“Pivot” and “Dispersion” — 2021 ANNUAL LETTER & 2022 OUTLOOK
Feb-24，2022 | 维世
“Defense wins championship”. History shows that great defensive players are the difference between mediocre and championship teams.
Despite their claims to embrace the benefits of effective diversification and anti-correlation, many institutions chase yield into the depths of low-quality assets, concentrate portfolios on a single factor or a single market segment, and fail to recognize changes in market structure. These behaviors often end in tears.
Featuring two key words, “pivot” and “dispersion”, 2021 was a challenging year for the institutions to navigate globally, with volatile market conditions that threatened to wreak severe capital impairments on a portfolio if not managed prudently.
High vigilance and ability to stay contrarian were keys to sailing through conflicting forces and preserving investors’ wealth in 2021, and hence becoming better positioned to play offense, patiently and strategically, when the right time comes.
I. 2021: PIVOT AND DISPERSION
1）The Great Policy Pivot
Recency bias and path-dependence are the enemies to navigating impactful policy regime changes.
After decades of zero-inflation, few investors predicted a 39-year record high inflation at 7%. Structural forces, such as the falling labor participation in the US, compounded with COVID-induced supply chain congestion and risk-averse behaviors in the labor market, clouded the financial market.
Abundant liquidity, the central bank “put”, zero-bound-interest-rate and low-inflation have been the decade-long backdrop for the appreciation of risky assets. Such a policy regime is now pivoting from global synchronized easing to global synchronized tightening, starting with EMs (with a few exceptions like China that is to be discussed separately), then the Nordic countries, the UK and US, followed by the EU.
Cognitive comprehension by capital market participants of such a policy pivot takes time. Therefore, the market will experience a period of heightened volatility with potential episodes of shakeouts before it can re-anchor itself to the new reality.
Contrasting the course of tightening seen in DMs and some EMs, a policy pivot towards easing in China is driving a foundational shift in its growth model. Draconian regulatory measures on education, Internet, and real estate sectors have permanently changed these sectors’ business models and substantially lowered expectations of their earnings growth. Massive layoffs from these sectors, paired with the country’s zero-COVID policy, have weighed on China’s economic vitality.
China’s policy pivot has also impacted global economy: the push for carbon neutrality has created severe supply side constraints – a driver behind the global inflation surge that can’t be ignored.
“Only the paranoid survive”. Long-term investors who survive are those who identify early signs of major risks. Many fund managers, brand-name veterans included, jumped on the bandwagon of becoming path-dependent after reaping a lucrative profit from the 2020 tech bull run, as well as on the back of a V-shaped economic recovery and America’s historic liquidity. Compounded with excessive leverage and gamified retail flows, the situation is a dangerous set-up for a flash crash.
In the offshore China market for instance, portfolio managers who ignored early signs of regulatory risks in high-flying sectors (education, TMT, biotech) that emerged towards the end of 2020 were later brutalized by the regulatory storm in the following July. China offshore high-growth sectors collectively plummeted by 40-90%.
2）Significant Dispersion of Performance Between Markets, Sectors and Amongst Manager Universe
The aforementioned pivots resulted in significant dispersion in multiple dimensions. Risk assets across different markets, and across different sectors within the same markets, behaved dramatically differently. Consequently, manager performances showed huge divergence.
At country level, the dispersion between China and the US in 2021 has cautioned our outlook for the US, particularly on the record-high level of valuation gap between the two countries over the past 10 years (Chart 2). This gap is subject to mean reversion under the opposite monetary policies of the two countries. Additionally, earnings expectation has been pulled forward and the US stock market is more likely to surprise on the downside if earnings growth does not meet expectations.
Chart 1: Significant performance divergence across countries in 2021
Chart 2: US-China Valuation gap has reached 10-year high
A hidden bear market emerged underneath the headline bull in the US, a dispersion that is deceptive to many. In 2021, 70% of Nasdaq gains was driven by 6 mega cap stocks, 65% of Nasdaq constituents had a 20% correction or more, and the average stock price decline from the peak was -39%.
This hidden bear market, together with the bleeding from the GME short squeeze, led to a disappointing year for technology hedge funds, especially when the manager attempted to invest “away” from MAMAA. Only 15% of technology hedge funds outperformed Nasdaq.
Violent market leadership rotation across global markets. In both the US and China (Chart 5), value outperformed, represented by energy, while growthy sectors such as biotech and technology experienced painful drawdowns, largely due to valuation compression.
Chart 3: Hidden bear: NASDAQ constituents on average 40% drawdown vs. peak of the year
Source: Bloomberg, Alpine Macro,the data as of 2021/12/31
Chart 4: Tech hedge fund underperformance in 2021
Source: Bloomberg, evestment
Chart 5: Rotation from growth to value represented by performance dispersion in sectors across markets
Source: Bloomberg，the data as of 2021/12/31. US sector performances are S&P sector performances.
US Biotech is measured by XBI index. China sector performances are MSCI Sector performances.
II. 2022 OUTLOOK
The tug of war in 2021 in major markets between the following forces will continue in 2022. Apply caution in early part of the year but be ready to play offense. The market nervousness seen at the start of 2022, with several intra-day reversals, indicates it is too early to make single directional calls. However, when the macro uncertainty driven by central bank policy pivot is priced in, we expect markets to re-focus on growth and that’s the time to play offense.
a) In the US, the sequence, speed, and magnitude of Fed tightening actions, including taper, rate hikes and potential balance sheet reduction against strengths of economic recovery. Underestimation of potency of Fed actions can be caught off-guard to cause extended volatility. Conversely, it is also dangerous to position a portfolio singularly on the anticipation of a Fed “chicken out” as it did in previous tightening cycles, or even in hope of a scenario that it “hits the brake when the car is still in the garage”, given inflation is well north of Fed’s long-term 2% target this time and can persist for much longer.
b) In China, pain in the real economy such as unemployment, high household debt levels, slowing effect by the massive deleveraging of real estate sector, unwillingness by corporates and consumers to spend against the speed and magnitude of stimulating policies, both monetary and fiscal, and whether policy pivot is fast and big enough to turn overall market sentiment.
Although we remain highly vigilant of market risks, we remind ourselves that attempts to predict macro is a fool’s errand. Building balanced and effectively de-correlated portfolios based on high hit rate of high-quality managers via rigorous manager research is the ultimate defense-and-offense strategy.
VS Partners wish you a roaring Year of the Tiger with health and happiness!
Ying (Vanessa) Xu
VS Partners (Hong Kong) Co., Limited
Executive Chairman, CIO
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 Source: CNBC. https://www.cnbc.com/2021/01/29/gamestop-short-sellers-are-still-not-surrendering-despite-nearly-20-billion-in-losses-this-year.html
 Source: CNN. https://www.cnn.com/2021/04/27/investing/ubs-nomura-archegos/index.html
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