The Mag Seven is Spending. China is Winning | Rupert Mitchell on the Coming Regime Change

Key Concepts

• China's Economic Trajectory: Rapid growth, "warp speed" progress in the last 5 years, potential for an 8-10 year bull market.
• Valuation as a Catalyst: Global quality stocks in China trading at "dirt cheap valuations."
• US Equity Market Concerns: "Capex time bomb" under Mag 7 drivers, valuations as a liability, AI spend's unclear earnings.
• Developed Markets Ex-US Outperformance: Expected significant outperformance versus US equities over the next decade.
• Private Credit Impact: Removal of "dross" from high-yield bond market, upgrading credit quality.
• Stock-Bond Correlation: Shift from negative to positive correlation, undermining traditional risk parity.
• Alternatives as Diversifiers: CTAs and trend following strategies, precious metals, emerging market local currency fixed income.
• Restaurant Industry as a Real Economy Indicator: Sensitivity to consumer spending, leading indicator for personal consumption.
• Emerging Market Opportunities: Uzbekistan as a potential frontier market becoming "real EM."
• Energy as a Real Asset: Long-dated futures contracts, global south energy demand, hybrid vehicle impact.

China's Economic Surge and Investment Opportunity

Rupert Mitchell expresses significant optimism regarding China's economic progress, describing it as having entered "warp speed" in the last five years. He believes the market is in the "foothills of potentially an 8 to 10 year bull market" driven by "dirt cheap valuations" for global quality stocks. Mitchell's recent trip to Hong Kong and Shenzhen, including visits to BYD, Tencent, and UB Tech, reinforced this bullish sentiment. He notes that while he was always impressed by China's progress, the last five years have seen an acceleration.

Key Points:

• "Made in China 2025" Fruits: China is now reaping the benefits of its decade-long industrial policy plan, leading to a globally dominant auto industry and advanced manufacturing sector.
• Strategic Supply Chain Shoring: This move is seen as a strategic masterstroke, making it difficult for other nations to replicate.
• Geopolitical Standing: China's actions have positioned it as an "equal pole in geopolitics," with leaders like Xi Jinping seeking to be taken seriously.
• Tencent's Evolution: Beyond its traditional WeChat, gaming, and cloud businesses, Tencent is leveraging less capex-intensive AI to enhance its individual verticals, making it a "one-stop shop for all aspects of the China story."
• Valuation Discrepancy: Despite strong fundamentals, Chinese stocks are trading at significantly lower valuations compared to their US counterparts.

US Equity Market Concerns and Developed Markets Ex-US Outlook

Mitchell contrasts the China opportunity with concerns about the US equity market, particularly the "Mag 7" drivers of S&P returns. He identifies a "capex time bomb" beneath these companies, suggesting their current valuations are more of a liability than an opportunity. The significant investment in AI is seen as having turned business models on their head, with unclear earnings outcomes.

Key Points:

• Mag 7 as a Liability: The capital expenditure required for AI is viewed as a significant risk for the Mag 7 at their current valuations.
• Contrast with Tencent: While Mag 7 companies are heavily investing in AI, Tencent's capex is only 10% of revenues, indicating a less risky approach to AI integration.
• Developed Markets Ex-US Outperformance: Mitchell anticipates a "significant period of outperformance" for developed markets outside the US, breaking a 10-15 year trend of US equity dominance.
• AI's Role in US Market: Resuscitated excitement about AI is seen as a primary driver for US equities, but the sustainability of this is questioned due to unclear earnings.
• Valuation Metrics: The S&P 500's Price-to-Earnings (P/E) ratio has doubled in the last decade, making further trend continuation reliant on "flows."
• Global Equity P/E Ratios: While ex-US equities have seen some rerating, they remain at more reasonable levels compared to the US, with India being an outlier of extreme expense.

The Bond Market and Credit Landscape

The discussion shifts to the bond market, where yields are coming down, suggesting a potential economic slowdown. However, credit markets are described as "not giving a right," trading near lows. Mitchell attributes this to private credit having removed "dross" from the high-yield bond market, thereby upgrading its quality.

Key Points:

• Bond Market Signal: Falling yields indicate a potential economic slowdown, prompting a call for buying bonds.
• Credit Market Resilience: Despite economic signals, credit markets remain robust.
• Private Credit's Role: Private credit has effectively cleaned up the high-yield bond market, leading to higher quality in the tradable market.
• Credit Hedge Strategy: Mitchell employs a credit hedge (SJB ETF) with moderate expectations for spread blowouts, considering a flip to long high-yield exposure if spreads reach 700-750 basis points over Treasuries.
• Upgraded High-Yield Index: The composition of the high-yield index has materially changed, with a significant increase in "fallen angels" (companies downgraded from investment grade).

Stock-Bond Correlation and the Decline of Risk Parity

A significant point of discussion is the shift in the stock-bond correlation. Historically, a negative correlation between stocks and bonds (the "risk parity miracle") provided a hedge during risk-off events. However, this correlation has turned positive, undermining the effectiveness of traditional 60/40 portfolios and risk parity strategies.

Key Points:

• Historical Negative Correlation: The period between 2000 and 2020 saw a negative correlation, beneficial for global investors due to a dollar kicker during equity sell-offs.
• Shift to Positive Correlation: The last six months have seen a move towards near-perfect positive correlation, rendering zero correlation ineffective as a hedge.
• Implications for Diversification: The breakdown of negative correlation necessitates a re-evaluation of diversification strategies.

Alternatives and Diversification Strategies

Mitchell outlines his "beta portfolio," which constitutes 70% of his investment strategy, focusing on diversification beyond traditional assets. This portfolio includes a significant allocation to cash, the SJB ETF, CTAs and trend-following strategies, emerging market local currency fixed income, and precious metals.

Key Points:

• Beta Portfolio Composition: Includes US-listed ETFs, mutual funds, cash, SJB ETF, CTAs, EM local currency fixed income, and precious metals.
• CTA Drawdown: CTAs are currently navigating their largest drawdown in a long time, with market conditions potentially creating vulnerable long positions.
• Momentum Strategy: Mitchell outsources momentum investing to CTAs, believing it to be the most successful investment strategy over time.
• Precious Metals Strategy: Physical metal exposure is a constant, while miners are viewed with caution due to momentum stalling. He anticipates re-entering miners when momentum repairs itself.
• Gold Miners' Efficiency: Gold miners are seen as more efficient than in the past, with capital allocation discipline instilled after years of poor performance.

Emerging Market Opportunities and Sentiment Indicators

The discussion highlights emerging market opportunities, particularly in Uzbekistan, which is poised to become "real EM." Mitchell uses the closure of country-specific ETFs (e.g., Egypt, Nigeria) as a sentiment indicator, suggesting that such events often precede significant opportunities.

Key Points:

• Uzbekistan as a Frontier Market: Hiring Templeton to manage a privatization fund, offering attractive valuations for state-owned enterprises.
• Hawkish EM Central Banks: Emerging market central banks are prioritizing positive real rates to maintain currency stability, contrasting with Western central bankers.
• ETF Closures as Sentiment Indicators: The closure of ETFs for specific countries or sectors can signal a bottoming-out and potential buying opportunity.
• Currency Devaluations: Typically mark lows for currencies, creating generational opportunities from the rubble.

"Acorns" - Specific Investment Ideas and Themes

Mitchell details his "acorns," which are specific investment ideas and themes, often with an international focus. These include short positions in US equities, lower beta exposures to China, global refiners, Canadian E&P companies, offshore drill ship players, and a "degenerate natural gas trade." He also mentions long positions in Gulf equities and esoteric positions in the rates market.

Key Points:

• Short US Equities: Primarily focused on discretionary spending impacting restaurants and fast-casual names.
• Lower Beta China Exposure: Avoiding "hot money" driven drawdowns.
• Global Refiners: Trading at discounts to replacement costs, with no immediate plans for new construction.
• Canadian E&P and Offshore Drill Ships: Early entry into these sectors, with a similar argument to refiners regarding limited new supply.
• Natural Gas Trade: A "degenerate" trade based on a forecast for a severe winter.
• Gulf Equities: Long positions in UAE, Qatar, and Saudi Arabia due to economic restructuring.
• Rates Market Esoterica: A position based on the potential for an accidental shortage of on-the-run 10-year paper.

Energy Complex and Consumer Sentiment

Mitchell provides an update on his energy positions, emphasizing his long stance on global refiners and Canadian producers. He views energy as a real asset and believes global south energy demand will continue to grow, especially with the affordability of hybrid vehicles from companies like BYD. He also discusses the restaurant industry as a leading indicator of the real economy and consumer sentiment.

Key Points:

• Energy as a Real Asset: Long-dated WTI and Brent futures contracts are held as a stable exposure.
• Global South Energy Demand: Forecasts for declining oil demand are questioned, given the lower per capita consumption in developing nations.
• Hybrid Vehicle Impact: Affordable hybrids from BYD could significantly increase energy consumption in emerging markets.
• Restaurant Industry as a Barometer: Restaurant owners have a keen sense of the real economy, and restaurant share prices have historically led personal consumption.
• Fast Casual Valuation Concerns: Many fast-casual chains are overvalued, trading on potential footprint expansion rather than P&L performance.
• Consumer Spending Squeeze: Declining same-store sales and hits to discretionary income, particularly for young people repaying student loans and lower-income cohorts.
• "Shopping Down" Effect: While some wealthier consumers may trade down to QSRs, this does not compensate for the loss of lower-income consumers.

Conclusion and Where to Find Rupert Mitchell

Rupert Mitchell advocates for a geography-agnostic, asset-class-agnostic approach to investing, seeking opportunities wherever they may be found. He emphasizes the importance of understanding sentiment indicators and contrarian opportunities.

Key Takeaways:

• Global Opportunities: Significant investment opportunities exist outside the US, particularly in China and other emerging markets.
• Valuation Matters: Focus on companies trading at attractive valuations, even if they are outside traditional investment narratives.
• Sentiment as a Signal: Pay attention to market sentiment, ETF closures, and contrarian indicators.
• Diversification is Key: Employ a diversified portfolio that includes alternative assets and strategies.

Rupert Mitchell can be found at blindsquirremacro.com, on Twitter at @SquirrelMacro, and on LinkedIn as Rupert Mitchell. He also maintains a Discord server called "The Dre" for his subscribers.