Out of sync…

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Major economies plunged into recession together a year ago. The path out is marked by divergence, not togetherness. There are two main reasons: Covid-19 and public policy. These will continue to be on investors’ minds. 

Covid-19 comes first. We learned last week that Europe slipped back into recession in Q1, as a surge in new infections led to renewed lockdowns. By contrast, a surge in vaccinations rather than disease helped to spur US economic growth in the quarter, to an estimated 6.4 percent on an annualized basis. Among emerging markets, India — which just a few weeks ago looked set for rapid GDP growth this year — is now suffering a terrible outbreak of infection. As bodies mount and fear spreads in the major cities of New Delhi and Mumbai, recovery is bound to slow. In China, where the arc of the Coronavirus Recession was both earlier and less intense, the economy is expanding apace.

The second reason for divergence is government policy. We have written about the extraordinary push to the US economy from the fiscal spending passed in 2020 and, already, in 2021. The third round of stimulus checks sent out in March led to a record 21 percent increase in personal incomes last month, beating expectations. RockCreek Founder and CEO Afsaneh Beschloss appeared on Bloomberg last Friday to comment. This increase in turn fueled a big rise in spending, 3.6 percent in real, inflation-adjusted terms, that put spending back on track with pre-pandemic trends. European governments are also boosting spending. But not by nearly as much.
Source: Bloomberg, RockCreek Group
Stock performance is also set to diverge as different sectors and companies flourish in a post-pandemic world. Last year, global indices were heavily impacted by Big Tech. The strong performance of a few large tech companies pulled up the S&P and the MSCI China. The extraordinary success of tech companies during the pandemic was not pre-ordained. A year ago, companies from Alphabet to Facebook were signaling that the pandemic could hit revenues as advertisers pulled back and consumers and businesses reined in spending. Contrast that with the outcomes for these companies — not just while we were all kept in by Covid-19, but also as the US was recovering this year.

First quarter earnings are coming in fast and furious and generally easily beating forecasts. More than 60 percent of companies in the S&P 500 have reported so far and approximately 86 percent beat earnings. We are on track to see the highest earnings beat rate on record going back to 1994. Last week, Big Tech took center stage and earnings, led by Alphabet and Facebook, recorded surging revenues due to digital advertising. Alphabet’s Q1 revenue rose 34 percent year over year and earnings beat Street estimates by an astounding 66 percent, as YouTube ad sales and Google Search revenues increased 49 percent and 30 percent, respectively. Facebook reported revenue 48 percent higher than a year ago and exceeded earnings forecasts by 39 percent. This was attributable to a 30 percent increase in average price per ad, as well as a 12 percent increase in number of ads shown.

Despite a positive earnings season so far, stocks have had a muted reaction overall. With much of the good growth news already priced in, the market is looking ahead to the prospect of higher corporate taxes and potential increased regulations. The silver lining — our expectations of annual growth of 10 percent this year — may cheer investors up again. Changing behaviors as we come out of the pandemic are also notable. While consumer spending and corporate advertising remain on strong footing, the impact of people getting vaccinated and returning to normal activities outside their homes is being reflected in declining user growth rates and online engagement for some technology platforms. Pinterest’s revenues were up 78 percent year over year and earnings were about 57 percent above expectations, yet its stock tumbled on news that Pinterest’s monthly active users only reached 478 million versus a forecasted 480.5 million. Netflix’s revenues were in line with expectations and earnings above Street estimates, yet shares sold off. Management had guided to six million new users and the platform only gained four million. The market also looked past Twitter’s strong revenue and earnings growth as its total number of monetizable daily users grew by about one million fewer than expected.

As we have been writing since the end of 2020, supply chains worries have come into focus as we emerge from the pandemic. This is an issue for the tech sector. Apple had a blow-out quarter with the company reporting 54 percent year over year jump in revenue and earnings that were 41 percent higher than consensus estimates. However, management warned that revenues next quarter could take a $3 billion to $4 billion hit as a result of the semiconductor crisis. Caterpillar and a host of other companies are warning about threats posed by input price inflation and bottlenecks in global supply chains. With equity market valuations at historically high levels, there will be little room for error in the quarters ahead. The challenge for 2021 — will market multiples (especially in the US) be sustainable even as earnings growth explodes. 
Observations and takeaways for investors:
Earnings announcements are not the only highlight of the quarter.

2020 was a record year for venture capital activity with $166 million of capital deployed across nearly 12,000 deals. This frenzied activity carried forward with nearly $70 billion invested in the first quarter alone (chart below), 40 percent greater than the prior record. Not only has there been a pickup in activity, but there has also been a significant increase in the velocity of investment activity — particularly for early-stage technology companies. 

RockCreek analysis indicates that the time between financing rounds is rapidly compressing with the size of checks increasing — particularly at the Series B stage. Subsequent funding rounds are closing within three months for the best companies rather than the historical cadence of 12+ months. Deel, a tech-enabled payroll and compliance platform for international employees and contractors, raised a $14 million Series A in May 2020 followed by a $30 million Series B in September 2020. Audio-based social app Clubhouse saw its valuation climb from $1 billion at its Series B in January 2021 to $4 billion at its Series C three months later. 

This frenzied activity has resulted in financing rounds becoming increasingly competitive as the top funds jockey for stakes in the best emerging companies. Simultaneously, the deployment period for funds has decreased from the customary three years to 12-18 months. Adding additional momentum to this flywheel is venture funds that are distributing record amounts of proceeds back to LPs as a result of a slew of recent IPOs (e.g., Airbnb, Coinbase, DoorDash, Roblox, Snowflake, etc.). These same investors are then recommitting to new venture funds in order to maintain target exposure to the asset class.
Source: Pitchbook, RockCreek Group

The private market activity and IPO market is just as busy as the crypto space, where we are seeing early signs of commercialization and product-market fit for certain blockchains. The jump in prices for cryptocurrencies and tokens across the spectrum (as of this writing, Bitcoin had appreciated approximately 80 percent year-to-date) are grabbing headlines. But there is more to the story. The fundamental picture is starting to take shape as many companies and outright blockchains are generating actual revenues that traditional investors can value and project. Dapper Labs, the Canada-based startup that created NBA Top Shot and CryptoKitties, has developed a blockchain, Flow, which is custom built for the next generation of apps, games and the digital assets that power them. According to the company, NBA Top Shot has 100 times as many users since the beginning of the year, with sales exceeding $500 million. Similarly, Uniswap, a leading decentralized cryptocurrency exchange (akin to Coinbase on a blockchain), saw an average daily volume of $1 billion per day during the month of January. With a flat transaction fee of 0.30 percent, that equates to approximately $90 million in revenue for the month for a product that was launched less than three years ago.

Vaccination diffusion and confusion.

President Biden noted in his address to Congress last week that the US vaccine rollout has been a logistical triumph. Former President Trump’s Warp Speed program to incentivize vaccine development was a scientific and medical triumph. What the US most needs now is a communications triumph: too many Americans are hesitant about taking the vaccine, potentially keeping us from reaching herd immunity across the country. The messages they are receiving are quite confusing: the CDC — and the Administration — have cautioned that you shouldn’t throw away your mask and party indoors just because you are vaccinated. Many may wonder: what is the point of risking a shot? 

Initial caution from the new Administration was understandable, given the terrible death toll from Covid-19 in America in 2020. But today’s public health messaging underplays the enormous benefit and risk reduction from getting vaccinated. And an unfortunate association of getting the vaccine with being “soft” doesn’t help — as many as 40 percent of Marines are still unvaccinated. President Biden, asked last week if he would mandate vaccination once the FDA has given full, and not just emergency, approval, said “maybe.” The private sector may well lead the way in requiring proof of vaccination, whether for workers or consumers — or travelers as the EU has set out. 

Emerging market pain: do markets care?

At the beginning of the year, it made sense to expect recovery in emerging markets to outpace that in developed markets — in a reversion to the usual pattern. This is not happening — for the two same reasons of Covid-19 and less space for US-style public support for the economy. On the latter issue, a number of emerging market central banks did ease policy in the initial stages of the pandemic. And their governments borrowed to support fiscal spending. These measures helped to soften the blow of the Coronavirus Recession and steer emerging markets back to growth. But developed nations have more scope for government action and are continuing to use it, notably in the US.

On Covid-19: it is no surprise that poorer nations are behind in vaccinations. What is perhaps more surprising is that two of the biggest emerging markets — Brazil and India — are experiencing among the worst Covid-19 surges. On May 2, The seven-day average of new cases was reported as 373,193 in India and 59,160 in Brazil. In both cases, it seems that behavior has triggered the latest surge. In India, large scale religious and political events took place with little masking and no social distance as people were optimistic that the country had escaped the worst of the virus with its young population. In Brazil, the government has tried to wish the virus away — an approach that has succeeded nowhere.

The tragic week in India caught global attention, as both new cases and mortality reached record highs, and far outpaced other major countries. The world is now responding, and beginning to send badly needed aid — it will take time for the curve to flatten.
Source: JHU
While Indian equity markets remained resilient in the face of the country’s calamity, finishing the week up over 3 percent in USD terms, investor sentiment did begin to turn negative on the last trading session of the week — perhaps in recognition of the dire facts on the ground. We would not be surprised to see the markets correct in the coming days and weeks. The Modi Administration has tried to limit the pandemic’s spread through a series of local lockdowns, to little effect. Millions of migrant works have left urban centers in a bid to wait out the crisis, significantly hampering the country’s vaccination efforts. We expect Q2 GDP to take a hit. There is still a chance the country will see a rebound in the second half of 2021, but many things must go right for that to happen. It’s not all bad news when it comes to investment opportunities. We continue to look for opportunities in healthcare, financials and IT. We also expect Indian IPOs, particularly in the technology space, to eclipse the capital raised in 2020, providing further fertile ground. According to Bloomberg data, so far this year over $3 billion has been raised through initial public offerings, compared to $4.6 billion for all of 2020. 

In Latin America too, the public health picture belies an otherwise healthy set of opportunities in technology and innovation-driven sectors such as renewable energy and fintech. Chile is leading the region, having already met its 2025 target of producing 20 percent of its energy needs from wind and solar and is on track to produce 25 percent this year. New projects and company listings provide a number of interesting choices. In the fintech space, the number of venture capital backed investments has mushroomed in recent years, (beyond the fintech darling NuBank), to include some compelling opportunities in Argentina, Colombia and Mexico that will soon give the likes of PagSeguro and Mercado Libre’s payments platform a literal run for their money. 

Elsewhere in emerging markets, Taiwanese markets had another strong week and year to date are far outpacing North Asia neighbors. Semiconductor specialist Mediatek led the rally as that stock rose over 16 percent. The stock reported better than expected first quarter earnings and guided 2021 revenue to be up 40+ percent year over year, led by 5G smartphone growth. The company also announced it will pay shareholders a special dividend per share from 2021 to 2024. This stronger commitment to shareholder returns is a welcome development that follows decisions made by other technology companies in Taiwan and Korea in recent years. Consequently, we have seen payout ratios increase throughout the region — a trend we expect to continue, particularly in the cash rich IT and communication services sectors.

As we have highlighted in previous notes, EM flows have remained positive this year, despite increased market uncertainty. This week was no different, with the added development that the pace of positive flow increased for the first time in weeks. Overall inflows nearly doubled to $2.3 billion, up from $1.2 billion the previous week. Within regions, North Asia saw the greatest interest, followed by Latin America.
Source: EPFR, JPMorgan, RockCreek Group

Bond traders doubting the Fed — should they?

Fed Chair Jerome Powell’s mantra has now become familiar. Yes, the economy is recovering. Yes, the vaccines seem to be winning the race against the virus — at least in the US. But no, unemployment is not yet low enough, nor inflation high enough to shift policy — or even to talk about shifting it. After last week’s recital of this mantra out of the FOMC meeting, bond markets initially seemed to agree with the Fed, with yields rallying from their pre-meeting highs. But by the end of the week, with strong economic data coming in on Thursday and Friday, bond prices dropped again. Markets are now back to pre-pandemic levels, but they surely have further to go — so traders should watch out. Powell has made clear that success for the Fed will mean higher inflation than we have had for many years — back in 2006, the Fed’s preferred measure of core PCE hit 2.6 percent, the highest since the early 1990s. In due course, tighter — more “normal” — monetary policy will be possible, as fiscal spending takes on the job of boosting economic growth, and likely needed to keep inflation anchored at the Fed’s 2 percent target. While the Fed waits to see inflation climb towards and then, for a “transitory” period, above its target, what should investors be watching for?

There is one key metric for when to worry about inflation taking off: a sustained wage push. Without a steady acceleration in wage inflation, it is hard to see how there could be widespread price inflation. So far, employers are reporting more difficulty in finding workers, especially for lower paid jobs. But average earnings are not yet rising sharply. Much-watched market measures of expectations also do not signal an untoward rise in prices; they are bullish on US real growth. 

There is a careful balance for the Fed to strike and Fed watchers to anticipate. The stated policy goals of both the central bank and the Administration include faster wage growth — at the expense of capital. President Biden wants corporations and wealthy stock owners to pay for his $6 trillion of planned spending — on relief for families, on infrastructure, on a stronger social safety net, with support for the less well-off in America. At the same time, the Fed does not want price increases to accelerate — that would take away the increase in real incomes that higher wages promise — nor the markets to implode as liquidity is withdrawn. 

Supply chain pressures are one channel that could push up prices: the Fed will be watching to see if price reaction is transitory or not. Investors are taking note of commodity shortages. Base metals first caught attention as forecasts for a strong rebound in global growth and speculation on large infrastructure investments spurred initial price rises in Q2 2020. Shortly after, low interest rates spurred homeowners forced to spend more time in their homes to push up lumber demand for renovation projects and new housing builds. This demand, coupled with low inventories at dealers and reduced sawmill capacity, continues to drive prices of lumber to all-time highs. 

Although nowhere near the price action of lumber, food prices have started to accelerate away from the pack. Corn closed the week at an eight-year high. Part of this recent price action is driven by strong demand from China. The USDA estimates that China’s imports of the grain will triple from its 2019-2020 level as the country continues to rebuild its swine herds, which were devastated by African swine fever in 2018-2019. China is also purchasing wheat and other commodities in large quantities.

Demand is not the only factor driving prices higher — the weather is also a culprit. Hot and dry weather in South America has hurt the corn crop there, while cold weather in the US has delayed planting. Aside from the weather, there is potentially a more structural issue of underplanting. According to USDA data, farmers intended to plant less than 1 percent more acres of corn in 2021. 

So, what does this shortage mean for investors? While stripped out of core CPI measures, the increase in food prices could affect consumers — albeit mildly. More interestingly, it should be a boon for farm incomes, which could spur capital investment in the years to come. The last major spike in the UN Food Price Index occurred in 2009 and 2010. This drove a sharp rise in farm incomes in 2010 and 2011 that coincided with a substantial increase in capital expenditures on equipment in the US. This could provide an opportunity for farm equipment manufacturers, particularly because the last major spending cycle occurred nine years ago, which is in line with general estimates of large farm equipment’s useful life.
Source: UN FAO, USDA and RockCreek Group
RockCreek Update
The RockCreek book club met this week to discuss Coffeeland: One Man’s Dark Empire and the Making of Our Favorite Drug by Augustine Sedgewick. Stay tuned for next month’s pick! 

Team RockCreek

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