Novum Alpha - Daily Analysis 5 July 2021 (10-Minute Read)
Now is not a good time to be a Chinese tech entrepreneur, especially not if your company has a dominant market share and you have a high profile.
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A magnificent Monday to you as markets mark fresh records.
In brief (TL:DR)
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In today's issue...
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Market OverviewNow is not a good time to be a Chinese tech entrepreneur, especially not if your company has a dominant market share and you have a high profile.
In the aftermath of the centenary celebration of the founding of the Chinese Communist Party, apparatchiks have been keen to demonstrate to Beijing their undying loyalty, going after tech firms to remind them that it is thanks to the Great Firewall of China built by the Party that has allowed them their success.
Fending off competition from U.S. tech giants, China's tech industry has blossomed because of the artificial barriers to China's cyberspace raised by Beijing.
But what Beijing gives, it can just as easily take away, as investors in some of China's biggest tech names are having to learn the hard way.
Investors in Chinese tech stocks will need to have a strong constitution and recognize that ultimately the recent spate of crackdowns on some of China's largest and most successful tech firms isn't so much about antitrust, but a lack of it.
For years, Beijing has not attempted to hide that it doesn't fully trust its tech entrepreneurs.
Able to raise money in foreign capital markets, while making money protected behind the Great Firewall, Beijing is now whipping its tech firms in place and investors are having to suffer the sting of that whip as well.
But even this too shall pass.
As soon as Beijing has "reformed" its biggest tech firms to its image and desire, they can get back to the business of making money in the world's second largest economy and their long-suffering investors will eventually be rewarded for keeping the faith.
Asian markets weren't immune from Beijing's ire with major indices a mixed bag in Monday's morning trading session with Sydney’s ASX 200 (+0.12%) and Seoul's Kospi Index (+0.39%) in the green, while Tokyo's Nikkei 225 (-0.48%) and Hong Kong's Hang Seng (-0.47%) were lower.
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1. Is Didi Chuxing a Victim of China's Party Politics?
Barely days after its mega U.S. IPO, Chinese ride-hailing giant Didi Chuxing has suffered a major blow, with the Cyberspace Administration of China (CAC) announcing a ban on the app on Sunday, citing serious violations by Didi Global (the U.S.-listed entity) (-5.30%) in the collection and usage of personal data.
Chinese authorities have been known to make major announcements affecting targeted companies over the weekend, especially Sunday, when staff are not likely to be in the office, to catch them flatfooted.
But what makes the recent move by Beijing so peculiar is the timing.
It’s not as if Didi Chuxing has been doing anything different recently, and one possibility is that the move by the CAC was targeted not so much at the ride-hailing app itself, but its shareholders.
While CAC’s ban on Didi Chuxing from China’s app stores doesn’t affect the current 500 million or so users who already have the app on their phones, it does affect the ability of new users to download the app from platforms including those operated by Apple (+1.96%), Huawei Technologies, Android Play Store and Xiaomi (-2.96%).
CAC’s probe came as a surprise and comes against a backdrop of Beijing flexing its muscles against its tech giants to remind them who stuffs their pork buns.
Significantly, the CAC move against Didi Chuxing affected Didi Global’s shareholders the most, including Tencent (-0.76%), owner of super app WeChat, Softbank Group (+1.65%) and Uber Technologies (+2.21%), none of which Beijing is particularly fond of.
While Didi Chuxing has come under increased scrutiny over potential issues ranging from antitrust to data security, it may simply be the latest victim of a China-wide dragnet to reign in the influence of its tech giants.
Because Chinese tech firms like Didi Chuxing are able to raise monies from America’s deep capital markets, following in the footsteps of Alibaba (-1.86%), by using the vehicle of the American Depository Receipt (a negotiable security that represents securities of a foreign company and allows that company’s shares to trade in the U.S. financial markets), there has long been a sense that while Chinese tech firms make the bulk of their profit from China, they are not “beholden” to Beijing as they do not suck on the warm teat of the state for their fortunes.
That sense of independence has (mistakenly) led some tech founders to become increasingly outspoken, for instance Alibaba’s Jack Ma, and a broader crackdown by Beijing to bring them in line, so as not to outshine China’s Communist Party and the cult of personality that has become China’s President Xi Jinping.
Since 2013, when President Xi took the helm of the world’s second largest economy, he has concentrated more power in himself and tolerated rather than fostered tech firms, whose outsized influence have continued to be a thorn in his side.
Which is why the latest move by Chinse regulators against Didi Chuxing has to be seen against a broader canvas of Chinese Communist Party control.
It’s highly unlikely that Beijing ultimately wants to breakup its massive tech monopolies – it’s easier to control a snake with a single head than to cage a hydra.
But it’s evident that the Chinse Communist Party also doesn’t want any tech giant to forget who’s really in charge and that they ultimately prosper at the Party’s pleasure.
Unlike other recent high-profile IPOs including Kuaishou Technology (-0.38%), Didi Chuxing is actually profitable, serving up US$837 million in the quarter to March, by pivoting to grocery delivery and car repairs when ride-hailing ground to a standstill during the pandemic.
And while many of China’s biggest tech giants are being battered right now, their markets and their role as market leaders isn’t about to go away anytime soon, they just need to ensure that their leaders offer sufficient tribute and adulation to who genuinely rules China – the Communist Party, the profits should follow.
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2. Stocks Are Just Getting Started
The adage “sell in May and go away,” may be getting replaced by “buy in July and watch it fly,” if current market conditions are anything to go by.
As global stocks continue to break one record after another, some of the world’s biggest asset managers are suggesting that things are only just beginning, with BlackRock, State Street Global Markets, UBS Asset management and JPMorgan Asset Management all expecting equity markets to keep rising in the second half of this year.
Even more asset managers are looking beyond American shores for returns as a rebound in corporate earnings and persistent central bank support continue to buoy the equity rally.
As vaccinations continue in earnest, central banks maintaining accommodative monetary policy and fiscal support showing no signs of waning, there are few negative scenarios for equities right now.
With German, Japanese and U.S. sovereign bond yields remaining lackluster, and credit spreads tightening to their lowest levels in over a decade, investors can’t be blamed for choosing to stick it out with equities.
And now that pent-up demand is being unleashed on economies, coupled with markets awash with cash, there is an incredible amount of liquidity looking to be parked somewhere.
But as more money chases fewer opportunities in stocks, the returns can be expected to moderate and the risks, increase.
Already, eight times the number of unprofitable companies on the S&P 500 have raised money through secondary share sales versus profitable ones.
But those capital raises may be just what the doctor ordered as expectations are high that many of these companies will see a sharp recovery in earnings as economies reopen.
Globally, profit expectations have bounced back to pre-pandemic levels and over half of S&P 500 companies have raised their full-year outlook over the past three months, one of the highest forecast corrections in over a decade.
At some stage of course, investors will start to scrutinize balance sheets and revenue forecasts more closely, looking for real evidence of a rebound and free cash flow, but for now at least, any non-zero number is a good place to start.
The only real risk now is that the new coronavirus variants defeat existing vaccines, but there is no sign of that yet.
And while there are signs that the European and U.S. economies are running red-hot, equities have often corrected in response to growth scares (a resurgent pandemic) or a large change in monetary policy (sudden tightening of credit conditions).
Stretched valuations are certainly a concern and will weigh on further gains, but these valuations will naturally start to rationalize as earnings improve, not necessarily as markets correct.
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3. Satiating Cryptocurrency's Energy Hunger Once and For All
For the uninitiated, the world’s two largest cryptocurrencies by market cap, Bitcoin and Ethereum, run on a protocol known as “proof-of-work.”
In a nutshell, computers expend computing power to solve complex mathematical puzzles to secure the blockchain that validates transactions on the network.
But harnessing that computing power is an energy-hungry exercise – imagine running a high-performance mainframe computer 24/7 and you get the idea.
And that energy demand has long been used as a criticism of cryptocurrencies, that they are a wasteful use of power.
Short of shifting to alternative means of securing the blockchain, cryptocurrencies for the most part have had to make do with “proof-of-work” warts and all.
But that may be set to change as cryptocurrencies race towards what’s known as “proof-of-stake.”
Instead of expending large amounts of computing power to secure a blockchain, “proof-of-stake” works on the basis that consensus mechanisms (to determine which transactions are valid and which are not) select validators (to secure the blockchain) in proportion to their quantity of holdings in the blockchain’s associated cryptocurrency and receive fees for doing so.
Until fairly recently, “proof-of-stake” was a major challenge for most cryptocurrencies because of the tendency of many cryptocurrencies to be concentrated in the hands of a small group of wallet addresses or “whales.”
Part of the concern of course was that these “whales” could collude to prioritize the validation of their chosen transactions or undermine the decentralization of that particular blockchain.
Yet as cryptocurrencies have evolved and their adoption grown more widespread, so has the decentralization of many of their wallets, reaching a critical point where “proof-of-stake” has become more viable than at any point in the past.
Ethereum has taken the lead to shift towards “proof-of-stake” with the upcoming London hard fork or EIP 1559 set to change the fee market and move the cryptocurrency space into a more energy-neutral ecosystem.
“Proof-of-stake” allows existing cryptocurrency holders the opportunity to generate returns on their “staked” cryptocurrency by using that to validate transactions on the blockchain.
According to a report by JPMorgan Chase c analysts, led by Kenneth Worthington, “staking” could potentially provide investors, both retail and institutional, an opportunity to generate returns from their cryptocurrency investments and facilitate more mainstream adoption.
An estimated US$9 billion worth of revenue annually is generated by “staking,” according to the report, a figure that JPMorgan Chase’s analysts estimate could balloon to US$20 billion after the launch of the long-anticipated Ethereum 2.0 next year, that will move to “proof-of-stake.”
“Not only does staking lower the opportunity cost of holding cryptocurrencies versus other asset classes, but in many cases cryptocurrencies pay a significant nominal and real yield.”
Worthington and his team also see Coinbase Global (-0.30%) potentially earning as much as US$500 million a year in revenues from staking by the end of 2025, when they estimate that revenues from staking could hit as high as US$40 billion.
“We see staking as a growing revenue stream for cryptocurrency intermediaries such as Coinbase and a source of income for retail and commercial owners of cryptocurrencies utilizing the proof-of-stake protocol.”
Under “proof-of-stake,” users put forward a certain amount of cryptocurrency and in return get the right to validate transactions on a network, earning more cryptocurrency in the process, delivering a yield on their initial stake.
“Yield earned through staking can mitigate the opportunity cost of owning cryptocurrencies versus other investments in other asset classes such as U.S. dollars, U.S. Treasuries, or money market funds in which investments generate some positive nominal yield.”
“In fact, in the current zero rate environment, we see the yields as an incentive to invest.”
Staking to secure a blockchain is not to be confused with staking in decentralized finance or DeFi.
While DeFi is far more speculative in the sense that the bulk of yield generated is in the native DeFi token and most of the borrowing that takes place in DeFi is linked to speculating on other cryptocurrencies.
“Staking” to secure a blockchain serves a fundamental role to validate transactions without the energy-hungry practice of a “proof-of-work” protocol.
According to the JPMorgan Chase report, the current market cap of “proof-of-stake” cryptocurrencies is estimated at some US$150 billion.
But the potential to earn yield through staking, dramatically changes the complexion of cryptocurrencies as an investable asset class and addresses two primary concerns – the lack of yield generation and the energy needs for securing cryptocurrencies.
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Jul 05, 2021