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Novum Alpha - Daily Analysis 19 August 2021 (10-Minute Read)

A terrific Thursday to you as markets continue to trend lower on concerns that the U.S. Federal Reserve may start tapering its asset purchases sooner rather than later.


In brief (TL:DR)

  • U.S. stocks wound down on Wednesday, with the Dow Jones Industrial Average (-1.08%), S&P 500 (-1.07%) and tech-centric Nasdaq Composite (-0.89%) all continuing to head lower as a top Fed official hints at an early taper, against a backdrop of flattening economic recovery data.
  • Asian stocks slipped early Thursday after a slide on Wall Street sparked by Federal Reserve minutes indicating officials could start paring stimulus from later this year.
  • Benchmark U.S. 10-year Treasury yields were little changed at 1.26% as investors digest the latest U.S. Federal Reserve minutes amid a highly uncertain outlook for yields (yields fall when bond prices rise).
  • The dollar held an advance.
  • Oil fell with September 2021 contracts for WTI Crude Oil (Nymex) (-1.41%) at US$64.54 highlighting the risks to the economic recovery from the impact of the delta variant.
  • Gold was higher with December 2021 contracts for Gold (Comex) (+0.13%) at US$1,786.80 as uncertainty over yields and equities saw some pickup in demand for bullion.  
  • Bitcoin (+0.43%) was at US$45,026 as inflows continued to lead outflows (inflows suggest that investors are looking to sell Bitcoin in anticipation of lower prices). 

In today's issue...

  1. Ratings Agencies Riled by U.S. Profligate Borrowing
  2. The Fed Taper & What It Means For Investors
  3. Cryptocurrencies Rise in the Most Unlikely Countries

Market Overview

Minutes of any meeting capture the moment as it was, not as it is, or as the may be. 
And while investors may be pouring over the recently released meeting minutes from the U.S. Federal Reserve, they also need to bear in mind that that meeting happened weeks ago. 
Back then scientists told us that existing coronavirus vaccines were sufficient to defend against the delta variant and the CDC advised that no booster shots were required for the vaccinated. 
And during those halcyon days, inflation data, thanks to robust consumer demand, was on the rise, with most predicting that the pandemic was in the rearview mirror. 
But the delta variant is threatening a rethink of those assumptions, with infections across the U.S. surging at a time when consumer demand, which makes up a full 70% of the U.S. economy is flagging.
Which is why word of tapering asset purchases, while spoken last month, are being interpreted today, against a changing backdrop. 
Of greater concern is that some top Fed officials are starting to waver on staying the course with quantitative easing as well as the interest rate schedule when it's not at all clear that the U.S. economy is out of the woods yet. 
And that is naturally having an effect on Asian markets which were roughed up on Thursday morning, with Tokyo's Nikkei 225 (-0.45%), Hong Kong's Hang Seng (-0.31%), Seoul's Kospi Index (-0.40%) and Sydney’s ASX 200 (-0.54%) all down in the morning trading session, 

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1. Ratings Agencies Riled by U.S. Profligate Borrowing

  • Ratings agencies which had prepared the ground for the last credit crisis are suggesting that the foundations for the next one are already being laid  
  • Loose credit conditions, record low interest rates and piddling yields are forcing investors to take on more risk in corporate debt, which may come back to bite them should interest rates spike 
During the 2008 Financial Crisis, a significant amount of blame was put squarely on the shoulders of the ratings agencies who gave investors their seal of approval when it came to shaky mortgage-backed securities.
But to be fair to the agencies, their logic wasn’t entirely without basis.
Because if a dicey mortgage was grouped with a bunch of high quality, well-performing mortgages, the odds that the poorer quality debt would collapse the entire structure wasn’t all that high, but to rate them all “AAA” - the highest investable grade of security? Debatable. 
That having been said, given the market conditions of the day, even if the ratings agencies were to dial back those toxic mortgage securities to “BBB” would investors still have chosen not to buy them? Again, debatable.
But stung and sanctioned from their alleged involvement (to be fair everyone was complicit) in the 2008 Financial Crisis, ratings agencies are now sounding the alarm on a wave of U.S. corporate debt that they say could lead to a cascade of defaults.
Data from S&P Global Ratings reveals that sales of low-rated “speculative grade” debt has already surpassed US$650 billion this year, on track to surpass an all-time record despite there being over a third of the year left to run.
A backdrop of low interest rates has made it possible for some of the shakiest companies to raise debt on extremely favorable terms.
From cruise operators and airlines, to video game retailers and theater operators, some of America’s most fiscally unsound companies are borrowing copious amounts of money for pennies on the dollar.
Analysts at Moody’s and S&P are warning that while default risks are not immediate, especially given central bank intervention in the economy, the profligate borrowing is laying the ground for a future debt crisis.
Last March, at the start of the pandemic, the U.S. Federal Reserve stepped in to backstop corporate bond markets, soaking up debt of some of America’s biggest corporate borrowers to prevent a repeat of the freezing of credit markets that occurred in 2008.
But the Fed’s action, which caused borrowing costs on the highest-rated American corporate debt to plunge to near-Treasury levels, has forced investors to rifle through the couch cushion to hunt for other sources of yield.
Thus far, investors have shaken off the potential for the delta variant to put the kybosh on the U.S. economic recovery. 
But reduced consumer demand, coupled with a resurgent pandemic, at a time when the Fed is considering tapering its intervention, could provide the conditions for a perfect storm.
Higher inflation has the potential to push up interest rates, making companies with floating-rate debt particularly vulnerable to increased borrowing costs, at a time when the pandemic could stymie any resumption of pre-pandemic demand.
Investors will need to decide for themselves whether the ratings agencies who failed to cry wolf in 2008, are crying wolf now.

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2. The Fed Taper & What It Means For Investors

  • Top U.S. Federal Reserve official talks tapering as more voices on the central bank look hawkish
  • Markets have become addicted to central bank support, meaning that the Fed's goals and how it intends to achieve it may not align with the market's expectations   
“You taper if you want to. The Fed’s not for tapering.”
– adapted from “the lady’s not for turning” speech to the Conservative Party Conference on 10 October 1980, Margaret Thatcher, Prime Minister of the United Kingdom
For the longest time (in pandemic terms), the U.S. Federal Reserve has sought to assure investors both domestic and abroad, that the central bank’s steady hand would continue to have a role in the markets until such time that specific economic goals were met.
Some of the Fed's goals include maximum employment and annual inflation of 2%.
So far at least one of those goals looks likely to be met.
But now some of the Fed’s top brass are suggesting that the central bank’s emergency bond-buying program, which soaks up some US$120 billion in asset-backed securities and U.S. Treasuries every month, are ill-suited to an economy that’s being held back by supply constraints.
Speaking with the Financial Times, President of the Boston Federal Reserve Eric Rosengren said that he would support the Fed announcing tapering next month, with a view to winding up the bond buying spree by as soon as next June.
Rosengren’s comments immediately roiled U.S. equities yesterday with investors pricing in a sooner-than-expected Fed evacuation of the market.
But the knee-jerk reaction from investors may be disproportionate to the scale and manner of the Fed’s tapering of asset purchases, after all, this isn’t Kabul.
Instead, U.S. Federal Reserve Chairman Jerome Powell has repeatedly assured investors that any tapering, any revision of rates, would be clearly communicated to market participants, well in advance of their implementation, giving the market time to digest the information and respond accordingly.
But Rosengren’s views matter because next year, he’ll be a voting member of the powerful rate-setting Federal Open Market Committee, of which twelve members sit, including Powell, whose term as Chairman of the Fed ends in February next year.
The worry for investors is that policymakers may agree on the goals of the Fed, but disagree on the manner in which these goals can be achieved.
Speaking with the Financial Times, Rosengren worries,
“I do worry that undue leverage and price appreciation that could potentially be reversed down the road could undermine the ability to reach our full employment mandate over time.”
Rosengren is one of a growing chorus of voices at the Fed who are concerned that many investors are increasingly taking on more risk and asset purchases are not helping because the additional yield above safe U.S. Treasuries, demanded by investors for owning high-yield and more risky bonds, is hovering near all-time lows.
For investors, the prospect of a sharp correction across a broad range of assets is a clear and present danger, especially if Rosengren and other more hawkish members of the Fed can constitute a sufficient majority to realign policymaking. 

3. Cryptocurrencies Rise in the Most Unlikely Countries

  • Blockchain analytics shows increasing retail usage in countries like India and Vietnam 
  • Cryptocurrencies developing on two distinct tracks, with retail increasingly more significant in emerging markets, while institutional investors take center stage in developed markets 
A dong for your Dogecoin? A rupee for your Ripple?
At least that's what blockchain flows appear to suggest according to Chainalysis.
Despite cryptocurrencies being banned in India, CoinDCX, India’s largest cryptocurrency exchange which recently raised US$90 million in investment, giving it unicorn status, has boomed amidst surging local demand for digital assets.
While the rise of Ho Chi Minh-based Axie Infinity, which allows players to earn cryptocurrencies by playing decentralized games and collecting rare non-fungible tokens, has been riding high off soaring Vietnamese demand for digital assets as well.
Chainalysis reported that as global cryptocurrency adoption has risen by 881% over the past year, countries like Vietnam and India are leading the pack among the retail audience.
Using factors like peer-to-peer exchange trading volume and value received, a recent Chainalysis report focused on use cases related to transactions and individual saving, as opposed to trading and speculation and saw that countries like Vietnam and India had the highest retail adoption.
Part of the reason of course could be that as the coronavirus pandemic rages across much of India and Vietnam, more people are stuck at home with fewer entertainment options and have taken to playing decentralized games to generate cryptocurrency income.
For retail investors, playing Axie Infinity to generate cryptocurrencies, or providing liquidity on decentralized finance platforms to generate yield on their savings may be ways not just to make money, but also to pass time.
According to Chainalysis,
“In emerging markets, many turn to cryptocurrency to preserve their savings in the face of currency devaluation, send and receive remittances, and carry out business transactions.”
While interest in cryptocurrencies has surged over the past eighteen months, the quality of that surge has changed, with the Chainalysis report revealing that in emerging markets, adoption has largely been driven by retail investors, while in the U.S., Western Europe and East Asia, the charge has been led by institutional investment.
Cryptocurrencies have also created economic opportunities for talented developers and programmers in India and Vietnam, minting new millionaires and billionaires.
Take Axie Infinity for instance, the massively popular NFT game, which saw the value of its token go from around US$0.16 to US$70 in just under a year.
And success stories like CoinDCX and Axie Infinity will encourage more Indians and Vietnamese to look into opportunities within the cryptocurrency space, not just as a means to get rich, but also to build new applications, tailored for their booming local markets, something which Chainalysis has already considered,
“Growing transaction volume for centralized services and the explosive growth of DeFi are driving cryptocurrency usage in the developed world and in countries that already had substantial adoption, while P2P platforms are driving new adoption in emerging markets.”
“Our biggest question for the next 12 months is how much adoption will continue on those platform categories compared to new and emerging models we haven’t seen yet.”

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Aug 19, 2021

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