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VPAM Monthly Macro Outlook Feb 2024

Updated: May 14

Chart of the month – Nvidia’s Euphoric Rise vs China’s Brutal Selloff

Nvidia (LHS) 1st Jan 2023 to Present

CSI 1000 (RHS) 1st Jan 2023 to Present

All eyes were on Nvidia and its quarterly earnings announcement last Wednesday. The company was described as “the most important stock on planet Earth” by a certain investment bank. Nvidia delivered once again, beating estimates on all fronts. The stock has rallied 61% YTD. Nvidia’s bull case is well appreciated and it’s euphoric 4.5x stock price growth has seen it propel to become the third most valuable company in the United States. Nvidia has a clear edge or advantage over its competitors for its AI chips. We also have no doubt that the positive speculative feedback loop behind the AI mania could push valuation multiples beyond what seems remotely plausible. However, if returns on capital and profit margins are extremely high, other companies will enter the market to compete. That is how capitalism works. At 32x sales and 68x cash flow, the company has some heroic growth assumptions.

China, on the other hand, has seen a brutal selloff since 2H 2023, extending its losses into the new year. The fundamental bear case for China is well appreciated. As we have noted, there are three elements to our process. First have the odds (valuation) on your side. Second, identify a divergence between price, beliefs, and fundamentals (profits). Third, take an asset on when there has been a phase of emotional capitulation or rapid (waterfall) price action to the downside. Chinese equities fit these criteria. Our sense is that the third element is now underway, especially in onshore equities.

Artificial Intelligence and the History of Bubbles

The current speculative episode in Artificial Intelligence has many parallels with the first bubble in 1999/2000. As George Soros noted on bubbles, “Every bubble has two components: an underlying trend that prevails and a misconception relating to that trend. When a positive feedback loop develops between the trend and the misconception, it sets a boom-bust process in motion.” We are not suggesting that the bubble is about to burst right now, but with the non-linear parabolic action especially in the Magnificent 7,

there is reason to question how long more the rally can run. One way we thought to handicap or bound the potential euphoria is to look back at some survivors of the first technology bubble. CISCO is an excellent example from Dot.Com 1.0. The company traded over 60x sales in the 2000 episode. It has delivered on profits and is still a highly profitable business with trend ROE just under 30%+. However, price has never regained the earlier peak. In conclusion, the price you pay still matters for your future return.

Nasdaq Index – Internet Cycle (October 1998 to December 2001) Rebased to 100 (Dark Blue)

Magnificent 7 Index – AI Cycle (November 2022 to Present) Rebased to 100 (Light Blue)

Japan’s Nikkei Rallies to an All-Time High

34 years after its peak in 1989, Japan’s Nikkei Index has finally surged to an all time high. Japan’s stock market has had a blistering start, gaining more than 17% in the first two months of the year. We once described Japan as the Buzz Lightyear market “to infinity and beyond”. This was clearly an exaggeration, but we have noted a genuine improvement in trend returns on equity since the start of Abenomics. In recent years, Tokyo Stock Exchange reforms have driven companies to undertake capital efficiency measures and we now see shareholder capital return in the form of buybacks and dividends tracking to all time highs. This has been key in underpinning long run stock

performance. Moreover, we note an intimate link between a weak Yen and a strong Japanese equity market. A weak Yen boosts Japan’s overall corporate earnings. The Yen has depreciated back to the 150-level as bets of a BoJ rate hike have been pushed back. Even with the eventual exit of NIRP, we do not think this would warrant a big move for the Yen given Japan’s negative terms of trade and negative real yield differential against the United States. Put differently, an orderly depreciation of the Yen is unlikely to be a major headwind for the Japanese equity market. In conclusion, we see further upside to Japan’s secular bull market.

Nikkei Index 1980 to Present (Dark Blue)

China’s Piecemeal Stimulus and Policy Support

This year, we enter the year of the Dragon. Let’s hope it is a lot more auspicious than the last three years for Chinese assets. As we highlighted on multiple occasions, the widely appreciated prevailing bias on Chinese equities is a deeply bearish one. The recent 25bps cut to the 5 year loan prime rate (LPR) and the 50bps cut to the reserve ratio requirement (RRR) can be at best seen as gradual and piecemeal. A key question on China macro in this current episode is why policymakers have not eased money and credit conditions and unleashed more aggressive fiscal policy? The answer is multifaceted and complex.

The first constraint is likely the aggregate level of debt, at over 300% to GDP, considering the contingent liabilities of local governments. The second constraint might be the currency. If the Chinese authorities did engage in more aggressive rate cuts or US style quantitative easing, that might put downward pressure on the currency (even in a semi-closed capital account). Domestic deposits (if permitted) could swamp foreign reserves. It is also notable that FDI in China has fallen to a 30 year low. In conclusion, our big picture point here is that there is probably a constraint on more aggressive fiscal and monetary policy amplified by the structural challenges of debt, deflation and deteriorating demographics.

China’s GDP to Debt Ratio (Dark Blue)


Top Investor Questions

Q: What are risks to this rally in US Equities?

A key quarrel we have for US equities is the absence of risk compensation. The equity risk premium (earnings yield minus the treasury bond yield) is near zero. Put differently, there is little to no additional compensation that an investor is yielding by taking on the additional risk of owning US equities compared to US bonds.

We note that valuations are stretched with S&P 500 trading at a one year forward P/E of 21x. Market breadth has also been very narrow, driven mainly by the performance of Magnificent 7. S&P 500 is on a historic extended winning streak of 15 out of the last 17 weeks.

US Equity Risk Premium % (Dark Blue)

Q: What is our view on the US Dollar?

To start 2024, markets had priced meaningful rate cuts and a “soft or no landing” as the consensus belief. However, in recent weeks, there has been a shift in the prevailing bias on future short rate expectations given the resiliency of the labour market and sticky inflation data. The December 2024 SOFR implied yield has increased by 100bp from the recent trough to around 4.5%. We think this likely opens the path for sustained Dollar strength and a higher path for Fed policy rates.

US Dollar Index (LHS)

SOFR December 2024 Implied Yield % (RHS)

Q: What other markets in Asia are we bullish on?

Vietnam is one market that we already have exposure to and remain very bullish on its medium to long term growth and return potential. Vietnam’s VN-Index is the second best performing market in Asia YTD after Japan, rallying 10.7% to start the year.

Vietnam is an economy that we’ve long lauded for its golden population phase, growing export market share and positive GDP growth trend. The rally this year has been driven by an improving macro backdrop amid a record-low interest rate environment. If Vietnam can complete regulatory reforms that would enable its stock market to upgrade to Emerging Market status, we see further upside given the potential retail and passive inflows to its market.

Vietnam Export Market Share % (Dark Blue)

VPAM Monthly Note February 2024
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