Tech Driven ‘Creative Destruction’ Remains Key Global Trend…

‘Admittedly, during the First and Second Industrial Revolutions the magnitude of the destructive component of innovation was probably small compared to the net value added to employment, NNP or to welfare. However, we conjecture that recently the new technologies are often creating products which are close substitutes for the ones they replace whose value depreciates substantially in the process of destruction.’ New NBER paper on the latest wave of technology driven ‘creative destruction’

Academic economists are beginning to wake up to the macro implications of the accelerating digitization and dematerialization of the global economy, which has been a key structural theme both in terms of its impact on interest rates, inflation etc. but also portfolio weightings – earnings power across many established sectors will be destroyed by new entrants, who will see earnings explode even as they offer services at a fraction of the cost of incumbents e.g. instant messaging versus SMS revenues. The point the study is making is that unlike previous disruptive cycles (the industrial revolution from the mid-19th century, the first IT revolution from the 1970s) much of this mobile/cloud based service innovation destroys value within the overall economy to the extent that there is a net loss of profits, jobs etc., a topic I’ve covered recently in notes looking at deep automation/robotics and the sharing economy trend. However, one thing I’d note is that nearly every tech innovation of recent years from instant messaging to social media has been initially dismissed as trivial, but that ignores the huge impact of rapidly scaling network effects in creating utility for consumers and market value for investors. The value of LinkedIn or WeChat to users lies in the critical mass of peers they offer access to and the value to investors is the near zero marginal cost of adding new users. There are certainly too many mobile messaging services and the sector in aggregate is overvalued, as highlighted in previous notes, but the opportunity for the winners to take revenue from the established offline media and financial services sectors remains compelling. Against this secular backdrop, the NASDAQ Internet Index hasn’t quite regained its March peak but is 20% above the low set in early May after a brutal selloff as momentum positions unwound; the US Biotech Index, which led the momentum stock selloff in Q2, has broken out to a marginal new high and is up almost 30% from its mid-April low. Analysts have been upgrading their earnings estimates for the Biotech sector, with earnings now expected to rise almost 40% this year.

Meantime, Facebook, Google, and Twitter all reported above consensus results for Q2 and forward earnings for the internet sector have risen to a new record with about 20% compound earnings growth expected across the sector over the next few years. Chinese web stocks have generally continued to beat expectations from Tencent to Alibaba, the former driven by mobile gaming leveraging the 350m WeChat user base and the latter by mobile e-commerce, with active users up to 188m in Q2 and mobile up to almost 33% of gross sales volume. I noted in the 10th September note last year on the sector that: ‘China’s combined dominance as a smartphone market and manufacturing base has very bullish implications for domestic web software and service companies. For software companies from Google to Microsoft, smartphones are simply the platform for profitable content delivery. The value of content consumed on Android devices will explode in the coming years, starting with ‘in -app’ click through purchases in games and ads viewed while browsing, but smartphones will become the terminal of choice for e-commerce and the decision point for offline retail purchases too.’ Alibaba’s float is likely to drive volatility in smaller Asian tech sector names as portfolios reposition to fund their allocation, particularly as the internet sector has regained its Q2 losses, but it’s hard to see Alibaba generating the 13x 10-year returns of Google which was a very misunderstood business model at its $95 IPO price. For non-benchmark huggers, there will be a tactical trading opportunity in the wider Chinese tech ecosystem over the next couple of months – the secular outlook for the digitization of the Chinese and other EM economies remains very bullish. On that note the more modest but still multibillion float of e-commerce start-up incubator Rocket Internet bears watching. It’s an odd company which has been accused of ‘cloning’ established online business models, with its hugely well-funded operations led by former management consultants rather than entrepreneurs and little of the typical Silicon Valley start-up culture. Nonetheless, it has established leading positions in e-commerce markets across ASEAN, which ex Singapore are several years behind China in terms of development but will catch up rapidly as smartphone penetration rates rise and mobile payment systems mature.

China Rallies as Corruption Crackdown Intensifies…

Of the various market developments while I was on vacation, the most notable in global markets was the accelerating (if somewhat extended near term) rally in Chinese equities which justified the tactical overweight stance and preference to India since Q2. I highlighted banks and real estate exposure as likely beneficiaries of a reversal in extremely bearish positioning and flows; all China had to do was avoid the much feared implosion and indeed the macro data has been modestly improving since April, just as the last few unreconstructed China sell side bulls capitulated. Of course, the credit/GDP ratio continues to trend higher (with credit growth at 19% y/y in Q2) and the risk of a systemic crisis over the next few years remains very real, triggered potentially by deposit flight from the core banking system amid chronic corporate duration mismatching. As well as receding fears of an imminent growth crash, global investors seem to be positioning for the ‘through train’ implementation from October (with both HK and China net equity inflows rebounding since June), when barring technical issues as divergent settlement structures are patched together international investors will be able to trade A shares via the HK exchange while mainland investors will be able to trade H shares via Shanghai, subject to quotas both ways.

While ultimately this should see the H share premium over mainland stocks erode on a sustained basis, it’s unclear whether mainland retail flows into HK will outweigh foreign arbitrage flows back in the early months. The average H share index premium over mainland stocks has traded in a 7-11% range in recent weeks. Most A-shares that are dual-listed are small-caps that trade at a premium on mainland exchanges to their HK prices and indeed the overall market traded at a premium regularly in 2012 until H1 last year. The powerful H-share rally of recent weeks has provided double digit arbitrage opportunities in leading financial names with some individual names like Ping An Insurance Group (an attractive secular exposure, as covered in a recent note) as wide as 15%. In investing as in economics the ‘free lunch’ isn’t meant to theoretically exist, but this one is being served on a silver if slightly grubby platter. Back in the April 4th note on Chinese banks (which were widely seen as toxic at the time) I noted that: ‘The high profitability of Chinese banks versus pre-crisis US and European peers will help absorb the inevitable spike in NPLs. A lot of bad news is in the price for Chinese banks and reality is likely to be a little less awful than feared if a full scale real estate crisis can be avoided…’ The rally since suggests a growing number of investors are taking that more sanguine view and alongside the ‘surprise’ rally in materials and industrials trading at mid-single digit multiples, it’s been a classic case of there being a price for everything.

While the services PMI was weak reflecting the on-going real estate slowdown (and as I’ve emphasised, from Macau VIP revenues to slowing top end real estate and watch sales, the widening corruption crackdown which is now targeting the military elite and the Shanghai administration has been a key factor in suppressing what was always hugely wasteful money laundering related activity), near term SOE restructuring/pension fund reform news flow should further boost sentiment. Investors will probably bet for now that Xi’s centralisation of power, unprecedented since the Mao era, is a harbinger of a more radical economic overhaul that will boost flagging productivity growth and ever rising credit intensity.

Of course, Russian bulls thought that of Putin’s autocratic tendencies not so long ago too but he institutionalized rather than tackled corruption, making patronage the bedrock of his political power. The Xi parallel is possibly more with Yuri Andropov, the pragmatic and worldly KGB chief who briefly headed the Soviet Union before Gorbachev and to tackle plunging productivity and pervasive graft began an anti-corruption and economic liberalization drive that attempted to modernize the system without compromising the Party’s monopoly on power. Had he retained power through the 1980s rather than being succeeded prematurely by Gorbachev, there would have been a lot more ‘perestroika’ and a lot less ‘glasnost’ and the USSR would likely have limped on for another decade or longer rather than collapsing in chaos. Beijing has drawn the lessons…