FED Rates Hikes Can't Kill Consumption Boom, is the US really booming or just a flash in the pan?

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

1) The US post-pandemic interest rate cycle has shifted from "Higher" to assessing how long it will be "Longer". The GDP for the third quarter and the strong consumer spending data in September indicate that the US, as a current account economy, is unlikely to experience a rapid deterioration in its economic fundamentals within a quarter. This is due to the tight labor market and low leverage in the private sector. Therefore, expectations of a rate cut have not emerged.

2) In this situation, marginal liquidity changes become particularly important. Regarding asset liquidity, there is still pressure in the fourth quarter, but Dolphin Research believes that the liquidity pressure in the fourth quarter will gradually decrease compared to the shock effect caused by the massive issuance of bonds in the third quarter (pay attention to the US Treasury's bond issuance plan for the fourth quarter).

3) In this situation, Dolphin Research has started to focus on the extreme undervaluation opportunities brought by the "liquidity desert" in the Chinese asset sector. It has gradually started to invest in some stocks with high cost-effectiveness after extreme valuation declines, seizing opportunities to pick up the pieces.

This week, major US companies will continue to release their earnings reports. Dolphin Research will track these reports in real-time. Please continue to follow Dolphin Research.

Here are the details:

Last week, information on US consumer spending in September and GDP for the third quarter was released. Dolphin Research will first look at the macroeconomic fundamentals to see where the US economy is currently heading.

Ⅰ. Still a "Sense of Security" under high employment

A simple background - Behind the continued strong consumer spending in July and August in the US, in addition to stable growth in total personal income, the real growth actually comes from the extreme suppression of "thrift increment" (incremental savings) under the condition of relatively stable "source increment" (income growth rate).

By August, the savings rate of US residents (how much money is saved or invested out of every $100 of disposable income earned) had dropped to 4%. Apart from the second half of last year, this is the lowest level since the collective entry of Americans into the "post-subprime crisis, high savings rate (7-8%)" era.

However, just when Dolphin Research thought that the savings rate had dropped to 4% and there was basically no room for further compression, the savings rate in September dropped significantly again - to 3.4%!

This has also led to a significant increase in consumer spending in September compared to August (an income increment of $78 billion corresponds to a consumption increment of $139 billion), driving the current growth rate of consumer spending to remain higher than the growth rate of income. Of course, the secret to the continuous squeeze on savings distribution in the United States during this cycle fundamentally lies in its strong confidence - super savings + super cash flow (low unemployment rate + stable wage growth). In the current labor market, where there are still 1.5 job vacancies for every unemployed person, the key issue is to observe the trend of corporate employment demand.

However, at present, the household/private leverage ratio and interest payment pressure are not high, and the real economy is relatively strong. After the interest rate has reached between 5.25% and 5.5%, the interest rate hike has entered a "longer" game period.

In this stage, the key is to see when high-frequency economic data will begin to reverse the current trend of false rebound and show a trend of growth fatigue. As we enter the release cycle of October economic data this week, the first to be released are still PMI+ employment data, which will reveal the latest employment growth trend. This is crucial for anticipating when interest rate cuts may come.

Ⅱ. is the US economy really strong or just a bubble?

Looking back at the US GDP in the third quarter, since residents' consumption of goods and services accounts for 70% of the overall GDP, and US residents' consumption data is released monthly, the strong consumption in July, August, and September has already laid a solid foundation for the robust performance of the US economy in the third quarter.

However, among the three major drivers of GDP composition, in addition to the strong "increase" in consumption, government investment and consumption have been in a stable growth state since the fourth quarter of last year due to fiscal deficits.

What has truly rebounded in these two quarters is the relatively weak corporate investment (including inventory investment + fixed asset investment) in this cycle. In the third quarter, it can be clearly seen that companies have transitioned from destocking to restocking. Moreover, the increase is not small, reaching 66 billion US dollars. And in terms of fixed asset investment by enterprises, the biggest change in the third quarter was that residential investment clearly hit bottom and turned positive; non-residential investment was mainly represented by essential investments in the US industrial chain, such as research and development, software, and other intellectual property rights investments. Traditional categories of investment in the third quarter, such as non-residential buildings (factories, warehouses, plants, commercial buildings, etc.) and equipment, showed a slight decline after a surge in the previous quarter.

In the end, driven by strong consumer spending, government investment, and inventory accumulation by businesses, the quarter-on-quarter annualized growth rate of US GDP has reached 4.9%, resembling that of a developing country.

At this point, the key question once again comes down to whether this growth rate will become the normal pace for the US to enter a "reindustrialization" phase or if it is a result of loose monetary policy.

From an economic fundamentals perspective, Dolphin Research believes that in addition to the factors of industry inventory affecting real estate and automotive sectors (as described in the two previous in-depth quarterly reviews, see Peeling the Onion: Where Did the Recession Go and Can It Come Back?), and the fiscal stimulus (see The "Brotherhood" Behind NVIDIA and Tesla, Can It Continue in the Second Half of the Year?), the amount of currency (M2) required to generate one unit of GDP still significantly exceeds the trend of previous inflation rates.

III. Another Test of Liquidity!

Looking at the liability side of the Federal Reserve's balance sheet, after the continuous reduction in reverse repurchase agreements (which can be understood as the "idle funds" accumulated during the pandemic period) and the impact of selling government bonds, there is still a large amount of "idle" funds compared to the pre-pandemic period.

And if the Ministry of Finance only issues short-term bonds, it can partially offset the impact of the Fed's liquidity reduction by using the slower-moving inert reverse repo funds (with slightly lower returns) to purchase short-term Treasury bills with longer maturities but higher returns.

Last week, the Fed continued to use this operation: after shrinking its balance sheet on the asset side, it offset the liquidity impact of the balance sheet contraction by reducing the reverse repo balance (injecting liquidity) on the liability side.

After the Ministry of Finance obtains funds from bond financing, it becomes a real deficit investment in the real economy. The monetary multiplier effect of fiscal funds is much higher than the funds lying in the Fed's reverse repo balance account, and the "stimulating effect" on the economy is significantly stronger.

However, if the Fed issues long-term bonds, it is difficult to use reverse repo funds to absorb them because the maturity mismatch is too severe. At the time of the issuance of long-term bonds, the proportion of holdings by overseas buyers is declining, turning the Fed's bond issuance into a real "water-drawing effect".

So the remaining question is, will the Ministry of Finance continue to further expand the supply of long-term bond issuance in the fourth quarter? Dolphin Research's strategic judgment is that it may not.

1) Among the additional issuances in the third quarter, there was a need to supplement the TGA account, and the current TGA supplement demand is basically in place; the overall issuance of Treasury bonds may be roughly the same as the third quarter.

2) As long as the overall amount of Treasury bond issuance in the fourth quarter does not increase, it may still be difficult to increase the proportion of long-term bonds in the short term. This is mainly because the inversion between long-term and short-term bonds is becoming smaller and smaller, and the difference in interest cost management between the issuance of long-term and short-term bonds is not significant. On the other hand, in the third quarter, the increased issuance of Treasury bonds consumed about 0.8 trillion in reverse repo balances, and there is still 1.5 trillion left, compared with around 0.3 trillion before the epidemic. This balance is estimated to be enough for the Ministry of Finance and the Fed to "get through" another quarter.

Of course, long-term bonds have a clear advantage in terms of convenience of use: they reduce the pressure on the Ministry of Finance's cash flow management, because short-term bonds need to be repaid quickly, while long-term bonds lock in long-term funds and are generally repaid at maturity.

Under the current circumstances, based on Dolphin Research's judgment on the impact of the ratio of long-term to short-term bonds on liquidity disturbance, it is believed that the bond issuance plan for the fourth quarter to be announced by the US Treasury Department this week is more important than the already-consensus issue of the Fed's interest rate hike this week.

Summary <1-2>: Dolphin Research still tends to believe that:

1) Fundamentally, the current tight balance in the US labor market and the low leverage of the private sector mean that the economic fundamentals are unlikely to deteriorate rapidly within one quarter;

2) However, in terms of asset liquidity, there is still pressure in the fourth quarter, but compared to the shock effect brought by the massive issuance of bonds in the third quarter, it will gradually diminish (pay attention to the US Treasury Department's bond issuance plan for the fourth quarter this week).

3) In this situation, Dolphin Research has started to pay attention to the extreme undervaluation opportunities brought by the "liquidity desert" in the Chinese asset sector, and has gradually adjusted its portfolio by selectively investing in undervalued stocks with high cost-effectiveness.

IV. Portfolio Adjustment

As mentioned in the previous portfolio strategy, Dolphin Research will closely monitor whether certain stocks have reached the extreme pessimistic valuation level. Last week, Dolphin Research started to invest in two companies, Kuaishou and Shidai Electric, which were believed to offer good valuation cost-effectiveness. The specific reasons are as follows.

V. Portfolio Returns

In the week of October 27th, the virtual portfolio of Alpha Dolphin had a positive return of 1.5%, outperforming the S&P 500 (-2.5%), and was consistent with the Shanghai and Shenzhen 300 Index (1.5%), but weaker than the Hang Seng Tech Index (3.9%) and MSCI China (2.5%).

Since the start of the portfolio testing until the end of last week, the absolute return of the portfolio was 23%, 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 US dollars have now reached 125 million US dollars.

VI. Individual Stock Profit and Loss Contribution

After the recent sharp decline in most Chinese assets, there are signs of stabilization, and stocks with relatively solid fundamentals, such as Huazhu, Ctrip, Netease, and even Li Auto, have started to rebound in advance.

However, in the absence of significantly better-than-expected performance from the giants in the US stock market, the fact that they are overvalued has led to a general valuation adjustment.

Dolphin Research analyzes the major changes in stock prices and the possible reasons as follows:

VII. Portfolio Asset Allocation

After adding Kuaishou and Shidai Electric to the virtual portfolio this week, the latest portfolio holds 21 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's portfolio are as follows:

Ⅷ. Key Events of the Week

Following the sell-off of tech giants' earnings last week, the US earnings season continues this week, with Apple, AMD, Qualcomm, and others releasing their earnings reports. Dolphin Research has compiled the specific focus points as follows: