The Flying Carp Becomes the Dragon

Become the Dragon

On Day 1 of the lunar new year, I opened the year with a morning run to Lei Yue Mun, enjoying the sights along our beautiful harbor, particularly the transformation of East Kowloon, with my destination being the village's "flying carp".

Chinese legend states that while many carp swim upstream against the river's strong current, few are capable or brave enough for the final leap over the longmen (登龍門) falls, and if a carp successfully makes the jump, it is transformed into a powerful dragon.

Like so many, it feels as though I've been swimming upstream these difficult years; for Hong Kong residents, we’ve had tremendous distractions since the 2019 protests, and with the overly heavy-handed Covid restrictions, it’s made for very difficult backdrop to think clearly and critically about the markets and the future.

Thus, I am hopeful 2025 is the year to be brave enough to have conviction in my research, ideas and process, and to finally make the jump over the longmen, and become the dragon.

2024 Year in Review

In retrospect, I should have anticipated that 2024 would have been a trading range for financial markets given the lead into the US elections. I had very little success trading the markets this year.

Although my overall theme that China would catch-up to Japan was accurate, my implementation was unsuccessful as I had several names that drastically moved adversely, such as Guangzhou Investment, Kerry Logistics and Yanzhou Energy. Similarly, the Japanese names that I was shorting, such as Mitsubishi Electric and Japan Steel, seemed invulnerable to most of the overall market.

I entered into a long/short trade in June, which briefly had success the first few months and into October, but due to the Trump victory in November, the Chinese stock market deteriorated, and all the over-valued names in Japan and Australia, resumed their climbs.

Towards the end of the year, Australian banks were at all-time highs, Japanese stocks, presumed to benefit from the AI / Datacenter craze, were strong, and the Chinese market remained unpopular. Thus, this trade went against me on both sides of the market.

Nevertheless, as I enter the new fiscal year, I remain holding this trade as I remain committed to the technical levels, and anticipate mean-reversion. I still find many stocks in Hong Kong as attractive and would like to hold long-term within an “income portfolio”. 

I will look to trade more tactically this year, as I remain confident that my process of identifying anomalies is sound. I had two very good calls in 2024 on buying the HKEx and shorting Sapporo Breweries, but I just need to be more frequent in implementation of these ideas.

The Future of our Fragrant Port

As I consider my investment strategy for the coming year(s), I must first begin with my thoughts on Hong Kong, a city where I have been based for over two decades. I have never been asked so frequently as this past year on whether I am contemplating leaving the city. Hong Kong is going through a soul searching phase, and the opinions for the city’s future are very diverse.

In general, I remain positive of the outlook for the city. The crux of my outlook is based on the high quality of lifestyle, which will continue to attract young and ambitious people from China. Hong Kong is among the safest cities in the world; it has a very desirable lifestyle of leisure and career opportunities; has world-class infrastructure; and, remains a low tax destination.

Just reflecting on the past few years, it's remarkable to consider all the new developments that have been completed, which have enhanced the connectivity and attractiveness of the community. These include:

Hong Kong’s primary advantage is that it has the most global ecosystem in Asia, and that the greater Asia region represents over 2 billion people. Hong Kong is the most logical financial center for the region. The investment community is very experienced in international transactions, and investors have access to deals and opportunities in every corner of the globe. New York and London are the only two global cities that are comparable to the depth and diversity of the financial services sector. Thus, it will remain and continue to develop as an important wealth management destination for the region, in my view.

Analogous to Switzerland, Asian entrepreneurs and investors will choose to domicile their assets in Hong Kong. This is validated by the growth of our monetary base, which now exceeds $2.3T in customer deposits - the largest per capita of any city in the world. This will be the anchor industry, and serve as a platform to develop niche sectors, such as bio-tech and fin-tech.

Having said that, the Hang Seng is a dud investment class, and has gone nowhere in over 15 years. Apart from the occasional rally, which is short lived, the Hong Kong market reached a peak of 32,000 in 2007, and although it revisited those highs in 2018, it will likely not return to that level in the next decade, unless there is a major unanticipated development.

Hong Kong, in my experience, is not an attractive buy-and-hold asset; it’s a buy-and-trade market around inflection points and high-probability setups. Unlike the U.S. markets, there are not big institutional funds, nor high-frequency traders, that are more informed than the retail investor. The changes in market sentiment represent opportunities.

The local economy was most certainly on an unsustainable path over the past twenty years given the dependency on residential real-estate as the driver of the economy. As most of the new developments were utterly unaffordable to the local community, real-estate had become a de facto export product, which was only consumed by the mainland Chinese.

With the Chinese property sector having declined by over 80 percent in the past five years, Hong Kong has lost its anchor industry. The city likely will never recover to its previous levels of excessive government surpluses and inbound Chinese mainland visitors. Nevertheless, most of the developers are well managed and learned from previous property cycles, and thus there is no excessive leverage in the system. We will survive, and adapt to the prevailing market conditions.

My major risk concern for Hong Kong is the boundary of the integration with China. In my view, the integration has been a resounding success as many Hong Kong residents are enjoying the benefits of the convenience of traveling across the border for shopping and leisure activities.

The concern; however, is where will policy makers draw the boundary on integration in terms of work permits, healthcare and school access, rule of law, and most prominently, taxation. Hong Kong’s main economic benefit is that it has a much lower tax base than China; exporters leverage this advantage by keeping trading operations in Hong Kong so as to enjoy the tax benefit.

It's unclear if China’s long-term plan is complete integration on all fronts, and that is a major uncertainty to the economy for those planning for the next generation.

The Last Five Years

In addition to reflecting on Hong Kong’s future, I am greatly influenced by a little post-trauma. Five years ago, I recall enjoying Valentine's day, Feb 14th 2020, with my family over a delicious cheese fondue dinner. It was a very peaceful evening, where everything in the world seemed all well. In fact, the S&P achieved a new all-time high that week of 3,200.

I recall that I was getting concerned about the financial markets. There had already been a serious outbreak in December in Wuhan, with very graphic images of a heavy handed lockdown of the city, and various rumours of this unknown virus. Yet, the US markets continued to shrug off bad news.

In December and January, my good friend Erik Townsend of Macro Voices had held a couple deep dive shows focused on this new strain of flu, which was called C19 at the time, and he was advising listeners of the potential for a global pandemic due to the very high R0 (“R naught”).

I suppose that I had a bias in that I experienced the SARs virus in Hong Kong in 2003, and thought that C19 would be isolated in Wuhan and would likely be curtailed in a few months. I was very wrong, in hindsight, but I was concerned enough that I covered all of my Hong Kong stock holdings in February. However, my reluctance to take a short market position set the tone for the next few years as I was bothered by having missed out on an opportunity.

Suffice it to say, the COVID years were very distracting where I was reluctant to make any major trades or investments. I am cognizant that I remain distracted and have biases towards a more bearish outlook. But, as I approach the next four years, I remain adamant that the big macro shifts that were in development years ago remain intact.

If anything, governments’ reaction to COVID was a huge success story as it showcased that today’s governments have much better tools to stabilize the economy and markets. Mobile wallets, for instance, accommodate printing “money for the people” in terms of handouts or consumption vouchers that can only be used for specific items. The UK, Canada and other countries kept businesses fluid with conditional loans that were forgiven as long as employment remained stable. And, the financial markets at no point went into free-fall, as they have tremendous automation and proved more stable than any previous crisis.

My main thesis is that we are in a period of “muddle through” economics. I do not envision any severe crisis but rather I expect we’ll see more choppy market conditions, and periods of aggressive sector rotation between regions and asset classes. It will remain a challenge to think critically given past memories.

The New World Order

As we embrace the Trump 2.0 era, we need to recognize that the prevailing global economic system is greatly imbalanced. The US has been the consumer of the world, and we are now transitioning away from that model. I am hopeful that we can move towards a more sustainable model, where there are reciprocal trade relationships; but the migration will likely be a difficult transition.

I have been skeptical of the US economy for most of the past decade, as I do not believe the US technology stocks have the unlimited earnings potential that they seemed priced to have. Amazon, for instance, is a very low margin business and is very nearing saturation. Tesla has benefited from subsidies and limited competition. Facebook is a crap product; WhatsApp is a utility. Although I do like Google, I cannot think of a situation where I’ve ever clicked on their advertisements, and yet that’s the largest source of their revenue.

In my view, the US bull market has been largely driven by changes in market structure, which has facilitated the growth of passive investment funds. I cannot think of another reason why investors have not taken profits in these past few years. As the majority of wealth is held with the over 65 generation, you would expect there would have been a sell-off as these investors reduce market exposure. This has not happened, however.

Although several notable market commentators have attributed the US valuations as a function of the excessive growth of the money supply, I am doubtful of this thesis. We haven’t seen an inflation of the stock market in Europe or Japan while they have employed monetary expansion.

My thesis is that the US has become overly institutionalized, and that a few investment houses, such as Blackrock, have great influence on the markets due to their sheer size. I remain skeptical of the resilience of the US economy as I know the challenges of the middle classes are real, and I see the bull market as destabilizing, rather than creating a “trickle down” wealth effect. Social tensions in the US are prevalent.

A few facts that must be considered in asset allocation at the moment:

I review the above in the context of what it may mean for the future of the US economy and US-China trade relationship. We can certainly continue to muddle-through and deal with issues as they arise; however, if we continue along the current trajectory, with a rising US stock market and an accelerating trade imbalance, the projection will not be pleasant.

Is the World becoming Japan?

My overall thesis has been that we are in a deflationary era where global consumption is declining due to aging demographics as well as changing consumption habits. The global economic system is fragile because of dependence on U.S consumption, which is saturated.

And, the world is changing. The younger generations do not consume products as their parents did, but rather consumer services. In the developed markets, we have likely reached peak consumption in terms of physical goods; we don't need two cars per household, nor a cottage or sailboat that are used sparingly. We are clearly in a deflationary environment, and Japan is the only proxy on how it will unfold.

Deflation is not that bad, however. Japan does not get the credit it is due; it is rarely recognized for its unique attributes. Low inflation is widely known but how about: low unemployment; low health-care spending; low crime; low homelessness; and so on.

Japan, unfortunately, is an exception due to its cohesive culture, and successfully responded to their economic challenges by “toughing it out” in terms of accepting low growth. They have worked as a community to over-come various social challenges, and have adapted to develop a unique economic model.

I greatly admire the Japanese manufacturing industry, which I regard as the best in the world at leveraging the global supply chain. They have facilities throughout SE Asia and China, and source components in the market which is optimal. Japanese firms are generally well received in all the markets where the operate as the Japanese engage with the government and localize with the culture.

Correspondingly, the Japanese maintain their intellectual property within Japan, and focus on R&D and innovation. This is a key strength in their global operational model. Japan, in my view, should be the pilot country that others try to emulate.

Having said that, Japan has experienced a “lost generation” due to their housing bubble, which made household ownership unaffordable for a generation. This should be recognized as among the top concerns for countries like Canada, Australia, and others which are now experiencing property bubbles. Either deal with the pain of a property correction, or deal with the decay of your youth.

I fear most of the G7 nations have traditional resource and manufacturing economies, and given their export dependency with the US, they will struggle to stimulate domestic consumption and to build a service-oriented economy. As a Canadian, I’m particularly worried about our countries ability to pivot from an export-oriented market to an innovation and intellectual property economy (which we have plenty of success stories). So, are we becoming Japan … I wish we could adapt as well.

In any case, the past 15-year bull run of the U.S. equity market does not agree with my deflationary thesis. Nevertheless, in my view, 2025 has strong potential for a major reversal in prevailing global asset allocation. In this sense, Japan is not a proxy because the Nikkei’s bubble in 1990s was only a fraction of the Nasdaq!

Mòuh Só (What to do)

Similar to last year, my strategy is to remain defensive and employ tactical trades, largely mean-reversion setups with 3 to 4 month holding periods.

I do not anticipate a financial crisis, but rather I do see an end to the long standing US bull market, and I would like to position accordingly.

Many of the same themes from last year remain, as last year was uneventful in terms of shifts in asset allocation.

But, unlike last year, the year of the Snake requires mòuh pa (no fear) in order to leap the longmen and …

become the dragon.