WE THINK: Dollar appreciation leading to another crisis?

3Q22 Review

It’s been a grim 3Q for year 2022 for the global stock markets–Wind China-A Index fell -12.61%, while NASDAQ resulted in -4.11% after a short-lived rebound (falling -23.65% from its peak). A-share market performance was pathetic – rebounds were short-lived. In September, Zijing Mining, Wuxi Biologics, Huayou Cobalt … one after another we have seen blue-chips stock price falling day after day. “Guess who’s next tomorrow” became one of the a hottest sad-joke discussed on the internet in China. In fact, some of the most popular investment themes in 2Q22, such as electric vehicles photovoltaic industry, have seen huge retreat from their highs (dropping 28.7% and 21.16% respectively in 3Q), testing the faith of their believers. Meanwhile, after adding 75bps to the fed fund rates, the dollar index continued its rise against all other assets, causing most assets to drop against the dollar and further upsetting investors’ risk appetite. On the other hand, Bank of England had to intervene and stabilize its bond markets for the first time in history: market rumored that UK’s pension funds were facing liquidity issues due to the acute price drop of bonds (with some recorded over 50% loss on its face value). BoE had to step in and stabilize its wilting bond market, providing liquidity to avoid potential systematic risks. 

The up-scaling of Russo-Ukrainian war brings humanity closer to nuclear war than ever

Russian President Vladimir Putin had ordered a partial mobilization of 300,000 reservists to bolster his forces in Ukraine, the first call-up in Russia since World War II. Heightened tensions with Ukraine and its supporters, and now with both Nord Stream 1 & 2 blasted and malfunctioned, hopes to lower short-term inflation pressure, via the supply of Russian natural gas, vanquished. The probability of ending such conflicts in close future has diminished, and poses more uncertainties to the already critical energy-shortage and inflationary pressure. German Ex- Prime Minister Angela Merkel has warned politicians to treat Putin’s comment with seriousness, and making sure that future negotiations are always working towards a better future for everyone.

As different parties trying to progress towards their own perfect solution, civilians like us could only pray for a rational mind from the political leaders to avoid the disastrous outcome of a nuclear-war outbreak; whether or not the Russo-Ukrainian war would lead to a nuclear war, military or economic disputes would not end soon. The energy crisis for European states and its affects to the already inflating global economy put the leaders of the world into a more problematic situation. We do not know if Russia would succumb to the sanctions and internal affairs, but from the history of Iran, Venezuela, Cuba, and North Korea, it would seem an unlikely event.

The Fed’s stance is always the most important

The Fed announced a rate hike of 75bps on September 21st, with Fed fund rates now ranged 3 - 3.25%, its 3rd consecutive rate hike in the year and the most frequent rate hike since 1981. Dollar Index rose as a result, marking its 20-year high on the 26th with 114.58. As of September 2022, The Dollar Index has risen 16.86% for the year.

Other major economies have followed the Fed’s path – with England, Europe, Hong Kong SAR, all raising rates as a result. However, with weakened economic activities, most currencies saw a drop against the green back. RMB, as the second strongest economy, has also dropped 12.21% against the dollar. As rate hikes continue for the dollar, more and more overseas capital would return to US onshore – currency depreciation, fund outflow, higher funding costs, all these causes of a weakened economy are rooted from Fed’s rate hike, and tightening that leads to more overseas capital returning to the US. From the Fed’s latest comments, it is their utmost priority to control inflation at all costs, including a potential recession – the US has shown strong support from employment and economic data, suggesting the Fed could have more room to further increase fund rates, while other weaker economies or highly-leveraged companies won’t have such leisure; History has taught us that, during a dollar appreciation cycle, some countries would face economic hardships.

Financial or economic crisis becomes more likely in other countries during a Dollar appreciation cycle, with Latin-America’s crisis in 1982 and Southeast Asia’s financial crisis in 1997 the two most recent examples in the last 40 years; the extremely low-rate environment since 2008 has forged an economic environment where many governments and companies possess higher than usual leverage. Right now, with a sharp change in the global fiscal environment, together with a dampened global economy due to COVID-19. The only improvement as compared with the crisis in 1982 and 1997, is a better global risk management framework and crisis management experience for most financial institutions and government bodies.

Is the crisis imminent? Time will tell

In 2022, Sri Lanka has defaulted as a result on its heavy reliance on tourism. Argentina has sought financial aid from the IMF. Developed markets like Japan, England, Europe have all suffered from a depreciating currency and a rise of funding costs. Companies with large dollar-based debt see increasing pressure, and the continuity in rate hikes is likely to mount more pressure on those highly leveraged companies. Meanwhile, it is hard to predict which company to be the first victim (Credit Suisse being the latest victim from market rumors), such drought in liquidity is unlikely to resolve in the close future. Let it rain and time will tell us who wasn’t prepared.

We have yet to see the peak of this crisis: an appreciating dollar has led to multiple financial crisis in different regions in the past. Thus, judging from the fact that the Fed has a solid economic foundation to support its rapid rate hike actions, one should expect it would cause, to a certain extent, defaults and bubbles to burst. The domino effect would start somewhere, but how far would it reach? How long would it last? How does such chain reaction of defaults end? All these questions are too hard to predict, but at least we believe that, right now, it is too early to call for buying on dips right now – patience would pay and such opportunity may not be too far away.

What about A-share markets? Keep calm while others panic

China’s taking a totally different stance on its fiscal policy: with August CPI around 2.5%, China’s problem is not inflation but deflation, so tightening is not necessary but loosening is more preferred. More policies announced to support the real estate markets, we can see that both US and China are addressing their own economic problems with their most proper response.

Right before its national holidays started, the Chinese government has issued more loosening policies to support its real estate market: lowering first-buyer mortgage rate for Housing Provident Fund purchase, relaxing the lower limits first-buyer mortgage rates in cities with housing price drops, tax rebate on the capital gains tax for home-trading, etc. With a series of loosening housing policies to support the market, we can see that the governors are paying more attention to the slowdown in real estate market, especially when real estate developer CIFI Group has also faced liquidity issue, albeit its financials has always been prudent and solid. The huge contrast between China’s housing market and US’ rental market is exactly a phenomenon of how both countries are facing different economic issues of its own, where tightening is necessary for US while loosening is needed in China.

As energy prices has been surging since the Russo-Ukrainian war outbroke, the energy industry in US, which is the largest oil producer and exporter in the world, benefitted from such rising prices. Also, US’ military & defense industry has also seen increasing demand due to the geo-political tensions. In addition, US has been promoting, with tax benefits and policies, the return of manufacturing jobs back to US since Trump’s office. Such motives are now seeing its effect and provides strong employment data in US, giving the support needed by the Fed to continue the rate hikes. Meanwhile, as China’s energy consumption is largely based on coal-powered electricity, the country’s energy consumption has been self-sustainable and unaffected by the surge. Therefore, as Europe, Japan and Korea are all dependent to foreign energy supplies, cost of energy production has risen significantly, causing some damages to their competitiveness when compared to China and US.

We are probably in one of the cheapest valuation periods of time for Chinese equities (in terms of P/B ratio). While we won’t suggest to dive into the market fully, investors be aware of factual reality vs. perceived reality. As a motto in Rabbit Fund, one should focus in doing what’s right in long-term.

We expect the policies would loosen during the post-pandemic era in China. The services industry and employment would see significant improvement in the close future. If the recent loosening policies for the real estate segment could provide resilience to the surviving real estate corporations, there’s a large change for improvement on the fundamentals of China’s economy. With A-shares in its lower levels, the capital markets in China perhaps can surprise the world with its resilience. We suggest to be cautious but not overly pessimistic; be prepared with investment portfolios of quality, and patiently wait for the right timing. As the grand master Warren Buffett once said, “be fearful when others are greedy, and greedy when others are fearful.”

May Our Country continue to Foster and Prosper!

May our Friends stay Happy and Joyful!

Weizhi   

National Day, 2022. Shenzhen   

本期《偉志思考》簡體中文版鏈接：

偉志思考：這輪美元升值會否引發大危機？

https://www.rabbitfund.com.cn/news.php?act=view&id=494