Novum Alpha - Daily Analysis 20 May 2021 (10-Minute Read)
A terrific Thursday to you even as markets take a turn for the worse. Time for a little tipple to dull the nerves?
In brief (TL:DR)
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In today's issue...
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Market Overview"Please sir, may I have some more (stimulus)."
Investors are pouring over the minutes of the most recent U.S. Federal Reserve meeting, trying to read the tea leaves to determine if the Fed will taper (lower its asset purchases) or otherwise turn hawkish.
While the Fed has pledged to remain dovish on interest rates (inflation be damned, let them eat cake!), it hasn't been so clear in its approach towards asset purchases.
To aid the economy, the central bank has been buying copious amounts of Treasuries and mortgage-backed securities to put a lid on borrowing costs and facilitate a recovery as the U.S. struggled during the pandemic.
But with inflation (allegedly) heating up, investors are now concerned that the Fed may ratchet back purchases, souring sentiment on stocks.
To be fair, all the Fed meeting minutes revealed was that the central bank will entertain a debate on the matter.
Surely investors have stronger constitutions than to drop stocks on the first signs that Fed governors are having a bit of a chat over a spot of tea?
In contrast, Asian stocks were firmer on Thursday's morning session with Tokyo's Nikkei 225 (+0.04%) and Sydney’s ASX 200 (+0.88%) up while Hong Kong's Hang Seng Index (-0.74%) and Seoul'
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1. Bonds, Huh, Yeah, What Are They Good For? Absolutely Nothing
Fed on the false promise of diversification, many investment portfolios comprise of some mixture of stocks and bonds.
In order to counter the volatility in stocks, bonds are added into the mix to provide a steady stream of income, and to smooth out the inevitable kinks in a purely equity portfolio.
The logic is seductive in its simplicity, because it’s assumed that stocks move inversely to bonds (i.e. when stock prices rise, bond prices fall and vice versa), the two act as counterbalances to each other to reduce portfolio volatility.
Until now.
Concerns over inflation has injected volatility into not just stocks, but bonds as well, undermining the latter’s role as a safe haven asset to ballast a portfolio.
On a day when the markets were selling everything from commodities to cryptocurrencies, U.S. Treasuries (which one would expect to rally) barely budged and the benchmark yield of the 10 year U.S. Treasury Bill responded with a “blah.”
Historically, the S&P 500 and U.S. 10-year Treasury Note have not been so positively correlated since 1999, with the 60-day metric reaching 0.5 (1.0 is perfect correlation) on Wednesday.
In contrast, the average correlation between the S&P 500 and the U.S. 10-year Treasury Note for the past two decades was -0.3, what you’d hope to see if you were looking to balance out a portfolio.
And if this positive correlation between stocks and bonds persists (and there is every reason to believe that it will because of inflation concerns), it would mark a necessary shift in investor attitudes towards plain vanilla 60/40 stock and bond portfolio splits, or strategies such as risk-parity.
To be fair, the stock-down, bond-up correlation has only been around since 2000, before which periods of inflation made such relationships less predictable and portfolios more volatile.
Nonetheless, the U.S. Federal Reserve is promising that inflation, as evidenced by the fastest U.S. consumer price index increase in April since 1982, is “transitory” and the central bank will be patient in withdrawing monetary stimulus.
And if the Fed is to be believed, the stock-bond correlation could eventually return to normal, either way, investors may need to rethink their existing portfolio paradigms.
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2. Is Tech's Time Up?
When Henry Ford rolled out his first car, the Ford Quadricycle Runabout in 1896, his neighbors laughed at him because they were convinced that the loud, vibrating heap that belched thick plumes of black smoke would never replace the dignified mode of transport of the time – the horse.
Similarly, investors dismissed the internet before the dotcom bubble and then became disillusioned in its aftermath.
Some are becoming disillusioned again.
With more time spent online during pandemic lockdowns, the assumption is that as vaccines get into arms, people who are out and about again will spend less time locked down to their screens.
Some investors also fear that higher near-term inflation may force central banks to raise policy rates, hitting expensive tech stocks with high growth expectations priced into their valuations.
That thinking stems from the view that higher interest rates would reduce the present value of long-dated cash flows, but such a view doesn’t take into account the new policy framework that the U.S. Federal Reserve rolled out last August.
Under the Fed’s new policy framework, the central bank can let inflation run hot for several periods, to make up for past undershoots.
So if inflation has been low or negative in previous periods, it can shoot above the Fed’s 2% target in subsequent periods, evening out overall inflation.
And that suggests the Fed will be slow to lift rates from zero, and Fed officials have been repeatedly urging investors to look through near-term inflation volatility.
Judging by the minutes of recent Fed meetings, it is possible to surmise that the central bank is more committed to its new policy framework than markets are giving it credit for, meaning that rates will remain lower for longer than general expectations.
And rates aside, let’s not forget that tech firms were doing well even before the pandemic – it’s not as if connecting with friends, watching videos and shopping online were a recent invention.
An examination of the MSCI World Index reveals that the tech sector has had better earnings than any other sector over the past five years, and looking beyond the tip of one’s nose, the long term shift towards digitalization mean that the pandemic has only accelerated these trends.
In the immediate term, a move into so-called “value” stocks that are more sensitive to the economic cycle, may hurt some tech stocks, which were the darlings of the pandemic trade, but that could also provide a shot in the arm for other companies like semiconductor manufacturers, including Intel (+0.95%), Taiwan Semiconductor Manufacturing Co. (-0.53%) and Samsung Electronics (-0.13%).
While geopolitics and supply chain disruptions could roil chipmakers, the high capital cost and handful of players in this industry mean that they still enjoy strong pricing power.
With a global economy eventually back to shopping again, the rise of the internet of things or IoT, will mean that ultimately everything will need a chip (even a toaster!) and that means the demand side of the equation for chipmakers is likely to be durably strong.
To paint tech with a broad brush is too simplistic, especially when approaching tech as if all tech firms are made equal – they are not.
Those tech companies which are likely to be most affected by rates are the highest growth and least profitable companies – the money burners.
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3. Is China Really Cracking Down on Cryptocurrency?
If you just got invested in cryptocurrencies over the past year, congratulations! You’ve finally experienced your first crash!
Given that many investors (particularly retail) have only just started looking at cryptocurrencies since 2020, they have only known growth and rallies.
For seasoned (perhaps diamond) hands in the cryptocurrency space, crashes are par for the course.
To put things in perspective, since 2011, Bitcoin has suffered four crashes of more than 80% and no fewer than 16 crashes of greater than 30% (17 if you include what happened over the past 24 hours).
Welcome to cryptocurrencies!
You’ll come for the profits, you’ll stay cause you’re hanging on for dear life.
And while there are as many reasons being attributed for the recent crash as there are cryptocurrencies, one possible factor that stands out is the allegation that Beijing is cracking down on cryptocurrencies.
But is that true?
On Tuesday, three financial industry associations, which include banks and online payment firms, reminded their members to not offer any cryptocurrency-related services, including account openings, registration, trading, clearing, settlement, and insurance.
But those restrictions are not new, and have been in place since 2017, when Beijing basically banned cryptocurrency trading in China.
That the “reminder” came from a trade association and not Chinese authorities should be telling.
For years, Chinese have been trading cryptocurrencies, using it to spirit away capital from the Middle Kingdom and running some of the biggest cryptocurrency exchanges on the planet.
And it’s estimated that as much as 75% of all Bitcoin mining occurs within China as well.
One possibility is that cryptocurrencies aren’t the target, but clearing the path for China’s digital yuan could be.
Controlled by the People’s Bank of China, China’s digital currency provides Beijing with a heightened ability to monitor economic activity and its people, and more importantly, gives Communist apparatchiks the power to financially “erase” undesirables.
Being both programmable and trackable, a digital yuan would give Beijing hitherto unfathomable control over China’s enormous economy, allowing Chinese policymakers to know every consumer choice and give the Chinese Communist Party the power to directly affect spending behavior, for instance by setting a expiration date on certain digital currency issuances.
Yet that attempt to gain such power over the economy has the potential to also spur a demand for cryptocurrencies in the future, because the greater Beijing’s desire for control, the stronger the urge from Chinese nationals to send at least a part of their net worth offshore through anonymous stores of value and mediums of exchange (can you think of any?).
If nothing else, the media headlines which said that China was “cracking down on crypto” were entirely misleading.
It was an industry association and not an official pronouncement from the People’s Bank of China, reminding financial institutions not to give in to the temptation to provide cryptocurrency services and to possibly protect the Chinese from the volatile swings the nascent asset is so notorious for.
Think of it as a public service message more than anything else.
Because China has more or less “banned” cryptocurrencies since 2017, none of this is new news.
But it didn’t help with the current bearish sentiment in the market anyway, from Elon Musk’s tweets, to a risk-off sentiment in broader markets, the Chinese financial industry association announcement didn’t do anything to help.
Some cryptocurrency investors already have “diamond hands” (never selling regardless of conditions), but it looks like increasingly they’ll need diamond constitutions as well.
Hang on tight and welcome to the cryptocurrency club.
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May 20, 2021