his article is a public speech presented by Mr. Peter Kurz, aka. Mr. Taiwan.
The presentation was an independent session in the 12th QIC Taiwan CEO week with 140 institutional investors and also the main event in the follow on Power Dinner with 120 corporate leaders.
The brave new world, in reference to Aldous Huxley’s classic novel, refers to the rather dysfunctional environment we face in light of the Sino-American trade war, COVID, supply chain disruptions, inflation and actual war, both real (Ukraine) and threatened (Taiwan). So how should we deal with these situations in the context of our investment strategy?
I will talk about this in 3 broad categories: the Economy, Geopolitics and the Markets.
To begin with, I see is the biggest challenge to the global economy, is this debt bubble.
Economy – Policy Mistakes lead to Debt Super-cycle
As we can see, over the past decades, the amount of debt as percent of GDP globally has been rising steadily, and is proven to be fairly fluid on the upside and fairly sticky on the downside. It’s easy for corporations and governments to add to their debt levels; it’s harder to pay them down. Moreover, the process of increasing the supply of debt had the effect of increasing the supply of US dollars on the market, because most of this debt was US dollar-denominated. And this increase in US dollar supply helped suppress US dollar appreciation which in turn supported the “risk-on” market environment of the past 15 years. A weaker US dollar lessens the debt service burden of highly indebted emerging market economies, not to mention Europe and Japan as well, while boosting US corporate earnings. Conversely to pay down this debt load requires taking US dollars out of the market to repay borrowings, therefore reducing the supply of US dollars in circulation boosting US dollar performance versus other currencies. Given the importance of the US dollar as the world reserve currency, we can argue that a weak US dollar boost global liquidity and, in turn, financial market performance while a strong US dollar creates recessionary pressure on economies and commodity prices as well.
I believe there were three key policy mistakes that brought us to this point and what has to be done to reverse these entrenched problems.
Policy mistake 1: Low Interest Rates
First of all. I think most would agree that the Fed brought interest rate down too low for too long following the 2008 financial crisis leading to this surge in both corporate and public debt as a percent of GDP in US and globally. Therefore, to offset the impact of this excessively low rates for an excessively long time period, we’ll need higher rates, and for longer as well.
Policy Mistake 2: Pro-cyclical Fiscal Policies
The second policy mistake is from fiscal policy side to the extent that the government was pursued pro-cyclical fiscal policies. I have here the US federal budget, on an inverted scale, versus the unemployment rate. Typically, the two lines follow each other in degree and in direction. However, during the 2017 to 2020 period, the Trump income tax cuts were implemented at a time of historically low unemployment rates thus providing stimulus to an already over-heated economy. This was soon followed by the massive government transfer payments following the Covid epidemic further creating a further excessive economic stimulus leading to the high inflation rate as we are now enduring.
Policy Mistake 3: Rampant Stock Buybacks
The last policy mistake as was the financial market oversight level. The US SEC turned a blind eye to very aggressive share buybacks by corporate in America that had the benefit of creating at least the artifice of rising EPS growth by simply reducing shares outstanding. Share buybacks, too, artificially boost demand for, and thus the price of shares all funded by the issuance of corporate debt. Corporate boards happily support these share buyback programs during periods of rising share prices and eschew them during bear markets. Thus, share buyback programs, too, are pro-cyclical, adding fuel to an already strong stock market, and in the process leveraging up corporate balance sheets. While in a weak market, especially one triggered by rising interest rates, reducing buying support for shares while corporate profits are furthermore squeezed by rising debt service expenses. Moreover, corporations will increasingly rely on share issuance, rather than buybacks, to fund the retirement of increasingly burdensome debt levels thereby increasing share supply and suppressing price performance. Add to this the fact that the recently passed Inflation Reduction Act levies a 1% tax on stock buybacks going forward. So this could be a headwind for US stock market and to the extent that US stock market leads global markets, our stock market here in Taiwan as well.
Another Third World Debt Crisis Coming?
The World Bank recently issued the warning that we may be heading for another 3rd world debt crisis on the scale not seen since the 1980s. This risk is again driven by the upward spike in interest rates which you can see in the above chart suggesting that every time we’ve seen interest rate hikes of this magnitude – and of course the interest rate cycle is not over yet – an economic recession has ensued. Just to put it the scale of the problem into context, the Belt & Road debt burden on emerging economies alone is more than double what the total 3rd World Debt outstanding was in the 1982 crisis. Now granted that was 40 years ago, but nonetheless, the Belt & Road debt burden is a small portion of current total outstanding.
We can take a look at which countries are the most exposed and not surprisingly many of the same names we saw 10 years ago in Europe crisis appears as among the weaker and more highly leveraged countries in Europe. Not all are listed here but among the bigger ones of those not listed above, Scandinavia features quite prominently, as do Argentina, Malaysia as well. But I want to point out that Taiwan, as is often the case, maintains very conservative balance sheets both at the public and private levels and therefore to the extent that there is this disruption from a global debt crisis, Taiwan should be the least impacted.
Geopolitics - A New Cold War: US vs. China
Now let’s turn our attention to the geopolitical risk of rising tensions between US and China with respect to Taiwan in particular.
Chimerica Lost
First I would like to just highlight the state of play of Chimerica, the term coined by Niall Ferguson describing the unspoken, unwritten pack between US and China where by US export jobs and its industrial base to China – and indeed Taiwan has been doing very much the same – in return for China re-exporting finished consumer goods at much lower prices back to US market. So you can see that as this Chimerica effect came into play, nominal wage growth did come down pretty noticeably during the 2000’s versus prior decades, leading to a period of price stability and superior corporate profitability. And yet the same time, real wage growth actually faired relatively better than it did during periods of higher nominal wage growth, again due to lower consumer price levels. So it’s sort of a win-win for all involved, at least up until very recently when the tariff war between the US and China erupts as well as other disruptions from COVID, supply chain bottlenecks and the like. In fact now it looks like we are moving in the opposite direction as de-globalization is becoming the dominant trend.
The Face of Deglobalization
And we can measure that de-globalization by just looking at the total global trade versus GDP of the top three countries in the world in terms of population and you can see that they are all engaging in policies that are either protectionist or otherwise depressing trade flows. And while that trend began more than a decade ago, it’s been gathering steam particularly since the 2018 the tariffs were mooted, and this is injecting an element of inefficiency and friction. Reducing trade creates inflationary and also recessionary pressures on economies. In fact, the Rahm Emanuel, US Ambassador to Japan, recently admitted that the intention of American trade policy was to sacrifice, to some extent, cost reduction in favor of a “predictability premium”. We are consciously trying to increase the cost of goods we manufacture as an offset to risks of supply chain disruptions due to COVID lock downs or geopolitical instability. So again, this longer term trend may be somewhat of a headwind to global economy and stock markets.
The Most Dangerous Place on Earth
So now we move to what The Economist a year ago referred to as the most dangerous place on Earth. Let me discuss this issue in the most balanced way I can as I think China does has a legitimate concern. If you look at the map here, China’s access to the Pacific Ocean, to its overseas trade routes and to its oil supply chains all could effectively be blocked by a ring of US allies along its entire coastline. From the American standpoint, the United States is concerned that if Taiwan were to be retaken and ruled by China, its influence to the region could collapse, and those blue color countries could turn purple, or even red. So that do we do with this situation? There are basically three solutions: The first is a military confrontation, which we all agree is one to be avoided. The second is a diplomatic one, and I think here we need to think more creatively, more so than has been the case up until now. It’s not a simply a matter of Taiwan independence versus reunification, there has to solutions under consideration And I’d just like to throw out a few such ideas as examples. Consider, for instance, the British Commonwealth model where both sides share a common sovereign, or the EU model where both sides share common institutions at industrial level, progressing even to the political level over time. Or Taiwan declares neutrality like Austria, Switzerland or Finland with its neutrality and security being by a mutually accepted entity such as the UN or the EU. The very process of such discussion would be tremendous progress in and of itself. I mentioned a third alternative and that is simply to wait until China itself becomes a more liberal, more democratic or more pluralistic society into which Taiwan would be willing to integrate. That has been the rationale for the ‘status quo’ approach of the past decades. This is obviously something we’d all like to see but nothing that we can count on in the short term. One final optimistic point I’d like to make is that if we look back to periods of similarly rising cross-strait tensions, such as the 2018 outbreak of the US-China trade war or the 1996 Taiwan Straits Crisis, when things were looking most grim for Taiwan, these proved to be the best times to buy Taiwan equities. In the case of the 2018 trade tariffs, when we all thought that Taiwan will be the biggest loser in this standoff, it actually benefited quite substantially in so far as the world economy needed to rely on Taiwanese company to manage the redeployment of the electronic supply chain out of China, into Vietnam, Taiwan, India and even the United States and Japan. And this is actually increased Taiwan’s corporate domination of this sector and its pricing power as well. We’ve seen that in the semiconductor industry sector most notably.
East vs West: It’s the Economy…..
Finally, if we really are to split into two distinct geopolitical blocs, between East and West nations, the land mass of both blocs looks pretty similar in scale. But from the economic standpoint, there is no comparison. The Western bloc economy is more than three times of size of that China plus Russia plus Iran and Venezuela and so forth. And for countries to dominate in technology, in military capability and obviously per capita income you need to be part of a larger economic base. And I think this will give China some pause as they pursue their sort of autarkic progression or link up with Russia which obviously has been greatly economically isolated following its recent invasion of Ukraine. So from this stand point, I also remain optimistic that China is not going pursue this path aggressively and there is room for negotiation, for diplomatic solutions as we move forward.
Market - bear market: Old but not over
Yield Curve Point to Recession
Turning to the markets, let’s first of all look at the yield curve as a good indicator of the risk of recession. In fact, it’s a damn good indicator. It hasn’t failed yet although the timing of the recession tends to lag the curve inversion by 6 to 12 months. We are at as deep an inversion as we’ve seen since 2000. And again, we are not over yet in this interest rate cycle. The yield curve anticipates recession because it reflects the market expectation of slowing long term growth but beyond that, it constrains credit growth in a system that normally short funds long term investments.
Markets Leads Economy by about six Month
The good news is, though, that the stock market itself leads the economy by 6 months. We’ve seen stock market bottoms occurring typically about two quarters prior to the beginning of economic recessions, and so we are to some extent already pricing in a lot of that future economic risk. If the yield curve is forecasting a recession by mid-year 2023, let’s say, then the markets should bottom in early 2023.
Bearish Sentiment is Peaking
And indeed if we look at how institutional investors globally are positioned, they have done a considerable amount of selling already. We are not quite at the lows of equity exposure we saw in the June bottom of this year, at which point QIC did call for a short-term market rebound, but we are getting back to those levels pretty quickly. And in any case, we are at sufficiently low levels to suggest that the extent of the down side of the market should be limited.
US Cash Weightings Recovering
In terms of liquidity, we look at the US market and the weighting of money supply versus market cap. That blue line here at its higher level along its trend suggest the sufficient liquidity to new market to keep prices buoyant.
Taiwan Cash Weightings Also Recovering
For Taiwan we are looking at a neutral situation, not a buy and not a sell but nonetheless offering some comfort that the worst probably is behind us in terms of share price declines.
Taiwan Money Supply Trends More Negative
However, liquidity is likely to continue to contract here in Taiwan, especially if and as the Fed continues to tighten and the US dollar continues strong. Not only is the aggregate themselves declining in terms of monetary growth, but M2 growth is declining faster than M1 growth, indicating direction of money flow is moving away from risk assets, i.e. equities, in favor of safe assets such as time deposits.
Taiwan has an Independent Interest Rate Policy
Finally, in terms of interest rate policy, Taiwan does tend to follow its own path, often with lesser rate hikes then we’ve seen in the US and sometimes moving in different direction altogether. But that said, to the extent that US rates do exceed Taiwan rates, this will clearly put pressure on the NT dollar as I mentioned earlier as well.
Bear Market Outlook
Historically, bear markets are considerably shorter than bull markets, lasting only about a year and a quarter, on average, with the index falling by about one-third from the prior cycle high. On that basis, we could see the Taiwan stock index decline to 12,000 and the S&P to 3,000 before this bear market is all over, and based on a one year plus trajectory, starting from the last market peak in December 2021, we probably are looking at a market bottom sometime in the early part of next year. I want to add, though, this cautionary note from Richard Russell who wrote in his Dow Theory Letter back in 1987 (and by the way, I actually read this comment back in 1987 in the aftermath of the stock market crash back then), “A bear market lasts as long as it takes for you to lose all your investment capital.” By this, he meant that typically in a bear market, we tend to chase the short, sharp bear market rallies often buying near the top and sell it into the sharp selloff that follow. Until eventually we lose all our money and give up entirely on the market and that’s when the bear market is over. So please avoid that trap and keep your powder dry for the better entry point to come, I think, over the course next year.
Investment Strategies
So what do we do here? Again, to WAIT probably is a good strategy to follow for the short term. But I think there are still opportunities to look at even now. First, there are now a number of New Economy companies listing on the Taiwan stock market Software, Data, AI, SaaS and so forth. And secondly in the biotech space. Here the Taiwan biotech sector index in red shows how well it performed versus similar indices in Hong Kong and Nasdaq markets. Taiwan biotech companies have been benefiting from the fact that they have unique access to the two largest pharma markets in the world: the US and China. The long gestation period really beginning back in early 2000 is now beginning to bear fruit.
New Economy in Taiwan
When we look at the New Economy companies in Taiwan, we can see that they are very much under-represented relative to peer markets elsewhere in the world, in terms of number of companies and especially in terms of percentage of market cap. The lower market cap implies either that these companies are still quite young or that they are deeply under-valued, or perhaps a bit of both. Let’s look at them:
New Economy Companies in the 12th QIC Taiwan CEO Week
We have actually 10 of these companies attending our conference this time, representing the AI, Cloud, Telecom, Urban transportation, E-commerce and Bioelectronics segments. And the interesting thing about this is that being in this New Economies, they have far greater scalability than any manufacturer would have. And they are able to cross borders more effectively as well. This is a critical point because we know that the Taiwan domestic market for services is somewhat limited and they typically have no access to China. And they do so primarily by focusing on the B2B segment. The AI companies typically provide solutions to companies in developing marketing strategies for e-commerce. Groundhog is helping telco companies in siting and designing their base stations to greater communication efficiency. eCloud Valley allows corporates to seamlessly access the cloud, AWS in particular. Gogolook has the biggest database of telephone numbers in the region providing a service both to individuals, identifying incoming calls, and to corporations in assisting their activities in KYC, data security and so forth. Gogoro is a very well-known name in urban transportation. Helios marries Taiwan’s dominance in the semiconductor space and biotech to create semiconductor solutions for early stage disease diagnosis. So, many interesting names to look at here.
Taiwan Biotech Revenue Ramp
As for the biotech sector, we’ve seen a significant ramp in revenues in the past year and expect acceleration to continue. Previously, there had been a couple of false starts in this sector in terms of stock price in 2014 and 2016, which led to a lot of volatility and a lot of disappointment. Thus, sector share price performance was actually trending downward since then and only now are we beginning to see some real revenue growth as we get some drug approvals coming through. You can see here some new drugs were approved in the major markets by PharmaEngine, TaiGen, TaiMed, PharmaEssentia and Oneness. Foresee followed the 505(b)(2) regulatory pathway, which is taking existing drugs and repurposing them or reformulating them. They have a very innovative formulation technology that is actually applicable to other drugs going forward as well. And then finally even in biosimilars where it is extremely difficult to get approval in the United States, EirGenix has been able to do so for their Herceptin biosimilar as well. So a lot to take a look at here.
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