Hello there,

A wonderful Wednesday to you as the war in Ukraine escalates and takes a sinister new twist with Russian shelling of the Ukrainian capital of Kyiv.

In brief (TL:DR)

• U.S. stocks continued to fall on Tuesday with the Dow Jones Industrial Average (-0.56%), S&P 500 (-0.72%) and the Nasdaq Composite (-0.28%) all down as commodity costs dim economic growth prospects.

• Asian stocks rose Wednesday, bringing some respite from the volatility sparked by Russia’s invasion of Ukraine on signs of Chinese central bank loosening.

• Benchmark U.S. 10-year Treasury yields were at flat at 1.85% (yields rise when bond prices fall).

• The dollar was steady.

• Oil climbed with April 2022 contracts for WTI Crude Oil (Nymex) (+1.41%) at US$125.44, around the highest since 2008 and upping inflationary pressures.

• Gold edged higher with April 2022 contracts for Gold (Comex) (+0.32%) at US$2,049.90 and remains well over US$2,000 territory on search for havens.

• Bitcoin (+1.97%) rose to US$41,450 on a sudden surge in Asian trading and may perhaps be driven by retail demand which has been buying the dip on stocks.

In today's issue...

1. How much inflation can an oil shock cause?

2. Who’s Buying in these Markets?

3. The “Smart Money” Gets Crypto, Should Mom-and-Pop Get It Too?

Market Overview

Turmoil in commodities is continuing due to the war and sanctions on resource-rich Russia that are cutting it off from the world economy.

Major supply disruptions and an ensuing inflationary shock could stifle global growth.

The war and disarray in flows of raw materials all point to continued volatility across a range of assets. Commodity costs underline the inflation challenge for the Federal Reserve, which is expected to hike interest rates next week.

Asian markets were mixed Wednesday with Tokyo's Nikkei 225 (+0.62%) and Sydney’s ASX 200 (+1.04%) up, while Hong Kong's Hang Seng Index (-2.33%) and Seoul's Kospi Index (-1.09%) were down.

1. How much inflation can an oil shock cause?

• Energy prices in and of themselves are not necessarily long-term inflationary – higher prices could see a cut back in consumption which could lead to a lower demand for goods and services.

• The biggest risk for investors at this volatile juncture may end up not being inflation at all, but central bank policy error.

Taco Tuesday has given way to Throwback Thursday as it’s beginning to look a lot like Nixon all over again with oil brushing against US$140 a barrel yesterday and commodity prices spiking to fresh all-time-highs giving investors a sense of déjà vu and concerns over a 1970s type scenario.

To be sure, all of the ingredients of a throwback to the 1970s are there – geopolitical turmoil (instead of the Middle East, this time it’s Europe), seemingly uncontrollable energy prices and high inflation.

Could stagflation (high inflation and low or negative growth) be back in fashion again?

The thinking is that high energy prices (and to a lesser extent other commodities) will feed into other prices and dampen consumption.

But energy prices in and of themselves are not necessarily long-term inflationary – higher prices could see a cut back in consumption which could lead to a lower demand for goods and services which could then prove deflationary and catch central banks in the midst of a tightening cycle unawares.

Fortunately, the northern hemisphere is moving into the summer months and demand for heating will decrease, whereas America’s summer driving season may see shorter trips because spending more on energy could see consumers cut back in other areas.

If energy prices get high enough, demand will either dry up (cycle to work much?) as more money goes toward buying the same or smaller amount of energy, leaving less purchasing power for everything else.

Furthermore, comparing our present epoch to the 1970s is also misleading because during the Nixon administration, inflation expectations were already elevated in the months before the 1973 energy crisis.

That is much less true now, as evidenced by the negative correlation between energy prices and core inflation (excluding energy and food) over the past decades.

The biggest risk for investors at this volatile juncture may end up not being inflation at all, but central bank policy error.

The U.S. Federal Reserve may unwittingly choke the economy by tightening too quickly, but the risks are not high as their counterpart across the Atlantic looks set to maintain an even keel with the Russian invasion of Ukraine ongoing.

Whereas the European Central Bank was looking to tighten prior to the Russian invasion, there is no appetite for monetary policy hawkishness that would almost certainly push the eurozone into recession.

Meanwhile the Chinese central bank is loosening to revive China’s slowing economy ahead of a major leadership “renewal” to pave the way for President Xi Jinping to rule for life.

Against this backdrop, the U.S. Federal Reserve is likely to stay within market expectations of rate hikes, but at a much slower pace than prior to the Russian invasion.

2. Who's Buying in these Markets?

• Retail flows stand in stark contrast to hedge funds which last week sold over US$4 billion of stocks, the most on record.

• That retail flow has prevented the worst capitulation of stocks, even lifting such meme stocks with the prospect of turnaround like Bed Bath & Beyond.

The so-called “smart money” has had it with equities – institutional investors are offloading equities and licking their wounds, rotating into everything from commodities to cash in a traumatized market.

But there remains one persistent optimist – the retail investor, which has been lapping up stocks in a strong parallel with the coronavirus crash and how that episode ultimately played out.

Despite volatility sufficient to make anyone’s neck snap and dreadful images of war being played out live in Europe, retail traders have just plowed money into the U.S. equity market for the 9th straight week, according to data from Bank of America.

Retail flows stand in stark contrast to hedge funds which last week sold over US$4 billion of stocks, the most on record.

Unlike most Asian markets, retail investors are a relatively new source of flows for U.S. equity markets, which prior to the pandemic were the exclusive stomping ground for institutional flows.

By some estimates, retail investors can make up as much as 1 out of every 4 trades in the market, as opposed to Asia, where retail investors make up as much as 80% of flows.

That retail flow has prevented the worst capitulation of stocks, even lifting such meme stocks with the prospect of turnaround like Bed Bath & Beyond (+5.30%).

Whether the “smart money” gets it or not is highly debatable, especially since retail traders dove into stocks just as they were bottoming during the pandemic, demonstrating a steely resolve and profiting massively from it just as institutional investors lost their nerve.

It may of course be that retail traders simply “got lucky” and bought the market just as it was bottoming out, but the powerful psychological conditioning of the past two years is difficult to ignore.

During the meme stock craze, even professional investors took to scouring Twitter (+0.86%) and Reddit to determine where the retail horde was headed to next and to hop on their bandwagon.

There is some data to support that this time may be no different.

According to data by Bank of America, S&P 500 returns following periods of big retail trading inflows have been reliably above average whereas the index’s performance has lagged when retail traders have left the markets.

It may well be that retail investors with their ears to the ground act as a slightly better indicator for future returns and a sudden peace in Ukraine could see markets rally faster than investors can pour into markets, akin to what happened when the Fed intervened in 2020.

Even ignoring a sudden reversal, are stocks even cheap to begin with?

The S&P 500 certainly looks much more reasonable today – at 18.3 times profits, the S&P 500 is at its lowest level since one month after the 2020 pandemic crash is now in line with its five-year average.

Considering that many investors effectively doubled their money had they bought the dip after the pandemic selloff, the temptation to do the same today is very high and those who may have missed that boat are now looking to get aboard this one.

3. The "Smart Money" Gets Crypto, Should Mom-and-Pop Get It Too?

• Even as more institutional investors muscle into the cryptocurrency space, there is a reluctance by regulators to provide mom-and-pop investors access to these products.

• If nothing else, regulators could provide greater access to a growing asset class that investors want to participate in anyway, via an ETF that would also protect investor rights and recourse.

The one democratizing factor about cryptocurrencies and the trading thereof has been the almost non-existent barriers to entry, meaning that retail investors were the first past the post and many ordinary lives were changed by the transformative (speculative) potential of the nascent asset class.

But even as more institutional investors muscle into the cryptocurrency space, there is a reluctance by regulators to provide mom-and-pop investors access to these products.

While leading financial hubs like New York and London waver on allowing cryptocurrency ETF products that hold actual digital assets as their underlying, secondary financial centers like Zurich and Toronto have been making hay while the sun shines.

Sao Paolo has also emerged as an unlikely candidate to push the envelope in Latin America, with the Brazilian Securities Commission recently opening the door to the world’s first two decentralized finance ETFs.

These DeFi ETFs invest in a basket of tokens issued by decentralized applications like Uniswap, a decentralized exchange, and Polygon, that aims to make transactions on primary blockchains like Ethereum, faster.

Zurich’s SIX Swiss Exchange has a long list of cryptocurrency exchange-traded products, which are the functional equivalent of ETFs, but are labeled as such for regulatory reasons.

And Canada, Sweden, Germany, Jersey and Liechtenstein have all approved products investing either in individual cryptocurrencies or baskets of such securities, with Australia and India likely to follow suit.

But the quest for a physically-backed Bitcoin ETF in the U.S. remains elusive, with the U.S. Securities and Exchange Commission having so far rejected over a dozen applications for a Bitcoin ETF or other similar products, arguing that the applicants have so far not gone far enough to prove how their products will not be susceptible to manipulation.

Other leading financial centers outside of New York, like Singapore and Hong Kong, have also been reticent to greenlight such products, instead raising significant barriers between the US$10 trillion ETF industry and cryptocurrencies, which now boast a market cap of around US$2 trillion (on a good day).

Yet this reticence on concerns over consumer protection seems somewhat disingenuous, especially given that retail investors can avail themselves of cryptocurrencies directly, which they have always been able to access through cryptocurrency exchanges, and now through decentralized exchanges.

If nothing else, regulators could provide greater access to a growing asset class that investors want to participate in anyway, via an ETF that would also protect investor rights and recourse.