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VI Fund - The Economic Machine: Where Are We at Today?

The Economic Machine - Where Are We at Today?

It has been 6 months since the turn of the year and the world is a vastly different place.

If the previous years’ hardships were glossed over by the tales of humanity’s resilience and innovation, 2022 has brought about many issues that can only be said as consequences of past actions.

As much as our fund’s focus has been on the individual companies’ strengths and their prospects to generate returns, it would be hard to ignore the macroeconomic events and how it is largely entwined with the capital markets. Understanding these events would shed some light on why our investment strategy is behaving the way it is, and gives further comfort or provides insight on whether the strategy is suitable for us.

We would like to disclaim that we are not economists and will not claim to be knowledge experts on such matters. From here, we’ll like to share some thoughts on the current climate and how we are seeing the markets right now.

Economic Cycle

The world is, unfortunately, suffering the consequences of the previously unbridled rates of quantitative easing of pumping capital into the economy to save it from the impacts of COVID, but it has had disastrous impacts on the economy, with inflation growth numbers hitting new peaks every month1. Similar to reading a map, to understand where we might be headed and how we get there, we should first understand where we are.

With reference to Ray Dalio’s “How the Economic Machine Works” video on YouTube2, he provided a simple template on how to understand the economy – which is summarized into:

  • The economy is the sum of all transactions made in society – government, banks, businesses, people, etc.
  • One man’s spending is another’s income: more spending = larger the economy.
  • The economy is affected by two cycles: the short-term debt cycle & long-term debt cycle.
  • These debt cycles govern the expansion or contraction of an economy.



The short-term debt cycle

Inflation.. a different kind?

During the pandemic, the US Federal Reserve made no hesitations to prop the economy up by printing over $3 trillion in a short period of little over three months, encouraging spending (transactions) to prop up the economy, when quarantine threatened to put the economy into a standstill.

After the unprecedented rates of quantitative easing and stimulus checks handed from the governments around the world to their citizens, the logical thinking would be that it will lead to inflation. A broad-based definition of inflation would be: “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services”. However, if that happened two years ago, why are we just waking up to the reality of it?

When inflation is mentioned, we would immediately think about the cost of our necessities/living increasing, things like food and petrol, which has a big impact on our everyday lives. If left untended, it would severely compromise our living standards and have big implications for the lower-income families that can be priced out of living. This can be classified as Consumer Price Inflation, which is driving the headlines nowadays.

However, we were already experiencing inflation during 2020 - Asset Price Inflation, but there was no fanfare. After all, asset prices at all-time highs are good for us, right?

Asset price inflation tends to happen during periods of low-interest rates. As Lyn Alden4 put it:

"Think of it like this. If the government and central bank were to create a trillion new dollars and give the 100 richest people in the country an extra $10 billion each with that money, what would they spend it on? All of their physical needs and desires are met many times over already. They’re not going to eat better, travel more, or really do anything differently in terms of personal consumption than they’re already doing. Instead, they’ll buy more financial assets, like more stocks or real estate, and push those prices up with this extra demand. This money won’t get out and push the prices of things like copper or beef up."


As governments provided these stimulus checks, due to the speed it was reenacted and distributed, almost everyone received the monies whether they needed it or not. People who did not need the money suddenly found themselves with extra cash which allowed them to do the things they could not.

Asset prices hit all-time highs across the board: the S&P hit 33 record-high closes in 2020, and 70 times in 20215. Home prices skyrocketed, and even cryptocurrencies saw their market capitalization hitting all-time highs of $3 trillion. People were slightly cautious, but the economy seemed stronger than ever with the next technological revolution – bringing everyone onto the cloud and internet which will drive economies of scale.

Tales of generational wealth being created through these asset classes brought more passengers on board this seemingly infallible ride to riches and threatened to leave those who did not board behind. “Have fun staying poor” was a common term heard when one did not choose to hop on the cryptocurrency ride, and even the most disciplined would have had trouble staying away.

From the short-term debt cycle, the next step was not if, but when the central bank would increase rates, but the speed caught everyone off-guard.

Bubble...Bubble...Bubble Pop?

It all came to a shuddering stop when supply chain issues were brought to the forefront – exacerbated by the Russia-Ukraine conflict.

China halted its economy for two months in a bid to arrest the spread of a new wave of COVID, bringing a stop to the manufacturing industry which was already behind on meeting demand. Russia and Ukraine play a large part in the world’s economies, with them being among the important exporters of oil and liquefied natural gas. More importantly, they play a large role in food prices, exporting a combined nearly a third of the world’s wheat and barley, 70% of sunflower oil, and large suppliers of corn. Russia is also the top global fertilizer producer.

The destruction of infrastructure caused by the war and the subsequent sanctions put in place has placed further pressure on the already limited supply, bringing about large increases in prices. To alleviate pricing pressures, governments around the world started to implement export bans to protect their locals: India, Egypt, Kazakhstan, Kosovo, and Serbia banned wheat exports6,7; Malaysia implemented a chicken export ban; Indonesia restricted exports of palm oil. The rising protectionism movement further feeds into consumer price inflation.

To cool inflation, the Feds are now increasing rates, but the rate of it has surprised many but is understandable – with the rates of inflation increasing at an alarming rate and not slowing down, it might continue to do so if nothing changes.

Investors are spooked at the revised rates which the Feds are implementing, and this has had the desired effects on asset prices. Markets have entered bear territory: the S&P 500 is down 22% off its peak, and the Nasdaq is down 29%. The two largest cryptocurrencies, Bitcoin & Ethereum, have dropped more than 70% from their respective peaks as well.

Deleveraging Stage?

So how bad can it get? How fast will the Fed raise hikes, and to what extent will they raise?

The overall economic numbers are mixed: employment is recovering, but not at the pace of inflation. The latest GDP numbers were -1.5% quarter on quarter, but consumer spending rose (3.1%), spending on housing, utilities, and motor vehicles8. Spending on gasoline and energy goods dropped, but imports surged more than expected. All these point toward a strong demand in the economy, but there are some factors to be worried about.

There is a feeling that the Feds will likely attempt to increase interest rates at all costs, even at the risk of recession, since they would not want to be caught in the “deleveraging” phase of the long-term debt cycle with limited tools in their toolkit – where the central bank is unable to lower interest rates to spur the economy when it shrinks too much.


Long-Term Debt Cycle

One of the main roles of the Fed is to ensure a stable monetary policy through the buying and selling of US government securities to influence interest rates. They had already extended themselves during the pandemic, and the economy seemed strong enough for them to start unwinding the asset purchases before increasing interest rates at a controlled amount. However, the plan was shot to pieces once there was an unexpected global shortage of necessities due to China and Russia/Ukraine incidents. As Biden puts it: “Inflation is largely the fault of Putin”.

There are likely some ways to go as the Fed has continued indicating that they would do whatever it takes to bring inflation under control9, and has indicated that they are even willing for the economy to undergo a recession. This should continue unless there is a drastic reversal of inflation or potential events: such as China reopening its economy resulting in supply issues being resolved, or the Russia/Ukraine conflict ending and sanctions being lifted. One more potential event might be the lifting of tariffs previously imposed on China.

Asia

The Chinese markets on the other hand are seeing a slight recovery, and have seemingly bottomed out in March and April, and have recovered 20% from the bottom seen on 15 March. Similarly, the Hang Seng index has recovered 15% from the bottom.

Ever since we wrote about the concerns we had with China; China slumped into a bear market before China’s Lunar New Year. Speculations of whether the “national team” of state-owned investors was coming into smooth markets, but the stock rout continued with the new geopolitical risks.

Furthermore, there were concerns about the potential delisting of Chinese shares trading in New York, the surge of COVID cases in major mainland cities including Shanghai and Shenzhen, and concerns about China providing support to Russia towards their invasion of Ukraine. That was the last straw for investors and these geopolitical uncertainties have seen almost $6bn in net outflows from foreign investors, intensifying on the backs of rumors that China was ready to aid Russia. JPMorgan Chase downgraded the Chinese internet stocks as “uninvestable”, and the Hang Seng Index hit 18,415 points on 15 March, a level last seen in 2016.

We were seeing companies at multi-year lows, with most of the risks already priced in. The question is, how long can it go?

As if the Chinese officials had enough of the stock rout, Liu He, a vice-premier known to be President Xi Jinping’s right-hand man and main economic adviser, vowed to roll out market-friendly policies and complete the rectification of big platform firms as soon as possible. Whilst they did not indicate the period, this was a “light” at the end of (what seemed to be a never-ending crackdown of the technology) tunnel. The platform companies that were directly involved, Alibaba and Tencent, jumped upon this announcement.

China also managed to contain the spread of COVID within two months and has since reopened and is exploring dynamic-COVID zero in the future, which will likely happen. However, a dynamic approach might be a way to not fully shut down the entire city like before, and impacts on their economy might be less significant.

With that being said, China might stand a chance to be able to perform better in the short run. The only obstacles would be them still being unable to resolve their Chinese developers defaulting issues, COVID returning with vengeance, and possibly them needing to face the consequences of taking advantage of the sanctions that the West has put on Russia and purchasing cheap Russian oil for themselves. It is unlikely that the West will risk actions that will result in further price hikes, but we should note the repercussions down the road.

Hidden Champions Fund

As previously mentioned during our annual meeting, investing in China is a different ballgame. The government publishes five-year plans frequently, and companies that are in line with their goals and plans tend to get a boost.

We are positioned in those industries, mainly Solar, Electronic Vehicles, Semiconductors, Infrastructure, and some small other industries. We are also looking to invest in the beaten-down tech sector which has dropped significantly from new heights. We are actively monitoring the volatile markets and are actively switching between a few target companies.


Tho Jinliang | Investment Analyst
VI Fund Management Pte Ltd




S&P 500 index


Nasdaq index

Appendix:
1 https://www.cnbc.com/2022/06/10/consumer-price-index-may-2022.html
2 https://youtu.be/PHe0bXAIuk0
3 https://www.livemint.com/industry/banking/lessons-from-the-fed-s-3-trillion-money-printing-11592322603528.html
4 https://www.lynalden.com/inflation/
5 https://www.forbes.com/advisor/investing/stock-market-year-in-review-2021/#:~:text=It%20was%20a%20wild%20year,the%20Nasdaq%20Composite%20gained%2021.4%25.
6 https://www.cnbc.com/2022/05/18/countries-banning-food-exports-amid-rising-prices-inflation.html
7 https://www.channelnewsasia.com/commentary/india-wheat-export-ban-trade-china-world-trade-organization-2753011
8 https://tradingeconomics.com/united-states/gdp-growth
9 https://www.barrons.com/articles/fed-powell-recession-inflation-51655486687

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