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Daily Analysis 2 June 2022 (10-Minute Read)

Hello there,

A wonderful Wednesday to you as rate hike fears ripple through the markets putting the kybosh on last week's recovery.

In brief (TL:DR)

  • U.S. stocks slipped for a second day with the Dow Jones Industrial Average (-0.54%), S&P 500 (-0.75%) and the Nasdaq Composite (-0.72%) all lower as the U.S. Federal Reserve mad clear its resolve to keep up the pace of rate hikes.

  • Asian stocks fell on Wednesday as a strengthening dollar and rate hike fears fueled a selloff.

  • Benchmark U.S. 10-year Treasury yields rose to 2.922% (yields rise when bond prices fall).

  • The dollar gained.

  • Oil slipped with July 2022 contracts for WTI Crude Oil (Nymex) (-2.12%) at US$112.82 as Saudi Arabia pledged to make up any shortfalls in supply from an European Union ban of Russian exports.

  • Gold fell with August 2022 contracts for Gold (Comex) (+0.09%) at US$1,847.00 as the dollar gained.

  • Bitcoin (-6.25%) buckled to US$29,753, alongside other risk assets as the prospect of higher rates dampened sentiment.

In today's issue...

  1. Fed Officials Stick to Rate Hikes for Better or Worse

  2. Private Equity "Ponzi Schemes"?

  3. Bitcoin's Worst Decoupling Ever

Market Overview

Global stocks look set to face fresh headwinds as central bankers from Washington to Belgium amplify hawkish messaging in their quest to rein in inflation.

U.S. Federal Reserve Beige Book data also showed an unexpected slowdown in 4 out of 12 of the central bank's districts, suggesting that measures to dampen price pressures may already be working.

Asian markets were lower with Tokyo's Nikkei 225 (-0.17%), Seoul's Kospi Index (-0.91%) and Hong Kong's Hang Seng Index (-1.79%) up, while Sydney’s ASX 200 (-1.04%) down in the morning trading session.

1. Fed Officials Stick to Rate Hikes for Better or Worse

  • U.S. Federal Reserve policymakers indicate their resolve for rate hikes even as the Beige Book report indicates that 4 out of 12 districts see slowing growth.

  • Fed measures to cool the economy may already be working and the cooling should be seen in a positive light as signs that the central bank's attempt to engineer a soft landing for the economy may be possible.

In Star Wars Episode IV: A New Hope, a rebel X-wing starfighter pilot bears down on a critical weak point of the ominous Death Star battle station while his wing commander tells him to stay on target despite Imperial TIE fighters bearing down on him.

With steely-eyed focus, the rebel pilot tries to take aim at an exhaust port that could bring down the Death Star, only to be shot to shreds by Imperial TIE fighters, all whilst staying on target.

And now, U.S. Federal Reserve officials, for hawk or for dove, are staying on target as they run the gauntlet that is inflation, even as the prospect of recession bears down on the U.S. economy.

On Wednesday, even as the Fed’s Beige Book survey reported the pace of growth slowing, and four of the Fed’s 12 districts reporting that their economies had slowed, policymakers continued to back plans to raise rates by 50 basis points or more this month.

Fed officials remain convinced that the U.S. economy is sufficiently resilient to weather any storm, even one of their own creation.

Last month, the Fed hiked borrowing costs by 0.50% and indicated that the subsequent two rate-setting meetings in June and July were likely to provide more of the same.

Hawkish comments by Fed policymakers on Wednesday, rattled markets which had started to bet on less aggressive Fed tightening, based on the minutes of the last Fed meeting.

Last week, Atlanta Fed President Raphael Bostic also added to dovish speculation by suggesting that it might be appropriate for the Fed to take a pause on rate hikes in September.

There are signs that the Fed’s attempt to cool the economy may already be working as the Beige Book report reveals economic activity and price gains moderating in parts of the U.S. as households and businesses navigate higher borrowing costs and supply disruptions from the Russian invasion of Ukraine.

But knowing the Fed and its response to inflation, it’s likely to swing too far to the opposite end of the spectrum before hastily pulling back and investors need to prepare for sudden shocks before diving back into buying.

2. Private Equity "Ponzi Schemes"?

  • Europe's largest asset manager Amundi Asset Management CIO warns that there are signs of "Ponzi" type behavior in some corners of the private equity market.

  • Lack of transparency means that it's possible for private equity managers to sell back and forth to each other at inflated prices in order to goose up valuations and returns.

One of the benefits and drawbacks of private equity is its long-term investment horizon and lack of transparency.

As any seasoned investor will tell you, the best returns are from opportunities that few (if any) know about and nothing describes that better than private equity, which involves buying up stakes in private companies or heaping leverage on them to gin up valuations.

While private equity has been no stranger to controversy, whether for its fee structure or its over reliance on leverage, it has also helped precipitate some of the world’s largest alleged frauds, including the implosion of the once vaunted Abraaj Group.

And now, Europe’s largest asset manager Amundi Asset Management’s Chief Investment Officer Vincent Mortier is warning that some corners of the private equity landscape are starting to resemble a Ponzi scheme.

In a presentation on Wednesday, Mortier noted,

“You know you can sell (assets) to another private equity firm for 20 or 30 times earnings. That’s why you can talk about a Ponzi. It’s a circular thing.”

Whereas managers like Amundi have little room to obfuscate the value of their holdings, trading in public stock and bond markets.

Private equity, in contrast, typically locks up investor monies for several years, and information about whether target companies have gained or shrunk in value only becomes public if they are listed or if managers choose to disclose the price that they sold it for to another buyer.

Meanwhile, quarterly assessments of the NAV or Net Asset Value in a private equity fund, which is crucial because that’s where fees are calculated from, are often no more than sophisticated guesswork based on public market equivalents.

But where this becomes worrying is when private equity funds start playing musical chairs with each other, selling assets back and forth.

In 2021, private equity struck US$42 billion worth of deals in which they sold portfolio companies amongst themselves and there are strong incentives for managers to inflate the prices that they sell to amongst each other.

Mortier noted,

“Just because there’s no mark-to-market doesn’t mean there’s no risk.”

Private equity funds flush with cash in recent years, given their ability to borrow at low interest rates, are now facing headwinds from tightening monetary policy that could possibly see them resort to the sort of behavior that Mortier is warning about.

A growing body of investors are seeking opportunities in the private equity space, especially given elevated valuations in public markets and bond yields which are historically low despite recent run-ups

3. Bitcoin's Worst Decoupling Ever

  • Bitcoin skips out on the rebound in stocks but joins in on the decline.

  • The lack of rebound for Bitcoin despite a rebound in stocks may be due more to portfolio rebalancing for stocks and bonds than anything to do intrinsically with correlation.

You know those couples? The ones who you can’t stand being around because when they’re good together, they are sickeningly sweet, but when they erupt on each other, it’s like being in the middle of a warzone?

Bitcoin and stocks appear to be having that exact relationship because they’ve de-correlated in the good times and re-correlated in the bad times.

Before the end of last week, investors bemoaned the strong correlation that Bitcoin had with assets such as tech stocks, hoping for “decoupling” so that the crypto asset class could make its way higher, independent of the vagaries of the broader market.

But crypto investors should be careful what they wish for, because they just might get it.

Last week, even as stocks rebounded strongly, Bitcoin sank lower, taking other cryptocurrencies down with it and this week, it appears to be coupling again with other risk assets at a time when risk aversion is again weighing on the class.

Dipping below US$30,000 again, a significant level of support, Bitcoin fell alongside the tech-heavy Nasdaq 100 Index for a second straight day.

While traders speculated last week that cryptocurrencies would begin to decouple from risk assets as investors focused more on industry specific factors, those views have since come under pressure from Bitcoin’s re-coupling with tech stocks and other risk assets.

If nothing else, Bitcoin has had the worst sort of coupling and decoupling with risk assets like the Nasdaq 100 – skipping the rallies but joining the declines.

Of course the decoupling may have had entirely nothing to do with Bitcoin itself and the rebound in stocks could have been due to the end of the month scramble by funds to rebalance stock and bond portfolios.

As stock prices plummeted, typical 60/40 stock and bond portfolios became overweight on bonds, and in an effort to preserve the ratio in these allocations, managers may have raced to top up their stocks, leading to a sharp increase in price just before the end of the month.

No such requirement exists for cryptocurrencies, which is why they may not have enjoyed the bump up, even as stocks did.

And that is likely why despite the fact that cryptocurrencies have seen an increasingly strong correlation with stocks, the former skipped out on the rebound that the latter enjoyed towards the end of the month.

90-day correlations between Bitcoin and the Nasdaq 100 now stand at around 0.68 (a reading of 1, indicates the two assets move in the same direction and with the same magnitude whereas -1 indicates they are perfect opposites).

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