Mid Year Update-Risk Assessment
“After another large improvement in May, the U.S. LEI now stands above its previous peak reached in January 2020 (112.0), suggesting that strong economic growth will continue in the near term,” said Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board. “Strengths among the leading indicators were widespread, with initial claims for unemployment insurance making the largest positive contribution to the index; housing permits made this month’s only negative contribution.
Time for a pause?
Thanks to the extremely supportive fiscal and monetary policies, the US economy indeed made a V-shaped recovery. The first-quarter GDP rose by 6.4%, 0.4% above its level in the same quarter of 2020. On the employment front, there are now 385k US unemployment claims, while the pre-COVID average was 300k. With a blue sweep, Democrats pushed their spending agenda to the maximum, with a $1.9tn rescue plan in March, and another $4tn for infrastructure in the making. This spending, which was combined with a faster than expected vaccine rollout, which resulted in a broader reopening, which would increase US GDP growth to 5%-6% this year. As we have mentioned in our outlook, we think an overly stimulative fiscal policy and a slow-acting federal reserve (Fed) would lead to a surge in the inflation narrative. As shown in Headline PCE, the price index for the past month rose 0.3 month over month, and 3.6 compared to a year ago. Aside from the fiscal/fed policy, COVID supply chain shortages are also causing increased commodity prices, leading to an even more upward surprise to inflation data. A healthy rate of growth in inflation is beneficial in the early stages of economic recovery; A permanent growth in the rate of inflation will be harmful, which leads to a higher interest rate in the long run that would discourage business borrowing and investment, and lower exports and savings. We can look for wage growth and the labor market to determine whether inflation is transitory. If the labor market continues to tighten, and combines with steady wage growth, then inflation is likely to last longer, and we won't be likely to get a clear picture until August or September since extended unemployment benefits end by Sept 5th for all 50 states. As a result of these upside surprises on growth and inflation, we can expect the Fed to start to consider a near-term rate hike. They did lay out two hikes in 2023 at their latest FOMC meeting, and we can expect more tapering talks if the inflation data stays at this current level.
The US equity market (S&P500) rallied about 14% YTD and 83% since the March low. We have witnessed one of the greatest wealth generation periods in history, where many retail traders see a surge in their net worth by participating in the post COVID recovery trade. As we have mentioned in our 2021 outlook, we think value and inflation-related companies would outperform in the first half, and, lo and behold, we saw one of the, if not the largest, short* and gamma squeeze** in modern equity market history. This was led by a video game retailer called GameStop (GME) which surged almost 2000% in a matter of two weeks. The fact that some major long/short equity hedge funds still had companies that were most impacted by the COVID lockdown on the short side after a series of successful vaccine development is beyond us, but surely, their clients did not pay 2 and 20 for some easy consensus shorts to hedge their long alpha, which also did not work since these funds had to de-gross due to leverage.
The value trade is still in play, but the degree of the forward earnings upside surprises might have reached an exhaustion. These early cycle/cyclical company's earnings recovery were primarily driven by mean reversion in retail sales and spending due to the COVID lockdown. Retail sales ex-auto contracted by 0.7% in May, though the prior two months showed significant upward revisions. Similarly, headline retail sales dropped by 1.3% and core control sales decreased by 0.7% mom. The data is likely to continue to moderate as we push past through COVID comps and services spending drives consumption renormalization. Now, it is up to these companies to execute their post-COVID growth plan to show the public that they have what it takes to capture more, or new, market shares, rather than sticking to their same pre-COVID business model.
A random walk on corporate finance
“In the short-run, the stock market is a voting machine. Yet, in the long-run, it is a weighing machine.”
The famous Columbia economics professor, Benjamin Graham, noted that in the short term, the market tends to reflect investors’ expectations on how a company is doing and will do based on analysts' targets, quarterly earnings, or just simply how others ‘feel’ about the company. However, in the long term, a company's value is the present value of the business’s future earnings or how much capital can be returned to its owner in the future.
In the prior outlook, we stated that many narrative-driven companies, i.e. pre-revenue or not yet profitable companies such as special-purpose acquisition companies (SPAC) and some new IPO listings, are trading apart from their fundamentals, but after the January cyclical companies’ short/gamma squeeze event, these companies have dropped below their pre-SPAC merger announcement price. One might say that the decline of the market value of these SPACs is due to a liquidity shift, where companies like GME pulled retail interests away from SPACs. While this might be true, we have to acknowledge that unlike some of these pre-revenue SPACs, retail companies like Gamestop had a solid customer base and were indeed generating cash flow to their shareholders prior to COVID. Moreover, these retailers were trading at a valuation with the assumption that the COVID lockdown was permanent, which is unrealistic, especially with the successful vaccine rollout and accelerated reopening. Therefore, we can argue that valuation was a driver during the initial stage of the surge in GME, before the short/gamma squeeze event, which gave value investors enough time to capture underappreciated companies before the crowd turns them into a story stock or voting machine.
There are many ways to determine a company’s present value. Perhaps, the most common in practice is the discount cash flow model (DCF), which is the sum of the cash flow that a company generated in each future period divided by one plus the discount rate (WACC) raised to the power of the period number. One of the factors that can change the outcome of the DCF model is the interest rate. If the interest rate rises, assuming other factors stay the same, the present value will decline. Since we have been in a low rate environment for a long time, it’s very important for us to be aware of the Fed rate projection in the coming years, which is likely to rise. Technology-rated companies might be the most vulnerable since they have the longest duration. This means longer-dated cash flow in the future is less valuable today in a high interest-rate environment. However, the traditional DCF model is far from perfect. This is especially true when it comes to valuing early-stage innovative companies, because it fails to capture the exponential growth rate when a new product catches on with the masses, its sales can grow exponentially for a time. Normally, we construct a multi-stage growth model to forecast a company’s free cash flows. We assume a high growth rate for the early stages, then a terminal growth rate that will grow in perpetuity. The problem with this multi-stage growth rate model is that we assume high growth is linear and will transform immediately into a low growth rate once a company reaches its maturity stage. While it's difficult to maintain exponential growth for a long time due to the law of diminishing marginal returns, as each innovation reduces production costs by less and less, companies can grow their free cash flows exponentially for a longer period. As we pointed this out in our 2021 outlook, innovative companies often are not properly modeled until exponential growth pulls away for linear growth. For investors with a long-term horizon, these innovative companies offer the most upside potential during an uncertain environment.
“Investors need to pick their poison: Either make more money when times are good and have a really ugly year every so often, or protect on the downside and don’t be at the party so long when things are good.”
2021 Risk assessment
Early this year, we quoted Oaktree’s Howard Marks, “the odds aren't on your side.” Marks thinks investors should be defensive due to high uncertainty and lower prospective returns. We’ve acknowledged his point and argue that “while uncertainty is high, there are still areas for upside returns”, and we lay out these areas: underappreciated value, deep value emerging markets (EM), base metals, and commodities. As of May, most of these areas have indeed generated alpha, and some, such as value companies like Gamestop, EM like Vietnam, Metal, and commodities like copper, corn, etc., have even exceeded our expectations. However, now that we have captured most of these returns, with nearing peak growth expectations and policies, we think it is a good time to turn defensive*** and protect these massive returns so we can have the capital to deploy when the opportunity presents itself. Therefore, unlike earlier this year, where we focused on upside surprise, now, we are in the hunt for downside risks:
Global Monetary Policy Tightening: Robust central banks’ policy responses around the world had resulted in a stronger growth rate and higher inflation. To avoid over accelerated inflation, some major central banks around the world have started to adopt a more hawkish tone. Most notably, the Norges Bank (Norway) is expected to hike rates around the end of this summer. Additionally, the European central bank (ECB) is likely to taper its assets purchasing program later this year. Other EM central banks have already moved ahead of the crowd, with Turkey, Russia, and Brazil raising their rates about 200bp, 125bp, and 225bp, respectively. The current US fed is taking the "outcome-based" approach, which means they will react to the data instead of anticipating it; this leaves them with not much time to react if inflation indeed becomes more persistent, and they will have to tighten even sooner while the economy passes the early stages of recovery and begins to grow at a slower rate. This would cause a sharp drop in broad market indices, as we have noted earlier, and a rise in the interest rate would cause a decline in equity valuation. Perhaps, the biggest policy risk for all is China. While we were bullish on the Chinese equity market last year, given their first in and first out status, we had become less favorable due to its outperformance over the rest of the world last year, slowing economic growth momentum, and weakening credit demand. Notably, Chinese companies overall defaulted on 74.75 billion yuan ($11.4 billion) of local notes during the first three months of 2021. This was more than double the old record set of the prior year. If the Chinese start policy tightening while having weakening signs in growth data, it would lead to not just a major slowdown in growth, but also a disruption in their credit system, as many companies are having trouble paying off their corporate bonds.
COVID Resurgence: While we don’t have much information on the new delta variant (The B.1.617.2 strain), it is causing many problems in developing countries where vaccination rates are low. India, for example, had to lockdown its economy again. Moving forward, we should not roll out the risk of mutations in these areas with less medical capabilities, which could lead to vaccine-resistant variants. In addition, easing in social distancing and pent-up demand could result in overcrowded hotspots worldwide, making tracking more complicated once a new variant has developed.
Liquidity/Leverage Unwind: As new and younger traders join the market, we are seeing a record surge in margin debt along with call option buying volumes since those seen from the dot-com bubble. Overleveraged positions could lead to a flash crash in underlying assets if risk management is not present. This was the case in the cryptocurrency market, where massive leverage was used in retail trading, and it caused a leverage unwind when the price moved below a certain level and triggered auto selling to cover margin risk in early May. As a result, we saw a 50% drop in many major cryptocurrencies led by Bitcoin and Ethereum. While we are encouraged by a new wave of market participants, we do want to raise caution as we move past the early stages of economic recovery, where the easy money was made. It will take more than technical analysis or social media stock tips to generate returns, especially if these new traders will be playing along or against some of the largest institutions. These institutions are trained for a more complex investment environment. If we take a look at history, we can see a similar story unfold: new generations of traders join the market due to excess liquidity, wealth was created, but it was only lost once the liquidity became scarce.
Fiscal Policy: There are some upsides and downsides if the Democrats lose midterms. The upside would be strong fiscal discipline, which will prevent the economy from overheating. On the downside, it can delay timely responses if we face another black swan event. However, the most important fiscal risk is the Biden administration’s $3.3tn tax plan. This plan’s increases in taxes are bearish for the markets. If the income tax rate for top earners rises to 39.6% and the corporate tax rate rises from 21% to 25% or more, S&P 500 EPS would be reduced by 7% and trigger a wave of retail selling, which technology companies could be affected by the most due to re-shoring (The tech industry prefers to stash profits at low-tax offshore jurisdictions). Additionally, Biden's push to higher wages would bring margin pressure to high labor-intensive industries. Particularly, consumer discretionary companies will be impacted the most.
As stated in the 2020 risk assessment, risk management is critical at the current market backdrop. As we are getting into the later stage of global economic recovery, things are likely to take a pause as the above risks resurface to investors. It will take patience and discipline to wait for the right opportunities. Sometimes it's helpful to revisit the fisherman’s principle in our prior note: “expect nothing but following the process you have developed through trial and error.”
“The definition of a great investor is someone who starts by understanding the downside. You must make the judgment in advance as to how much downside risk you are willing to take”
*Short squeeze: To close out on their position, traders who previously sold short on their asset must buy it back to cover their positions. Closing out of their short trades simply adds more buying pressure to the market, thus further fueling a rise in the asset’s price.
**Gamma squeeze: Market makers often buy or sell underlying stock to hedge option exposure; when share prices rise sharply, shares are bought by market makers as a hedge, thus driving stock even higher.
***Defensive positioning: cash holding, High-quality companies, Long term bonds.
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