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Daily Analysis 14 February 2022 (10-Minute Read)

Hello there,

A Happy Valentine's Day to you as investors hope to find love from the markets against a backdrop of invasion and inflation.

In brief (TL:DR)

  • U.S. stocks wiped out week's gains on Friday with the Dow Jones Industrial Average (-1.43%), S&P 500 (-1.90%) and the Nasdaq Composite (-2.78%) all caving on a potential Russian invasion of Ukraine and rising hawkish rhetoric from U.S. Federal Reserve policymakers.

  • Asian equities slid Monday amidst mounting geopolitical tension in Eastern Europe.

  • Benchmark U.S. 10-year Treasury yields rose two basis points to 1.96% (yields rise when bond prices fall).

  • The dollar was steady.

  • Oil's extended a rally with March 2022 contracts for WTI Crude Oil (Nymex) (+1.50%) at US$94.50 as the U.S. warns of an imminent Russian invasion of Ukraine.

  • Gold strengthened with April 2022 contracts for Gold (Comex) (+0.69%) at US$1,854.80.

  • Bitcoin (-1.17%) pushed lower into the week at US$41,734 as traders contended with diminished risk appetite against a backdrop of growing geopolitical tension and monetary policy tightening.

In today's issue...

  1. Minting Money in Mining Stocks

  2. What happens when you buy the dip that doesn't stop dipping?

  3. Institutional Investors Buying Crypto Like Shares

Market Overview

Stocks slid Monday and crude oil extended a rally as geopolitical risks over Ukraine rippled through global markets, spurring demand for havens such as sovereign debt.

Tensions over Russia’s military buildup near Ukraine are entering a potentially decisive week, with the U.S. warning an invasion may be imminent and President Vladimir Putin accusing America of failing to meet his demands.

Russia has repeatedly denied it plans to invade its neighbor, and a diplomatic push to try to resolve the situation is continuing.

The uncertainty is dealing another blow to markets that are already skittish about high inflation and the prospect of aggressive Federal Reserve interest-rate hikes to tame it.

Asian markets were mostly lower on Monday with Sydney’s ASX 200 (+0.35%) up, while Tokyo's Nikkei 225 (-2.16%), Seoul's Kospi Index (-1.53%) and Hong Kong's Hang Seng Index (-1.17%) all lower on concerns over the risk of a Russian invasion of Ukraine.

1. Minting Money in Mining Stocks

  • Mining stocks become potential source for reliable dividends in an era of rising commodity prices and soaring inflation

  • Years of underinvestment in extraction means that commodity prices are likely to stay higher for longer, benefiting mining companies which have shunned expensive mining projects and cut debt to focus on regular returns from operations

A long-ignored sector, mining stocks have seen a sharp change of fortune as yield-starved investors look for assets that can deliver strong income streams at a time of persistently high inflation.

Over the past week, two of the world’s biggest natural resource companies have blown past their record highs – BHP Group (-2.35%) and Anglo American (-0.56%), boosted by rising commodity prices and the prospect of big cash returns when reporting season starts in the coming week.

Other major mining companies, including Glencore (-0.78%), Rio Tinto (-1.28%) and Vale SA (-1.74%) are expected to declare strong dividends with the prospect of more to come, as demand outstrips supply.

Consumer price inflation in Europe and the U.S. have meant that the mining sector is one of the few that have been able to deliver yield to keep pace with rising prices.

Against a backdrop of higher inflation, one of the biggest challenges for investors has been to find real income opportunities, something which mining stocks are increasingly prized for.

Dividends from other sectors including banking, hospitality and travel and leisure have more or less dried up because of the pandemic, or reduced to cater for its effects, but the mining industry has filled that gap.

In the over a decade since the 2008 Financial Crisis, the mining industry has transformed dramatically under a new generation of leaders who have sought to slash debt, shunned expensive and splashy investments in massive projects and shifted to dividend policies linked to earnings.

Years of feast and famine have bred a far more conservative mining industry, which as recently as six years ago, found itself almost on its knees when a slowdown in demand from China, a reliable consumer of commodities, saw prices collapse and threatened to do the same to some of the mining sector’s biggest names as well.

But a new generation of management which has been more restrained in its extraction strategies could also mean huge upside in the years to come for investors.

Reluctance to pour cash into big new mines has left the pipeline of extraction projects particularly low, just as demand for metals key to the electrification of transport, especially nickel and copper, is primed to take off.

Higher demand at a time of underinvestment in extraction means that prices will almost inevitably rise, but the sector is also not without its risks.

Cash generation could be squeezed by higher oil and freight costs while workers are demanding higher salaries to work in the mines, eating into margins at a time when mining companies will need to double down on investments to reduce carbon impact from operations.

Nevertheless, if the investment thesis holds, holding on to mining stocks may make absolute sense against a backdrop of soaring consumer prices and insatiable demand for commodities.

2. What happens when you buy the dip that doesn't stop dipping?

  • Stock market bulls run into their first major roadblock against a backdrop of soaring inflation and potential Russian invasion of Ukraine

  • Overall market risk appetite has not disappeared completely, with investors still moving into companies which should benefit from a broader reopening

Up till fairly recently, investors buying the dip on U.S. equities would be reliably rewarded not too long thereafter.

U.S. equities have withstood everything from fresh coronavirus variants to soaring inflation and a hawkish U.S. Federal Reserve, but while the pain tolerance of perpetual stock market bulls may be formidable, it isn’t infinite.

And that became apparent last Friday, when a confluence of bearish macro news finally buckled the steely resolve of the stock market’s most optimistic investors.

A potential Russian invasion of Ukraine, against a backdrop of the fastest pace of price increases in the U.S. in four decades was enough to push major indices in the red, giving up weekly gains, with the benchmark S&P 500 capping its biggest 2-day drop in 16 months.

In the end, bulls buckled as Washington warned of a Russian invasion of Ukraine as early as next week as U.S. Federal Reserve policymakers raised their hawkish rhetoric against soaring price pressures at home.

Bets that the market would be able to take elevated interest rates in its stride more or less played out for most of the week, but the prospect of a major conflict in Eastern Europe was a bit more than most investors could bear.

But for all the angst over rate hikes, there are few signs of stress in the equity market with data compiled by Goldman Sachs (-1.99%) revealing a basket of stocks with weak balance sheets beating out strong ones for a ninth week in twelve.

Many stocks with dicey balance sheets are doing well because of an expectation of a return to normally, including airlines and cruise lines, which are feeding off the re-opening narrative.

Given that many re-opening stocks have not had a chance to catch up to their pre-pandemic levels, their imminent rise may just be assisting them to return to fairer valuations, whereas frothy tech stocks may be challenged in the immediate period.

In any event, writing off equities altogether would be misguided.

As demonstrated by the stellar rebound of e-commerce giant Amazon, the prospect of strong economic growth and decent earnings have continued to surprise even the most pessimistic investors.

3. Institutional Investors Buying Crypto Like Shares

  • Institutional investors recognize the value of holding cryptocurrencies, more so than just holding straight equity in the companies working on protocols

  • Cryptocurrency tokens allow a myriad of income opportunities for investors, from price appreciation to a share of transaction fees

For investors in traditional assets, cryptocurrencies can appear to satisfy very little outside of a speculative itch – they don’t confer equity ownership or pay out dividends like stocks, they don’t track the general movement of the economy and they aren’t tied to any “real” assets.

Yet for those astute investors willing to look through the noise, cryptocurrencies represent an entirely new facet of investing – future control of key software protocols that allow cryptocurrency holders to determine their path of development or earn returns from securing their blockchains.

Which may be why some of the world’s most savvy investors are taking a substantial bet on Polygon, a protocol used by developers to make Ethereum transactions a lot faster and cheaper.

Polygon raised US$450 million from investors not by selling equity, as is typical for most venture investments, but by parting with its Matic cryptocurrency to receptive buyers from SoftBank Group’s Vision Fund 2, Mike Novogratz’s Galaxy Digital and investment giant Tiger Global Management.

Over 40 investors participated in Polygon’s token sale which was capped at 10 billion tokens.

But these tokens represent far more than a traditional equity holding.

A Layer 2 protocol, Polygon offers tools for developers creating decentralized applications or dApps, which tackle some of blockchain’s most vexing challenges, including network congestion and transaction fees.

Transaction fees have soared in the wake of Ethereum’s growing popularity and periods of peak transaction volume have seen interest in so-called Layer 2 protocols as a potential solution.

Layer 2 protocols work by taking transactions from Layer 1 blockchains like Bitcoin and Ethereum, compressing them and posting them back to the original blockchain at a fraction of the time and cost, taking a small protocol fee for each use.

That Layer 2 solution has enabled protocols like Polygon to support over 7,000 dApps with 130 million unique users and over 3 million daily transactions.

Selling tokens directly to investors has enabled Polygon to focus on its development, achieving the equivalent of a public offering without the cost and distraction.

Matic token holders don’t just get to enjoy the upside of any price increase in the token, they can also run validator nodes for transactions, earning a piece of the roughly US$100 million in transaction fees that Polygon earns annually from processing transactions.

In some ways, holding the token is even more powerful than holding equity.

Although this round of investment for Polygon’s Matic tokens comes with a three year lock-up, provided the Layer 2 protocol continues to remain popular, a liquid (and hopefully lucrative) market for these tokens would enable investors to trade in and out of their positions with ease.

Demand for Matic tokens is also expected to be relatively robust, as they are needed by developers and ecosystem contributors for building dApps on Polygon – akin to credits used to pay for cloud computing services.

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