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The only things that seem to go up on days the market is open are gold and Tesla. We don’t advise buying the EV manufacturer at 200x forward earnings. Gold is a different matter. With US M2 money supply growth in Third World territory, dollar weakness will be persistent.
The US dollar July 27 broke through a six-year support line at 94.35. We have been dollar bears for the past two months and remain ursine with respect to the US currency.
Gold used to trade with Treasury Inflation-Protected Securities (TIPS), but has broken out into a new range during the past week.
There’s a whiff of brimstone about the market. When Ray Dalio, head of the world’s largest hedge fund, warns against a “capital war” in which the United States might withhold coupon payments for China’s trillion dollars of Treasury debt, it’s not surprising to find a bit of extra bid for an asset that no central bank controls, namely gold.
Rumors of a capital war, including a US effort to cut Chinese banks out of the SWIFT payments system, are exaggerated. That sort of recklessness would blow up the world financial system and crash the dollar, as the rest of the world shifted out of dollar payments to less vulnerable alternatives.
The risk of disaster is big enough to make us hold the yellow metal but not big enough to add to positions. There are alternatives to gold, and they are to be found in Chinese and Korean equities.
Several factors are at work in the dollar crash:
- The US recovery has stalled according to all high-frequency indicators, including Google’s mobility data;
- The uncontrolled coronavirus pandemic suggests that more pain is to come for the US economy;
- Both political parties agree that increasing the federal deficit to put more spending power in the hands of consumers is the right course of action. The market doesn’t agree;
- There is a slight but still significant risk of what Bridgewater Capital CEO Ray Dalio called a “capital war” between the US and China, including the possibility of US actions to block China’s access to US dollar funding markets.
The United States faces a real risk of an eventual funding crisis. Household consumption makes up 70% of GDP. The April-May spike in the household savings rate to the mid-20% range portends a sharp economic contraction. That is why Washington is anxious to support consumer spending power.
The Covid-19 pandemic meanwhile will keep unemployment high. Small businesses (with fewer than 50 employees) account for nearly half of US employment, and 40% of small businesses do not plan to reopen, according to a June LendingTree survey. If households continue to build precautionary savings, the US will have a prolonged and deep recession. The Conference Board’s consumer expectations index plunged from 132 in February to a low of 86 in May and remained at 92.6 in July.
The one area of comparative strength, namely homebuilding, reflects savings (homes are a desirable asset with US mortgage rates at record lows), and still was below the year-earlier level in June. The consensus economic forecast sees a year-on-year fall of 5% in US GDP in 2020. More deficit spending and expansion of the Federal Reserve balance sheet will be required to mitigate the recession, including another $1 trillion of emergency aid now before the US Congress.
Expectations of long-term economic weakness are evident in 30-year inflation-protected Treasury yields, a market variable over which the Federal Reserve has little influence. These fell from 1.2% in March to 0.4% in July, the lowest on record.
As noted, TIPS do not provide an adequate hedge against extreme monetary moves, for the simple reason that they are denominated in a currency issued by the Federal Reserve, which is willing to expand its balance sheet indefinitely. Alternates to the US dollar, including Euro as well as gold, have traded in close correlation as the dollar weakens.
Asian currencies, especially CNY and KRW, will benefit from dollar weakness. Along with Taiwan and Vietnam, China and South Korea have kept Covid-19 under effective control. China’s RMB has held steady at around 7 to the USD and has considerable room to appreciate. Risk reversals indicate that the market will pay more to take positions on RMB appreciation than on depreciation.
The Asian equity alternative
Chinese stocks are cheap compared to either European or US stocks. The forward price/earnings ratio for both Europe and the US has hit a record, because the numerator (equity prices) recovered even while the denominator (expected earnings) continues to shrink. The valuation of the Shenzhen 300 index is on the high side of an historical range (but nowhere near the peak of the 2015 bubble) while the valuation of US and European stocks has risen to hitherto unknown levels.
We prefer BABA at 29X forward earnings to its nearest US equivalent, Amazon, at 91X forward earnings. Alibaba is not just a retailing giant (in a duopoly with JD.Com). Alibaba (BABA US) holds a 33% share in Ant Financial, whose coming IPO is likely to value the fintech company at $200 billion.
That’s about 8% of Baba’s current $667 billion valuation. At least half of that appreciation is already built into the stock price (which rose 5% after the Ant IPO announcement), but there is another 4% or so of upside to be priced in. More importantly Ant Financial, with nearly a billion customers, represents a stable and profitable franchise.
As China accelerates plans to control its own global payments in its own currency, moreover, Baba and its consumer-payments competitor Tencent will have enormous room for global growth. Baba isn’t cheap on a price-earnings basis, but most of its stock price appreciation during the past two years has come from earnings growth rather than multiple expansion. Its forward P/E of 29 is on the lower side of its five-year trading range.
China Construction Bank (HK 939)
CCB, the best-managed of the big four state-owned banks, is trading at a forward P/E of 4.7 in H-shares (vs. 5.7) in A-shares. All the major Chinese banks have challenges, including understated loan losses and the (extremely unlikely) prospect of a “capital war” with the United States which might deny them access to dollar funding markets. Nonetheless the compensation for risk is handsome in this case.
By contrast, the European bank stock index SX7E trades at a forward P/E of 15, and the S&P Bank Stock Index at 17. Extremely lax monetary policies in the US and Europe make it impossible for banks to make money on ordinary financial intermediation. Bank loans still earn positive real yields for Chinese banks, by contrast, and banks still make money by taking deposits and making loans. At triple the risk compensation of US and European banks, CCB looks cheap.
China Life (HK 2628) H-shares have always traded a bit cheaper than A-shares, but now the Hong Kong-traded stock of China’s largest life insurance company are selling at half the price-earnings ratio of the Mainland equivalent.
Samsung (5930 KS) is well positioned in a number of key markets. As Western companies (most recently Intel) abandon chip fabrication, Samsung’s franchise will expand, in part because the world needs more fabricators than TSMC.
Its smartphone business will gain market share as Huawei struggles to obtain 7 nanometer chips for its top-of-the-line smartphones, and its 5G equipment business will also benefit from global diversification of providers. At a forward P/E of 15 it is trading rich to historical levels, but its price still remains well below the February peak.
Most of all, we like the Korean won at these levels. The KRW has been steadily rising since hitting a low of 1,285.73 against the dollar on March 19 and now stands at 1,193.17. The KOSPI has risen by about the same amount as the Nasdaq (51%) since mid-March, but arguably has substantially more upside as Korea has defeated the coronavirus and is making a robust comeback.