Daily Analysis 11 March 2022 (10-Minute Read)

Hello there,

A fantastic Friday to you as stocks begin to flounder amidst a worsening risk sentiment.

In brief (TL:DR)

  • U.S. stocks were lower on Thursday with the Dow Jones Industrial Average (-0.34%), S&P 500 (-0.43%) and the Nasdaq Composite (-0.95%) all down.

  • Asian stocks fell Friday as a broad risk-off mood took hold amid hot U.S. inflation data and continued negative news out of Ukraine.

  • Benchmark U.S. 10-year Treasury yields fell two basis points to 1.97% (yields rise when bond prices fall) but are generally rising higher as U.S. Federal Reserve policy tightening draws into sharper focus ahead of its March meeting.

  • The dollar rose against most of its major peers.

  • Oil inched higher with April 2022 contracts for WTI Crude Oil (Nymex) (+0.45%) at US$106.50, but the initial concerns over supply shocks has since taken a breather.

  • Gold was lower with April 2022 contracts for Gold (Comex) (-0.42%) at US$1,992.00.

  • Bitcoin (-6.11%)fell sharply to US$38,417 on a broader selloff of risk assets in general and with traders now focusing on Fed policy to affect potential upside in the face or rising inflation and failed peace talks between Russia and Ukraine.


In today's issue...

  1. U.S. Inflation Hits Fresh Highs Putting Pressure on Fed to Tighten

  2. Signs at the Edge of the Market Spell Potential Trouble

  3. Cryptocurrencies Won the Battle, Can They Win the War?


Market Overview

This latest evidence of inflationary pressure in the U.S. snapped fledgling rallies across global markets as hopes of progress in talks between Russia and Ukraine faded.

U.S. Consumer Price Index data compounded investors’ concerns about the risks to the global economy from the conflict-driven surge in commodity markets over the past couple of weeks.

Meanwhile, more firms are turning their back on Russia in response to the invasion of Ukraine.

U.S. President Joe Biden is reportedly set to call for an end to normal trade relations with Russia, clearing the way for increased tariffs on Russian imports.

Asian markets fell Friday with Tokyo's Nikkei 225 (-2.05%), Sydney’s ASX 200 (-0.94%), Hong Kong's Hang Seng Index (-1.70%) and Seoul's Kospi Index (-0.71%) were all down.



1. U.S. Inflation Hits Fresh Highs Putting Pressure on Fed to Tighten

  • February’s price increases mark a fresh high, with the fastest annual increase since January 1982.

  • Monetary policy is a blunt tool with which to reign in price pressures, and hiking rates by as much as 0.50% at subsequent policy meetings could be the last straw on the camel’s back that pushes the U.S. economy into recession.

Even during normal times, being a central bank policymaker is challenging, but in these abnormal times, it can be almost impossible.

While few had any doubt that U.S. inflation numbers would be set to rise, helped in no small part by the ongoing Russian invasion of Ukraine roiling energy and commodity prices, the bigger doubt lies with what the U.S. Federal Reserve will do about it.

Although much of the U.S. inflation in recent months could have been attributed to supply chain issues, with the price of used vehicles contributing to solid price pressures, the war in Ukraine has complicated matters by spilling over inflation to the price of food and fuel.

Combined, Russia and Ukraine produce significant amounts of the foods and fuels as well as metals, that the world relies on and that has seen the U.S. Consumer Price Index (CPI) increase another 0.8% in February, to 7.9%, following a smaller increase of 0.6% in January this year.

Given that Russia only invaded Ukraine in the last week of March and was canceled from the global economy thereafter, the full effect of excluding the country’s resources from global markets will only really be felt this month and are likely to show up in the inflation reading taken next month.

February’s price increases mark a fresh high, with the fastest annual increase since January 1982.

Even when food and energy prices were stripped out, so-called “core” CPI jumped by 6.4% or 0.5% month-to-month.

The latest report captured just the final week of February, when Russia launched a full-scale invasion of Ukraine and Western allies retaliated with punitive financial sanctions and therefore are unlikely to reflect the full extent of their impact.

With the war wearing on in Ukraine, a prolonged crisis could not only dent growth, but also further entrench inflationary pressures that have already begun to take root across a broad swathe of the U.S. economy, leading to concerns of stagflation (high inflation, low or negative growth).

For now, bets are that the U.S. Federal Reserve will proceed with its largely expected 0.25% interest rate hike this month, and likely move the federal funds rate close to a neutral level that neither aids nor constrains economic activity, estimated at around 2% to 2.5%.

But the risks of policy error are higher than ever before.

As it is, monetary policy is a blunt tool with which to reign in price pressures, and hiking rates by as much as 0.50% at subsequent policy meetings could be the last straw on the camel’s back that pushes the U.S. economy into recession.



2. Signs at the Edge of the Market Spell Potential Trouble

  • Now a new point of weakness is surfacing in the credit markets – in the U.S. junk bond market.

  • Even investors who aren’t watching junk bonds should keep an eye out for them as they will be the first to signal signs of trouble – it’s the bullets that you don’t see that ultimately take down the plane.

During the Second World War, British planes that had been badly shot up but somehow managed to limp back to base were studied to see which portions needed more reinforcement.

Initially, engineers thought that the areas which received the most number of bullet holes would need to be strengthened when they realized that they should do the opposite, because the planes that didn’t make it back would most likely have been shot in the areas that weren’t being observed.

It was from this simple observation that British engineers worked to strengthen the parts of the plane that would improve the survivability of the aircraft and help to lose less crews and war materiel and helped the Allies win the war.

And now a new point of weakness is surfacing in the credit markets – in the U.S. junk bond market.

Prior to the Russian invasion of Ukraine, investors who had otherwise priced in a more hawkish Fed were nevertheless relaxed on the prospect of a hard landing in the face of tightening as there were few signs of stress in the high yield bond markets.

Until fairly recently, money managers had viewed U.S. high-yield debt as somewhat insulated from Russia’s invasion of Ukraine and its toll on global markets, but signs of high yield debt for energy companies soaring could also come at the expense of the broader market.

Although higher energy prices mean bumper earnings for junk-rated energy companies, which have marched higher since Russia’s attack pushed oil up, it will compress margins for other junk-rated companies which would face greater costs.

Over the past month, only high-yield energy debt has made money for investors, whereas the rest of the market, especially bonds for airlines, tumbled, on concern over higher jet fuel costs.

Even U.S. Treasuries, the world’s biggest bond market, are flashing signals that traders are more concerned than ever of a U.S. recession, possibly at the worst possible time as the U.S. Federal Reserve prepares to hike interest rates.

CCC-rated debt, one of riskiest segments of the U.S. corporate bond market is more sensitive to the economic backdrop, and less to interest rates, and risk premiums for this category of debt against highly-rated debt, has widened to its highest level since December 2020, when concerns of the pandemic weighed heavily on many companies.

Even investors who aren’t watching junk bonds should keep an eye out for them as they will be the first to signal signs of trouble – it’s the bullets that you don’t see that ultimately take down the plane.



3. Cryptocurrencies Won the Battle, Can They Win the War?

  • Across the border, Ukraine was receiving millions of dollars’ worth of cryptocurrencies to buy everything from bullet-proof vests to night-vision goggles to fight off the Russian invaders.

  • While cryptocurrencies may be down again, they are far from out, and the longer the war in Ukraine persists and the Russian people continue to live off the international financial grid, the more the debate on the role of cryptocurrencies will intensify.

Right up till the time that the first Russian tank rolled across the border with Ukraine, cryptocurrencies had more or less followed a narrative similar to other risk assets – facing downwards pressure from the prospect of a tightening U.S. Federal Reserve monetary policy that had hitherto lifted all manner of risk assets.

But that all changed when Russian banks were booted out of SWIFT, the international messaging system essential for cross border bank transfers.

The punitive Western sanctions on Russia that followed, the most extensive the world has ever seen, saw the value of the Russian ruble plummet and ordinary Russians scramble to buy everything from white goods to cryptocurrencies in a vain attempt to fight against the rapidly crumbling value of their money.

Meanwhile, across the border, Ukraine was receiving millions of dollars’ worth of cryptocurrencies to buy everything from bullet-proof vests to night-vision goggles to fight off the Russian invaders.

If ever there was a need to showcase the battle-readiness of cryptocurrencies, in particular Bitcoin, to cater to geopolitical turmoil, this was it and what was a theoretical value proposition will now be studied in Harvard Business Case studies for years to come.

But while cryptocurrencies proved their ability to move seamlessly across borders even as tanks, rockets and missiles did the same, it also raised uncomfortable questions over whether they could also be used as a tool to avoid sanctions.

Meanwhile, governments who had been quite content to leave cryptocurrency regulation on the backburner are now finding an urgency to focus on the issue, especially if cryptocurrencies can be used to blunt the effect of sanctions.

As markets were roiled from the Russian invasion of Ukraine, cryptocurrencies, if only for a brief moment, emerged as an unlikely safe haven, breaking their correlation with equities including the Nasdaq 100 and the S&P 500, which it had been tied closely with just a week earlier.

But for all the success of cryptocurrencies, the events of the past week also highlighted how much more work needs to be done.

That cryptocurrencies departed from other risk assets last week and very rapidly returned to earth shows that the debate on their role in a typical investment portfolio is far from settled.

But what is perhaps more significant is that the events of the past week highlighted the two increasingly divergent financial systems that are playing out – the traditional and the digital.

Throwing an entire country’s banking system off the global grid is in some ways a card that can only be played once.

And now that that card has been played, the attraction of a censor-proof store of value and medium of exchange that can cross borders may be increasingly evident as the world reels from the shock and awe of the financial equivalent of Armageddon leveled on Russia.

Regardless of how an investor views cryptocurrencies, whether as risk asset or safe haven, the Russian invasion of Ukraine is drawing significant attention to the nascent asset class and with greater interest, could come greater participation.

Consider that for an ordinary Russian who suddenly finds themself without access to McDonalds or Ikea and the prospect of Moscow confiscating their monies and stopping withdrawals, the volatility of Bitcoin is probably the furthest thing from their mind.

And that invites investors to consider the biggest elephant in the room – China – where capital controls are a way of life and cryptocurrencies have long been a conduit by which Chinese with the means, spirit money out of the country.

Because if an authoritarian regime in Moscow could crackdown harshly on capital controls, what’s to stop Beijing?

And that certainly must be figuring in the decision-making matrix of countless Chinese people who have seen the value of their homes fall, while their beloved tech giants take a drubbing, with trillions of dollars’ worth of market cap erased.

So while cryptocurrencies may be down again, they are far from out, and the longer the war in Ukraine persists and the Russian people continue to live off the international financial grid, the more the debate on the role of cryptocurrencies will intensify.

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