The pivotal fight between China and the US is over the microchip

Michael Collins, Investment Specialist, Magellan Asset Management

January 2021

Teaser: The campaign for dominance in semiconductors could hurt both countries.

Japan's Kioxia Holdings, which in the early 1980s invented flash memory computer chips, was set for one of the country's biggest initial public offers for 2020.  In September, however, the semiconductor maker reduced the asking price of its offer by 25%. Days later, the company postponed indefinitely a float that was initially set to value the company at US$16 billion. Kioxia's CEO blamed the IPO suspension on "market volatility and ongoing concerns about a second wave of the pandemic". Given that at the time the Nikkei 225 Index was close to its highest in three decades, that explanation didn't wash.

Everyone knew why Kioxia halted its IPO. Anonymously sourced media reports had warned Kioxia would abandon its float because China-US tensions were reducing the company's profitability. Of note for Kioxia's fortunes, the US in August decreed that non-US companies would need Washington's permission to sell microchips made using US technology to Chinese telco Huawei Technologies and its affiliates. The talk was that Washington's restrictions on Huawei would cost Kioxia sales and lead to a global glut and thus lower prices for flash-memory products.

The US restrictions on Huawei sting because China makes less-advanced microchips and relies on more-advanced US supplies. China is aware its inferior chipmakers make the country vulnerable amid the 'decoupling' between China and the US that is centred on technology. Beijing thus intends to become the best and self-sufficient in the pivotal microchip industry that is worth more than US$420 billion a year in global revenue, where half the sales are to Chinese firms.

Microchips form the key battleground in the rivalry between Beijing and Washington because the integrated circuit - a piece of silicon that contains nanoscopic electronic circuits - ranks with the internal combustion engine and electricity as an invention of consequence for everyday life. The integrated circuits pioneered in 1958 by Jack Kilby at Texas Instruments when the US military was seeking a lightweight computer for the Minuteman missile's guidance system underpin so many essentials to modern life it can be said that we are in the microchip age.

As Beijing and Washington see it, the country with the best 'brains of computers' will dominate biotech, business, cyberwarfare, economic, military and other fields. Both will mobilise vast financial and political resources to ensure their microelectronics industry is the world's best - and China is behind in production facilities and technical know-how in this US-private-sector-dominated industry, even if most microchips are made in US-allied countries such as Taiwan and South Korea.

A microchip industry split on Sino-US lines decades after the industry established global production networks, however, will come with costs and risks for both countries and the world. For US and allied companies, lost sales to China, reduced economies of scale and lower prices mean reduced profits, less research and fewer advances in chip technology. The risk for the US is that the country will lose its commercial and military edge in chips that are heading into their third generation of semiconductor materials.

China's decision to elevate microchip self-sufficiency and excellence to a national priority means that billions of dollars are destined to be spent to ensure China has the best semiconductors. The cost of this, in theory at least, is that resources are being diverted from elsewhere. Chinese businesses and consumers could face higher-priced chips than otherwise and these might still be inferior to foreign peers (just like Australia's protected car industry meant higher prices for vehicles). The overarching risk for China is that in pursuing self-sufficiency Beijing is turning towards protectionism and government direction as an economic development model. 

For the world, the cost of the microchip wars could entail slowed advances in almost every field, which spells opportunities and wealth forgone. Increased tensions between the world's biggest powers over this tiny technology could change the global balance of power and might turn their rivalry into hostility, perhaps over Taiwan, the world's biggest source of made-to-order chips. China, the US and the world would be better off if the microchip wars was toned down.

The competition over microchips could, of course, lead to advancements that help the world. The battle over chips has been simmering for a while - Beijing, for instance, stymied Qualcomm's bid for NXP Semiconductors in 2018 for security reasons - with little harm done seemingly. The US is granting exceptions to its microchip bans to Huawei's smartphone business, so maybe the chip wars will be a phony confrontation. Chinese companies are said to be sitting on vast stockpiles of US production inventories so the sting of the US actions might be delayed and Sino-US rivalry might settle down. If the chip war were protracted and heated, the costs of the contest could be mostly hidden for society at large. Few people would be able to quantify lost advancements, reduced capabilities, higher costs than otherwise, lower speeds than otherwise and unknown alternatives forgone. So why worry?

Because regions vying for self-sufficiency in semiconductors is a recipe for disrupting the global microchip industry at a time when ageing and depopulating western societies with debt-ridden economies need all the productivity boosts they can get. And the global political ramifications would be vast if China were to overtake the US in semiconductors, given the associated changeover in global power.

Autarky in tech by 2035?

The Chinese Communist Party in October held the 5th plenary session, or annual convention, of the 19th Communist Party Central Committee, which, along with the National Congress that appoints the committee, is one of the party's two highest decision-making bodies. The key job of the plenary session was to devise the 14th Five Year Plan (2021-2025). At the end of the session, the party issued a communiqué that unexpectedly in the title included the words "and 2035 long-term goals".

The release said the party had bought forward by 14 years to 2035 the goal for China to become a rich country radiating "scientific and technological strength". (Deng Xiaoping, the leader who launched China's reforms from 1978, had previously set 2050 as the year when China would achieve "socialist modernisation", Beijing's term for parity with the US.) The plenum release said that by 2027 the country would achieve its goal of having a modern military by "strengthening the army with science and technology" by optimising "the layout of the national defence science and technology industry". To help achieve economic and military goals, the party elevated to a "strategic support" self-reliance in technology, which implicitly prioritises excellence in microchip production as a national goal under China's new 'dual circulation' economic model. This is the term for Beijing's policy of self-sufficiency in critical industries such as technology and energy that has seen it set aside an estimated US$1.4 trillion for tech by 2025.

China has much to achieve in microchip expertise if it wants to surpass the US in semiconductors on this timetable. The US restrictions on Huawei, especially the curbs in May that stopped the Chinese company receiving supplies from Taiwan Semiconductor Manufacturing Company or TSMC, the world's largest chipmaker, exposed the hollowness of China's 2015-launched 'Made in China 2025' plan to dominate in future technology spheres such as artificial intelligence, biotech, driverless vehicles, fifth-generation telecommunications, quantum computing and more (and in some areas, especially 5G telecoms, China is already a leader). Without excellence in semiconductors, first marked as a Chinese priority in 2014 when Beijing set up a US$150 billion investment fund focused on chips under what was known as the Guidelines to Promote the National Integrated Circuit Industry, the wider goals are hard to achieve.

Irking also for China's leaders is that much of China's supply of world-class semiconductors comes from what Beijing considers to be its rogue province of Taiwan - that's where headed the losing Nationalist side in the civil war that bought the Communists to power in 1949. TSMC, the world's best at making sophisticated chips, must heed the US restrictions because it relies on manufacturing equipment that contains US technology and the US is the largest destination of TSMC's exports. China's other major sources of memory chips are South Korea's Samsung and SK Hynix and Micron of the US. Chip products from these companies can be easily blocked by Washington too.

Thus Beijing is seeking self-sufficiency. China has already invested billions of dollars to boost chip production and can boast gains. From virtually no production in the late 1990s, China produces about 15% of the world's chips now and that number could treble within five years. Semiconductor Manufacturing International Corp, China's biggest contract chipmaker usually known by its initials SMIC, and Yangtze Memory Technologies, China's first 3D NAND flash memory maker, are among Chinese companies setting goals to use local and non-US equipment in production to circumvent US restrictions. Alibaba and Baidu are investing in microchips while Huawei plans to build a microchip production plant in Shanghai. Government subsidies are reportedly encouraging many more Chinese companies to enter the industry.

But there are questions over the sophistication of Chinese microchips (though not the quantity it is capable of making). US companies dominate the software that designs the most advanced chips such as sub-10 nanometre chips. US companies Applied Materials and Lam Research and ASML of Europe and Japan's Tokyo Electron dominate the production (fabrication) process for advanced semiconductors. Through these companies, the US government can control which allied countries have access to the cutting-edge technology used to design and lay out chip circuitry. It is a formidable task for China to overcome its shortfall in intellectual property but not an impossible one.  One help for China is that the petering out of the corollary to Moore's Law - that chip capabilities increase due to a doubling in the number of transistors per chip every two years - might mean the gap to the US edge is shrinking.

China's pledge to get better at making microchips could lead to advances that help society and the wider world. But the billions, even trillions, of dollars to be invested in an invention already more than 60 years old is only likely to lead to incremental improvements rather than breakthroughs. The money to be spent will come with 'opportunity cost', a term that economists use to describe the alternatives foregone. Sums to be spent on microchip development are amounts diverted from elsewhere.

Some warn that China is reversing the opening up to the world that led to its industrialisation, an about-turn that could backfire in terms of the country's advancement. Even if China were to gain an edge over the US in chips, that feat would likely only provoke greater tensions with the US and its allies.

US leadership under threat

Perhaps the start of the microchip wars dates to 2017 when one of the last acts of the administration of US President Barack Obama was to unveil a strategy to secure US supremacy over semiconductors in regard to China. Congress during the administration of Donald Trump built on that proposal with legislation such as the CHIPS for America Act of 2020 and the American Foundries Act of 2020 that offered tax breaks and grants respectively to bring the microelectronics industry back to the US. Other developments of note include Washington's ever-expanding trade blacklist that specifies restrictions on Chinese organisations for aiding certain Chinese government policies. Companies ensnared include Huawei, Chinese telco ZTE in 2018 and SMIC in October last year. Other events in the chip wars extend to the US blocking the supply of sophisticated manufacturing equipment to China such as when in 2019 the Netherlands government decided not to renew the export licence for ASML's extreme ultraviolet scanner to SMIC. More still include blocked takeovers such as Washington's refusal to allow Singapore company Broadcom to buy Qualcomm in 2018 due to fears of loss of control of intellectual property. Such decisions come with costs for the US side, most obviously in lost sales for US companies. An overarching danger for the US is that the strategy backfires by costing it leadership in semiconductors.

Boston Consulting Group, which estimates the US market share in chips at 45% to 50% in 2018, says US leadership is grounded in a virtuous innovation cycle. The pivotal advantage of the US is that access to global markets has allowed US chipmakers to achieve the economies of scale needed to fund huge investment in chip research and development that has consistently advanced US technology ahead of global competitors (at least until recently).

Boston Consulting reckons that China's semiconductor industry (not including the manufacturing facilities built by foreign semiconductor companies in China) covers only 14% of its domestic demand. It estimates the Made-in-China-2025 plan could increase China's semiconductor self-sufficiency to about 25% to 40% by 2025, which would reduce the US's semiconductor share globally by two to five percentage points from 2018 levels.

Every time Washington broadens restrictions on Chinese access to US technology, US market share loss deepens. The consultancy warns that US companies could lose 18 percentage points of global market share and 37% of their revenues from 2018 levels if the US completely bans semiconductor companies from selling to Chinese customers. Plunging revenue would force US microchip makers to slash research and investment, thereby reversing the US industry's virtuous innovation cycle. "As a result, South Korea would likely overtake the US as the world semiconductor leader in a few years; China could attain leadership in the long term," the consultancy warned.

It would be a different world if China were the global leader in advanced semiconductors. And, as the experience of Japan's Kioxia shows, it could be a lesser world as China and the US fight to dominate a world defined in nanometres.

Making Sense of Nonsense

Robert Swift, Delft Partners

February 2021

If something is too hard or whacky then there is a tendency to ignore it and hope it goes away. The recent bizarre price moves in GameStop and AMC and other 'marginally solvent' companies is just such a case in point. However, 'hope' is not a strategy and it can pay to rummage in the information cellar where you might find something useful / or learn a lesson? So we'll have a stab at making sense of what looks like nonsense. We might come to a useful conclusion?

Briefly what has happened is that certain financially and strategically challenged companies have seen their share prices rise suddenly and dramatically to levels way beyond rational. (Isn't the whole market irrationally priced? Ed.) This has caused large losses by funds which had short positions in these companies.

It is not unusual for short positions to go wrong. We have run hedge funds and can testify that while we were careful to hedge our shorts with longs as best we could using risk models and a great deal of pragmatism and modesty, we still occasionally got 'whacked' by a short going against us with a wild and what seemed like unexplainable lurch upwards.   

Three aspects strike us as being noteworthy here in this recent spate of irrationality.

1. Short positions are potentially unlimited in their loss making. Consequently short positions should be hedged by long positions in risk equivalent factors, and constantly trimmed or fed. As we observe them, in many 'hedge' funds, there is no hedge; nor is position sizing as a % of client capital prudent.

For what it's worth we had more but smaller positions on the short side because they tended to be more volatile and more correlated. Additionally we shied away from remaining short a very small market capitalisation because bankruptcy meant that we couldn't buy back our short position since trading tended to get suspended, and that at that point the specialists in business reconstruction got involved and would know more than we did. Remember that at one point GameStop was trading at about $3 and as such had a market capitalisation of about $200m. What was the point of being short that if the market cap was shouting 'imminent bankruptcy'?

We don't know enough about the hedge funds that got whacked but guess that a loss of that magnitude meant a pretty large $ position as a % of client capital and trying to pick up pennies in front of the steam roller- when suddenly the steam roller sped up.

This stuff is so self-evident we will write no more on this.

MUCH more interesting is the fact that:

2. The short positions were very heavily advertised &
3. The buyers were also working to advertise their actions to the market

So we think the broader issue here is 'market manipulation' - on both sides of the ledger. It has been represented as "nasty evil hedge funds" aka the establishment vs brave individuals working together to earn a crust. Yet aren't both sides aiming to profit as 'consenting adults' with loud voices in a liquid market which has been increasingly heavily regulated and supervised?

Has the pursuit of profit entailed market manipulation (which is illegal) and if so, how is this alleged manipulation by the buyers of GameStop so different from what routinely happens?

Movies have been made - Boiler Room's pump & dump, Wolf of Wall Street, for example - about market manipulation and fraud. Research companies routinely make pronouncements about how company X is using fraudulent accounting and that they expect bankruptcy - all the while with a short position or being paid for their research by funds with a short position.

If investors work the other side 'in concert' to drive up a company's share price in the knowledge that short covering will kick in, is this not the same?

So which bit if either, is illegal? Which bit is just "business"?

Additionally one may argue that if I'm the CEO and I make some comments in an analyst call, abiding by Reg FD, I can move the stock. If I benefit from that too obviously, I go to jail. But if I buy back the company's stock it has the same effect. That's not illegal. Although I still benefit.

There are however rules on buy backs but not on short selling research, nor on trading to squeeze the shorts. The difference here then perhaps is that it is NOT the company which is disseminating the news but market participants trading against each other. So we have to ask whether this is to be discouraged by more regulation on the basis that it is damaging to the economy or dangerous for individuals who need to be prevented from self-harm.

We hope not. We are (naïvely?) convinced that stock market prices contain information; when 1 stock goes up, we think that is because fundamentals have improved, or the company's outlook has or something macro has changed that affects the company. Aside from GameStop, we've seen Softbank allegedly deliberately manipulate the market very recently. If you believe fundamentals will reassert themselves then you use this irrationality as part of your process. Run-ups in stocks trigger momentum models which should be part of any risk model menu. Serial correlation leads to understatement of volatility and portfolio managers assuming too much risk complacently. So portfolio managers should incorporate the risks in price momentum and serial correlation in their portfolio construction.

For the retail crowd, this just calls into question the wisdom of following ponderings spilled daily by people like Jim Cramer about XYZ stock being up 20% or biggest gains/losses of the day. If there's no information content/price discovery in the stock market and price moves can be ruinous, that should force us all back to fundamentals, which then becomes an opportunity to talk about how out of date our accounting statements are versus modern business and the difficulty of pricing intangibles. We recall in the mad Asian frenzy of the early 1990's how stock splits would cause a frenzied buying on the KL exchange by retail investors because "you got more shares for your Ringgit" as was explained to us. We also saw this behaviour in China almost two decades ago when the market was dominated by retail traders chasing news. To the best of our knowledge the Chinese did not change much at all but let losses fall where they did. The US should be capable of letting this outcome befall all investors - retail and professional.

Funnily enough we professionals DO already live with and utilise a lot of irrationality such as the January effect, price momentum as a strategy, and the so called Santa Claus effect. We actually rely on it since our investing strategies incorporate other people's irrationality! So simply put we should seek more news flow since news flow reduces information hoarding.  

Our conclusion in this specific US example is this. If you can't bear losses, don't play - either as a retail investor or as a professional. Retail may be sneered at as 'stupid' (unorthodox) but they too have a right to play?

It's more worrying to us that this strange turn of events is symptomatic of a broader malaise? This behaviour is symptomatic of a late stage capital markets circus with a belief in perpetually free money and a free get out of jail/trouble card always at hand. There's plenty of froth around, as evidenced by the listing of over 272 SPAC (Special Purpose Acquisition Companies) which have raised US$88 billion since August 2018... of which 193 with $63 billion are still searching for a target... and with 219 raising US$73 billion in 2020 alone. 1929 anyone?

Fake news and 'crowd think' isn't confined to "Freddy Starr ate my Hamster" nor that "Elvis Presley is living on the moon" but now permeates the stock market too and continually fed by poor monetary policy.

It is absolutely crucial that we prevent moral hazard permeating more deeply into the financial system. It's not more regulation we need here, it's "more consequences" and an acceptance that there should be no free put option.

We'll finish with a quotation from JM Keynes writing in the 1930's after the crash. It's not Reddit nor GameStop nor AMC we should be blaming, but what has led us to this systemic speculation?

"Speculators may do no harm as bubbles on a steady stream of enterprise," he wrote. "But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

If you want more thoughtful pieces on the rigged casino that has been created by years of policy ineptitude, then we can happily supply you with William White's latest thoughts.

Why Inflation Might Return and Why You Need to Worry About It

Steve Johnson, Forager Funds Management

14 January 2021

Extraordinary. It is an overused word. It's also an odd word, to me at least. Why does something that is unusual or infrequent have an extra amount of ordinary? Anyway, we can safely use it to describe 2020 without being accused of hyperbole. Travel plans, living arrangements, schooling, workplaces and shopping were thrown into turmoil by a virus that spread around the world, caused governments to lock citizens in their homes and killed almost two million people. For those of us in financial markets, the March crash will sit alongside the 2008 Lehman-induced meltdown as a placemark in our careers.

At Forager, it was an especially extraordinary year. The Forager International Shares Fund returned positive 38.3% for the year. In absolute terms, that is an outlier. Relative to the MSCI AC World Net Index in $A, which returned 5.8%, it is the sort of result you hope for once every couple of decades.

The Forager Australian Shares Fund's 21.6% return is less of an outlier - you could argue it was overdue given the underperformance of the prior two years - but it was extraordinary nonetheless. That 21.6% encompasses a fall of 54% between 1 January and 23 March, followed by a 166% rise between that nadir and 31 December.

You should expect us to perform well in volatile markets. But the magnitude of the performance is particularly pleasing. My thanks go out to the entire Forager team for their outstanding work in a difficult year and our loyal Forager clients, who allow us to do our jobs in dysfunctional markets.

The game that never stops

One thing I like about marathon running is the well defined end-point. You train hard for a few months, eat well, dial it back for a week and then it's race day. Once the finish line is behind you, it's time for a cold beverage, a few weeks of rest and all the pies you can eat.

Running an investment portfolio in a year like 2020 is nothing like running a marathon. There is no finish line. Like a two year old child, it needs to be fed and monitored every single day. And the better your returns, the faster markets are moving, the more monitoring and feeding it needs.

If 2020 proved anything, it was that predicting the future is extremely difficult, if not futile. Look no further than my February blog Corona no virus for global stocks, two weeks before a market meltdown. That also shows that prognostications are not a prerequisite for above average returns.

When anything can happen, nothing is a surprise

We didn't predict the market bottom in 2020. We didn't anticipate the fastest bear market recovery on record. We simply tried to construct the best portfolios we could with the opportunities that were in front of us. We recognised that the best opportunities on the 23rd of March were very different from those on the first of January, and made quite dramatic changes to both portfolios.

In fact, writing a blog that looked foolish in hindsight was probably a blessing in disguise. It served as a timely reminder that great investment returns come from finding great investment opportunities. While many of those who predicted a market meltdown were wasting their time trying to identify the bottom, we were out there looking for stocks to buy.

We will take the same approach in 2021. Start with the view that anything could happen, and we won't be surprised.

A monetary epoch?

One thing that could happen, that most people think won't, is that we look back on 2020 as more than just a market crash. It may be seen as the end of an era.

Will inflation return? That was the question on the cover of the December 12 edition of The Economist. The answer will define the next decade, perhaps two, of returns on almost every asset class.

In September 1981, the 30-year US government bond was yielding 15% for an investor who held it to maturity. In the early 1990s, my parents were still paying interest rates of 18% on their mortgage. Today's yield on a 30-year US bond is less than 2%. A mortgage loan in Australia can cost you less than that.

For the past three decades, interest rates have inexorably fallen alongside inflation expectations. Today, central bankers are far more concerned about inflation never coming back than it ever getting out of control again. Investors are using low long-term interest rates, based on a lack of inflation concerns, to justify sky- high prices for property, infrastructure assets and Tesla shares.

There are theories, from ageing populations to technological improvements and low cost labour substitution, that explain low inflation or even deflation as a permanent feature of the developed world. I don't have a strong view that those theories are wrong. But I know that when the whole market thinks something can't possibly happen, the consequences of that assumption being wrong are significant.

Why might inflation return?

Some investors and economists - particularly of the pessimistic kind - have been predicting the return of inflation ever since the financial crisis of 2008/9. It hasn't happened, the argument goes, and therefore it won't.

Throughout the past decade, monetary policy was extremely accommodative. But it didn't have much help. The private sector - including consumers and banks - spent most of the decade in balance sheet repair mode. Fiscal policy wasn't helping, as politicians caved to austerity demands every time their economies started to recover. Just like the recovery from the Great

Depression of the early 1930s, this recovery was mired in fits and starts. This pandemic-induced crisis might be more akin to a war than a financial crisis, though. By the end of 2021, all three components will be surging in the same direction. Morgan Stanley estimates the four largest economies will expand central bank balance sheets by some 38% of GDP in 2020, almost four times the amount of purchases following the financial crisis.

And the same G4 economies will be running the largest fiscal deficits since the second world war at the same time. The US government deficit is expected to be 14.9% of GDP in 2020 and remain at 9% of GDP in 2021. Despite all of the bailouts in 2009, the US government deficit never exceeded 10% of GDP.

Perhaps most surprisingly, consumers around the world are in rude health. Unemployment has not risen as much as expected, and the large stimulus programs and a lack of things to spend their money on means consumers are flush with cash (see chart below). The lockdowns have hit a small percentage of the population hard but, as a whole, the savings rate in Australia soared to more than 20% of disposable income, a level unprecedented in RBA records.

Three-pronged inflation push

The aggregate picture is one of substantial pent up demand meeting more monetary and fiscal stimulus in late 2021 and into the following years. Perhaps we look back on this period as the monetary equivalent of the Second World War, one giant stimulus program that finally brought the economy to life.

Nonagenarian investor Charlie Munger once said "knowing what you don't know is more useful than being brilliant." Some of the brightest economics minds in the world have a patchy track record when it comes to macroeconomic forecasts. Perhaps demographics and technology do mean we never see inflation again. But the world is about to test the theory. And we won't be buying anything that assumes higher interest rates can't possibly happen.

LIGHT AT THE END OF THE TUNNEL - BUT WE'RE STILL IN THE TUNNEL

Marcel von Pfyffer, Arminius Capital

20 January 2021

• Coronavirus vaccines will help us return to normal, but there will be risks, obstacles, and delays through 2021.

• 2021 will bring a W-shaped recovery in the economy and the share market: two steps forward, one step back.

• The Australian dollar is headed toward USD 90c much faster than we expected.

After the grim events of 2020, the November news of three coronavirus vaccines set off a surge of investor optimism about the future. But the existence of coronavirus vaccines does not guarantee that life will automatically return to normal in the near future. For Australia and the world, there are many hazards to be avoided or overcome before we can find our way out of the dark tunnel of the pandemic.

First, there are the logistical complexities of distributing the vaccines throughout the world at very cold temperatures, followed by the administrative challenges of administering them to millions of people. In developed countries like Australia, the public health system will accomplish this task quickly and without difficulty. In poor countries with weaker healthcare systems, the task will be much slower and harder.

We should not underestimate the size of vaccine wary members of the population. Recent polls indicate that more than 40% of US citizens are unwilling to get vaccinated at present, and even in Australia a quarter of survey respondents have expressed reservations. These numbers are important because - depending on the complex epidemiological assumptions and calculations - herd immunity may only be achievable if 80% of the population is vaccinated. The US has a history of being very slow to adopt public health measures, and the failures of the initial US response to the 2020 pandemic raises doubts about the speed, breadth, and adequacy of the US vaccination program. Globally, the recent double-digit deaths of people who had just been vaccinated has not helped the smooth marketing plan that the drug companies' PR machines were probably hoping for.

Then there are the potential problems with the vaccines themselves. Although the clinical trials have been rigorous, they have not been large enough or long enough to remove all uncertainties about the vaccines. Therefore, as is obligatory with all newly approved drugs, the public health authorities in each country will track what happens to those who have been vaccinated. Clinical experience with new vaccines over the last century points to eight important risk areas:

• Manufacturing quality must be carefully monitored. In 1955, more than 200,000 children in five US States received a defective polio vaccine from bad batches manufactured by Cutter Laboratories. This mistake caused 40,000 cases of polio and 10 deaths.

• One or more of the vaccines may generate problematic side-effects in some classes of people. Minor allergic responses to vaccines and vaccine components are common, but none of the three vaccines triggered a pattern of serious adverse events during clinical trials. It should be borne in mind, however, that each of the Phase III trials only covered 40,000 to 50,000 volunteers. Administering the vaccines to billions of people expands the sample size by a factor of nearly one million, so there may be some surprises.

• Because of the timeline acceleration caused by "Operation Warp Speed", clinical tracking of the volunteers in the trials is less than three months so far. It is not unknown for new drugs to demonstrate negative side-effects in the longer term. For example, in September 2004 Merck voluntarily withdrew its osteoarthritis drug Vioxx (Rofecoxib) from the market, because evidence had built up since the drug's 1999 approval that it was associated with increased risk of stroke and heart attack.

• Because of the short follow-up period, it is not yet clear how long COVID-19 immunity lasts after vaccination.

• For safety reasons, children, the immunocompromised, and women who are pregnant or breast-feeding were excluded from the clinical trials, so we know little about the effects of vaccination on people in these classes.

• Vaccines are often less effective in the elderly because their immune systems no longer function as well as they used to. The complex and lasting symptoms observed in many cases of COVID-19 suggest that vaccination may not provide complete or durable immunity.

• Although the vaccines reduce or prevent COVID-19, we do not yet know how effective they are at preventing disease transmission to other people. If they do not prevent transmission, herd immunity will take longer to achieve.

• The normal mutation processes of the coronavirus may make some vaccines less effective.

Any setbacks in the global vaccination program would cause temporary damage to investor sentiment. In the longer term, other more effective vaccines will be developed - there are currently 18 candidates in Phase III trials. In the short term, travel and tourism stocks, as the sectors worst affected by COVID-19, would give up much of their recent gains.

For these reasons, we continue to expect a W-shaped recovery in the Australian economy and share market. We forecast this sort of recovery back in June, when it became obvious that COVID-19 would have recurrent outbreaks until herd immunity was achieved. The subsequent outbreaks in Melbourne and Sydney have confirmed our forecast. The additional possibility of setbacks in the vaccine rollout reinforces our belief that two steps forward will often be followed by one step backward.

For Australian investors, we recommend riding the Australian market up, buying the dips but avoiding risky sectors. Over the next six months, economic recovery will propel the Australian share market upward even if there are minor corrections. In the second half of 2021, however, the risks will increase as any vaccine problems emerge. In addition, the Australian government needs to find its way to a truce, if not a peace treaty, in the trade war with China.

While the broad market will keep rising in the long term, some sectors will become over-priced as optimism outruns reality. As noted above, the longer herd immunity is delayed, the longer it will take the tourism and travel sectors to return to profitability. Speculative stocks, e.g. in fintech, mining, and biotech, have floated upward on a tide of stimulus money, and the withdrawal of stimulus payments means that the tide will go out and leave many investors stranded.

Back in June, we forecast that the Australian dollar (AUD) would rise against the US dollar (USD) over the next three years, reaching at least USD 84 cents and possibly USD 90 cents. Since then, our prediction has been coming true faster than we expected. The AUD has risen 11% against the USD since end-June, and it could rise another 10% to 20% within twelve months, thanks to the US mishandling of the pandemic, debt-funded multi-trillion dollar stimulus packages en route in 2021 and the ongoing dysfunctionality of US politics.

GameStop

Michael Frazis, Frazis Capital Partners

31 January 2021

Well, that was one of the more engaging weeks in finance I can remember!

I recorded some views on iTunes and Spotify. Slightly new format so please have a listen and let me know what you think.

Here is one of the original posts on r/wallstbets outlining the case before the stock went up over 100x. 

This story had everything, including the juicy villains of SAC/Point72 (caught multiple times for insider trading), Citadel and Robinhood.

Robinhood marketed themselves as by the people/for the people, while cynically selling their order flow to Citadel for the express purpose of front-running their own clients. Robinhood indeed.

They largely got away with this, but will never by the same after they halted purchases of heavily shorted stocks last week, severely harming their users who were net buyers. 

It's uncertain whether this was due to pressure from their real client Citadel, or whether they were simply running out of cash, which given the emergency cap raises late last week, is almost certainly true. As politicians from all sides are sensing opportunity in the moment we may well find out. 

There are also some new heroes, specifically the hive mind of reddit. There are 7 million people on r/wallstreetbets. If they have $5k each, that's $35 billion of dry powder. That's more than enough to push around a heavily shorted stock.
 
We've noted before that when bearish investment professionals heavily short a widely loved company, the love tends to win out. This has happened time and again across our portfolio with Tesla, Afterpay and Carvana et al. The r/wallstbets crowd was generally very bullish in 2020, again forming an opposing view (and position) to the 'smart' money. We know how that played out. 

We were observers the Gamestop saga, rather than participants, but before you ask, January went OK. The rotations that ripped through the long/short community were largely neutral, though whether the short losses trigger a market sell-off remains to be seen.

The long term consequences are profound. Long/short funds may never be the same. Certainly, institutions should think twice about allocating pension money to long/short funds that:
- did not perform in the crisis of 2020, and
- can toast billions of dollars in days with a single misjudged trade. 

It's a familiar irony that long/short strategies sound like sensible risk-managed approaches, but so often prove the opposite. 

This is all very positive for cryptocurrency: people will long remember the manipulative moves of Citadel and Robinhood. 

One final point: it's important thing to remember that all short squeezes end in the same way: a collapse in price. Once the forced buyer folds at the top, there is no reason for anyone else to buy. Best keep that in mind.

Having said that, this may not be over. The memes and use of language over the past week has been second to none. In fine form comes the phrase: 'is the squeeze squoze?' 

According to the website, with Gamestop short interest still at over 100% by some measures, the squeeze has not, in fact, yet been squozed.

Michael

Disclaimer

The information in this note has been prepared and issued by Frazis Capital Partners Pty Ltd ABN 16 625 521 986 as a corporate authorised representative (CAR No. 1263393) of Frazis Capital Management Pty Ltd ABN 91 638 965 910 AFSL 521445. The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.

The information provided is for general information purposes only, and does not take into account the personal circumstances or needs of investors. The Company and its directors or employees or associates will use their endeavours to ensure that the information is accurate as at the time of its publication.  Notwithstanding this, the Company excludes any representation or warranty as to the accuracy, reliability, or completeness of the information contained on the company website and published documents.​

The past results of the Company's investment strategy do not necessarily guarantee the future performance or profitability of any investment strategies devised or suggested by the Company.​

The Company, and its directors or employees or associates, do not guarantee the performance of any financial product or investment decision made in reliance of any material in this document. The Company does not accept any loss or liability which may be suffered by a reader of this document.

This webinar from Collins St Asset Management was recorded on 9 December 2020.

During this half hour webinar Michael Goldberg (Managing Director & Portfolio Manager) and Rob Hay (Head of Distribution & Investor Relations) will share:

- Their contrarian insights into the Australian economy for CY2021;

- Why backing the infrastructure thematic requires a flexible and 'non-consensus' mindset; and

- Their top 3 stock picks for playing in the infrastructure space over the next 12 - 18 months.

Regulation, Rates and Inflation - Risks to Watch in 2021?

Andrew Clifford, Chief Investment Officer, Platinum Asset Management

5 January 2021

While stock markets continued their strong run over the last quarter, from early November it was notable that many companies with economically sensitive (cyclical) businesses experienced strong stock price performance. Similarly, there were strong price moves across a broad range of commodities (particularly iron ore and copper) over this same period.

These moves in markets are consistent with investors pricing in continuing improvement in the global economic outlook for the year ahead. The commencement of these stock and commodity price moves aligned with the US election and the announcement of successful COVID-19 vaccine trials.

While the high-flying growth stocks continued to perform well, the continued economic recovery potentially poses a threat via higher inflation and interest rates. Similarly, the 'anti-monopoly' movement is gaining momentum, not only in the US and Europe, but also in China, which represents a potential risk to the business models of many of the popular growth names. It is certainly too early to make such bold predictions about either interest rates or changes in regulatory regimes, but the unfolding of events over recent weeks lead us to restate our conclusion from last quarter that: We believe extreme caution is warranted in regards to the market's current 'high flyers', while opportunities abound elsewhere.

The election of Joe Biden as the next US President is likely to reduce the uncertainty around the US-China relationship generally and trade and tariffs in particular. While the complaints around China's behaviour on various fronts, from the South China Sea to unfair trade practices, had strong bipartisan support in Washington and within the US government, it appeals to us that President-elect Biden is a far more conventional politician than his predecessor. As such, we would expect a more traditional negotiated approach to the various issues rather than random decrees issued via Twitter.

Such a considered approach is likely to recognise the deep interdependence of the US and China economies, especially in industries such as semiconductors and electronics, where neither side can operate without the other in the medium term. From a political point of view, we acknowledge that it would be difficult for President-elect Biden to outright reverse the bans on Huawei or lift recent sanctions on Chinese companies linked to the People's Liberation Army (PLA), potentially these measures can be quietly diluted over time. However, even if they stand, a more reasoned approach to trade and tariffs is likely. The importance of this, is the certainty that it brings both to businesses in making long-term investment decisions and for investors in assessing the long-term potential of companies.

At the time of writing, the Georgia Senate run-off elections were about to take place. Success in both seats would result in Democrats having effective control of the Senate and the potential for Biden's policies on infrastructure spending (including green initiatives), expansion of the Affordable Care Act (designed to provide affordable health insurance coverage for all Americans), funded by a reversal of some of Trump's tax cuts, to be put into place. Whether this result unfolds (the polls and betting markets suggest a very tight race), it is highly likely that substantial ongoing fiscal stimulus will occur. In the final days of 2020, the US Congress passed a stimulus bill valued at US$900 billion, or 4.4% of GDP. By any standard this is a significant fiscal spend, particularly when considered in light of the previous US$2 trillion of stimulus that is still flowing through the system and an economy that by all measures is recovering very quickly.¹

The news of successful COVID-19 vaccine trials and subsequent regulatory approvals reduces uncertainty on the pathway out of the pandemic. The day-to-day news regarding new COVID-related lockdowns in Europe (as well as locally), together with rising infections in the US make for sombre reading. However, the beginning of vaccination programs in the US and Europe offer a very clear light at the end of the tunnel. While there remain unanswered questions around the longevity of the immune response, new variants of the virus are developing, and there are significant logistical issues in dealing with the vast numbers involved, it is highly likely that substantial portions of the US and European populations will be immunised by the end of 2021. China has also approved a locally developed vaccine for use in the general population, which is likely to be used broadly in the developing world. It should also be noted that there are numerous other vaccines in late stages of development and through time, individual vaccines will be refined in response to outcomes of current programs.

While we have been of the view that the development of an effective vaccine was highly likely (as discussed by our portfolio manager and resident virologist, Dr Bianca Ogden in the article "COVID-19: Demystifying this Frightening Disease"), the start of the vaccination programs significantly reduces the risk of shutdowns and travel restrictions continuing beyond the end of 2021. Again, this reduces the long-term uncertainty faced by businesses, particularly those impacted directly, such as travel-related industries. Of course, the year ahead remains difficult, but in the context of the stock market, the value of companies is determined by at least a decade of future profits, not just the next six to 12 months.

The 'anti-monopoly' movement has also continued to gain momentum not only in the US but also China. In the US, the Federal Trade Commission and 48 states filed two antitrust lawsuits against Facebook, focused on acquisitions and the impact on competition. The Department of Justice filed a case against Google claiming they used anti-competitive tactics to protect its monopoly over search. These cases join various actions in the European Union and Australia's move to make the likes of Facebook and Google pay other media outlets for the use of their content. In China, regulators outlined restrictions on how consumer data can be used in relation to anti-competitive practices. Investigations have also commenced into suspected anti-competitive practices at Alibaba, financial regulators having earlier suspended the initial public offering (IPO) of their financial arm, Ant Group.

The dominant e-commerce and technology giants have amassed huge user numbers over the last decade, providing them with enormous market power and highly profitable business models. Indeed, social media platforms have been seen as responsible for swaying elections and enabling uprisings. Our key point is that governments the world over will attempt to rein in this power, and as such there is a genuine risk of additional regulation for dominant players in e-commerce, payments and social media.

One interesting development has been shortages in a range of commodity products from steel to electronic components and silicon wafers, despite the global economy remaining at pre-COVID levels. The explanation behind these shortages is likely multifaceted. The demand for goods (electronics, autos, home furnishings and renovations) has been strong while services (travel, eating out and entertainment) has been weak. Thus, there has been a short-term boost in demand while suppliers of inputs potentially cut output on initial expectations of reduced demand or COVID-enforced closures. Potentially, these shortages and the associated higher prices may be relatively short-lived, however, a lack of significant investment in new capacity for a period of time in many of these industries may see longer-term shortages developing.

This has all occurred before any economic benefit that may accrue from the continued post-pandemic opening or improving business optimism following the US election. With governments around the world likely to continue spending to accelerate the economic recovery, this could potentially exacerbate the shortages over the course of 2021. While there is no evidence of a rise in inflation in goods and services in the major economies yet, it is easy to see an inflation scare unfolding as the year progresses.

The stock market bull run has continued, though the better performance of economically sensitive stocks is an interesting development. In most respects, the stock price recovery of these 'real world' businesses is hardly surprising. Economic activity continues to recover and vaccinations provide a pathway to full recovery over the course of 2021. The potential for better trade relations between the US and China under a Biden presidency point to less risk of the world slipping back into tariff-inspired manufacturing recessions, as experienced in 2018-19.

Governments continue to promise more spending, focused on real world activities, such as infrastructure and 'decarbonising' projects (i.e. renewable energy and electric vehicles). Additionally, valuations were generally deeply depressed, as investors avoided companies facing any uncertainty in their future earnings.

On the other hand, the speculative mania in growth stocks has continued to a large extent unabated. The market for new listings has remained excitable with many stocks continuing to debut at prices of 50% or more above their issue price.

Issuance of special purpose acquisition companies (SPACs)² continue, as have elevated levels of retail participation in the market. Valuations have moved from extraordinary to even higher. The one area that has slowed somewhat are the 'megacap' FAANG stocks (Facebook, Amazon, Apple, Netflix and Google owner Alphabet), perhaps in response to the various antitrust initiatives, or possibly reflecting the beginnings of a loss of momentum for growth stocks more generally.

As we have stated in previous reports, manias tend to end abruptly. The significant bull markets of the last 40 years have come to an end when monetary conditions tighten. While it is hard to imagine a traditional central bank tightening cycle currently, potentially a slowing of the printing presses may be enough. Alternatively, an inflation scare could push long-term interest rates higher with ramifications for stocks whose valuations are based on the premise of near-zero interest rates.

When a collapse in the stock prices of growth stocks comes, it too should not come as a surprise. When companies are valued on multiples of sales (not profits) of 20 times or more, the probability that their business will meet investor expectations on growth rates and profitability, to justify the valuation, is simply remote. A select few may achieve what is needed to provide investors with a reasonable return, but in aggregate one should ultimately expect substantial losses on the holding of a portfolio of such stocks.

2020 was certainly a most unusual year and perhaps doubly so in the stock market. However, the two bedrocks of our investment approach remain. Firstly, investors' cognitive biases will cause them to overemphasise recent events and news. This means the best investment opportunities can often be found in areas the crowd is avoiding; while those investments the crowd is embracing are best avoided. There is nothing to suggest that 2020 has changed basic human psychology. Indeed, the evidence shows quite the contrary, with significant returns achieved in unpopular areas, such as semiconductors and commodities.

Our second fundamental investment principle is that the price you pay for an asset will determine your return. While you may buy overvalued stocks that move higher, over time this approach is unlikely to yield good returns, as ultimately the stock price will reflect assessments of future profits and cashflows from the business.

Of course, we know that speculative bull markets can run for a long time, but the pain for those investors who don't exit the party in time can be significant.

1  Source: Congressional Budget Office, EY.

2 SPACs raise funds from investors and use those funds to acquire existing, privately held companies with the intention of taking them public via an IPO.

DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management ("Platinum"). This information is general in nature and does not take into account your specific needs or circumstances. You should consider your own financial position, objectives and requirements and seek professional financial advice before making any financial decisions. You should also read the relevant product disclosure statement before making any decision to acquire units in any of our funds, copies are available at www.platinum.com.au. The commentary reflects Platinum's views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information.

Damen Purcell, COO of Australian Fund Monitors, speaks with Rob Hay, Head of Distribution & Investor Relations at Collins St.

Since inception the fund has performed strongly returning 17.29% per annum. However the volatility of the past 2 years has provided Collins St with strong opportunities and the fund has outperformed the ASX 200 Total Return Index by 8.99% per annum since January 2019.

In this webinar, John Deniz provides an update of the Fund's performance for 2020 along with Paragon's current market outlook and the Fund's positioning.