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Quarterly Review Q1 2022 (JAN-MAR)

Key Points

  • Rate hikes will become more aggressive

  • Decoupling & onshoring based on ideology is going to be more receptive

  • Return on capital in Europe is going to be low for quite some time

  • China's population risk could be overemphasised

Rate Hikes

With the US Federal Reserve increasing the federal fund's rate target to 0.25%, we believe this will create an endowment effect where future rate hikes will become more aggressive unless the probability of recession starts to creep into the mainstream media. With US inflation figures averaging around 5%-7% even before the war in Ukraine, we do not believe a soft landing is possible. Instead, we believe the probability of a recession in the next few years is high. With a record amount of junk bonds that are positioned to be refinanced in the next three years, risk premiums will increase by multiples and defaults are to be expected. When economic growth stagnates around 2% (or even lower), the risk-to-return capital formula will no longer remain as generous as they were during the pandemic.

On the bright side, capital from overvalued bond markets will still need to seek an alternative besides cash. Some might opt for American equities, but they are just as pricy as some bonds. Great companies in Japan, South Korea and China could become more attractive destinations for institution capital. Undervalued, export-orientated companies based in these countries are potential investments that deserve significantly more capital allocation.

Decoupling and onshoring

Economic repercussions due to the conflict between Russia and Ukraine were clearly felt in the rise of oil + wheat futures. In the long-term onshoring of industries closely tied to what politicians prescribe as “national security” (e.g., semiconductors) could lead to suboptimal capital allocation and thus lower growth.

Globalisation is here to stay, but the magnitude could shrink for quite some time. Global supply chains have proven to be cost-efficient but are also quite vulnerable. Yet the fear of a complete reversal in globalisation is overdone. Shifting manufacturing back home would require heavy capital investments and would yield negative cost-saving benefits, without significant government support, it could not be done. Yet with all major developed economies running fiscal deficits, allocating significant resources to the corporate sector is highly unlikely.

Instead onshoring would be focused on industries that already focus on domestic manufacturing (e.g., semiconductor fabs). The return on capital could be debated, but since it won’t be as cost-effective as offshoring, the odds of a higher return are low. One distinction to also point out here is that instead of returning to the domestic market, companies would opt to expand in countries that are deemed to be in the same ideology camp. Thus, an American manufacturer of electric components might shift its production to Japan or Thailand. Yet even this wouldn’t be easy, China enjoys an absolute advantage in manufacturing as it dominates most of the processes involved in the production line. Capital allocation resulting from inferior political motives produce sunk costs paid by the average consumer.

Return on Capital in Europe

Pragmatism might be taking a backseat for some time in the EU decision-making process. Cutting off Russian energy, increasing military expenditure and acceptance of refugees are all going to hinder the fiscal balance sheet of European governments. A hidden issue here is that it’ll take a lot more convincing for Europe to dial back on these capital-intensive policies based on an emergency when their economic costs outstrip the moral benefits.

The conflict in Ukraine could at best last until the 9th of May (Victory Day), which contains high symbolism in both Russia and ex-Soviet countries. Yet to judge this as a fact would be naïve. The decoupling between Russia and Europe has already been scheduled to be a long-term process. Its reversal will be taking much more than the end of the conflict in Ukraine. Investors should also judge Europe’s bureaucratic process in approving infrastructure projects. For European firms, energy reliability will transition into a more variable cost factor, and depending on the sources of energy, weather futures could potentially be a much more logical business than once thought of. (Enron)

China’s population problem & work-skill mismatch

China has a long-term population, Crisis. China has a long-term unemployment Issue. Both have been frequent titles for media (opinion) outlets such as The Economist. The co-existence of these two topics is rather bizarre. One would ask, wouldn’t a lower population base contribute to lower unemployment? If so, one article must be wrong.

Looking at the data, China does not have a population crisis imagined by many western media outlets. With the end of the real estate boom, there will be another round of fresh labour that will enter the low-mid end of manufacturing. Despite the recent regulatory crackdowns, online retail regains on a growth trajectory and the demand for retail workers will descend in a similar matter as witnessed in the US.

The current unemployment rate could act as a buffer between a decreasing population and a less productive workforce. Another thing to consider is the actual retirement rate. China currently has the retirement age set at 50 for women and 60 for men. This should result in a sizable retirement population, but no data could be found on the actual percentage of people that do retire. From raw observations, we cannot reject the notion that a significant number of retirees continue on working both full-time or part-time as the present pension payments cannot satisfy all of life’s needs.

Signs of prolonging China’s retirement age have already been placed on the schedule. With that in mind, for investors, this so-called “population crisis” could prove to be rather insignificant. A core principle for investing is to allocate capital to the more efficient corporate entity. Output per worker is more important than the company’s total output. For companies that aim for a global customer base and maximise their worker’s output, a marginally smaller working population wouldn’t rock the boat.


Sub-optimal capital allocation. China’s economic conditions will remain bleak in the near future. Private capital is seeking extra risk premiums and not enough public capital is being injected into a regulation-haunted market economy. Potential areas of capital deployment are focused on consumables that enjoy low price elasticity. Most of which are priced too generously at this moment for us to even consider entering. Luxury goods that act as alternative storages of wealth could also be an area of consideration. With both Chinese monetary and fiscal authorities determined to lower the purchasing power of the RMB (we estimate by about 10%), a sizable group of consumers would opt-in for more stable sources of wealth storage.

China’s 5.5% GDP will be met, but sustainable growth could be very hard to foster. Overall, strategic caution for this year could only benefit the value investor.

ACH Insights

08 APR 2022


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