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Novum Alpha - Daily Analysis 28 July 2021 (10-Minute Read)

There's nothing that investors fear more than uncertainty and right now there's a whole lot of uncertainty coming out of China.

A wonderful Wednesday to you as markets wind lower on concerns over the coronavirus and China. 

In brief (TL:DR)

  • When a butterfly flaps its wings in China, the Dow Jones Industrial Average (-0.24%), the S&P 500 (-0.47%) and tech-centric Nasdaq Composite (-1.21%) all fall amidst a Chinese crackdown on major sectors, while coronavirus variants weigh on sentiment.     
  • Asian stocks extended declines Wednesday as a rout in China and a mixed response to major U.S. technology earnings spurred caution.
  • Benchmark U.S. 10-year Treasuries slipped to 1.240% (yields fall when bond prices rise) as the fear meter ticked up. 
  • The dollar was little changed after a two-day retreat.
  • Oil rose with September 2021 contracts for WTI Crude Oil (Nymex) (+0.57%) at US$72.06 as investors shrugged off concerns over the pandemic to bet on consumption. 
  • Gold edged higher with December 2021 contracts for Gold (Comex) (+0.30%) at US$1,809.40. 
  • Bitcoin (+8.11%) rose to US$39,833 as investors bought the dip below US$40,000 with outflows leading inflows (outflows suggest that investors are looking to hold Bitcoin in anticipation of higher prices). 

In today's issue...

  1. In China You Need Permission to Win 
  2. Hong Kong is Not New York with Chinese Characteristics
  3. Tesla Takes an Impairment on its Bitcoin Holdings

Market Overview

There's nothing that investors fear more than uncertainty and right now there's a whole lot of uncertainty coming out of China. 
With no cow too sacred to slaughter, investors were understandably adopting a sell first and worry about the rest later approach. 
Asian markets headed lower alongside the Chinese purge with Sydney’s ASX 200 (-0.71%), Tokyo's Nikkei 225 (-1.44%), Seoul's Kospi Index (-0.40%) and Hong Kong's Hang Seng (-0.24%) all lower in the morning trading session. 
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1. In China You Need Permission to Win
  • Investors are speculating which will be the next sectors that may come under Beijing's purge of profits 
  • Investors have abandoned Chinese shares on concerns over which will be the next shoe to drop
In Australia they call it the “tall poppy syndrome” where the tall poppy sticks out of the field, and then gets cut first.
Yet the pursuit of individual excellence has always been the bedrock of capitalism, where individual profit or gain is prized because overall it increases the economic good.
But with China, that formula is not so straightforward.
Even though on the surface, China, with its gleaming cities and bustling ports, appears to be the epitome of capitalism, just below that surface has always been the undercurrent of socialism, albeit with Chinese characteristics.
For almost a decade, investors were lured to Chinese investments on the basis that the world’s second most populous country also happened to be its second largest economy as well.
And for the most part, in the decade up to Chinese President Xi Jinping taking power, investors could rely on the consistency that Chinese leaders, although perhaps not individually any more interesting or distinguishable than shades of wallpaper, also provided the certain backdrop to make money.
Chinese entrepreneurs and global investors picked up that gauntlet and pursued profit with sometimes reckless abandon.
But that decades’ long pursuit of individual glory has now been called into question by what appears to be the most broad crackdown on the core of capitalism itself – chasing profits.
Shares of Chinese tech and education companies have tumbled for three consecutive days and investors are worried that China’s massive property market might be the next shoe to drop.
Yet is China really abandoning capitalism?
Probably not.
There are reasonable justifications for Beijing’s recent moves.
China may be wary of its companies pursuing capital offshore in places like New York – a matter of control and concern over the possible leaking of sensitive data.
Afterschool education service providers have been weakening the social fabric by exacerbating inequality, both perceived and actual.
More households are invested in the Chinese stock market than at any point in the past, with retail investors making up more than 80% of local stock markets, a sudden price decline could have an outsized impact on income and consumption.
The MSCI China Index, which covers the country’s large and midcap companies, has a price-to-book ratio of 2.3, over 27% higher than the 1.8 it was nursing prior to 2015’s Chinese stock market crash.
Foreign investors also now hold seven times more in Chinese stocks or around US$550 billion, than they did in 2015 – on Monday they dumbed US$2 billion worth of it.
China knows that foreign flows are particularly fickle and it may be better to shake out the weak hands now, to prevent the hurt on Chinese hands later.
For global investors looking at Chinese equities however, the purge may be far from over, with some analysts predicting further crackdowns to spillover to China’s wobbly and overleveraged property sector, healthcare and insurance.
It’s hard to be a winner in China, mostly because you stand out. 
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2. Hong Kong is Not New York with Chinese Characteristics
  • IPOs in Hong Kong suffer amidst a Chinese crackdown of afterschool education shares 
  • Chinese companies that would otherwise have gone public in the U.S. may also find that they have no friend in Hong Kong
If Beijing had its way, its companies would raise money almost exclusively within its borders, but Hong Kong would do as well.
As the past year has demonstrated, China has not shied away from asserting its authority (and rightly so) over its own territory.
Although in-principle, Hong Kong is meant to be governed by its own set of laws inherited from the British common law system, increasingly, such principles are observed more in the breach.
But Beijing is not foolish enough to believe that its actions in Hong Kong do not have consequences, especially for the capital markets, where global investors have long seen the former British territory as a halfway house for investment into China – all of the prospects of the world’s second largest economy, without the vagaries of emerging market laws.
Except that that narrative no longer appears to be valid.
In the wake of a brutal crackdown by Beijing on some China’s biggest industries has sent many of Hong Kong’s initial public offerings reeling.
Shares of firms in Hong Kong that had gone public this year are up just 4% from their IPO prices on average, according to data compiled by Bloomberg on companies that raised at least US$50 million.
To put those gains in perspective, they’re smaller than those in India, South Korea and even Thailand.
While Hong Kong remains one of the world’s biggest venues for IPOs, the shadow of Beijing over the territory and the recent crackdown on whole industries has made investors less optimistic about IPO performance in the coming periods.
Kuaishou Technology (+2.11%), a Chinese short video startup that became the world’s biggest IPO this year, is now trading below its offer price, despite soaring some 161% at its debut in February, after raising US$6.2 billion in one of Hong Kong’s most popular deals.
Tencent (-3.72%), creator of the ubiquitous WeChat app has also slumped on mounting expectations that ad revenues will be hit by Beijing’s crackdown on its for-profit afterschool education sector.
Until and unless Beijing comes out to unequivocally draw clear lines in the sand – simply sending Chinese firms to IPO in Hong Kong may not have the intended outcomes. 

3. Tesla Takes an Impairment on its Bitcoin Holdings
  • Tesla takes a mild impairment on its Bitcoin holdings 
  • Given Tesla's massive cash balances, Bitcoin would hardly make a dent, but investors should watch more closely for companies whose businesses have now been overshadowed by their Bitcoin holdings like MicroStrategy (-7.60%)
Few if any analysts expected Tesla (-1.95%) to take anything other than an impairment on its Bitcoin holdings.
The benchmark cryptocurrency’s sharp selloff in the second quarter of this year forced the electric vehicle maker to report a US$23 million impairment in its earnings, table stakes really in a highly volatile asset class.
According to Tesla’s second quarter earnings report, Tesla’s Bitcoin holdings were worth an estimated US$1.3 billion at the end of the second quarter, but that’s also catering for the fact that Bitcoin was below US$30,000 at the time.
While it’s not entirely clear how much Tesla paid for its Bitcoin, with some suggesting that the company purchased Bitcoin in January, when Bitcoin was around US$40,000, the electric vehicle maker does not record gains and losses on its Bitcoin holdings using mark-to-market accounting.
Instead, Tesla accounts for Bitcoin as an “indefinite-lived intangible asset” a category that is usually associated with franchises, and meaning that it does not recognize a gain unless it actually sells its Bitcoin holdings.
For those interested in Tesla’s books, that means that gains in Bitcoin appear as reductions in operating expenses, and losses only need to be recorded if the price of Bitcoin drops below its acquisition price.
There may be little sympathy for Tesla’s impairment, especially as many investors blame Tesla CEO Elon Musk for declaring that the company would no longer accept Bitcoin as payment for its vehicles due to environmental concerns over fossil fuel use in Bitcoin mining.
However, the recent Chinese crackdown on cryptocurrency miners may provide the perfect opportunity to restart closer to more renewable sources of energy, and Musk has also backtracked to say that Tesla will start accepting Bitcoin, once it becomes clear that transition has occurred.

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Jul 28, 2021

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