Powell No Longer the Savior, U.S. Exceptionalism Wanes: What Drives the Bull Case for Equities?

Hello everyone, I am Dolphin Research!

Through the strategy weekly reports over the past two weeks, Dolphin Research has roughly outlined the possible scenarios from now until the third quarter—the current valuation of U.S. stocks is likely to oscillate between a lackluster market and downside risks until the end of the third quarter. Afterward, U.S. stocks should wait for the U.S. debt ceiling to be lifted and a significant correction in U.S. stocks, combined with fundamental trends, to look for structural investment opportunities.

Last week, except for Japan and South Korea, the overall market performance was weak. Nevertheless, there are still some points worth discussing, such as Powell's interest rate meeting and the correction in Hong Kong stocks. Let's take a closer look:

1. "Stubborn" Powell

At the interest rate meeting on June 18, the Federal Reserve, as expected by the market, kept the Fed rate unchanged. The Federal Reserve has maintained the basic rate unchanged since late December last year for half a year.

The key to this meeting was the update of the economic outlook, where the Federal Reserve was very hawkish. Fed Chair Powell, whose term ends in May next year, appeared very stubborn. The specific changes in the outlook are:

a. Lowered GDP growth expectations for this year and next; b. Raised unemployment rate expectations for this year and the next two years; c. Raised inflation expectations; d. Based on this set of numbers, raised policy rate expectations for 2026 and 2027.

Clearly, this set of forecasts implies a stagflationary economic outlook. Based on this economic forecast, Fed members have reduced the expected rate cut for 2026 and 2027.

The attitude implied behind this set of data is:

a. Believing that both the current PCE (2.65-2.15% over the last three months) and core PCE (2.9-2.5%) are at their lowest this year, and prices are likely to edge up as tariffs seep into residents' living costs;

b. In the case of marginal price increases in 2025, tolerating the unemployment rate rising further to 4.5% from the current level, maintaining a 50 basis point rate cut, while reducing the rate cut for 2026 and 2027.

However, due to Powell's departure in May next year, the market is unlikely to seriously price in the reduced rate cut for 2026 and 2027. But the reality to face this year is that the Fed indeed needs to observe the impact of immigration and tariff policies on the economy and prices. If the final rate cut indeed occurs in November and December, then the third quarter's economy will face dual pressures of unchanged interest rates, economic slowdown, and treasury issuance absorbing liquidity, meaning U.S. stocks may face marginal downward fundamentals and liquidity withdrawal to the bond market.

2. Hong Kong Stocks: Liquidity Abundance Does Not Mean Indiscriminate Asset Selection

The current Hong Kong dollar exchange rate is still near the weak-side convertibility guarantee of 7.85, while the HIBOR overnight rate is 0.02%. Since Hong Kong operates under a linked exchange rate system, the exchange rate near 7.85 cannot depreciate further, leaving only the direction of appreciation.

Originally, if the exchange rate was around 7.78, a more central position, it would be almost cost-free to borrow Hong Kong dollars to buy U.S. dollar assets, and with the Hong Kong dollar depreciating, going long on the U.S. dollar would be almost risk-free.

But now that the Hong Kong dollar exchange rate has reached the weak-side convertibility guarantee, the remaining directions are only sideways and appreciation. If it remains sideways, one can continue to go long on the U.S. dollar, but if the Hong Kong dollar appreciates—when Hong Kong banks exchange Hong Kong dollars for U.S. dollars with the Monetary Authority. Under what circumstances would banks prefer U.S. dollars again?

Let's first flashback to why the Hong Kong dollar strengthened before. We know that in the past few years, Hong Kong dollar funds chasing U.S. dollar assets suffered a triple hit in stocks, bonds, and exchange rates as the U.S. dollar fell, forcing them to reduce their U.S. dollar and U.S. dollar asset positions and return to the local currency, thereby increasing demand for the Hong Kong dollar.

Currently, to make banks switch back to U.S. dollars, two conditions are likely needed: a. The previously unhedged U.S. dollar longs have now done exchange rate protection; b. The U.S. dollar has started to appreciate again.

Currently, the short-term conflict between Iran and Iraq may suppress risk appetite, and the U.S. dollar may have a short-term recovery potential. But in the long term, with the dismantling of American exceptionalism, non-U.S. assets returning to their local currencies should be a structural trend.

Therefore, the liquidity of the Hong Kong dollar should remain relatively abundant in the future, but it should contract compared to the current state of abundance. In a relatively abundant liquidity environment, if the Iran-Iraq issue ultimately suppresses risk appetite and then rebounds, the structural market of Hong Kong stocks may continue. However, it is important to actively monitor changes in the Hong Kong dollar exchange rate and interest rates during the process and pay attention to risks.

Last week's IPO of Haitian Flavouring & Food in Hong Kong broke, indicating that even in a liquidity-abundant environment, the market still demands growth, valuation cost-effectiveness, and asset uniqueness, rather than mindless rallies. Unlike CATL's relatively reasonable valuation in the A-share market, Haitian's high valuation with single-digit EPS growth and a PE around 30 still affected the new stock's returns.

3. Portfolio Returns

Last week, the virtual portfolio Alpha Dolphin of Dolphin Research did not adjust its positions, falling by -1.3% for the week, underperforming the observed markets—S&P 500 (-0.2%) and CSI 300 (-0.5%), but outperforming MSCI China (-1.4%) and Hang Seng Tech (-2.0%).

Since the portfolio began testing (March 25, 2022) until last weekend, the portfolio's absolute return is 88%, with an excess return of 87% compared to MSCI China. From an asset net value perspective, Dolphin Research's initial virtual asset of 100 million USD exceeded 191 million USD as of last weekend.

4. Individual Stock Profit and Loss Contribution

Last week, the Alpha Dolphin portfolio underperformed the U.S. stock index, mainly due to significant previous gains in Pop Mart and a correction in gold. Dolphin Research explains the specific stocks with large fluctuations as follows:

5. Asset Portfolio Distribution

The Alpha Dolphin virtual portfolio holds a total of 18 stocks and equity ETFs, with 7 standard allocations and the rest underweight. Assets outside of equities are mainly distributed in gold, U.S. Treasuries, and U.S. dollar cash, with the current ratio of equity assets to defensive assets like gold/U.S. Treasuries/cash being approximately 52:48.

As of last weekend, the asset allocation distribution and equity asset holding weights of Alpha Dolphin are as follows: