Strategy: The Changing Geopolitical Landscape and its Implications for Inflation Volatility. Commentary on how China is impacted by Fed & Rates

Strategy & Education for Members: Geopolitics, Inflation, Rates, and China

Note: I will be sending more Strategy notes like these to our Private Substack/Patreon members. As a result, my Bi-Weekly reports will be briefer/more concise given that intermittent Strategy reports will capture my views on a rolling basis. My next Bi-Weekly report will be released Sunday Evening Jan 16th.

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To survive in 2023 and beyond, Investors must connect the dots and push themselves to acquire more knowledge to stay on top of the Game.

Members,

I wanted to take a moment to write to you today a brief note about a few things that I believe should be on your radar. These notes are designed to be timely, and given that everyone’s time is precious, I will do my best to make them as concise as possible.

Here is what we will discuss.

• Discussion Point 1: The fact that Kevin McCarthy has won the House votes to become Speaker, and what his new role will mean for U.S. and China markets. What does this mean for Ukraine? For Inflation?

• Discussion Point 2: How I am thinking about this upcoming inflation report, and more importantly the path ahead (not just this report)?

• Discussion Point 3: How to understand the Fed’s impact on China-market shares? Investor Education provided using fundamental analysis and methodologies.

We are days away from a critical inflation report that will influence Fed policy and commentary in the upcoming January FOMC.

If you are focused on understanding the levers of inflation, how to think about “inflation volatility”, and also the Fed’s impact on China shares (BABA, KWEB components), this strategy note will give you further guidance.

Scenario analysis and a reaffirmation of prior views are provided.

Much of what we have discussed in Fall 2022 both publicly and privately are coming to fruition for China.

However, the road ahead for U.S. and China markets will not be as obvious. Investors will have to work harder to achieve alpha. Or in this case, protect it.

Discussion Point 1: On Kevin McCarthy winning Speaker of the House

Republican Kevin McCarthy has prevailed in his nomination for Speaker of the House.

To secure the win, he has had to make compromises with Republicans on the “far right” part of the political spectrum. One of these compromises is the amount of aid that the Republicans want to see be given to Ukraine.

Now for my long-time members, back in Fall 2022 in October, you may remember that I wrote that there is a possibility that greater Republican influence at the White House will mean more friction over the handling of funds for Ukraine.

Back in Fall 2022, I wrote that a Republican sweep of both the House and the Senate (which did not happen as they only claimed the House) would be incredibly bullish for markets.

This is because a grid-locked Congress will challenge further funding to Ukraine, and without further assistance from the U.S., the end result of the Russia-Ukraine conflict will soon come to a conclusion. In terms of who will win, I’m not going to comment on this (but you can come to your own conclusions).

The bottom line is that the War would end, and mark a serious pause in Food Inflation, one of the most critical points of contention in U.S. and Global CPI.

With Kevin McCarthy having won the seat, but having made compromises to reduce Ukraine aid, it is possible that 2023 is the year that Food Inflation peaks as the War may come to a conclusion within 12-18 months. Without further financial assistance, the statistical odds of surviving continued military operations diminishes by the day.

In my opinion, a very long-term bullish signal for markets as Food Inflation will come upon the conclusion of the war. My personal estimations are that an end to the Russia-Ukraine conflict could add up to 500 points on the S&P 500 and up to 3000 points on the Nasdaq.

However, the markets will not immediately price this in because the war is still ongoing. But the stage is being set for Headline CPI to come down faster than expectations in 2024 if the conflict comes to an end.

This is by no means saying that the market has bottomed as of today, but it does mean that as you track these events more closely, I would say that the War ending is perhaps one of the strongest signals that the worst is now behind us.

The key driving catalyst of Food Inflation today is unambiguously tied to the Russia-Ukraine conflict.

In other words, the Inflation Boogeyman is being summoned and sustained because of the conflict. Once the conflict ends, the Boogeyman will fade.

For now the conflict still rages, but I would say the ending (or concrete signs) of this war is going to have global markets soar tremendously.

I will keep you updated on this when there are important updates.

This is more of a long-term prognosis. For now, markets are focused on earnings season and CPI.

The road ahead for U.S. markets is still very challenged. If there is a post CPI surge back to 4100, I see that as a great window to scale out again.

Conversely, any serious crater down to 3700 will merit my attention to see if that’s a buying opportunity. If we get there, I’ll do inter-market analysis, and let the good folks here know my thinking.

Anything between 3800 and 4000 SPX is white noise and has no edge to Bulls nor Bears.

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Discussion Point 2: On Upcoming Inflation Report and bracing for longer term inflation volatility

Now personally, I think anticipating month-to-month CPI reports provide great entertainment value, but by no means will there be any serious way to forecast with precision what CPI will end up being.

The best way to evaluate CPI is in relation to a scenario analysis. I will provide you with my scenario analysis for CPI this week.

Here are the rules I observe:

• Where the index trades on the last day before CPI is released is important. If the index is too high ahead of CPI, the risks are higher. If the index is greatly depressed ahead of CPI, then the risks are lower.

• What the inter-market data shows is also important (Commodities, Precious Metals, FX)

• Understanding what is Consensus (currently 6.5%) - ambitious in my view, but achievable.

Here is what I think (my opinion only):

• With 3920 SPX today, the Buyside would need to see a <6.7% print to defend the 3850 level, and a 6.4%-6.5% (or better) print for the market to rally beyond 3950.

• If Inflation is 6.9-7.1%, I expect stocks to trade below 3900.

• If inflation ticks up over 7.1% from last month, I see a large selloff very swiftly back to 3800 or under.

Other scenarios I’m paying attention to:

• If the SPX trades at 4000+ before CPI, the market will need to see 6.3% or lower to keep running.

• If the SPX trades at 3800-3850 before CPI, the market needs to see 6.9% or better and it will stabilize.
  

More important than this one report is the general nature of inflation going forward.

The last thing that Investors want to see is Inflation Volatility (a situation where CPI comes down first, and then because Fed prematurely eases, it goes back up).

Inflation Volatility will wreak havoc on markets, so as investors, we actually do not want to see the Fed ease too quickly.

If they do, markets may bounce in the near-term but the longer term direction will be horrific as they are forced to tighten again more aggressively thus sowing deeper confusion among market participants.

If you look at markets from a multi-year standpoint, I think it would be fair to say that a secular decline has started to take hold in technology due to monetary policy.

The QQQ

QQQ’s most important company: Apple

If these downward trends continue in a structural fashion into the long-term, we’re talking about intensive wealth destruction for many investors who passively allocate capital.

The good news is that these charts use decades for timeframe reference, but it goes to show that after a bubble pops, refueling it takes substantial effort.

While multi-month rallies can and will happen, longer-term timeframe charts above suggest that the deflating bubble has only begun.

This is why it is paramount to ensure that you’re taking advantage of High-Yield savings accounts that now offer 3% or better as part of a core 2023 investment strategy.

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Discussion Point 3: How to understand the Fed’s Impact on China Shares

One of the questions that Members asked me recently was how will the Fed’s monetary policies affect China shares.

I will attempt to answer this in the most fundamental way possible. I will do this through steps and bullet points.

• Most companies that are publicly traded have their equity share price get valued from Wall Street DCF or Trading Comps models.

• These models are highly sensitive to several select inputs such as Revenue Growth rates, Gross Margins, EBITDA Margins, Discount Rates, and also EPS Growth

Because China stocks and their respective business models derive most of their revenue and business results from Mainland China, the Fed’s impact on their shares is related to the following model inputs:

• The Discount Rate - via the 10Y yield and the cost of debt

• Market Risk Premium - via heightened risks surrounding macro

• Strengthening of the Dollar, and subsequent weakening of the Yuan

Based on what I just discussed, from a fundamental standpoint, it is my view that the Fed tightening will have an indirect impact on China stocks in the KWEB ETF.

If the Discount Rate or Market Risk Premium go higher, then yes the WACC (Weighted Average Cost of Capital) goes up, and the equity value goes down.

However, the WACC is not nearly as important to model inputs like Gross Margins, Growth Rates, or EBITDA margins.

For this reason, the way to evaluate China shares continues to be understanding China macro conditions and not so much Fed tightening. In fact, I would rate U.S. sanctions/policy hawkishness towards China as more important than Fed tightening to evaluate China companies.

Of course, if you are a near-term investor, then yes, KWEB components have high correlation with QQQ when markets are in short-term phases of full risk-on/risk-off.

Over the long-term where you have many different economic and regulation cycles, China is not very correlated to U.S markets and offers diversification benefits.

The recent strength in China has been welcome.

That said, I do not change my intermediate-term caution targets for BABA once it nears ~130 or KWEB once it nears ~40. At 130 BABA, the name will trade at nearly the same valuation as the S&P 500 - a situation that foreign institutional investors have not priced in for quite some time.

Given the intense long-term competitive forces between the U.S. and China, it is objectively difficult for me to conclude that China shares (which are listed in the U.S.) will durably and sustainably trade at a valuation premium far over U.S. markets.

For execution purposes, I like to set stops rather than use market-sells. So let’s say BABA trades north of my 130 level to 135. I set a stop at 130. I stay in unless it pulls back below 130.

This way, you keep riding the upside and don’t sell prematurely.

Alibaba Weekly RSI is now 65, where 70 is the threshold for Overbought.

Keep holding but know that good times must be capitalized upon when the time is right as China policy is subject to change at any given moment.

That’s it for now folks - will be back with a Bi-Weekly report later this weekend set to release by late Sunday.

I know that many folks here really enjoy my reports in between Bi-Weeklies. I’ll produce more Strategy reports for you, and make my Bi-Weeklies briefer/more concise since my reports in between capture much of my views.

Stay safe as always, and tell friends/fam about what we do.

Your Strategist,
Larry