Market Insights Podcast – 4 APR 2022
In the past quarter, the market has witnessed a lot of history. After the crazy market, it is still hard for investors to relax. After suffering double digit losses during the 1Q 2022, the S&P 500 rebounded in March to finish just down about 5%. With the positive signals from the negotiations between Russia and Ukraine, market sentiment has obviously improved, global stock markets have continued to rebound and the three major indexes of US stocks have all rebounded to their levels before the conflict between Russia and Ukraine this year, exceeding the expectations of many investors. Resilient net inflows through 1Q 2022 meant ongoing buying of the dip while there were heavy redemptions in bonds, particularly credit. Momentum trading delivered the best returns in March as the index bounced whereas value stock was the winner overall in 1Q 2022.
The U.S. non-farm payrolls increased by 431,000 in March, hitting a four-month low. The unemployment rate fell to 3.6%, close to the pre-epidemic level. Average hourly earnings in March rose by 5.6% year-on-year, the highest year-on-year growth rate since 2007. After the release of the non-farm report, under the expected pressure of the Federal Reserve to raise interest rates sharply in the short-term, yields on short-term Treasuries rose much higher than those on long-term bonds. The U.S. 2-year and 10-year yield curves, the most closely watched recession predictor, were inverted.
While Fed’s actions have slowed economic growth, companies will still be able to achieve profit growth, justifying their valuations, especially US companies, which are almost immune to Russian sanctions. It may also be too early to talk about a recession, supported by improved openness and still low levels of leverage. The downside risk is that oil prices unexpectedly rise again and lead to a larger-than-expected tightening of monetary policy, while the upside risk comes from the start of corporate capital spending. Against this background, the overall trend of U.S. stocks is not pessimistic, although there may be disturbance, we watch closely the confirmation of earnings inflection point in the upcoming first quarter 2022 corporate results, which should be the fundamental reason for the market direction.
In fact, there is lack of other investment options in the market. Cash assets may provide flexibility but they do not yet offer any attractive returns. Also, bond yields are rising, which means that people are selling bonds and if the Fed is indeed embarking on a tightening cycle, it makes sense that yields are expected to fall further. Moreover, while commodities have performed well recently, investing heavily in commodities is not the right choice for many institutions. As a result, investors can only buy stocks.
Typically, the yield curve inverted suggests that investors expect long-term interest rates to be lower than short-term interest rates, a phenomenon widely seen as a sign of a potential recession. Last week’s yield curve inversion coincided with growing fears of an economic downturn amid rising inflation, Russia’s invasion of Ukraine and a slowdown in China. Yet recessions often lag behind the inverted yield. The data dating back to 1965 shows that the median time between the inverted yield and the recession is 18 months, which is consistent with the median time between the inverted start of the yield curve and the peak of the S&P 500. While the reversal of the yield curve is a good indicator of future economic distress, it is not a good timing tool for equity investors. For example, investors sold when the yield curve was first reversed on December 1988, who missed the subsequent 34% rise in the S&P 500. When the US bond yields were inverted again in May 1998, those who sold stocks missed an extra 39% rise in the market. In fact, the S&P 500 has a median return of 19% from the inverted yield curve of each cycle to the market peak.
Markets expect the Federal Open Market Committee (FOMC) to raise interest rates by 50 basis points to cope with the highest inflation in four decades at its meeting on May 3 and 4. In the Fed’s March interest rate forecast, officials’ median forecast was that the benchmark interest rate would be about 1.9% at the end of 2022 and then rise to about 2.8% in 2023. The most important information to be gleaned from the Fed in the coming weeks is the details on what it is going to do as regards balance sheet contraction. Any plans to engage in outright asset sales, as opposed to just letting maturing bonds run off, would be bearish for equities. However, despite 12 to 13 hikes over these 2 years, we believe it is unlikely would enter a recession. If the yield curve is a good predictor, it means that recession will happen in 2 to 3 years. So, it is not an imminent thing that investors should worry about. Concerns have grown among market participants that plans by the US Federal Reserve to aggressively tighten monetary policy this year to combat high inflation will result in a recession. However, the economy is doing incredibly well in the US and does not seem going into a recession. The Fed is also trying to slow the economy down. The current labour market is very strong. Now, there are still 11 million jobs that have not been filled in the US.
We do see economists revised down their 2023 GDP forecast from 2.2% to 2%, while they are still projecting 3.8%to 4% growth in 2022. Corporate margins have been one of the best indicators of the business cycle, so despite the yield-curve raising concerns about recession, margins suggest risk is low. What makes pricing equities versus treasuries so difficult in this cycle? Firstly, as the Fed is clearly behind the inflation curve, the uncertain time lags from rate hikes make it even more difficult to assess. Secondly, inflation has moved on from supply disruptions being the sole source of price spikes to a comingling of wage growth. The problem is that supply-push inflation is a much challenging problem than demand-pull inflation because the former does not respond to higher rates and tighter money but consumer and business spending does.
Our basic assumption is that the US economy can avoid recession, thereby reducing the threat of a sustained decline in the stock market. Therefore, investors should be prepared to raise interest rates, including possibly increasing their exposure to value and financial stocks, which tend to perform well as central bank policy tightens, rather than exiting the stock market and overreacting.
The White House announced the largest release of strategic oil reserves in US history, the media said that the United States would work with other members of the International Energy Agency (IEA) to release emergency oil reserves and international crude oil fell by more than 10% this week, which is the biggest weekly decline in nearly two years. European natural gas futures, which have been rising for days, fell more than 10% in one day and the gas outage crisis in Russia eased temporarily. After Putin ordered those countries that are “unfriendly” to Russia must settle natural gas in rubles from Friday, April 1, the Kremlin said that the ruble settlement order was irreversible but that gas supplies to Europe would not be cut off immediately. Gas deliveries will continue while the payment of the rouble is pending.
The US is looking at releasing 1 million barrels per day and potentially 180 million barrels in total, which is roughly a third of the total strategic petroleum reserves. US Energy Dept. says that first 90m barrels of oil will be released from May to July, another 90m barrels will be released from Aug to Oct. This could put a cap on international oil prices. The amount of Russian crude sanctioned from international markets is estimated to be about 3.5 million b/d. A release from the US of 1 million b/d over the next six months and the continued production hikes from the OPEC+ producers of 430,000 b/d over the same time frame would considerably narrow the output gap. Nevertheless, even if production could be achieved, it would reduce SPR inventories to about 300m barrels. This is very close to the 315 million barrels that the United States should hold to meet the 90-day net import protection set by the IEA. In other words, there may be no bullets available in the United States after this SPR release, which could eventually become a bullish signal for oil prices.
Another uncertainty comes from what will happen to Russia’s exports of oil and petroleum products. Although Europe has not imposed sanctions on Russian energy exports, self-sanctions by traders will disrupt the market and some refineries are already looking for alternatives. However, in the long run, the key to rebalancing the market is to increase commercial production, not to reduce reserves. Historically, the release of SPR will temporarily push down oil prices and then oil prices will rise with supply shortages. Oil prices are likely to rise after an initial brief pullback, while SPR may have to replenish crude stocks at higher prices. The inventory of strategic oil is limited, while commercial oil exploration is not but increasing production may be slow. Until OPEC+ production catches up, the deficit due to Russian sanctions will persist and oil prices are unlikely to move materially lower.
The preliminary thoughts on this potential shift with the upcoming hardware subscription service: according to existing user base and revenue data disclosed by Apple Inc, users spent an average of USD280 on hardware and USD69 on services in 2021. In other words, Apple users spent about USD1 a day on all Apple products and services last year. Given the importance of Apple’s technology platform to users’ daily life and the high user stickiness of Apple’s products and services, users may be willing to pay for it. The subscription services could shorten the hardware replacement cycle and increase the cost per user.
A series of innovative products have been released recently. In addition, the company has made good progress in the market for advanced driving assistance systems and its penetration is expected to increase from about 10% to 50% in the next eight years. The total size of this potential market could be as high as UDS300 billion and is expected to provide strong growth momentum in the future.
It asked shareholders to approve the split in order to pay dividends to shareholders. Tesla said that the plan had been approved by the company’s board of directors but did not specify the proportion by which the shares would be split. If approved, the split will be the latest since Tesla Inc. split the stock on a 5-to-1 basis in August 2020. Tesla’s consideration of stock split is a wise strategic move. The company increases its authorized share capital to allow a split in the form of a stock dividend. In additional, Tesla’s CEO Musk said that a test version of the FSD BETA for left-hand driving should be launched in Europe this summer and a right-driving version in a few months, depending on regulatory approval. US auto media Electrek recently analyzed the delivery time of Tesla and found that many Tesla models were nearly sold out by the end of 2022 despite the price increases and there was a large backlog of orders, especially Model Y. Model 3 seems to have been sold out in the United States for three months, which is similar to that of Model Y. Soaring gasoline prices are driving consumers to electric cars. Break through the global supply chain dilemma, Tesla’s Q1 delivery volume of more than 310,000 vehicles which is a year-on-year increase of nearly 70% and a record high. Investors should not only focus on the stock splits. The main reason for Tesla’s stock price to rise and possibly to rise again is its Master Plan 3, Starlink telecommunications system and its insurance, which will further increase Tesla’s value. Stock splits allow low entry in participating in investment in the company. However, investors would make a lot less by speculating on Tesla than investing into it.
There was an U-turns on both sides of the Pacific recently, with the US rescinding tariffs on 325 Chinese products while the US regulators have asked the US-listed Chinese firms to prepare for more audit disclosures. 270 Chinese companies are listed in the US, with a combined market capitalisation of about USD2 trillion or almost 4% of the value of all companies listed on US exchanges. China will lose access to the world’s biggest capital market, which has raised more than USD100 billion. New progress has been made on the issue of Chinese stocks listed in the US that the market is highly concerned about. On April 2, the China Securities Regulatory Commission clarified that if overseas regulatory agencies conduct investigations and evidence collection or conduct inspections in China, they should do so through a cross-border regulatory cooperation mechanism. China has proposed revising its secrecy rules involving offshore listings to remove legal barriers to cooperation between the U.S. and China on audit oversight, while shifting the responsibility for protecting state secrets to Chinese companies. The announced draft rules are the latest attempt by Beijing to resolve a long-standing audit dispute with Washington. The draft clarifies that Chinese companies are responsible for the information security of overseas listings. This reflects the openness of Chinese regulators to cross-border audit regulatory cooperation. The Chinese government is also willing to be in line with relevant international practices and will provide institutional guarantee for safe and efficient cross-border regulatory cooperation, including joint inspection. This is very positive news for US-listed Chinese companies that can comply with international accounting practices and they will continue to be able to raise capital in the largest capital markets.
The latest 4Q 2021 financial results showed that China Mobile is officially more profitable than Tencent. China Mobile’s Earning before Tax and Amortization in 2021 was 311 billion yuan. Tencent’s adjusted net profit was 123.8 billion yuan, up 1% from the same period last year. It is a big contrast! The old economy state-owned enterprises (SOEs) and the red-chips’ profit growth is faster than the private sector while valuations are on average single digit PE, with dividend yields are higher than their PE, such as Chinese state-owned oil companies may refer to the latest great 2021 results and dividend payout announcement.
Investor sentiment took a set-back last week as news of a tightening in measures to control the Omicron burst in Shanghai came alongside below consensus official PMI. The Caixin/Markit manufacturing purchasing managers’ index (PMI) fell to 48.1 from 50.4 in February – the steepest drop in 25 months. For investing in China markets, we want to see what concrete steps will be taken by the government. We will be watching upcoming data, such as credit growth, to demonstrate what the Chinese government is doing to support the economy. Also, to get a clearer picture of the profit potential of Chinese tech companies after the regulatory crackdown last year. The impact of the crackdown on profit margins, the company’s ability to grow, the overall business model, etc. There are too many unknowns. On the bright side, China’s monetary policy is going to be loosening and the rest of the world is going to be tightening and there is going to be a real point where money is coming out of the market in the US. That will be a good time to be overweight in China.
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