Market Review:
Domestic recovery weaker than expected, the anticipated recession in the United States did not occur, rate hikes have not ended but the valuation killing has ended.
Looking back on the first half of the year, the domestic situation was more pessimistic than we expected at the beginning of the year. At the beginning of the year, we believed that residents had accumulated nearly 4 trillion yuan in excess savings since the outbreak of the pandemic. As housing prices fell, down payment ratios decreased, and mortgage rates fell to historical lows, residents' ability to buy houses was actually improving. If confidence could be rebuilt, real estate consumption and investment were more likely to be better, and other aspects of the economy, including consumer spending and corporate investment, would also improve due to restored confidence. The “rebuilding of confidence” seemed to be the focus of the central government’s work at the beginning of 2023. However, at the end of February and the beginning of March, we found that the economic recovery was weaker than expected. This partly reflected the central government's intention not to solve economic problems through stimulus measures, and local governments, faced with reduced fiscal revenue and the gradual exposure of debt problems, found it difficult to boost the economy through leverage, and instead faced deleveraging pressures. On the other hand, it reflects that the restoration of confidence among enterprises and residents, without external forces, naturally requires more time for repair. Coupled with some long-term problems that have not been resolved, the restoration of long-term investment (especially private and foreign investment) and investment consumption by enterprises and residents is not so obvious. In the following months, real estate, automobiles, consumption, etc. all showed a trend of weakening recovery and intensifying industry competition. Relatively speaking, AI has shown great potential for improving productivity, driving companies to actively invest and participate, and is one of the few highlights. Some upstream hardware suppliers have already benefited from the global AI “arms race”.The situation in the United States is much better, with the economy generally better than expected, and the pace of rate hikes has slowed as expected (although rate hikes have not ended and the rate cut cycle has not yet arrived). Specifically, the recession that the market was worried about never occurred, employment was particularly good, consumer data was differentiated in structure but overall also showed resilience, and inflation began to fall but not as fast as expected. The Federal Reserve has clearly slowed the pace of rate hikes, on the one hand, because inflation has started to show a decline, and on the other hand, because local financial risks have begun to emerge under high-interest rates. In the first half of this year, interest rates were raised three times by a total of 75 basis points, and the benchmark interest rate rose from 4.33% to 5.08%. In comparison, interest rates were raised four times in the second half of last year, reaching 275 basis points, and the marginal increase in interest rates this year has significantly narrowed. Overall, last year's rapid and substantial rate hikes led to market valuation killing, and although interest rates are still rising this year, the 10-year Treasury yield reflecting the risk-free rate has generally fluctuated between 3.3-4%, and the risk premium has fallen somewhat, so the overall market valuation center has ended its decline.The structural situation is somewhat better, a typical example is AI, AI opportunities have brought hardware and cloud computing opportunities to end the cyclical downturn/slowdown of the industry ahead of schedule, providing significant excess opportunities. AI computing power leaders were very much ahead of expectations in Q1 financial reports and guidance for Q2, reflecting everyone's optimism about the prospects of AI and early investment and arms raceparticipation. Software and cloud service leaders, represented by Microsoft, have also launched various AI Copilot services and are expected to gain incremental users and higher charges. If the application and commercialization of AI can be achieved, it means that investments in computing power and other aspects will be sustainable and growing. The iteration of computing power technology will also bring about the demand for upgrading and increase in usage of various hardware, thus bringing various investment opportunities.
Investment Review:
High Position, Increasing Overseas Proportion and Reducing China Asset Proportion, Heavily Allocating to Technology Especially AI
Since the beginning of this year, we have been optimistic about structural investment opportunities including technology and consumer sectors (especially AI), and have maintained a high position. Structurally, since the end of October and the beginning of November last year, when there were signs of relaxation in pandemic control, we had good expectations for the domestic economic recovery and increased confidence in policies, with the proportion of Chinese assets once reaching 30-40%. However, as subsequent verification revealed that the fundamentals of the relevant companies were not as expected, the reason being that the focus of macro policies was not on increasing confidence but on safety, and the intrinsic economic recovery was hampered by the tightening of balance sheets, lacking internal momentum without strong external forces. Starting in March, we gradually reduced the proportion of Chinese assets, which is currently at 20%. On the other hand, the proportion of overseas assets has increased from less than 50% at the beginning of the year to the current 80%. The main reason is that the US economy has not experienced the recession that was worried about at the beginning of the year but has shown resilience. US assets are attractive globally under the circumstances of a strong economy, high-interest rates, and a strong exchange rate, especially in the technology and consumer sectors we cover, there are quite a few companies with extremely strong competitive advantages, and there is good growth potential which is expected to provide decent investment returns. Additionally, the explosion of AI since the beginning of this year has brought additional opportunities for excess returns.
Market Outlook & Investment Approach:
Relatively More Optimistic About Overseas Investment Opportunities
Our view of the market and investment approach for the second half of the year have not changed directionally. We are relatively cautious about domestic investment opportunities, reflected in higher risk premium requirements in valuations, and fully considering the intensification of internal competition issues, real estate and local debt risks, and the impact of household and corporate balance sheet repairs in the context of a downward adjustment in economic growth and a slowdown. We are relatively optimistic about overseas investment opportunities, which are relatively rich in resources, and will devote more research efforts.
The population is reaching an inflection point, the policy goal of “safety & stability” takes precedence over “growth”, and various balance sheets are shifting from expansion to contraction... These factors pose a risk that China could become a “large-scale Japan” in the medium to long term. This logic seems to have been widely discussed and has become a consensus, but if this risk becomes a reality, the current pricing is very insufficient. Therefore, we will be more cautious in looking at domestic investment opportunities, paying more attention to whether there is a possibility of industry pattern improvement in the context of industry growth slowing down or even stagnating, whether companies have a sustainable competitive advantage, and whether they can improve profitability and strengthen shareholder feedback through efficiency improvements.
Overseas, although there is short-term uncertainty, such as how high the Federal Reserve's interest rate hikes will be, when they will cut interest rates, and by how much, overall valuation risk is not significant. More importantly, benefiting from the global supply chain restructuring, AI innovation, robots, etc., some countries are expected to see an upward adjustment in their long-term growth potential. In the short to medium term, some industries have emerged from the economic downturn and have seen continuous structural growth opportunities under incremental demand, such as the AI field. Some industries that do not seem to be growing fast have also seen companies that have carved out niche growth opportunities, such as chain catering and sports brands. Additionally, some industries have shifted from pursuing growth and expansion to improving quality and efficiency, and with the empowerment of AI, expense ratios have already begun to decline significantly and there is still a lot of room for future reductions, thereby bringing opportunities for profitability improvements.
Looking forward to the second half of the year, we still believe that AI may be the most important source of growth opportunities for this year and for a long time to come, and this is true for both China and the US. AI's labor substitution and empowerment in mid-to-high-end industries have crossed the chasm, and have gradually crossed the stage from 0 to 1, and in the long run, it is a market opportunity of the trillion-dollar level. During this process, everything from AI infrastructure to AI applications will benefit. On the one hand, it brings opportunities for the strong to become stronger, and on the other hand, there are opportunities for pattern reconstruction from 0 to 1.
Main areas of focus at the moment:
AI: This is the most significant structural growth opportunity for the future, currently mainly including semiconductors and software, while also paying attention to the development of applications;
Overseas cloud computing investment opportunities. Optimistic about serving large enterprise customers and competitive niches in the cloud computing sector; Combining with AI is expected to improve efficiency and enhance user value;
Structural growth opportunities in semiconductors, mainly optimistic about opportunities related to advanced semiconductor processes, AI will accelerate industry growth;
Overseas travel and tourism service platforms: Benefiting from investment opportunities due to the increase in the share of personalized demand in travel and tourism;
Structural growth opportunities in the financial payment sector, mainly optimistic about monopolistic companies with strong network effects;
Domestic service industry, represented by vocational education and others, still has steady growth, value re-evaluation, and continuous dividend-winning investment opportunities;
Internet platform companies that still have good growth and are currently reasonably valued;
Branded consumer goods companies with good development prospects and currently reasonable valuations;
New energy vehicles: Optimistic about links/companies that can establish long-term sustainable competitive advantages, in the short term the industry pattern deterioration has not yet ended, relatively cautious.
Defense: Demand is unrelated to macroeconomic conditions and will benefit from future great power competition; low correlation with other investments can reduce portfolio volatility;
US Treasury bonds: Will benefit from future inflation decline and interest rate normalization, it is a low-risk asset that is better than cash and different from stocks;
We will be happy to include other directions that meet our standards.
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