2nd Half of Fed's Tightening, Stocks or Bonds, Neither Can Escape!

Hello everyone, here is Dolphin Research's summary of the core information on this week's portfolio strategy:

1) Last week, there were few macroeconomic data releases in the United States. The existing home sales data and manufacturing capacity utilization rate were not bad. Expectations for interest rate cuts are still distant, and the market is still trading with the expectation of "Higher for Longer". There is no expectation of a short-term interest rate cut to alleviate the trend of stock market valuation decline.

2) In terms of liquidity, apart from the continuous selling of US bonds, the TGA account increased by over 100 billion US dollars within a week, reaching 840 billion US dollars (the year-end target is 750 billion US dollars). This has led to a decrease in reverse repurchase balances and bank deposit reserve requirements, which are used to hedge against the increase in the TGA. The pressure of liquidity drainage is evident, and the US stock market still faces the dual problem of rising long-term yields and liquidity drainage, which is impacting valuations.

3) In this situation, in addition to the outflow of liquidity from external markets, the domestic market is also facing similar liquidity drainage issues. The issuance of local government bonds and the tentative issuance of national bonds have caused concerns in the market. Without central bank bond purchases (which would suppress the already significant pressure on the exchange rate), the issuance of local government bonds and national bonds will face significant liquidity drainage pressure. In addition, Hong Kong stocks have experienced a significant decline due to the dual liquidity drainage of the renminbi and the US dollar.

4) At the individual stock level, without the expectation of a short-term interest rate cut to alleviate the continuous rise in long-term yields and with ongoing liquidity drainage, the only way to maintain stock prices is through individual stocks delivering exceptionally strong performance. Therefore, this quarter's earnings season is particularly important and will truly reveal the "separating the wheat from the chaff" stage for individual stocks. Stocks with excessive storytelling, overvalued valuations, and weakened fundamentals may face a situation similar to Tesla's disastrous performance last week.

This week, major companies will release their earnings reports one after another. Dolphin Research will track the earnings reports of major US stocks in real time. Please continue to follow Dolphin Research.

Here are the detailed contents:

1. Economic Fundamentals vs. Stock Market: Fierce Battle

The biggest contrast last week, whether in China or the United States, is that the economic data was not bad, but the stock market completely ignored the fundamentals and directly experienced a free fall.

a. Let's start with the United States. Last week, the United States released two heavyweight but not-so-high data points: the existing home sales in September and the industrial output.

In terms of industrial output, both the output index and capacity utilization rate are in a recovery state. Among them, durable goods showed more obvious improvement due to the repair of the automotive and parts capacity utilization rate, while the driving factors for non-durable goods mainly came from industries such as petroleum, chemicals, and even marginal recovery in the plastics and rubber industry.

As a high-interest-rate-sensitive industry, the second-hand housing market in September is still in a bottoming out phase: under the condition of negative month-on-month growth in average prices, the sales volume has significantly declined.

However, looking at the month-on-month growth rate of newly started private residential construction, new housing investment has passed the period of continuous decline and has shown a bottoming out trend since May-June. In September, the month-on-month growth rate of newly started private residential construction has once again increased.

The real estate data in September has not deviated from the previous trend: under high interest rates, it is basically difficult to buy and sell second-hand houses, because it is equivalent to replacing low-interest debt with high-interest debt. The supply of second-hand houses is limited, and the corresponding transactions are relatively weak.

However, if there is demand for buying houses, the market will turn to the new housing market, which can drive the economy. This also means that the expected "freeze" of new housing investment has not occurred. After a continuous decline, new housing investment has shown a trend of stabilizing and rebounding in recent months.

Overall, whether it is capacity utilization data or real estate data, it still points to the resilient U.S. economy in this cycle.

A large amount of macroeconomic data released domestically last week also indicates the bottoming out and recovery of the economy, including September's social retail sales. For details, please click here. However, domestic assets, whether A-shares or Hong Kong stocks, have experienced a significant decline.

The core reason behind this is still the liquidity squeeze in the second half of the year, as Dolphin Research has mentioned before. The liquidity squeeze in the second half of the year means that even if the economic fundamentals are still there, the risk premium of equity assets with ultra-low valuations will face rebalancing.

2. how long will the continuous liquidity squeeze last?

Looking at the data from the week of October 18th, the Federal Reserve's quantitative tightening and the reconstruction of the Treasury General Account (TGA) continue to squeeze market liquidity. Firstly, the Federal Reserve's asset side has once again entered a normal pace of debt issuance, coupled with the continuous maturity of previous measures to rescue short-term bank liquidity. The Federal Reserve sold nearly $19 billion of assets in a single week.

However, on the liability side, the TGA increased by over $100 billion in a single week, causing other items on the liability side to need to be reduced by a larger magnitude in order to balance the increase in TGA and the decrease in asset-side Treasury bonds. Last week, reducing the scale of reverse repurchase agreements alone was not enough, and the bank's reserve balances decreased by nearly $70 billion. The decrease in the balance of reserves represents a tightening of liquidity in practical terms.

However, as of last week, the reconstruction of the TGA has basically come to an end, as the current account balance has exceeded the Treasury Department's year-end target of $750 billion, reaching $840 billion.

Next, we still need to observe the pace of the Fed's debt reduction, the pace of the expiration of crisis tools for small and medium-sized banks in the first half of this year, and the remaining issuance volume. In terms of marginal changes, we still need to focus on the issue of issuance scale.

Currently, it appears that the US Treasury Department did not use enough low-interest long-term bonds to pay for long-term structural interest costs in 2020. In 2023, with the issuance of too many short-term Treasury bills with higher interest rates, the Treasury Department will face significant interest payment pressure in the "Higher for Longer" scenario.

At the same time, the consensus reinvestment of the US government in infrastructure, chips, and green energy manufacturing means that the US is entering a phase of "re-industrialization," which will not be easy to reduce the deficit.

When continuous debt issuance is used for deficit financing and the issuance volume of long-term bonds is structurally increased, in the buyer's market, foreign official institutions, from the perspective of maintaining their own exchange rates or other factors, and the Fed's QT, are reducing their purchases of long-term bonds, resulting in fewer buyers and a continuous increase in long-term bond yields.

In the short term, due to the resilience of the economy, it is difficult for the Fed to lower interest rates under current conditions, resulting in a lack of expectations for downward short-term interest rates to hedge against the upward movement of long-term yields.

In this situation, it is difficult for the stock market to experience a broad-based rise at the beta level. Only individual companies that can deliver strong growth beyond expectations can maintain their stock prices in the overall market squeeze (such as Netflix last week). Investors may have to enter a phase where their stock selection ability is put to the ultimate test in search of alpha.

In this situation, the performance of individual stocks in their earnings reports becomes particularly important. This week, the US stock market enters the earnings season for technology giants. If high-valuation technology stocks cannot withstand the pressure, the overall pressure on the Nasdaq will still be significant. However, due to the basic economic fundamentals, companies like Meta and Google, which are pro-cyclical advertising stocks, are expected to see improvements in industry competition (the pressure from TikTok's regulatory issues has eased to some extent). At the same time, the economy is still growing, and advertising budgets should be decent. Dolphin Research roughly predicts that the US tech giants will not disappoint as much as Tesla did.

3. Is there still hope for the Hong Kong stock market's decline?

Dolphin Research attempts to understand this issue from two perspectives.

a) Due to the mismatch between the economic cycles of China and the US, China has been in a period of loose monetary policy and interest rate cuts, leading to a continuous decline in the yield of Chinese ten-year government bonds. At the end of August, it reached a historical low in 2020.

At the same time, the yield of US ten-year Treasury bonds has risen rapidly in the past two weeks and has reached 5%. This has led to a significant increase in the interest rate differential between China and the US, which corresponds to the continuous outflow of funds from Northbound investors.

b) Meanwhile, for Chinese government bonds, one issue to consider is that it may be difficult for the yield to continue to decline under such a large interest rate differential (further decline may affect the exchange rate).

At this point, in order to resolve local government debt issues, China has either replaced platform debt with short-term local government bonds (reducing debt costs but making local government debt more explicit) or the central government has issued some national bonds as a trial or signal (the market may be concerned about increased financing through national bonds under the background of local government debt). Both of these measures may extract market liquidity (if a large number of new bonds are ultimately purchased by the central bank, it may further increase exchange rate pressure).

However, the result of this situation is basically the extraction of market liquidity through bond issuance, leading to a decline in the price of Chinese government bonds, an increase in yields, and a narrowing of the gap with the yield of US Treasury bonds of the same maturity.

In terms of Hong Kong stock assets, both the tightness of RMB liquidity and USD liquidity are significant pressures on the Hong Kong stock market.

For Chinese concept stocks in this situation, just like the US stocks that are currently experiencing a liquidity squeeze, the only way to maintain stock prices is through strong performance delivery or dividend payment. Currently, only Pinduoduo and Luckin Coffee have assets that truly surpass cyclical performance delivery.

Otherwise, one can only rely on the logic of picking up cigarette butts to find deep value stocks that have fallen in the decline, such as those with market value mainly supported by cash, etc., and the certainty of rebound is higher after the valuation decline ends.

4. Portfolio Rebalancing

Based on the poor duration of Higher for Longer, Dolphin Research has completely divested its US Treasury holdings. At the same time, while trimming its valuation, Dolphin Research has temporarily divested from Baidu, while closely monitoring whether certain companies have reached Dolphin Research's extreme pessimistic valuation level.

5. Portfolio Returns

In the week ending October 20th, Alpha Dolphin's virtual portfolio returns declined by 1.4%, outperforming Hang Seng Tech (-5.7%), MSCI China (-4.7%), S&P 500 (-2.4%), and CSI 300 (-4.2%).

Since the start of the portfolio testing until the end of last week, the absolute return of the portfolio was 21%, with an excess return of 45% compared to MSCI China. From the perspective of asset net value, Dolphin Research's initial virtual assets of $100 million have now reached $123 million.

6. Individual Stock Profit and Loss Contribution

Among Dolphin Research's holdings last week, only SMIC and TSMC were in an upward trend, while the rest experienced declines. Looking at the entire coverage pool of Dolphin Research, the decline was relatively large, especially for companies with poor fundamentals or inflated valuations.

Dolphin Research provides the following analysis on the major companies with significant changes in stock prices and possible reasons:

7. Portfolio Asset Allocation

In the current week, Alpha Dolphin's virtual portfolio has divested from US Treasuries and exited Baidu, resulting in a new portfolio holding 19 stocks, including three core holdings and the rest being underweighted. The remaining assets are allocated to gold and US dollars.

As of the end of last week, the asset allocation and equity asset weight of Alpha Dolphin are as follows:

8. Key Events of the Week

This week marks the start of the intensive release phase of the US stock market earnings season. With overall market liquidity tight, expectations of interest rate cuts are nowhere to be seen. The only way to maintain stock prices is through the delivery of individual company performance. Therefore, the performance of the giants' earnings reports this week is crucial.

Among the giants, apart from Apple, the other four giants will all be releasing their earnings reports this week. We are waiting for the moment of truth: