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Novum Alpha - Daily Analysis 8 February 2021 (10-Minute Read)

Marching into Monday and I hope you're having a wonderful start to the week!


In brief (TL:DR)

  • U.S. stocks closed last week higher with the S&P 500 (+0.39%), blue-chip Dow Jones Industrial Average (+0.30%) and the tech-centric Nasdaq Composite (+0.57%) all up on signs of fiscal stimulus and U.S. stock futures point to a higher opening today. 
  • Asian stocks were mostly up to start the second week of February on the back of optimism in U.S. markets. 
  • The benchmark U.S. 10-year Treasury yield rose to 1.17% (yields rise when bond prices fall) at the end of last week, but will likely pull back slightly to start this week. 
  • The dollar steadied after Friday's slide. 
  • Oil continued to rise with March 2021 contracts for WTI Crude Oil (Nymex) (+1.07%) at US$57.46 as news that coronavirus cases in the U.S. are slowing and on optimism over renewed consumption. 
  • Gold was flat with April 2021 contracts for Gold (Comex) (+0.01%) at US$1,813.20. 
  • Bitcoin (-1.91%)  fell to US$38,764 as inflows into exchanges led outflows (inflows typically suggest that traders are looking to sell Bitcoin in anticipation of lower prices). 

In today's issue...

  1. GameStop Reveals All that's Wrong with the Economy's Incentives 
  2. Hong Kong Markets About to Find Out What It's Like without China
  3. Flash Loans Could Fuel Next Cryptocurrency Bubble

Market Overview

The Biden administration is looking to make an important and badly-needed shift in the U.S. economy - a shift towards economic wealth from work, as opposed to asset inflation. 
And while that shift is good for America, it may be bad for markets in the longer term.
Although it's hard to see how the U.S., which all but excoriated its own manufacturing base, will make that shift, it is an important one, as the entire U.S. economy has grown to become increasingly reliant on asset inflation to create the perception of wealth. 
In the meantime though, investors are just going along with the current narrative that is almost exclusively one of seemingly neverending asset price increases, even while actual economic activity is at its lowest in decades. 
Over in Asia, stocks were mostly up in the morning trading session with Tokyo's Nikkei 225 (+1.74%), Sydney’s ASX 200 (+0.76%) and Hong Kong's Hang Seng Index (+1.16%) all up strongly, while Seoul’s KOSPI (-0.64%) was the only laggard on losses from major automakers. 
1. GameStop Reveals All that's Wrong with the Economy's Incentives
  • GameStop (+19.20%) episode reveals just how closely tied the fortunes of Americans are with the health of the stock market 
  • Retirement incomes increasingly linked to the performance of the market are precarious, with the U.S. economy due for a shift from a focus on asset inflation, to economic wealth creation 
While much has been made of the GameStop trading fiasco, regardless of whether one takes the view that flash mobs or retail investors stormed a rigged financial system, the episode reveals how broken the incentive mechanism in the markets currently is.
Since the deregulation drive of the 1980s, led by then-U.S. President Ronald Reagan, central bank intervention to smooth out the business cycle using monetary policy has become the norm.
The abandonment of the Bretton Woods exchange rate system (that ties the value of fiat currencies like the dollar, to gold) and the rise of shareholder capitalism have dramatically reshaped the U.S. economy from one where prosperity was based on secure employment and income growth, to one in which the focus was on ever-rising asset prices as a measure of economic health.
Case in point – the prospect of a short term US$1.9 trillion fiscal stimulus package out of Washington is pushing stocks to record highs, distorting the traditional role of markets, which is to reflect the creation of value and prospects.
And that has resulted in a perversion of U.S. pension funds and other retirement accounts, where a large proportion of personal consumption expenditure is derived from ever-increasing asset prices, with such growth difficult, should there be a major correction.
That is one reason why the GameStop debacle has unnerved people – it’s a reminder of just how dependent Americans have become on the markets, which can be very volatile.
The transformation of markets to become the key driver of the economy and benchmark indicator of economic health, puts more short-term pressure on companies which cut costs by outsourcing, automating, using less union labor and dumping defined benefit pensions for 401(k) plans, which puts the responsibility of growing retirement nest eggs squarely on the shoulders of individuals.
And that’s not good.
Because if an army of Redditors have the ability to move not just a single stock, but entire indices, that makes the fortunes of entire retirement portfolios, which are more than ever tied to the fortunes of the stock market, appear extremely precarious. 
2. Hong Kong Markets About to Find Out What It's Like without China
  • Lunar New Year break will see mainland Chinese flows into Hong Kong stocks stopped from February 9 to 17 after record inflows 
  • Annual occurrence drawing greater scrutiny as more mainland Chinese money has flowed into the Hong Kong stock market than ever 
In perhaps a simulation of what would happen if Chinese investors were ever locked out of the Hong Kong stock market completely, the impending Lunar New Year holiday will see Chinese investor flows into Hong Kong stocks halted from February 9 to 17.
Trading links via Hong Kong’s exchange operator, which allow mainland Chinese traders to buy Hong Kong stocks is due to take a break for the Lunar New Year, slamming the door shut on record levels of inflows that helped propel Hong Kong stocks to their best year since 1985.
As valuations of Chinese stocks reached heady levels, Chinese investors sent their yuan to Hong Kong in search of bargains, snapping up a total of US$48 billion worth of stocks in Hong Kong’s companies in the first five weeks of this year, more than half of all of last year’s total.
Mainland Chinese investors were especially hot on Chinese firms listed on the Hong Kong bourse which tend to trade more cheaply than their mainland-listed equivalents, including stocks of firms like WeChat owner Tencent (+1.71%), Meituan (+0.70%) and China Merchants Bank (+0.47%).
Depending on one’s take of the Lunar New Year break, some investors may be looking to cash out some profits, but relatives gathering for celebrations may also swap stock-trading stories and strategies, which may renew interest in the Hong Kong market once links are re-opened.
Although the shutting of the links for Chinese investors into Hong Kong’s market is an annual occurrence, traders are watching the flows more closely this year because of their unprecedented size.
With more Chinese mutual funds piling into Hong Kong’s stock market, some investors are still bullish on the territory’s prospects.
Hong Kong continues to be a venue for an increasing number of hot startup listings and tech giants, including short video-platform Kuaishou Technology (+0.40%), which debuted last Friday, and Tencent Music Entertainment Group is planning a second listing in the city as well.
While the mainland Chinese investors may be taking a break, they’ll likely be back, and in greater numbers. 
3. Flash Loans Could Fuel Next Cryptocurrency Bubble
  • Flash loans with no collateral required made possible by an increasing amount of liquidity on decentralized finance or DeFi platforms
  • Decentralized exchanges are making it possible for traders to use flash loans to arbitrage price differences and to potentially manipulate market prices of cryptocurrencies, potentially inflating damaging bubbles 
Listen here
Now, that ain’t workin’, that's the way you do it
You play the guitar on the MTV
That ain’t workin’, that's the way you do it
Money for nothin’ and your chicks for free
- “Money for Nothing” by Dire Straits (1985) off the album Brothers in Arms
Since last summer, decentralized finance has steadily risen, offering a dizzying array of fresh options, including flash loans, which are essentially loans where no collateral is required.
How it works is that if the entire transaction can be executed within the same transaction block on the blockchain, no collateral needs to be posted, so the borrowing and return of the cryptocurrency needs to all be completed within one block’s update.
Because the blockchain doesn’t update as quickly as say a centralized ledger or database, what many in the decentralized finance or DeFi space have been doing is to arbitrage cryptocurrency price discrepancies between different decentralized exchanges.
The loan, the trade and the repayment are then bundled into the same block of transactions being processed on the Ethereum blockchain and executed simultaneously.
Because the time from borrowing to returning a loan typically takes seconds, the arbitrageur never had to post any collateral for the loan.
In this example, the transaction gets submitted to the Ethereum network, temporarily lending the borrower the funds, and if the trade isn’t profitable, the borrower can reject the transaction, and the lender gets their funds back in either case.
As far as the blockchain is concerned, the lender always had the funds and the borrower simply pays the transaction fees, in the case of Ethereum, gas fees.
These transactions have only become more viable because of the rise of decentralized exchanges and a significant increase in liquidity and volume on those forums – it would take far too long on a centralized exchange.
According to one of the biggest DeFi lending platforms, Aave, some US$2 billion worth of flash loans were processed last year.
And while some of the increase in that value would necessarily have come from a price rise in a wide range of cryptocurrencies, it could very easily provide the fuel for a GameStop-type episode in the cryptocurrency markets as well.
Because no collateral is needed for these flash loans, an army of Redditors could organize and, like the call options used to boost the price of GameStop, chase up the price of a target cryptocurrency as well using flash loans.
One thing that could prevent that from happening of course is that the flood of orders would necessarily shoot up the price of Gas (the fees required to process transactions) and also gum up the Ethereum blockchain’s ability to process those orders, but if there was sufficient stomach for the increased fees, the slowdown in processing time could actually help to bring in more players.
And that has the potential for flash loans to be used to manipulate cryptocurrency prices and inflate unsustainable bubbles.
But because it happens so fast, market manipulators are likely to get away with the spoils before they’re even noticed, gone in a flash. 

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Feb 08, 2021

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