shipping Costs reflect a classic demand/supply imbalance
There are also other signals from the energy sector. Natural gas prices (where there is some suggestion that Putin is trying to squeeze European winter supplies) have squeezed to 7 year highs, while Uranium (partially held pack by some technicalities around a new trading instrument) has also broken back higher. The chart below adds Natural Gas (red) to a number of Uranium company ETFs that we discussed earlier in the year (a NICE future for Uranium) and in particular in contrast to the steady unwind of the strong gains in the ‘Clean Energy’ ETF (shown here in white). All are indexed to 100 at the start of the year.
Whichever way you look at it, energy costs are rising
Back in June, the trigger for looking at Uranium was the announcement that Warren Buffet and Bill Gates were going to build small scale nuclear energy plants (starting on the site of an old coal mine in Wyoming), but the latest move may be connected not only to the end of the technical overhang from a new Uranium Trust, but also to the notion that Nuclear is the answer to the bitcoin mining conundrum. The reality is that, regardless of whether inflation becomes systemic, there are short term supply/ demand imbalances that will have meaningful impacts on either the sales or the costs line of many corporates. As previously noted, policies aimed at Zero Carbon, Zero Covid and Zero Interest Rates are all doomed to fail and, while they may benefit some in the short term, in general they will negatively impact markets and economies in the long run. Negotiating a way through these policy minefields, however well intentioned the policies may be, is going to be a major challenge for corporates and investors alike.
Long Term Trends
As well as having to re-evaluate how to navigate policy-induced cost and inflationary spikes, it looks like investors will also need to consider if the US retreat from Afghanistan marks a broader retreat from international markets by US capital, perhaps similar to the retreat by Japan in the early 1990s. If so, this would be very significant, since the price is set at the margin and if the new buyer at the margin has a different mindset, then historic prices trends and valuations cease to matter. During early September, we were moved to comment on a rare article from George Soros (George talks his own book), not only because it highlighted the increasing role of lobbyists trying to use ESG to influence policy and thus their own beliefs/book positions, but more importantly because it summarised a worldview (that of Wall Street speculators) that increasingly has no place in long term capital markets and particularly in Asia. His title “Investors in China face a rude awakening” is true, but not in the way he posits; the rude awakening is not as he suggests because Xi does not understand markets, rather it is because Xi and the CCP are not going to play by Wall Street rules. The (hugely underated) economist Michael Hudson puts it better than we can. Investors in Asian and Chinese economic growth are going to have to adjust their mental models of how the world works, Xi is focussing on the 99%, not the 1%.
The Chinese have ‘De-platformed’ the Platform Company Model
Investors wanting to participate in Asian economic growth are going to have to reset their investment models as well as their mental models of ‘how things work’. The standard Wall Street EM playbook of investing in the privatisation of infrastructure and other public goods as well as the (mainly western) financiers that enable the process has been summarily dismissed by the Chinese authorities. So too have the business plans of many of the multi-national ‘Platform Companies’ who had anticipated free access to the vast Chinese consumer market. The new Cold War between the US and China had already led to restrictions on access of many Chinese companies to the US economy – some, like Huawei and China Mobile due to alleged links to the Chinese military, while other such as TikTok on account of concerns over consumer data. Recent moves in the other direction include the suggestion of the city of Beijing taking stakes in the recently IPO’d Didi Global, also on concerns about data privacy.
As the US has withdrawn, the Shanghai Co-operation Council (SCO) has emerged over the last few months as the de-facto opposition ‘bloc’ to the US. It is no coincidence that Afghanistan is literally in the middle of this grouping, which contains all of its direct neighbours (plus India) and that it thus also physically sits in the middle of the One Belt One Road initiative, particularly with respect to the Chinese pipelines being built through neighbouring Pakistan and down to the Gulf. Then of course there are the rare earths, the copper, the natural Gas and the metallurgical coal. Lots of opportunities for capital, but not all through traditional routes.
On top of all this is the key question of how Europe responds to this new Bi-Polar world. Does it join one side or the other? Or does it create a seperate ‘third pole’? If the latter, then what does this mean for the role of the $? The SCO are already phasing it out and, as providers of much of the energy to Europe going forward, what price the survival of the Petro$? The upcoming restructuring of the Dax Index this month may well act as a catalyst to focus investors on the opportunity set represented in Europe equities, especially in the ‘new economy’ areas. Longer term, however, Europe has the opportunity to take the best of both sides – US innovation together with Chinese scale and capital intensity, especially in the provision of public goods. Alternatively it could take the worst of both, combining Crony Capitalism and Oligarchies with technocratic authoritarianism. FIngers crossed for the former. For (so) many reasons.