Forget China, look into Energy, Crypto, and Value

IN THIS PUBLICATION:

• Despite the China Tech bleeding apparently being over, we wouldn’t buy the dip.
• Even in a slowing economy, opportunity abounds in energy, crypto, value, and the private markets.
• The requisite ‘please don’t sue us’ disclosure: the below is not investment advice.

Recent Developments

• President Biden has nominated Jerome Powell for another four-year term, which the market has interpreted as hawkish. Consensus has the Fed hiking three times by end of 2022, although consensus has rarely called these events accurately.
• In 2018, when Powell became Chair, the Fed hiked from 1.5% to 2.5% (following the hikes already initiated by Janet Yellen in December 2015 after seven years of rates at 0%), only to do a 180 when the market tumbled in December, lowering rates again to 1.25% in support (lower than level initially inherited) before the pandemic took hold of the global narrative. Will he get cold feet once again?
• As expected, given the period of the year we’re moving into, Covid infections have been rising and Europe now seems to find itself in the most severe infection wave since the virus hit (as Germany’s Health Minister said, by the end of the winter everyone will be either “vaccinated, recovered, or dead”). Importantly, mortality rates are still below peak levels from previous waves, but there’s usually a time lag between infection and mortality, so keep an eye on any unexpected developments.

• What this means is that we’ll likely see renewed lockdown mandates across Europe, which we expect will be more difficult to implement this time around (rightfully so). Given this backdrop, the easiest trade here is likely US Dollar upside versus the Euro as lockdowns bring uncertainty, which is likely to drive safe haven (USD) inflows (for specific insights on foreign exchange markets, check Roger’s last Markets Update).
• This should fuel the continuation of US versus European stocks outperformance and could also give the Fed an excuse to delay hikes (a stronger USD already achieves some level of tightening, which should help slow down the pace of inflation).
• Energy-wise, natural gas prices eased to almost €60/MWh from the c. €120/MWh peak in early October after Putin’s commitment to increase supplies to Europe, but the disappointment over the realized level of natural gas exports (was Putin bluffing?) has led to a renewed bounce higher towards the €100/MWh level. What happens if the weather gets cold as f***? Will we get stimulus checks that’ll help us afford to heat? We heard it here first.

Why We Won’t Buy the Chinese Dip

The bleeding in China Tech seems to have finally stabilized.

Regular news readers might have also noticed that Ray Dalio, who’s been a long-term China bull and runs the largest Hedge Fund in the world with $223 billion in AUM, is launching a c. $500mn fund based in China.

• He’s been active in the country for several years now through a wholly-owned Shanghai-based subsidiary, but this effort doubles down on his longer-term vision that China is a market that will offer great opportunities in the coming decades (and, for him, fees).

At first glance, this correction (and Dalio’s bullishness) could present investors a reasonable opportunity to dust off some good old fundamental analysis and look at businesses like Alibaba or Tencent (trading at or close to the cheapest multiples in their history) to see if now’s a good time to buy long-term exposure to high-quality Chinese tech at a discount (through their US-listed vehicles).

We’re no experts in Chinese Tech and thus won’t discuss the fundamentals of each company. What matters to us more, nonetheless, is to highlight the fact that when foreigners buy Chinese Tech stocks, they’re not buying shares of the actual businesses that employ thousands of people, control the assets, and produce products or services (foreign ownership of most Chinese industries is prohibited), but rather own a piece of a Cayman Islands entity (called Variable Interest Entity, or VIE) that has agreements with the Chinese counterparty to receive a share of the profits and control its assets. It is estimated that c. 80% of all US-listed Chinese companies operate through a VIE structure.

But there is one (big) problem with this structure – the agreements between the Chinese company and the Cayman entity are not legally enforceable in China, meaning that the value of the shares held by foreign investors is fundamentally based on contractual agreements in which they have no legal say.