Hello there,

A magnificent Monday to you as Asian markets muddle through the last week of May with China souring sentiment.

In brief (TL:DR)

• U.S. stocks closed mostly flat on Friday with the Dow Jones Industrial Average (+0.03%) and S&P 500 (+0.01%) up marginally at the close while the Nasdaq Composite (-0.30%) was down.

• Asian stocks traded mixed Monday as investors assess the impact of China’s Covid policies on growth and the outlook for the world’s largest economies.

• Benchmark U.S. 10-year Treasury rose three basis points to 2.81% (yields fall when bond prices rise) as appetite for bonds firmed up.

• The dollar retreated.

• Oil rose slightly with July 2022 contracts for WTI Crude Oil (Nymex) (+0.37%) at US$110.69.

• Gold edged higher with August 2022 contracts for Gold (Comex) (+0.47%) at US$1,857.10.

• Bitcoin (+2.40%) recovered to US$30,190 (at the time of writing) out of the weekend as investors took to buying the dip.

In today's issue...

1. Emerging Markets Nursing US$5 trillion Rout Await Rebound

2. Markets are Only Reflecting Global Volatility

3. DeFi as Religion – TerraUSD was a Martyr, Not a Ponzi Scheme

Market Overview

Investors are grappling with concerns about an economic slowdown and prospects for more monetary tightening.

The war in Ukraine is fanning commodity prices, and supply chains remain disrupted by China’s adherence to its Covid zero policy.

Asian markets were mixed Monday with Tokyo's Nikkei 225 (+0.50%) up, while Sydney’s ASX 200 (-0.12%), Seoul's Kospi Index (-0.01%) and Hong Kong's Hang Seng Index (-1.58%) were lower on the morning trading session.

1. Emerging Markets Nursing US$5 trillion Rout Await Rebound

• The US$5 trillion rout in emerging markets is starting to look like a buying opportunity for plucky investors with the stomach to call a bottom.

• Many countries continue to nurse dollar-denominated debt and investors should be aware that that could quickly change conditions in unforeseeable ways.

Emerging market economies are being hammered by the double whammy of a strengthening dollar and investment outflows at a time when they’ve likely had to sell gold reserves to shore up their national currencies.

But the US$5 trillion rout in emerging markets is starting to look like a buying opportunity for plucky investors with the stomach to call a bottom.

Emerging market stocks have been hammered to below their average valuations over the past 17 years and local-currency bond yields have soared above a range that’s held since the 2008 Financial Crisis.

After 15 months of capital outflows, emerging markets have all but fully priced in risks and for some money managers, that means it’s time to go shopping again, not necessarily a spree, but at least nibbling on the corners cautiously.

But not all emerging markets are built equally, and some will no doubt be riskier than others.

Markets like Myanmar are “uninvestable” thanks to the ongoing civil war in that country, whereas Sri Lanka is lurching from one crisis to the next, with serious shortages of food and medicine.

But Malaysia, Indonesia, Vietnam and the Philippines look to be attractive given their young populations, growing manufacturing bases and a China that continues to be mired in zero-Covid lockdowns.

Many countries continue to nurse dollar-denominated debt and investors should be aware that that could quickly change conditions in unforeseeable ways.

The war in Ukraine, fresh pandemic outbreaks, rising inflation and U.S. Federal Reserve hawkishness also play major roles in determining the viability of betting on emerging markets, but the discount is reaching attractive levels.

Since its peak in early 2021, the equity values of 24 countries categorized as emerging markets by MSCI has fallen by US$4 trillion.

And spreads between emerging market sovereign dollar bonds over U.S. Treasuries have recently hit as high as 4.87%, just a hair away from the 5% in 2015 that triggered a dramatic comeback.

Nevertheless, the possibility of a recession or a slowdown in the world’s two largest economies – the U.S. and China – will all but certainly take emerging markets down with them.

But even the most intrepid investors contemplating a move into emerging market assets should probably wait until at least inflation peaks in the U.S. or the dollar starts to show signs of a pullback.

2. Markets are Only Reflecting Global Volatility

• Worries about inflation have been joined by concerns over a recession, one that central banks may either spark off or worsen in their efforts to reign in the effects of inflation.

• Although cash is being whittled away by inflation, perhaps sitting on the sidelines for now may not be the worst thing to do.

If you’re wondering why the markets appear to be swinging from optimism to pessimism on practically a daily basis, that’s because the global economy is throwing off nothing but conflicting signals.

As markets lurch into the final week of May, there may be some truth to the old market adage, “sell in May and go away.”

Last week marked a potential tipping point that could in the future be seen as the watershed moment for markets when a selloff that started in the most speculative assets and technology stocks, spilled over to profitable and established blue chip firms in a rout that has become far more broad-based.

Worries about inflation have been joined by concerns over a recession, one that central banks may either spark off or worsen in their efforts to reign in the effects of inflation.

Consumer goods, typically viewed as a relatively safe bet in times of economic uncertainty, have provided no harbor as last week earnings from two of America’s biggest big box retailers, Walmart and Target disappointed.

Although sales at both Walmart and Target were up, profits fell because of increasing costs and tightening margins, causing shares of both companies to experience double-digit price falls, something investors would be more used to seeing in riskier tech stocks.

And that was enough for the market selloff to spread to other consumer staple stocks, which had nothing to do with the situation.

Until fairly recently, analysts were convinced that stocks would remain resilient, especially given strong corporate earnings and buoyant U.S. consumption.

But these sanguine views are being challenged especially when even the most powerful retailers appear to be struggling to pass on cost pressures.

In the past, the withdrawal of liquidity after years of cheap money had typically hit the most speculative assets hardest, notably cryptocurrencies when the U.S. Federal Reserve attempted to hike rates in 2018.

However, this time looks different because investors are wary that the Fed’s tightening in response to inflation will dovetail with other problems elsewhere.

China’s doubling down on its zero-Covid policy is crimping domestic growth and snarling supply chains while European consumers are being squeezed by soaring energy costs and a war in their backyard.

Europe’s factories export plenty to China, but consumers there are hardly in the mood to buy anything – not a single car was sold in Shanghai last month.

All of which leaves the market on the verge of a tipping point and investors are understandably concerned that if a steeper slide is triggered, the swing on the downside could be magnified by structural issues.

The world has grown more interdependent than ever and yet could not be more polarized.

Younger investors who have only ever known loose monetary policy are now having to contend with a possible bear markets and central bank hawkishness.

Even supposed haven assets like gold and U.S. Treasuries are being hammered.

While investors may be tempted into commodities and energy stocks, a global recession would all but guarantee that they collapse as quickly as they rose.

Given how high commodity prices have already been bid up, investors whetting their appetite for some of that action, drawn by the previous multiyear lows the industry has suffered, may be walking into a bear trap.

Against this backdrop, what can investors do?

Although cash is being whittled away by inflation, perhaps sitting on the sidelines for now may not be the worst thing to do.

Instead of trying to catch the lowest low or the highest high, watching to see where the chips fall may set investors up for some long-term profitable trades, especially when the directional momentum is proved to be durable.

3. DeFi as Religion - TerraUSD was a Martyr, Not a Ponzi Scheme

• Hardcore DeFi believers haven’t completely given up on algorithmic stablecoins, despite the spectacular crash of TerraUSD and its sister token LUNA.

• As the DeFi space became more crowded, each new and shiny borrowing and lending platform had to one up the last one, offering more returns to attract investors.

Despite repeatedly laying out the cards to explain how the unholy trinity of TerraUSD – LUNA – Anchor Protocol was always (hopefully unintentionally) set up for failure, decentralized finance or DeFi diehards remain undeterred.

Hardcore DeFi believers haven’t completely given up on algorithmic stablecoins, despite the spectacular crash of TerraUSD and its sister token LUNA, going to zero, arguing that they remain key for moving to a world without intermediaries such as banks and brokerages.

DeFi had been one of the fastest growing sectors in crypto over the past several years, with a slew of borrowing and lending applications offering double and triple-digit annual returns, while yields in the staid world of finance were bordering on zero.

Investors (both clued-in and clueless) were naturally drawn to the prospect of what appeared to be risk-free returns that more than bettered the rate of inflation.

But like most other cryptocurrency projects, DeFi depends on attracting enough transaction volume to keep blockchain networks going and during the easy money times when the U.S. Federal Reserve was keeping the liquidity taps flowing, that was never going to be a problem.

As the DeFi space became more crowded, each new and shiny borrowing and lending platform had to one up the last one, offering more returns to attract investors.

But since the U.S. Federal Reserve hiked interest rates last November, and as the pace of tightening has gained to deal with inflation, investors who were willing to take more risks in DeFi for the added yields are now seeing U.S. Treasury yields soar.

The current benchmark 10-year U.S. Treasury yield throws just under 3%, a far cry from Anchor Protocol’s promised 19.75%, but also at a fraction of the risk.

While the real yield on safe securities is still below that of inflation, the implosion of TerraUSD demonstrates why that extra yield doesn’t fully compensate for the considerable risks involved.

The collapse of TerraUSD however hasn’t discouraged new attempts to create an algorithmic stablecoin out of nothing.

Last week Tron, whose founder Justin Sun is famous for paying millions to have lunch with Warren Buffett, launched USDD, another algorithmic stablecoin using an arbitrage mechanism that is more or less the same as what TerraUSD used to maintain its dollar peg.

Not to be outdone, Tron’s USDD is offering a whopping 30% yield for USDD depositors, as a promotional annual yield that is subject to change monthly.

And like TerraUSD, USDD will also be “backed” by a projected raise of US$10 billion through the Tron DAO Reserve, something akin to the Luna Foundation Guard, which is still being investigated by online sleuths trying to determine if the Bitcoin it held was ever really used to support the TerraUSD peg.