WE THINK: Why the Fed is becoming the problem itself ? How to face irrationalities in the market ?

The A-shares market extended its bi-polarized performance behavior. While the CSI 300 index didn’t record much volatility (-0.54%), the AI-themed stocks continued to attract market’s attention and capital, with turnovers remaining at its high and stock prices moving upwards with great volatility. Many hot-picks in the AI segment has reached its new highs this month. Meanwhile, photovoltaics companies issued earnings results (2022 and 1Q 2023), which many came with a pleasant surprise. Yet it did not stop the money outflow towards AI sectors. Market focuses more on investment logic rather than earnings currently, as we increasingly hear more noises about A-share markets being too irrational. 

Sino-US relationships: US Secretary of Treasure Janet Yellen has spoken recently regarding how US and China should collaborate in the future, which US National Security Advisor Jake Sullivan shared similar speech shortly after. We see an improvement in tonality which may hint for some better changes in the close future. 

US Financial Markets: First Republic Bank’s share prices fell off the cliff after its earnings announcement. It dropped over 98% since Nov 2021, and we believe FDIC would shortly taking control over the bank. 

But why is it that, having both outstanding economic and employment data, some US financial entities are on the brink of bankruptcy? Is it because of how the banks operate? Or is it that the Fed is the origination of such problems but the financial world paying the toll? 

An improved situation between China and US 

We continue to see positive signs from a better foreign affairs relationship between China and other major economies: French President, Euro Committee’s and even Janet Yellen has spoken out the importance of work together with China for fair competition.Stating clearly that the consequences of decoupling being disastrous for global economy, and based on the ideas of fair trade, positive competition between US and China should be a new way onwards. Yellen also mentioned about climate changes and debt-related topics could be discussed with China. 

A quote from Yellen speech as “US and China are the largest economies of the world, our economies trade over 700bn USD each year…we believe that the world is large enough for the both of us. China and US can, and should find a way to work together for the better future of the planet”. Yellen’s speech has come at a time where many US politicians hold extreme opinions towards China. One could believe that US politicians are slowly changing their stances since 2018’s trade war. And we believe that this should not limited to Yellen herself – While decoupling between the two is unacceptable, a way to work together and prosper in the future seems the only wise choice.  

Fed is becoming the problem itself, and financial institution are paying for it

For the longest time, the healthy and long-term economic growth was based on the policies of the Fed. The Fed would always cooldown the economy when it overheated by hiking rates, or signaling a strong rate hike cycle until inflation is under control, and vice versa. But what Bernanke has done in 2008 -- providing Quantitative Easing, or QE, to the market after effective rates has dropped to 0% and the economy has yet to see recovery, has not only saved the economy and larger companies from collapsing, but also becoming the “wonder-drug” for all economy problems. Powell threw out another round of QE without hesitation in 2020 to save the US economy from COVID’s damage. And this time not only subsidized companies but individuals as well, pulling up all confidence levels towards to recovery of economy. But we should all remember, that every glamourous looking scenes are hidden with unexpected dangers. If printing money was the wonder-drug for all problems, why such measures were not used throughout the history of mankind? We always emphasize the importance of rational investment, and we believe its also important for policy makers when deciding the fate of their countries.

As COVID died down, inflation closely followed and the Fed overlooked this inflation cycle’s fatality. There was just not enough time for the Fed to announce or signal to the market for a change in policy, and most financial institutions were unable to quickly change their stances to coup with the upcoming rate hike environment. Since March 2022, the Fed has increased it rates 9 times, from 0 to 4.75-5%, fastest pace in 40 years. This is just like when everyone was wearing in summer outfit and preparing for summer, while all of the sudden winter has hit the streets hard. We find it difficult to believe if such drastic changes in policy were not supported by stringent stress tests of the financial systems. 

Because of the short to none notice period, most financial institutions were unable to adjust their asset or investment portfolios to coup with a rapid rate hike environment. Although most of the media focuses on how Silicon Valley Bank, or SVB, has been too focused in its asset allocation strategies, while didn’t do enough financing business and overweighted too much treasury/ABS. While no one can justify the rationale behind SVB’s decisions, we do believe that Fed should bear the largest responsibility since its abnormally low interest rate environment had pushed financial institutions to overweight their holdings on low risk investments such as treasuries (and who from two years ago would believe that banks are failing because of their holdings on US treasuries). The rapid price drop in bonds has triggered huge amount of mark-to-market losses for smaller financial institutions that may now have such a large book to balance its risk outfits. Just like First Republic Bank, the latest victim and soon acquired by Morgan Stanley, has a large part of its assets allocated in mortgage-backed securities. Both SVB and First Republic Bank ranked 2nd and 3rd in the history of US collapsed banks, shortly after Lehman Brothers. And we ask our readers again, who you think should bear the responsibility? 

Why financial institutions are being hurt most? 

Theoretically, the Fed, through rate hike, can increase the prices of all goods to hinder consumption and commercial activities, reigning in inflation as a result. And for items like houses, cars and other luxury goods, increase in interest rate hinders appetite and could also help inflation. But the economy structure in 2022 limited the effect of the above theory – after the financial crisis in 2008, many American families and corporates has changed their borrowing model towards fixed interest instead of floating. This means that for most of the families who are under mortgage, the rate hike did not affect them economically. Morgan Stanley's Chief US Economist Ellen Zentner once pointed out, that before the crisis in 2008, about 40% of the mortgage rates are floating, versus only about 10% now. This implies that the sensitivity of a normal household towards rate hike has largely been weakened. The situation is the same for car and student loans. Maybe this is also the reason why we do not see a weakening signal from the job, housing and financial markets yet. This is also the reason why life has been tougher for financial institutions – financial institutions were unable to transfer the risk of rate hike towards the mass public. 

US inflation came from different angles: overly relaxed monetary policies before; anti-globalization or protectionism drives up prices for commodities and goods; upstream resources companies lacked CAPEX back in 2015 and coupled with carbon neutral policies making it difficult for financing, such companies are reluctant to produce more to meet the supply demands. All these issues could not be resolved by Fed's monetary policy alone.If the current situation continues, the risk of US overly adjusted their policies increases, thus laying ground for another round of global crisis.

How to face irrationalities in investment 

Looking back in my career, there are always complaints in different markets (no matter bull or bear). In a bear market, investors complain the market being irrational and ignoring fundamentals; during bull market, investors complain market being irrational (again), seeing asset bubbles to form and continues; meanwhile, during a structural bull market, investors would complain bull sectors being irrational, and bear sectors fundamentals ignored… all these phenomena are crucial to understand as an investment expert. 

Irrationality seemed like the recent label for Chinese markets. During 2019-20, it was a structural bull market where market leaders would always be granted the “Moutai of Something”. Capital rushes into the “Moutai” of each segments, and floods out from others. Such phenomena reached its peak at early 2021: because at 2020 year  end, holdings of funds were published and retail investors rushed to follow. This not only resulted into many retail investors rushing into stocks with unrealistic high valuations, but they also subscribed to those funds that embraced mostly, if not only, the sector leaders. We all know what happened next: theme rotation and the next one under spotlight was new energy. 

Opportunities often lies behind or outside of the spotlight. Behind the hottest investment topics in 2019-2021, what happened to those out of the it? Deep value stocks, coal or traditional energy sector, all became highly investible in our eyes. 

It is easy to complain on the irrationalities, especially if you did not benefit from the trend. But slowly, we have learned to become graceful towards all irrationalities, as we understand this is one of the most important characteristics of market cycle. As an investment manager in the listed securities market, we believe that 1) the most important part of alpha comes from pick stocks with revenues earning expansion, and 2) treating irrationality as friends. Because the market was irrational, the market provided stunning entry prices for quality companies. 

If we focused on complaining, we would have lost the opportunity of being irrational. We must embrace and understand what drives the irrationality during our investment journey. We should always make our ways to become a beneficiary of irrational markets, not victims nor complaints. 

Recent Market Strategy

Although the tech and AI sectors are still heated, market are stable overall. Valuations are slowly gaining traction. The government is determined and patient on economic recovery, meaning we can’t be overly aggressive nor short-sighted when it comes to result expectation. Long-termism is the key here. 

While it is easy to be influenced by short term gains of individual stocks or segments, these are noises that one investor must filter out. An example I always use to remind myself is LeTV: I often ask myself, given that I know how LeTV would rise in 2014-15, would I still be reluctant in investing in 2013? The answer is always the same – we would focus on things that we do best.

Wu Weizhi

May 2nd ,2023

本期《偉志思考》簡體中文版鏈接：

伟志思考：美联储已经成为了问题的本身了！ 投资中最难的事之十五--如何面对市场的“非理性”