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Looking Back, Looking Forward – 2021Q3

It has been an eventful quarter for China as the Chinese government launched more aggressive actions to address data security, antitrust, and social equality related issues in the past months. Those actions include opening a cybersecurity review into Didi Global, just days after the ride-hailing company went public in the US, and an abrupt declaration to essentially outlaw the for-profit after-school tutoring industry. In addition, it took aim at digital platforms’ monopoly power, implementing laws attempting to define what constitutes anti-competition practices among internet companies. The government imposed large fines on Alibaba, JD, and others, for alleged monopolistic behavior. Then the government lashed out at online gaming as “mind opium” and announced new rules that would limit video game playing for minors to three hours a week. Those aggressive corporate crackdowns were followed by the Evergrande saga, as China’s second-largest property developer by sales, was on the brink of collapse. Being the world’s most indebted developer, Evergrande’s debt problem was exacerbated by China introducing rules late last year to rein in the borrowing capacity of developers. China rounded up a crazy Q3 with widespread power outages, which has prompted economists to knock off half a point of its GDP growth forecast for 2021.

All those head spinning events may appear irrational and baffling. It is clear to us, however, growing at any cost is no longer the first priority for the Chinese government now the country is the 2nd largest economy in the world. The Party under president Xi is determined to seek to restructure the Chinese economy and society to resolve what they call the new “principal conflict” that is “between unbalanced and inadequate development” and “the need to improve people’s lives”. This new concept will likely encourage greater state intervention in the economy and increase China’s decoupling from the outside world. The likely result in a nutshell is a more inward looking China with slower economic growth. China accounts for nearly 18% of the world economy, and a slow-down in its GDP growth should be manageable. That said, different industries will likely experience different impacts depending on their reliance and relationship with China’s current and future economic structures.

Inflation and the Fed’s future policy moves remain the hottest chatter in the investment community. Inflation is still a big concern and it is fair to say for people who live in the US that are 50 years and younger, they likely don’t have any memory or experience with inflation like this. Inflation is literally everywhere, impacting everything from food, clothing, home improvement, to hospital services, and travel. It has also become the norm to see empty shelves at stores, and “Unavailable” on Amazon, an utterly unthinkable concept a year ago.

At the Fed’s September meeting, officials raised the core inflation expectation to 3.7% for 2021, compared to the 3% forecast indicated in June. They also see inflation at 2.3% in 2022, vs. prior 2.1%, and 2.2% in 2023, vs. 2.1% before. These forecasts are likely conservative. The August Survey of Consumer Expectations released from the Federal Reserve Bank of New York, suggests that respondents see inflation a year from now at 5.2%, up from prior month expectations of 4.9%. Three years from now, respondents expect inflation to be 4%, up from the 3.7% expected in July. Both readings mark record-high readings for data that goes back to 2013. Separately, the 5 Yr breakeven inflation, which implies what the market thinks the inflation rate will be on average over the next five years, has remained steady at 2.4% – 2.5%.

It is now almost certain the Fed will start tapering in November and finish early next year. We believe odds are high the Fed would need to start raising interest rates before the end of 2022, absent unforeseen negative events that cripple growth. There are obviously negative implications of higher interest rates on equity values, which has resulted in technology stocks’ underperformance in the past 3-4 weeks. If we take a historic look at equity discount rates, Applied Finance’s median Market Derived Discount Rates (MDDR) for industrial firms right now is slightly higher than the median from 1998 to 2021. Very interestingly, however, incorporating the 10 Yr US Treasury yield into our MDDR calculation, the median Equity Risk Premium (ERP) per our estimates, is nearly 250 bps higher than the median in the past 23 years, as the 10 Yr yield has crashed to ~1.35% from 5-6%. It is very possible that low interest rates are actually the reason behind high ERPs, as low rates suggest a potentially volatile macro-economic environment with low growth implications. Therefore, we believe it is not a certainty that higher interest rates would absolutely result in higher discount rates. ERP could decline, if investors believe higher interest rates are the appropriate policy actions to a potentially overheating economy with higher inflation expectations. That said, we continue to believe valuation for the US large cap equity market is rich and investors need to choose carefully.

Where are we in the legislative sausage making on Capital Hill? In August, a bipartisan group of 69 senators, including all 50 Democrats and 19 Republicans, passed a roughly $1 trillion infrastructure package, which includes investments on roads, bridges, Amtrak, expanded broadband access and more. The bill is now awaiting a vote in the House, where its passing has been tied to the success of a separate budget reconciliation package with a price tag of $3.5 trillion, dubbed as “human infrastructure” by the democrats. With moderate democratic senators Joe Manchin and Kyrsten Sinema opposing the price tag, the whispered number is $1.5-$2.3 trillion. Democrats plan to pay for the budget with taxes on the wealthy and corporations, uncollected taxes, and other measures. We believe the final budget will be much smaller than $3.5 trillion, which will in turn require smaller tax hikes, and that could be a “slight positive” for the market in the near term.

While short term investment themes and trends can be overpowering, Valuation and Wealth Creation is Timeless™. We continue to believe that for investors with long term horizon, investing in companies with attractive valuations, credible management teams, and a strong wealth creation track record and strategy is key to outperformance. Separately, we stress the importance of approaching equity investing from a portfolio’s perspective. The Valuation 50’s sector neutral discipline and our emphasis on diversification within a sector allows the strategy to have broad exposures to a wide spectrum of the economy, which tends to perform consistently through cycles, despite the impact some economic factors might have on certain industries at a given time, be that interest rate, inflation, or non-economic factors such as Covid or regulations. We will continue to focus on companies’ fundamentals and their valuation attractiveness.

Looking into the next couple of quarters, we expect US economic growth to remain strong. Consumers’ balance sheets remain in great shape and more workers will be returning to the labor force. Purchases delayed due to supply constraints or availability issues will likely be pushed to 2022, resulting in more even economic growth rates in 2021 and 2022, rather than showing a big fall off next year as previously expected. Bear equity markets are rare when economic growth prospects are so robust. Corrections are likely, however, especially when investors are challenged by rising rates, though at moderate pace, and rising tax rates, though likely much less than initially feared.

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Author

  • Jun Wang, CFA – Applied Finance Partner Joined Applied Finance, 2003. Portfolio Manager and Fundamental Research Analyst. B.A. Southwest University China, MBA from California State University, Fresno.

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