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Novum Alpha - Daily Analysis 21 October 2021 (10-Minute Read)

Corporate results have tempered but not dissipated worries that cost pressures, stoked by an energy crunch and supply-chain snarls, could endure and slow the pandemic recovery.

A terrific Thursday to you as stocks generally wind higher despite lingering concerns over inflation and growth. 

In brief (TL:DR)

  • U.S. stocks closed higher Wednesday with the Dow Jones Industrial Average (+0.43%) and the S&P 500 (+0.37%) up, while the tech-centric Nasdaq Composite (-0.05%) was down marginally on profit-taking.
  • Asian stocks were steady Thursday as investors weighed corporate earnings, elevated inflation and spillover risks from China’s property sector.
  • Benchmark U.S. 10-year Treasury yields rose one basis point to 1.67% (yields rise when bond prices fall) on uncertainty over the Fed's taper schedule. 
  • The dollar remained lower amid bets other central banks will boost interest rates before the U.S. Federal Reserve.
  • Oil climbed with November 2021 contracts for WTI Crude Oil (Nymex) (+1.10%) at US$83.87 as the rally in energy prices shows no signs of abating. 
  • Gold rose with December 2021 contracts for Gold (Comex) (+0.22%) at US$1,788.90. 
  • Bitcoin (+1.85%) was at US$64,989 after setting an all-time high as the first U.S. bitcoin ETF commenced trading, with outflows rising against inflows and profit-taking insufficient to crack the bullish sentiment in cryptocurrencies (outflows typically signal that investors are looking to hold Bitcoin in anticipation of higher prices). 

In today's issue...

  1. Should we Heed the Debt-to-Equity Ratio Warnings?
  2. Evergrande Struggles to Sell Assets
  3. Bitcoin Sets New All-Time-High Against ETF Backdrop

Market Overview

Corporate results have tempered but not dissipated worries that cost pressures, stoked by an energy crunch and supply-chain snarls, could endure and slow the pandemic recovery.
Investors are also grappling with the prospect of reduced central bank support and remain wary of the travails in China’s real-estate sector.
In Asia, markets were mixed with Tokyo's Nikkei 225 (-0.32%) down, while Hong Kong's Hang Seng (+0.27%), Sydney’s ASX 200 (+0.27%) and Seoul's Kospi Index (+0.31%) were up in the morning trading session.

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1. Should we Heed the Debt-to-Equity Ratio Warnings?

  • With the explosion in market capitalizations thanks to loose monetary conditions, a recent explosion in debt issuance has papered over a monstrous iceberg of assumptions that lays just beneath the surface.
  • Looking at the entire corporate sector’s debt-to-equity ratio is helpful the same way an index is expected to be indicative of where the markets are at the moment, yet provide very little information about individual stocks.
The danger with icebergs is that it’s not what you see that could kill you, but what lies beneath.
With the explosion in market capitalizations thanks to loose monetary conditions, a recent explosion in debt issuance has papered over a monstrous iceberg of assumptions that lays just beneath the surface.
Last month, analysts at Bank of America (+1.31%) noted that the loans and bonds carried by U.S. companies relative to market capitalization had hit a record low in the second quarter of just 23%, which should sound like good news.
While the ratio of corporate debt to equity has been drifting downwards for some time, bubbly equity markets have seen valuations soar and given the false impression that there’s incremental capacity to issue more debt.
But is there?
The BoA analysts also noted that the metric of debt-to-equity has sometimes foreshadowed stock market corrections, with the ratio hitting lows in 2000, just before the dotcom bubble burst, and again in 2007, before the financial crisis.
Nonetheless, equity valuations alone should not be the first stop in understanding leverage, even if debt-to-equity ratios seem to point in that direction.
And absolute debt levels alone can also be misleading if profits and cashflow used to service such borrowings are excluded from consideration.
Data from the U.S. Bureau of Economic Analysis found that corporate net cashflow between 2017 and 2019 soared by a quarter to US$2.5 trillion and as interest rates have plummeted, the servicing costs of that debt have fallen alongside.
Market capitalizations can in theory absorb substantial losses before debt becomes impaired, but equity value is not cash and in a market correction, can rapidly evaporate before a company has an opportunity to respond.
Looking at the entire corporate sector’s debt-to-equity ratio is helpful the same way an index is expected to be indicative of where the markets are at the moment, yet provide very little information about individual stocks.
Investors looking to glean insights from such ratios need to dig a little bit deeper to extract value – is the company borrowing to grow and acquire? Or simply to service existing debt? And more importantly, what are a firm’s cashflows like? 

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2. Evergrande Struggles to Sell Assets

  • China’s all-important property and construction industries have shrunk in the third quarter for the first time since the start of the pandemic, weighed down by a slump in real estate.
  • Power shortages and falling property real estate prices are eating into household wealth, of which real estate is estimated to constitute as much as 70%, and undermining consumer sentiment.
In more bad news for struggling Chinese real estate giant Evergrande Group, a potential sale of its property services unit has fallen through.
Earlier this month, the embattled real estate developer managed to raise US$1.5 billion through the sale of its stake in Shenjing Bank (-0.29%), but the cash raised is a drop in the ocean for a company sitting on some US$305 billion in liabilities.
Evergrande Group has already missed several interest payments and an offshore dollar-denominated bond will go into formal default this weekend if something is not done.
So far, bond holders haven’t received any interest payments or heard from the real estate developer about any contingency plans.
The deal to sell 50.1% of Evergrande Property Services Group to fellow developer Hopson Development Holdings (+4.95%) for some US$2.6 billion had been terminated last week, according to filings late yesterday.
Evergrande Group is in a race to sell assets, but many analysts expect that the real estate developer will in all likelihood have to undergo a massive restructuring to prevent a messy fallout.
Troubles at the Evergrande Group have now started to spillover into the broader Chinese real estate market.
Chinese luxury developer Fantasia’s US$206 million bond and Sinic Holdings’ US$246 million bond have both gone into default, while yields on riskier Chinese borrowers in Asian bond markets have soared to their highest level in over a decade.
The People’s Bank of China, China’s central bank, which until fairly recently has been deafeningly silent on the Evergrande Group crisis, has finally weighed in to reassure markets that the spillover effects were “controllable” while blaming the developer for creating the mess.
China’s real estate sector has shrunk in the third quarter year-on-year, amidst a push to reign in the highly leveraged sector, but there are signs that Beijing may be loosening up to prevent a messy fallout.
The PBoC has been pushing banks, almost all of which are state-owned, to approve mortgages more quickly while also shoring up liquidity at lenders.
Ahead of a crucial leadership reshuffle next year which will see Chinese President Xi Jinping assume an unprecedented third term, Communist Party apparatchiks can ill afford a financial collapse of the property sector which makes up a full 40% of the Chinese economy, 29% of GDP and some 70% of household wealth. 

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3. Bitcoin Sets New All-Time-High Against ETF Backdrop

  • Whether it’s Grayscale Bitcoin Trust or the shiny new futures-based ProShares Bitcoin Strategy ETF, if investors want to buy bitcoin, they should setup their private wallets and just go ahead and buy it.
  • After much anticipation, the ProShares Bitcoin Strategy ETF started trading yesterday, but it is NOT an ETF backed by actual bitcoin, instead it is backed by futures tied to the cryptocurrency.
So what if the U.S. ProShares Bitcoin Strategy ETF isn’t buying bitcoin? Those are just details right?
Despite the first U.S. bitcoin ETF not actually exerting any sort of “buy” pressure on bitcoin, instead, buying CME Group’s cash-settled bitcoin futures, which again, do not “buy” bitcoin, traders helped to rally bitcoin to a fresh all-time-high.
Surpassing a previous all-time-high, bitcoin cleared US$67,000 and surpassed its previous peak set in April.
The approval of the ProShares Bitcoin Strategy ETF has opened the floodgates for other filings, including Grayscale’s bitcoin trust product, which actually does hold some US$38 billion of bitcoin. 
Part of the euphoria in investment circles is that because the bitcoin ETF is regulated, it now becomes easier for financial advisers to add bitcoin exposure to client portfolios, albeit through futures.
What this does for actual bitcoin demand however, is less clear.
The U.S. Securities and Exchange Commission’s approval of the bitcoin-ish ETF is a stark departure from China’s approach, where the People’s Bank of China banned all cryptocurrency transactions last month, leading to an almost knee-jerk correction in cryptocurrency prices.
But that bearish sentiment was almost instantly erased when both the Chairman of the U.S. SEC Gary Gensler and Chairman of the U.S. Federal Reserve Jerome Powell, both articulated that neither had any interest in banning cryptocurrencies.
Fund flows into the ProShares Bitcoin Strategy ETF were overwhelming on its first day of trading.
Traders will also be able to wager on the price of the ProShares Bitcoin ETF through options as well, allowing investors to build significant positions in the fund without holding it outright.
For many institutional investors, the ProShares Bitcoin ETF and the availability of options presents an opportunity to gain exposure to the price of bitcoin, as many have investment mandates that prevent them from investing directly in the underlying asset.

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Oct 21, 2021

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