Novum Alpha - Daily Analysis 19 July 2021 (10-Minute Read)
Investors could do worse than take a break from the markets, especially given the deep uncertainty that hangs over the next phase.
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A marvelous Monday to you as stocks look set to get weaker this week.
In brief (TL:DR)
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In today's issue...
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Market Overview"Everybody needs a little time away, I heard her say, from each other."
"Even lovers need a holiday, far away, from each other."
- Hard To Say I'm Sorry, Chicago, off the album Chicago 16, (c) Warner Bros., Full Moon, 1982.
Investors could do worse than take a break from the markets, especially given the deep uncertainty that hangs over the next phase.
With signs that the coronavirus pandemic has not been fully put down, markets are being threatened with myriad issues, from simmering geopolitical tensions between the U.S. and China, to resurgent Covid-19 variants and rising inflation at a time when central banks are looking to pull back stimulus.
All of these factors combined are making it difficult for investors to plot the next course - go into cash in the event that prices could get lower, or stay invested, because liquidity remains abundant.
In times like these, it might be helpful to filter out the short term noise and revert to first principles.
Investors buy equities when they feel optimistic, and revert into bonds when they are not.
Despite key measures of inflation suggesting rapidly rising prices, investors are continuing to buy bonds, which means that growth concerns and the pandemic weigh heavier than fears of inflation.
And that's a bad sign.
If a resurgent coronavirus variant should ripple across the world again, it's not entirely clear if central bank stimulus will work again.
Stimulus worked in 2008 and then again in 2020, but at some point, it's like flogging a dead horse and no amount of assurances will soothe fear, which tends to be irrational.
But what is the commonality? Liquidity has to buy something. It can't sit still.
So while asset prices may seem some interim pullback, two out of three factors suggest prices will continue rise and even the third factor indirectly supports rising asset prices.
If the pandemic gets worse and countries are forced to lockdown again, central banks will keep the stimulus taps open and asset prices will be chased up by excess liquidity.
If inflation rises, and central banks pull back, certain stocks will rise and certain ones won't - tech will pull back while the reflation trade and commodities are likely to do well.
If economic growth splutters, central banks will keep liquidity flowing, chasing up prices and assets.
It's when there's a pullback in liquidity that markets become more circumspect.
If nothing else, that remains the greatest threat to the seemingly infinite bull run - a reigning in of liquidity.
In Asia, markets opened lower in Monday's morning trading session with Sydney’s ASX 200 (-0.80%), Hong Kong's Hang Seng (-2.11%), Seoul's Kospi Index (-1.14%) and Tokyo's Nikkei 225 (-1.49%) all down on myriad concerns from geopolitical tensions to the pandemic as well as inflation.
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1. China's Listing Honeypot Just Got Cracked
For over two decades Chinese tech firms and American exchanges have had a symbiotic relationship, with the latter engorging themselves on listing and transaction fees by facilitating global investors eager to invest in the world’s second largest economy.
But on July 10, Beijing announced that all companies trying to go public by way of another country’s exchanges will need approval from a newly empowered cybersecurity regulator, amounting to a death knell for Chinese IPOs in the U.S. and casting a shadow on the existing listings on American bourses.
The move, likely triggered by Didi Global’s (-3.16%) decision to push ahead with a New York listing despite objections from Chinese regulators, is sending shockwaves through markets, while Chinese companies that were in the process of listing in the U.S. reconsider their options.
One way of course is to list closer to home, Hong Kong remains a distinct possibility, or even Singapore, which is viewed by many as a suitable halfway house, not quite American, but not entirely Chinese either.
Yet putting a barrier between Chinese companies and America’s deep and highly liquid capital markets is a bit like cutting your nose to spite your face.
The symbiotic relationship between U.S. exchanges and Chinese companies has made both countries collectively richer in the process.
And most of China’s tech sector is well-represented on American stock exchanges, raising some US$100 billion in the process and gaining from one of the biggest bull markets in history.
But when global investors were buying shares of Chinese companies listed on U.S. exchanges, what were they really buying?
Not a whole lot it seems.
Because there are substantial restrictions on foreign ownership of Chinese firms, many of the biggest Chinese tech firms, including Alibaba Group Holdings (-1.24%) used a combination of Variable Interest Entities or VIEs and American Depository Receipts (ADRs are surrogate securities that allow investors to hold overseas shares).
On legally questionable ground, complex and opaque, the structure of these VIEs provided a backdoor way to turn Chinese companies into foreign firms with shares that overseas investors could buy.
Essentially, a Chinese company would sign an agreement with a foreign shell company (pick your island domicile) which provided investment in exchange for revenue from the Chinese company.
Foreign investors would gain a “controlling interest” via the shell company, but the Chinese owners retained the majority of voting rights in the original business back home.
The practice of splitting share interests isn’t altogether uncommon even for U.S. companies, where dual-class shares exist and founders often retain substantial voting rights, despite not holding the majority of shares.
And for years, investors, both American and global, accepted this legal halfway house to gain access to Chinese companies and the substantial marketplace that was being touted.
But since ADRs and VIEs were first introduced, China has substantially beefed up its capital markets and increased exchange trading links with Hong Kong that allow foreign investors to buy Chinese equities directly.
To be fair, China raising barriers is more of a response to American hostility than the other way round.
The previous Trump administration threatened to delist Chinese shares on American exchanges if they didn’t adopt tougher accounting rules that would increase transparency and hand over more sensitive financial information to U.S. regulators.
Beijing is merely responding to the prospect that a churlish U.S. administration may overnight declare that Chinese companies listed in the U.S. are entity-non-grata.
What that means for Chinese firms that continue to be listed in the U.S. however is less clear.
While a ban on VIEs seems unlikely, Beijing could force its firms to delist from the U.S. and then relist somewhere else, a costly and messy process that could take years.
Some companies like Tencent (-1.60%) and Alibaba Group Holdings fortunately have dual-listings in the U.S. and Hong Kong, and that could facilitate the unwinding, but others are not so fortunate.
Delisted ADRs are also not entirely worthless, as they can be traded off exchange or on OTC markets, with Hong Kong’s open markets and currency pegged to the dollar helping with that conversion process.
But for investors thinking that bets on Chinese companies, particularly tech firms with almost absolute monopolies, are a sure win, factoring politics in their investment decisions is now not only a part of the due diligence, it is key to the entire allocation process.
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Did you miss us at the Super Crypto Conference 2021? Watch it here... |
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2. Zooming to Future Profits
One of the bigger lurking questions over darling of the pandemic Zoom Video Communications (+1.45%) is where its future revenue streams were likely to come from.
Despite some hiccups, Zoom has become an almost indispensable tool for everything from business to education.
Meetings that used to be facilitated in person, are now just a Zoom call away and “Zoom” itself is becoming a verb, the same way that “Googling” became one as well.
And that all bodes well for Zoom investors, but a nagging question was whether Zoom could continue its breakneck growth after the pandemic and whether competitors nipping at its heels could gain a leg up on it.
Whilst pandemic restrictions have been lifted throughout much of the U.S., demand for Zoom’s services, whilst slowing, have not ground to a halt.
Paid users for Zoom’s video communication services have also continued to grow, with the virtual webinars, seminars and meetings a shift that is likely to prove durable.
In-person meetings are not likely to go away, but consider whether the average person would like to spend two hours in traffic to get to the airport, two hours at the airport and a several-hour flight for a meeting, instead of rocking up to their computer to do the same meeting and it becomes obvious where Zoom’s value proposition lies.
The bigger challenge for Zoom however was that competitors could package rival offerings free with other paid offerings, like when Microsoft (-0.10%) packaged Internet Explorer for free with Windows 95, ringing the death knell for Netscape.
But in an astute move, Zoom has agreed to acquire Five9 (+0.58%) for US$14.7 billion in stock, targeting a cloud service provider that could completely change the complexion of Zoom’s offering.
By acquiring Five9, Zoom now has the ability to offer to clients an entirely new value proposition – cloud customer services as part of its video call offering.
Imagine a situation where your contact center is now virtual and linked via Zoom.
Whilst it’s one thing to speak with a customer on the phone, imagine what a video call could do for customers in enhancing and improving customer engagement.
Investors have raised concerns this year on whether Zoom’s growth could continue at its current pace, as vaccinations increased and pandemic restrictions were lifted.
Yet Zoom has proved that it’s not only been able to sustain growth, it’s increased it as well, with its market cap pushing past US$100 billion and its management focused on acquisitions and user growth, instead of engaging in non-value creating share buybacks.
If Five9 is the first step in Zoom’s acquisition spree, then there’s hope yet for Zoom investors as the company branches out and enhances its product offering to move beyond just being a video communication provider.
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3. Cryptocurrency Investors Learn Leverage Cuts Both Ways
Over two days in May, it was all gone.
Traders rushing to top up margin calls on exchanges like Binance couldn’t get into the exchange because of outages, and highly-levered positions were automatically closed resulting in estimated billions of dollars in losses.
And it didn’t matter which way traders had bet either, whether long or short.
Creaky market plumbing, which even in the best of times can be unreliable, collapsed into a cacophony of calls for margin that left traders bewildered how their bets in the right direction could have actually lost money.
Part of the reason is market structure, the other of course, is complex derivative products that make it difficult to know for sure how much margin is needed.
For instance, Binance offers a product unique to the cryptocurrency markets with a variable leverage ratio that floats between 1.25 to 4 times.
In theory, a 20% plunge in the underlying digital asset off a short bet should translate into anywhere between a 25% and 80% gain.
Binance touts this unpredictability as a feature, because it allegedly prevents front-running, but given the manic swings that are typical of cryptocurrency markets, it can also result in completely unexpected outcomes.
During periods of extreme market volatility, cryptocurrencies can surge, fall and double back at breakneck speed.
Even if a short bet is called in the right direction, unless traders put down copious amounts of margin to cater for the unexpected ratcheting up of leverage ratios to say 4 times, they can get stopped out.
And some instruments even allow for leverage ratios well in excess of that, which in the cryptocurrency markets can lead to massive margin calls, completely out of what traders may have made provision for.
For instance, let’s say a trader has made provision for margins of up to 2x based on what they think that that market should act within.
If the market moves against the trader, even if it’s momentary, the margin requirement for a 2x bet and say a 4x bet could be more than double whatever the trader put into their margin accounts and unless the trader managed to top up the margin in time, they’d be stopped out and a “winning” bet in the right direction, now becomes a losing bet.
And that’s exactly what happened over two days from May 18 to May 19, when even some of the most robust cryptocurrency exchanges like Binance and Coinbase (+0.17%) saw their systems groaning because of heightened market volatility.
As more traders wanted to cash out their bearish leveraged bets, outflows caused the leverage ratio to spike, and when the program was forced to trim short exposure in rocky and illiquid market conditions to lower the ratio again, traders lost money.
Quite simply, these leveraged bets were forced to keep cutting positions at the worst possible time.
At the heart of the debacle was that Binance, does not answer to any market regulator and there is zero transparency how these leverage ratios are determined.
While a clutch of legal actions are being taken against Binance at this time, it’s not clear if they will succeed or if there’s a significant legal entity to even succeed against, another reminder that cryptocurrencies are volatile enough without adding leverage to the equation.
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Jul 19, 2021