Breaking Out Like A Teenager

1800 words – a 5 minute read.

Hey, we’ve all been there right? Twice if one is fortunate enough to have children (I have 2 young adult sons so check and check). One day the face is smooth and looking good; the next its hot, blotchy & pimply, literally overnight.

Well, things are popping fast and furious as our speed theme continues to manifest. We are not talking about inflation breaking out, though many want to discuss that. Nor are we talking about the USD, what some call a “wrecking ball” though DXY is down roughly 1% over the past 6 months & up less than 4% over the past year. We could be talking about Big Tech or Chinese overseas investments btu we are not. (Much, much more to come on both in the upcoming May Monthly) 

What we are talking about, what’s breaking out like a teenager, is Chinese equity and more specifically our preferred play on such, KWEB, the China tech ETF. We have been writing & positioning on this for months and its finally paying off. China equity broadly and KWEB specifically have broken out big time above their 200D resistance levels on solid offshore demand and BTE earnings.

Here’s Bloomberg this morning: “All the signs are pointing to a revival of Chinese stocks. Benchmarks in Hong Kong are having their best week in years. Foreign fund purchases of Chinese stocks through a trading link hit a record 22.4 billion yuan ($3 billion) on Friday. 

Improvement in China’s economy and earnings growth are driving things. All three main gauges in Hong Kong have rallied hard this week, with the Hang Seng Tech Index leading with a 13% gain. The city’s benchmark gauge has advanced near 9% this week, its best performance since late 2011. Meanwhile, the Hang Seng China Enterprises Index, which tracks Chinese companies, is also having its biggest weekly gain since 2015.

The Hang Seng Tech Index is close to erasing its losses for 2024. The gauge capped an unprecedented third straight annual loss in 2023 and is trading at less than 15 times its one-year forward estimated earnings, compared with a multiple of 24 times for the Nasdaq 100.

The stock gains “should be seen in the context of three years of underperformance which has left China cheap and under-owned,” said Kieran Calder, head of equity research for Asia at Union Bancaire Privee in Singapore. “This highlights the main risk for China bears this year: valuation and sentiment are so weak that just a little good news (or lack of bad news) can have an outsized market impact.”

Best weekly performance since late 2011; biggest weekly gains since 2015 – hot & heavy indeed!

Brendan Ahern of Krane, a noted China watcher, wrote earlier this week: “Despite my lack of a magic crystal ball, there is a rationale for why I am constructive on Chinese equities. The bottom in Chinese equities may have occurred on February 2nd after the derivative-induced meltdown in January following a multi-year ownership reduction in Chinese stocks. Since then, the outperformance of China Tech versus US Tech has been significant, about +18 %. This rally has garnered ZERO attention from the Western financial media. 

The underweight to Chinese equities started with US investors (Trump/Trade, War/Zero COVID/Internet regulation), followed by European investors (fearing Russia/Ukraine could be China/Taiwan), followed by Asian investors (slower exposure decline due to geographic/economic importance and proximity) and lastly Chinese investors. I suspect the re-rating of China will occur in the opposite order.

Step 1 might have already taken place as Southbound Stock Connect has been strong year-to-date with $26 billon of net buying versus $40 billon in 2023. Step 2 would be for Asian investors to take profits/a portion of their allocation in high-valuation US Tech, Indian, and Japanese stocks and reinvest in cheap Chinese stocks.”

What’s interesting to us at TPW is that the story is not just a bottom feeding one but rather a fundamental one that is supported by solid earnings growth and compelling valuation. We note that UBS just went OW China equity while GS sees 20- 40% upside in the China A share market. 

Here is JPM on the earnings outlook: “Consensus estimate for MXCN EPS y-y in 2024 has inched up to 14.7% from 14.3% at end March. Looking into the 1Q24 reporting season, for constituents with 1Q24 forecasts (73% of index weight), IBES estimates are calling for EPS growth of 12% y-y on the back of 6% y-y topline growth y-y and 77bps in NPM expansion. 

Post the 4Q23 earnings season, most of our 2024 adjusted EPS forecasts for the China Internet large caps are higher than Bloomberg consensus due to: 1) increasingly more benign competitive dynamics in the domestic market; 2) improvement in online penetration across key Internet verticals; and 3) strong digital content supply in the next few quarters. JPM sees increasing likelihood of earnings beats and upward revisions, and has turned more positive on the sector share price outlook over the coming 6-12-months.”

 At TPW, we particularly like that last bit about Internet large caps because that pretty much defines KWEB which has acted like a champ this week, breaking back above its 200dR as we discussed in last week’s Musings, handling the whole Tik Tok divestment bill passage with aplomb (up over 2% on the day vs XLK up .4%) and rocketing higher the rest of the week. It is up 10% over the past month & roughly 15% over the past 3 months vs XLK down 3% and 1% respectively – significant OP.

Here's a little more JPM on the valuation case for KWEB names: “The China Internet sector, particularly the large-cap stocks, has seen a systemic valuation multiple de-rating since 2Q23, when the re-opening trade started to fade. Technically, we attribute the sector-wide de-rating to net fund outflows from the sector, due mostly to a weakening China macro outlook post re-opening. Throughout 2023, large cap stocks’ 2024E P/E de-rated by an average 20%, against an average 24% positive earnings revision. 

 However, this systemic multiple de-rating seems to have come to an end in 1Q24. YTD, large-cap stocks had an average 3% PE multiple change, with more re-rating than de-rating (eight re-rated vs three de-rated). In our view, the ending of the systemic multiple de-rating could be evidence that net fund outflows have stabilized, and that a new norm of capital market conditions has begun, where a positive correlation between share price movement and earnings revisions will be re-established.

 As we see increasing likelihood of earnings beats and upward revisions, we turn more positive on the sector share price outlook on a 6-12-month view. We now expect multiple expansion to become a key share price driver as investors regain confidence in the sector’s earnings outlook on a 1-2 year view, particularly in some of the double-digit earnings compounders with 30-40% upside to PT.”

We don’t mean to belabor these points but we do think it is important to note the fundamental story behind the upside we see for China tech, encapsulated here with improving fundamental backdrops, double digit EPS growth, compelling valuations & dramatic under ownership. All this reinforces our 2 tech stack theme of China and the US going their separate tech ways which opens ALL of China for Chinese companies to dominate, not to mention expanding into the fastest growing region of the world, aka SE Asia.

Speaking of growth, we remain constructive on the fundamentals for the US and global economy. On the global side we note South Korea’s much BTE Q1 GDP growth of 3.4% Y/Y vs 2.2% in the prior Q; the best quarter since 2021 and well above consensus 2.4% estimate. Growth was driven by a combination of consumption, investment & exports.

There has been ton of US economic data released over the past few weeks and for the most part it comports with our view of continued solid growth with low inflation. Headline Q1 GDP may have surprised on the low end but underneath it is quite solid from the key consumption and investment perspectives. Real GDP growth was 3% Y/Y; fade the stagflation talk. Inflation data has been spotty, but today’s PCE report is in line with continued, gradual improvement (2.7% Y/Y).

We note that the bulk of the growth miss came from inventories and surging imports (M up 7% Q/Q, fastest increase in over two yrs.) both volatile & somewhat tied to the USD. We are developing a line of thinking on the dollar that suggests it could be ripe for a momentum sell off much like we have seen from Big Tech over the past month or so. 

The strong USD chorus, the wrecking ball commentary, the IMF – WB hype cycle all suggest a turn may be coming. DXY has been unable to make real headway even with the rapid rate backup coupled with surging speculator positioning (USD longs at 5 yr. highs according to Bloomberg). The USD strikes us as late cycle, extended, overbought & ripe for a sell off that could gather pace quickly.

The catalyst search is on: could it be a Trump victory come November with his threats/promises to surge tariffs offset by punishing those who talk the USD down? Could it be as simple as the ROW growth picking up such that ECB rate cuts (now almost assuredly pre Fed cuts) are seen as pro growth and thus Euro enhancing? An ECB rate cut coupled with Euro strength and USD weakness could be the tell.

Might it be some improvement in US inflation such that Fed rate cuts (1-2) come back onto the table. Perhaps it might be as simple as a China equity rally that leverages the entire EM complex such that money flows start to reverse, DXY breaks some technical levels and its off to the races?

Commodities, a solid portfolio diversifier and hedge to the recent (healthy) bout of US equity weakness would be a weak dollar winner. Schwab notes that: “rolling 60-day correlation between S&P 500 and Bloomberg Commodity Spot Index has slipped further into negative territory”. Commodities’ absolute & relative performance also suggest growth is not a concern for equities.

Our Global Multi Asset (GMA) flagship model portfolio remains with a material Commodity OW (no pun intended) paid for with a similar FI UW.

Last week, we wrote a fair bit about the IMF meetings and how the consensus should be faded. Our buddy, who is a long-standing attendee, shared his notes from the JPM survey that was taken during the confab. You got to love it: a whopping 3% of those polled were OW Chinese assets while a staggering 82% expect the USD to be higher by YE. Fade the consensus!