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Novum Alpha - Daily Analysis 27 September 2021 (10-Minute Read)

Markets climbed Monday as energy companies advanced with oil, offsetting concerns about risks from China.

 
A magnificent Monday to you as the markets climbed on lowered concerns over the potential fallout from China's Evergrande Group crisis. 
 

In brief (TL:DR)

 
  • U.S. stocks closed more or less unchanged on Friday with the Dow Jones Industrial Average (+0.10%) and S&P 500 (+0.15%), while the tech-centric Nasdaq Composite (-0.03%) was lower.
  • Asian stocks edged up at the open Monday with traders keeping an eye on China Evergrande Group’s debt crisis. but sentiment still strong. 
  • Benchmark U.S. 10-year Treasury yields rose 1.454% (yields rise when bond prices fall) at the end of last week. 
  • The dollar slipped. 
  • Oil continued to gain with November 2021 contracts for WTI Crude Oil (Nymex) (+1.51%) at US$75.10 on expectations of demand as the world economy reopens. 
  • Gold regained ground with December 2021 contracts for Gold (Comex) (+0.40%) at US$1,758.70.
  • Bitcoin (+4.49%) recovered to US$44,208 as investors digested the news that cryptocurrency transactions would be illegal in China but unaffected elsewhere with outflows pipping inflows again (outflows suggest that traders are looking to hold Bitcoin in expectation of higher prices). 
 

In today's issue...

 
  1. The Reflation Trade That Was Not to Be
  2. Evergrande Will Not be China's Lehman Moment
  3. China is Serious About its Cryptocurrency Ban
 

Market Overview

 
Markets climbed Monday as energy companies advanced with oil, offsetting concerns about risks from China.
 
While global equities notched their first weekly advance in three as traders shrugged off concerns over a U.S. Federal Reserve pullback in stimulus and contagion risks from China Evergrande Group, risks remain. 
 
Investors are shifting their attention to risks from China where a looming energy crisis is brewing and worries about Evergrande simmer, despite broad expectations that a mega corporation like the Evergrande Group will unlikely be allowed by Beijing to implode. 
 
In Asia, markets edged up in the morning trading session, with Tokyo's Nikkei 225 (+0.35%), Seoul's Kospi Index (+0.56%), Sydney’s ASX 200 (+0.96%) and Hong Kong's Hang Seng (+1.15%)  all reflecting growing confidence that the Evergrande Group debt crisis will be resolved. 
 

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1. The Reflation Trade That Was Not to Be

 
  • This year has proved more challenging as macro hedge funds bet on the so-called reflation trade – where huge levels of fiscal and monetary stimulus were eased against a resurgence in global demand and rising inflation. 
  • With unprecedented levels of liquidity flooding into the financial system, macro hedge funds have often been caught flatfooted by market moves increasingly bearing little correlation with macroeconomic fundamentals.
 
Macro hedge funds which had enjoyed a miraculous 2020 have so far spent most of this year licking their wounds.
 
Betting on global bonds, currencies and equities, macro hedge funds enjoyed bumper returns in 2020 fueled by collapsing bond yields as central banks slashed interest rates, pushing bond prices higher (yields fall when bond prices rise).
 
Then when stocks saw a resurgence in late March of last year, as liquidity flowed into asset markets, macro hedge funds profited off that trade as well.
 
But this year has proved more challenging as macro hedge funds bet on the so-called reflation trade – where huge levels of fiscal and monetary stimulus were likely to be eased against a resurgence in global demand and rising inflation, which would hit government bonds.
 
According to that investment thesis, macro hedge funds would then be able to flip their bets on government bonds like U.S. Treasuries, and position their portfolios for higher yields, as demand for Treasuries was expected to fall (bonds generally perform poorly in periods of high inflation).
 
And while headline inflation numbers soared, the benchmark U.S. 10-year Treasury yield confusingly sank, falling from over 1.7% in March to just 1.2% last month (it currently stands around 1.4%), as investors bet that the U.S. Federal Reserve would be firmly in control of price increases.
 
The result has been returns of just 2.8% on average by macro hedge funds which have trailed the hedge fund industry’s 9.5% for the first eight months of this year, according to data firm eVestment.
 
Macro funds have tended to do better than their hedge fund counterparts during periods of financial turmoil, such as bad news or market shocks, including famous bets by George Soros during the collapse of the United Kingdom’s Exchange Rate Mechanism with West Germany’s Deutsche mark and the 1997 Asian Financial Crisis.
 
With unprecedented levels of liquidity flooding into the financial system, macro hedge funds have often been caught flatfooted by market moves that increasingly bear little correlation with macroeconomic fundamentals.
 
From GameStop (-3.18%) to AMC Entertainment (+0.075%), cryptocurrencies to bond yields, trying to analyze the economic impacts of quantitative easing can be akin to trying to read tea leaves or goat entrails.
 
But while macro may be down, it is certainly not out.
 
The prospect of China’s Evergrande Group collapsing under the weight of its own borrowings has already increased market volatility in recent weeks and central bank tapering could presage a rise in yield volatility.
 
Inflation has already forced several emerging market banks to hike rates, including Turkey and Russia, while the OECD has sharply increased inflation forecasts.
 
Markets so far have been fairly sanguine about the prospect of inflation and volatility, and it is in periods of relative calm that macro hedge funds build up strong positions to make returns when everyone else would have been caught off guard.
 

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2. Evergrande Will Not be China's Lehman Moment

 
  • While the Evergrande Group is being allowed to flounder for now, it won’t be allowed to collapse in a messy way, as evidenced by Chinese firms continuing to sell dollar-denominated bonds throughout this month
  • Most traders are taking comfort that there are precedents for Evergrande Group to follow, such as the massive restructuring of conglomerate HNA Group
 
China’s Communist Party is a conscientious student of history.
 
It’s been said that following the collapse of the Soviet Union, China’s Communist apparatchiks were so concerned that the same fate could befall them as well, they made it mandatory to study the U.S.S.R.'s collapse in order to prevent a similar occurrence in China.
 
And it’s that pragmatism that led to sweeping economic reforms in China, which wrought forth the world’s second largest economy.
 
In that same vein, the Chinese Communist Party is also well aware of how the collapse of the Evergrande Group could very rapidly become China’s Lehman Brother’s moment.
 
Despite its gleaming towers, expansive bridges and highspeed railways, China is still very much an emerging market, warts and all, and global investment flows as well as confidence can just as easily reverse.
 
Which is why investors closer to Beijing have recognized that while the Evergrande Group is being allowed to flounder for now, it won’t be allowed to collapse in a messy way, as evidenced by Chinese firms continuing to sell dollar-denominated bonds throughout this month.
 
Chinese traders helped stabilize Shanghai’s benchmark CSI to end the week just 0.1% lower despite the turmoil at Evergrande Group.
 
Most traders are taking comfort that there are precedents for Evergrande Group to follow, as an alternative to a messy collapse, such as the massive restructuring of conglomerate HNA Group.
 
China's Communist Party has not had a single mega corporation collapse on its watch and certainly not one with so much exposure to average investors, who soaked up billions of dollars’ worth of Evergrande Group’s wealth management products.
 
Helping matters along is that the bulk of Evergrande Group’s US$305 billion in liabilities is owed onshore to the Chinese banking system, which is almost entirely state-owned.
 
Just US$20 billion of Evergrande Group’s dollar-denominated bonds are owed offshore.
 
 

3. China is Serious About its Cryptocurrency Ban

 
  • Beijing threw down the gauntlet to make it painfully clear it would no longer tolerate cryptocurrency transactions, no matter how innocuous
  • The move suggests that Beijing intends to attack the “cryptocurrency problem” from all angles, from law enforcement to monitoring internet traffic
 
That Beijing has always had it in for cryptocurrencies is no big secret, but the efficacy of the measures has always been less clear.
 
Last Friday however, Beijing threw down the gauntlet to make it painfully clear it would no longer tolerate cryptocurrency transactions, no matter how innocuous.
 
Almost immediately, Huobi, a cryptocurrency exchange popular with the Chinese, immediately stopped allowing new users to register their accounts with a phone number from China.
 
But cryptocurrencies have been banned from China for some time.
 
As far back as 2017, Beijing banned initial coin offerings or ICOs, then cryptocurrency exchanges and this year cracked down on its massive cryptocurrency mining industrial complex.
 
Last Friday, the People’s Bank of China, the Chinese central bank, along with nine other government institutions including China’s Supreme Court, the police, as well as internet and securities regulators, published a missive to ban all cryptocurrency transactions.
 
The move suggests that Beijing intends to attack the “cryptocurrency problem” from all angles, from law enforcement to internet traffic.
 
Beijing also closed long-standing loopholes that enabled Chinese citizens to maintain cryptocurrency exchange accounts with offshore exchanges such as Huobi and forbid platforms from hiring locally for roles including marketing, technology and payment, all in an effort to stymie access to Chinese customers.
 
While cryptocurrencies tumbled almost immediately following the announcement, they rebounded just as quickly, erasing most of the losses by Monday in Asian trading.
 
Some traders are of the view that a blanket ban by Chinese authorities on cryptocurrencies are only going to enhance the attractiveness of the nascent asset class, after all, that which is forbidden is often the most desired.
 
And China’s crackdown on cryptocurrencies is also coming against a backdrop of a wider restriction of freedom in the Middle Kingdom, from video games to afterschool education, millions of Chinese are being swept up in the most comprehensive social experiment mounted by the Chinese Communist Party since the Cultural Revolution.
 
Beijing’s sweeping measures may convince those of more liberal persuasions that had they had any hesitation to shift at least some of their substantial assets offshore, now would be the time to be decisive about such a move, and what better way to spirit wealth abroad than through cryptocurrencies.
 
 

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Sep 27, 2021

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