Newsletter commentary Aug 2020

In August, the CSI 300 index rose slightly, with a year-to-date increase of nearly 18%. In August, the Nasdaq index rose by nearly 10%, and has risen by more than 30% year-to-date. The market cap of several major technology stocks as percentage of total market cap has reached a record high.

When market continues to rise, it is often said that this time is different. It would usually be proven wrong, because history does repeat itself most of the time. But sometimes history indeed has different rhythms. Although very few, it does exist and it is very important. We would like to think what might be different this time.

We believe that buying stocks and buying China may be a kind of crustal movement in the history of investment. It overwhelms daily fluctuations and dominates the trend. Compared with crustal movement, daily fluctuations may be nothing more than turbulence.

There have been such things in history. In 1959, there was a major reversal in the US stock and bond investment paradigm. In the past, investors only bought stocks when stock yields were higher than bonds. Later this rule was broken. The reason behind this is the stability of stock dividends and the increase in the number of dividend-paying stocks, and more importantly, changes in the inflation environment.  From 1800 to 1940, the cost of living in the United States only increased by 0.2% per year. In 140 years, it only increased by 28%. However, the average annual inflation rate from 1941 to 1959 was 4%. The nature of bonds changed from a financial instrument that rarely defaulted to a risky investment. Meanwhile, investors no longer regarded stocks as an asset with unpredictable returns and risks, and started to look at the dividends in the future. For the growth opportunities and the hedging against inflation, it became a trend to invest in stocks at a premium. People who remembered the old days were still

the main players in the market. Although this new trend was visible before 1959, there was still a gradual process of transition from "cigarette butt" investment to the pursuit of future growth.

Behind this change in 1959 was the sharp rise in the risk of bonds relative to inflation and the increase in operating stability after stocks emerged from the Great Depression and can withstand inflation. Now the relationship between stocks and bonds has undergone very interesting changes again. Bond yields declined from about 20% in the 1980s to almost 0% now. This has never happened since the concept of interest was born, and it seems that it is difficult to rise sharply in the future. At the same time, in stock market winner-takes-all has become a market rule and those companies continue to strengthen their moat.

The bond market is usually much larger than the stock market. The "permanent decline" of bond yields will increase the demand for stocks. This is a structural change, we believe.

It has been some time since China’s economy has contributed the most to the world’s incremental growth. Also It has been a long time since it became the second largest economy with a share of about 15% of the world economy. However, China’s assets have been very small in the allocation of global investors. Now, after the opening of China’s capital market, the pattern began to change. After the epidemic, more global investors have seen the value of China's economy as an independent engine. Investing in Chinese stocks has become as important as investing in Chinese industrial sectors in the 1980s. China’s economy’s net exports account for very small share of China's GDP, but it is still the world’s most important contributor to the growth. It is also true that China’s internal circulation is already an important source of global economic growth.

For Chinese people, stock assets used to be an investment category with a mediocre experience. Although the long-term total return was actually not low, the volatility has been too big. Compared with the steady rise of real estate, the experience was very mediocre.  At the same time, there were many wealth management products that provided high risk-free returns. Now those competing products’ attractiveness has drastically declined. In the future, the volatility of the Chinese stock market will decline. One of the reasons is the change in the government's positioning of the stock market. Just like investing in stocks in the United States, no one wants to fight the Fed. The Chinese government’s market positioning is very important to the Chinese market. Another source of stability is the rapid advancement of marketization and internationalization of the Chinese stock market. At the same time, the quality of listed companies in China is greatly improving, and the registration system has further accelerated this trend.  Therefore, in the future, stocks will gradually become a fundamental asset allocation category for the public. This potential demand is huge and has already become a reality.

The basic logic of modern macroeconomic regulation and control is also beneficial to stock investment. The recovery of residents’ income depends on the recovery of economic activities, and the recovery of economic activities depends on the return of animal spirits. The return of animal spirits depends on the rise of asset prices. The rise of asset prices depends on fiscal and monetary stimulus. Various combinations are basically variants of this logic. The rise in asset prices is always in a more powerful position than the recovery of wage income. The return on equity is always faster than the growth of nominal GDP. Income generally does not exceed the nominal GDP growth rate, so the gap between rich and poor is endogenous. The risk tolerance of high-net-worth individuals is higher, and the proportion of demand for high-risk assets such as stocks will be greater.

In a transparent world, consumers need cost-effectiveness, companies need profits, and resources are allocated globally. As a result, the differentiation between companies has intensified, and the rate at which companies create wealth has also accelerated significantly.

Buying stocks and buying China is a likely trend supported by underlying logic, similar to crustal movement. From a historical perspective, the attractiveness of stocks has fallen sharply, but from a relative perspective, stocks seem to be the best choice.

Even if there is crustal movement, turbulence is not no longer important. China's economy will continue to recover in the next few quarters, although the rate of improvement from the previous quarter has slowed down. The impact of the global epidemic on the economy is gradually controllable. Stocks are more expensive than before, but from a relative perspective, it is still acceptable.

The current market has benefited from the global monetary easing. China’s monetary policy has begun to gradually normalize. As the epidemic becomes controllable, it is normal to expect the Fed’s easing to normalize sequentially, which is a test for the financial market.