Novum Alpha - Daily Analysis 14 July 2021 (10-Minute Read)
While the U.S. Federal Reserve has remained dismissive about the highest pace of price increases since 2008, investors have started voting with their feet already, exiting positions across the board from tech to cyclicals and Treasury yields have spiked in response to expectations of higher inflation.
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A wonderful Wednesday to you as markets enter a bit of a midweek slump.
In brief (TL:DR)
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In today's issue...
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Market OverviewThe thing about inflation is that it's never really a problem until it becomes one.
While the U.S. Federal Reserve has remained dismissive about the highest pace of price increases since 2008, investors have started voting with their feet already, exiting positions across the board from tech to cyclicals and Treasury yields have spiked in response to expectations of higher inflation.
But a closer look at the inflation data may reveal much ado about nothing.
To be fair, while CPI data was far outside economist ballparks, as much as a third of those price increases were due to the secular rise in used vehicle sales, which are both seasonal and an outlier, given that the U.S. is both reopening coinciding with the peak summer driving season.
And CPI data is also being compared with last year's data, in other words, an abnormally low base, which is why markets may be reacting far in excess of any genuine threat of a withdrawal of liquidity by the Fed.
At the very most, the Fed may begin to consider bringing forward rate hikes, but even if policymakers were to do so in early 2023, that's still a long time from now and with everything to play for.
There are signs already that not everything is well with the global economy.
China's move to reduce its reserve requirement ratio for its banks is disconcerting and suggests that GDP growth numbers are not as rosy as Beijing would have the world believe (they almost never are).
And the delta variant of the coronavirus is threatening to push reopened countries back into lockdown at a time when the early gains from mass vaccination programs are starting to taper off.
All of which provides more than enough justification for the U.S. Federal Reserve and global central banks to stand back and stand by.
In Asia, stocks were understandably weaker in Wednesday's morning trading session with Sydney’s ASX 200 (+0.22%) higher as inflation is expected to buoy commodity prices denominated in dollars, while Seoul's Kospi Index (-0.38%), Tokyo's Nikkei 225 (-0.15%) and Hong Kong's Hang Seng (-0.48%) were all down, taking their cue from Wall Street.
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1. Banks Are Earning More from Less
“Three, six, three.”
For bankers of yore, these numbers will bring fond memories of the days when being a banker was a far simpler job, you pay three percent on deposits, charge six percent on loans, and are on the greens by three o’clock in the afternoon.
But financial innovation and a low interest rate environment have forced many a banker to think out of the box to create far more with far less.
Second quarter earnings yesterday revealed that JPMorgan Chase more than doubled profits last quarter despite falling revenues, as lower interest rates, lackluster loan demand and a slowdown in trading activity from the height of the pandemic weighed down returns.
Goldman Sachs saw higher revenues from its asset management business, particularly from private equity investments, to make up for falls in its markets business which slipped due to lowered market volatility.
With much of the “easy money” that banks typically earn through net interest income, the difference between what banks pay on deposits and what they earn on loans and other assets, now a sliver of what they used to be thanks to government stimulus and a flattening Treasury yield curve, banks are having to get more creative in how they generate income.
Trading desks provided banks with a solid stream of revenue during the sharp recovery in markets from March last year, but further growth from those divisions appears to be slowing down as markets appear to be reaching terminal velocity.
And the fallout from the Archegos Capital Management implosion will give more than some pause to the swashbuckling prime brokerages of many banks, keen to ensure that risk management is robust in the event of another market fallout.
Low hanging fruit in the form of the release of funds from bad loan provisions are gains that have already been realized, but one bright spot for banks remains mergers and acquisitions activity which appears to be picking up steam.
Private equity firms have had their busiest six months on record, striking deals worth over US$500 billion and helping to propel global M&A activity to an all-time-high.
Acquirers flush with cash from easy credit conditions and successful share sales are in an acquisitive mood, while target companies are proving more willing to come to the table on uncertainty if valuations could get any more favorable given future uncertainty.
Investment banks such as Goldman Sachs and JPMorgan have made a windfall from fees associated with the dealmaking frenzy, with total M&A fees globally hitting US$17.9 billion in the first half of this year and the two banks sitting high atop their league tables.
Looking ahead though, several factors bode well for banks, including the prospect of higher interest rates, which will help their net interest income, as well as the development of new products and sectors, including digital assets, which has seen strong demand from high net worth clients.
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2. Everything Just Got Pricier
It should come as no surprise but with supply chains shred to ribbons by the coronavirus pandemic and a reopening U.S. economy demanding everything from cars to casseroles, prices are heading northwards.
The U.S. Consumer Price Index or CPI surged in June by its most since 2008, topping all forecasts and testing the U.S. Federal Reserve’s commitment to ultra-loose monetary support for the economy.
The U.S. CPI jumped a further 0.9% in June and excluding the more volatile components of the CPI such as food and energy, rose 4.5% from June last year, the largest advance since November 1991.
But investors are well-advised to read between these high headline numbers before battening down the hatches and dumping tech stocks.
For starters, comparing June’s CPI with a year ago is like comparing apples to oranges.
Last June, the U.S. was in the depths of a pandemic which few would have guessed it would have so quickly climbed out of, and vaccines, while promising, were nothing more than a pipe dream at the time.
Used vehicles accounted for more than a third of the gains in the CPI, coinciding with the peak summer driving season, and a number that is almost guaranteed to moderate in the coming periods (consumers don’t typically keep buying used vehicles month-on-month).
A pricing rebound in categories which weren’t even available last June, including hotel stays, car rentals, apparel (sweatpants anyone?) and airfares, as well as make-up and consumer discretionary purchases have all contributed to outsize price increases.
Qualitatively, nothing about the elevated CPI compared to a year ago should surprise and if nothing else, prices are just heading back to normal.
More importantly, the Fed uses the Personal Consumption Expenditure or PCE price index as its preferred measure of inflation, which looks at what businesses are selling rather than what consumers are buying and considers things like the substitution of goods when something gets more expensive, in determining its rate-setting policy.
And so there’s no reason (for now at least) to see the Fed reacting to the most recent CPI data by either paring back stimulus or raising interest rates in the immediate term.
Nonetheless, investors see the CPI data as putting pressure on the Fed to bring forward interest rate hikes, with the U.S. Treasury yield curve flattening, emboldening traders to bet that the Fed will increase interest rates earlier in 2023 than scheduled.
That seems somewhat premature.
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3. Give the People What they Want - Cryptocurrencies
“Computer says no.”
At first blush, one would think that the world of robo-advising, where sophisticated software programs recommend investments to clients would pair well with cryptocurrencies, but so far the two have made for uncomfortable bedfellows.
Robo-advising has become more popular of late based on the assumption that algorithms, which are not susceptible to the human emotions of fear and greed, are able to deliver more consistent returns.
Charles Schwab (+0.21%), the U.S. financial services giant has predicted that assets managed by robo-advisers will cross US$460 billion by next year, even as automated choices have come under far more scrutiny from the U.S. Securities and Exchange Commission.
Yet one massive gap for robo-investing has been cryptocurrencies.
While zero-fee digital brokerages like Robinhood and SoFi have made cryptocurrencies available to individual retail traders, so far, they have fallen outside the purview of robo-investing.
Part of the challenge is that licensed robo-advisers have a lot to lose from adding cryptocurrencies into the mix, the biggest of which is their investment management licenses.
Despite big returns this year, cryptocurrencies remain highly volatile and robo-advisers have a duty to act in the best interest of their clients, meaning that the expectation of a high positive return must far outweigh any portfolio risk, which is challenging when it comes to the nascent digital asset class.
Robo-advisors which would appeal most to millennials and Gen Z are also reaching out to the same demographic for whom an overwhelming majority see cryptocurrencies as a legitimate form of payment.
According to a Harris Poll concluded earlier this year, as many as 58% of Gen Z (18 to 24) saw cryptocurrencies as a legitimate form of payment, with the figure soaring to 69% for millennials (25 to 40).
And even as cryptocurrency prices have tumbled, a younger generation of investors have continued to snap up digital assets with a Gemini survey revealing that the average U.S. cryptocurrency investor is a 38-year-old male with a household income of at least US$110,000.
But as fees have dropped across the board and with the robo-advising space becoming more crowded, robo-advisers are understandably looking to cryptocurrencies where they can charge a premium for their expertise.
Whereas a typical robo-adviser could charge around 0.25% as a management fee, equivalent cryptocurrency robo-advisers could levy fees of as high as 2% and in some cases even charge a performance fee on top.
Part of the reason of course is that the cryptocurrency markets can be bewildering, and its speed and complexity can be daunting to the average investor, especially someone who has just barely gotten into stocks, allowing robo-advisers with the wherewithal to venture into the asset class to charge a premium for their service.
And as Gen Z and millennials are starting to have more investable assets, their comfort with digital financial products and cryptocurrencies means that at some stage, even the most conservative robo-advisers will need to look at the nascent asset class.
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Jul 14, 2021