COVID, inflation, deflation, global growth prospects, interest rates and a bunch of other things that I could probably write a book about, all worry me. However, all the above aside, the thing that mostly worries me above all others is the value of the dollar.
Taking a cue from Star Wars, the dollar is something like the force. When there is balance in the force, things work ok, and the galaxy is peaceful. But when there is a disturbance in the force, then all hell breaks loose.
Similarly, when the dollar’s value is balanced, the global economy is growing, and things are moving alone ok. But when the dollar becomes strong, then things don’t work so well. A strong dollar means there are fewer dollars available for the global economy to function properly. It also means companies and countries that have dollar denominated debts must pay more. But it might also mean a headwind for US companies that rely for a big portion of their profitability from global markets.
A higher dollar might also mean market participants are buying dollars as a safe haven trade. And every time this happens, it does not fare well for equities.
So, if we look at the chart above, one can probably say that as long as the EURUSD pair remains above 1.17, risk assets should continue to do well. But if the pair falls and remains below 1.17, then chances are we might see correction.
On the other hand, if we see the pair above 1.22, then chances are risk assets will continue to perform well, and we might see a strong upward move in equities.
The bottom line is that there are countless things that worry me, and countless things that can cause a correction in the equity space. However insofar as the dollar, if it remains at current levels, it will be one less thing to worry about. And if we see the EURUSD pair above 1.22, then we can say with a little more confidence that the Force will continue to be with risk assets.
With US 10-year bond yields around 1.25% (as of Thursday July 22) the question is, what is the bond market telling us?
Some say the bond market is pointing to stagflation from 2022 and beyond. Others say yields will rise because of inflation, and that these low yields are “transitory”. Other say the low yields point to the continuation of the pandemic with the Delta variant.
Then there are others who think at the bond market is not telling us anything anymore. The low yields we are seeing, despite inflation, are probably a reaction to the liquidity created by central banks. Let us not forget at the Fed the ECB and the Bank of Japan are all continuing to create liquidity at a record pace. So maybe the bond market it is not telling us anything anymore because it can’t.
So where does this leave equities? The answer is by themselves. Stocks do not have bonds to give them a hint of what might happen in the future. And while analysts, economists, and pundits alike are all confused about what the bond market is saying, it’s probably safe to say we should not look to bonds for any kind of direction.
The bottom line is that market participants are very confused as to what the bond market is saying. This confusion stems from the fact at the bond market is giving us conflicting signals based on what we have been conditioned to think for many years now. Maybe low bond yields are a bad omen for global growth, or perhaps not. One thing is true, this is not your grandfather’s bond market.
Up to about 50 years ago, inflation was the main worry of central banks, primarily because high inflation eroded consumer purchasing power.
Today however this has changed, and the main objective is economic sustainability. By this I mean Central Banks want a continuation of growth with or without inflation. Besides, why increase interest rates and crash the economy making a mess of things, only to lower interest rates to try to inflate the economy, and then do the entire thing all over again?
Many say these asset purchases will cause inflation. Yes, it might happen in the future, but over the past 30 years or so, the lessons to be learned are that we are not in the 50s – 70s anymore.
Which brings us to the discussion on when the Fed will lower or even eliminate the 120 billion dollars in bonds it purchases each month.
My guess is that the Fed will continue these purchases for longer than we imagine. The reason is, the last thing the Fed wants are higher interest rates. Higher rates will affect negatively both the labor market and asset prices. Both stocks and real estate prices are likely to trend lower, which will have an impact on the wealth effect, which will eventually impact the real economy.
Also, contrary to many years ago, the US government today has a much higher debt load. Higher interest rates mean more dollars to service this debt. And with fiscal spending still running, the last thing the US Treasury needs are higher outlays for servicing its debt.
So, while you will not hear the Fed saying it, higher interest rates are not what it wants, even if inflation persists. Insofar as what risk assets will do, we do not know. While logic dictates the liquidity created should continue to be supportive for markets, practically speaking the outcome is not a given.
You have probably heard the phrase buy the rumor sell the news. Well, the rumor for a while now has been inflation, and the news is that we are seeing very strong inflationary pressures. At least that is what many pundits say. So far however, the market is not selling the inflation news.
Markets as we know are forward looking mechanisms, and mostly do not price what is happening today but what might happen in the future. Now, the Fed’s favorite inflation metric is the PCE, or Personal Consumption Expenditures Index. As the chart below depicts, PCE probably peeked some while ago.
Coupled with the fact that 10- year yields also peeked several months ago (chart below), the Fed might be right in shrugging off the inflation talk, and calling inflationary pressures transitory.
Now I am not smart enough to be able to predict if inflation is transitory, if the Fed is right, or if those who worry about inflation are right. However, the market seems not to worry, and we do have indications that inflation may have peeked several months ago.
If this proves to be correct, then the market is correct in not panicking, and the Fed will also be proved correct with its transitory theory. Either way, if we assume the market is the be the best indicator of what is going on – in the sense that we are not seeing panic selling because of inflation fears — then chances are that inflation, is not a risk to the market overall.
The Fed last week basically told us what most of us suspected.
First, the Fed was optimistic about economic growth, while anticipating higher inflation, while stressing that COVID is still a risk.
The Fed will continue to purchase $120B of assets each month until, and I quote, “substantial further progress has been made toward the Committee’s maximum employment and price stability goals”. At the same time, is has not given the market when tapering will begin.
The Fed is also insisting higher inflation is transitory and is mostly due to supply chain “bottlenecks”.
Finally, the Fed shed some light on when it might raise interest rates or takeoff. This expectation is now set towards the end of 2023.
Overall, the bond market does not seem to worry about inflation, siding with the Central Bank. Please note it now seems yields peeked several months ago.
Also note that even assuming rates do rise towards the end of 2023, that is a very long way in the future to be able to position any portfolio. However, it might be a headwind.
The dollar initially rallied, but it has since given back most of its gains. As a sidenote, I personally do not consider the Fed statements dollar positive.
Overall, the Fed is still very accommodative, and does not want to surprise markets, giving a heads up of its intention’s way in advance. This is very market positive, because it provides participants time to digest and price everything in advance.
The bottom line is that the Fed continues to be supportive of both the economy and markets, but please note that now we have two headwinds. First at some point the markets will be concerned about interest rates if they rise, and second, inflation concerns are on everyone’s mind. If we add to these the valuation landscape, investors need to be extra cautious looking ahead.
May CPI in China came in about 1.3%, below the average estimate of 1.6%. This was mostly due to weak pork prices. Please note the CPI Index in China is heavily geared towards food. The producer price index on the other hand rose by a whopping 9% Y/Y, mainly driven by oil, metals and chemicals.
Chinese PPI is a function of higher commodity prices, not due to internal factors. This means inflation is not exported outwards. So, what happens in China in CPI or PPI terms, stays in China. In other words, don’t expect China to be an exporter of inflation as many have suggested. Please note that for the last 30 years or so, China is a deflation exporter, not an inflation exporter.
Last Thursday headline CPI in the US rose 5% Y/Y, the fastest pace since 2008. Used car and truck prices were partially to blame, posting an almost 30% rise Y/Y.
It is the norm for economies to experience pent up demand when coming out of a recession. However, this time around we also have supply chain disruptions due to the pandemic, but also supply chain disruptions because of politics.
But a rise in commodity prices due to supply shortages and disruptions has always been temporary. This is the main reason why Central Banks insist inflation will be transitory.
But the question is, what does the market have to say about all the inflation talk? The market is taking the inflation talk with a big yawn. We have not seen a correction in equities, nor a huge rally in bonds. In fact, when US CPI figures was published last Thursday, the 10-year US bond rallied and yields fell below 1.5%, after rising to almost 1.75% several months ago.
So insofar as the market, the message from the bond market is that it is siding with the Fed, and so far, it is not worried about persistent rising inflation expectations.
Finally let us not forget that even if inflation persists for the next several quarters, the reasons why inflation has been low for a long time have not changed. And the two main reasons are demographics and technology innovation.
I don’t claim to be an expert on the crypto space and don’t really understand it. Yes, blockchain might prove useful, but I fail to understand why a crypto asset should be worth billions because of the usefulness of blockchain. Second, I disagree that cryptos are a hedge against inflation. I also disagree with the notion that cryptos will replace currencies, or that they are an alternative to Central Banks.
However irrespective of what one believes, what is important for investors at the moment is that the regulatory cloud we have mentioned in the past is just beginning. And the regulatory assault on the crypto space is coming from multiple sides.
SEC chairman Garry Gensler in a recent House committee hearing, made it clear that there is no investor protection regime for the crypto space at the moment, implying the need for regulation. He also mentioned regulating exchanges and that he was concerned about price manipulation. Coinbase, for example, is registered in most states as a money transmitter, not as an exchange.
Meanwhile in China, where banks have been banned from getting involved in crypto for several years now, is also preparing more regulatory scrutiny. As a result, two miners said they will cease operations in China citing “regulatory risks”.
Finally, the Biden administration’s tax enforcement plan released Thursday calls for transactions of more than $10,000 to be reported to the IRS. This might lead to many investors liquidating their holdings before any such plan becomes law.
We don’t really have a crypto strategy and as a general rule of thumb don’t get involved in the space. However irrespective of the different opinions about cryptos, investors who venture in the space need to be aware of the regulatory risks. These might include, but not limited to, tax liability risks, regulatory scrutiny of exchanges, clarity in the ownership structure of many cryptos, and investor protection regulations.
Please note that the appeal of the crypto space has been that it was a non-regulated and decentralized investment. However, if regulators enforce the same regulatory scrutiny on the crypto space as in other investments, that could alter the appeal of the space, and the value of cryptos as perceived by participants in the space.
Inflation scares have been around for years. In fact, there has never been a moment over the past 20 years or so that market pundits have not reminded us about the dangers of inflation, as a result of Central Bank policies.
The word on the street over the past several weeks has been that inflation is roaring back. As a result, the market will correct because of higher interest rates ahead (they say). In fact, as Bloomberg reported, inflation expectations are at 16-year highs.
So, let us talk about inflation. Yes, inflation this year and perhaps next year will be elevated, but from the very subdued levels of 2020 (the Covid year). Also, the last time inflation was above 4% was towards the end of the previous financial crisis. As a rule of thumb, inflation tends to spike when exiting a recession.
However insofar as interest rates are concerned, it took the Fed many years to feel comfortable raising rates, and even then, at an anaemic rate of 2.5% in 2019. But raising rates back then almost threw the US economy into recession, that forced the Fed to take everything and introduce extraordinary accommodation actions. This even before COVID.
Yes, bond yields have moved up a bit over the past several months, but this is more of a reflex reaction of markets. I don’t think it’s a sign of long-term inflation returning, or that yields will be spiking a lot higher, thus prompting investors to sell equities and move to treasuries.
The Fed will not make the same mistake in made in 2019, raising rates for the sake of raising them, that almost threw the US economy in recession. Also, the fact that the Fed continues to purchase assets, will deter yields from moving much higher.
And yes, real rates will continue to be negative, perhaps for years. However, this is also not a reason for Central Banks to raise rates and threw economies into recession. The extraordinary accommodation Central Banks are providing will be with us for a very long time to come.
The bottom line is that I would not worry much about inflation. As the Fed and ECB have said, inflation will be transitory. Longer term, demographics and technology are still deflationary forces, and will most likely overtake inflationary forces. So, while markets might correct as inflation ticks up a bit, chances are a correction will be another dip buying opportunity.
The chart below from Goldman Sachs research shows that short interest for the S&P 500 Index are at all-time lows. In other words, those that are betting on the index falling, are a very rare breed.
Many years ago, this chart would have been interpreted as a contrarian indicator. The logic being that, with record bullishness everywhere, it’s probably time to sell. However, this time around I think we have to take this data at face value. And that is none other than a bullish indication.
The reason why short interest is probably so low, is not for a lack of institutional investors who think that markets cannot go down, but probably because they have been squeezed out of their positions in attempting to do so.
With liquidity continuously coming into the market from all sides (Central banks and physical spending), it is no wonder equities keep going up.
Also keep in mind that bonds, especially sovereign debt, is not an option for most institutional investors. If institutions want yield, they will not find it in debt, unless they want to take on a lot of risk. And when searching for yield, equities are probably the route at the current time.
The bottom line is that all roads continue to lead to equities. The record low short interest is probably a testimony to this. And contrary to the past, a record short interest currently cannot be interpreted as a contrary indicator, but has to be interpreted at face value, that being that is still a very bullish market.
While major indices don’t show it, and most investors don’t see it, many parts of the technology sector are crashing. And by that, I mean that many stocks have been falling for months now, even if this internal technology correction has not affected the major indices (yet).
Almost all EV stocks are way off their highs, perhaps with TESLA having corrected the least. Even highly covered and talked about stocks like Quantum Scape, that is developing a next generation battery for EV cars has gone from about $130 to $28. AMD had its best quarter ever and has fallen about 15% from its last report. Even Apple has not been able to rally, even if its quarter blew the consensus away. ZM has fallen over 50% from its highs, and DOCU which reached almost $300 a share last year, is trading at around $190.
In fact, perhaps a better illustration of what has been happening is the ARKK EFT, that has many of the high flying names mentioned above.
The ARKK ETF has lost about 1/3 of its value from its high, and down about 20% year to date.
The question is, is this technology correction over and might many of these stocks be a buy?
My answer is no. Even after a huge correction, most of these names are still not investable. The reason being valuation concerns. In my book, stocks like AMD and ZM would have to fall by an additional 60% or so, before valuations make any sense.
The next question is, will the correction in technology bring the entire market down? The answer is we don’t know, but so far, the major indices are not showing signs of stress (yet).
However, if stocks like Apple make a serious correction, then all bets are off. The market will probably correct by a lot. But in order for that to happen, we would have to see a lot of money exiting this market, especially from passive funds.
And what might be the reason for a rush to the exists from investors? Two things come to mind these days, inflation and an increase in capital gain taxes in the US.
However, don’t blame the correction on neither of these issues. At its core, the correction we are seeing in the technology space has everything to do with valuations and investors getting carried away than anything else.