Novum Alpha - Weekend Edition 7 March 2022 (10-Minute Read)

Hello there,

A magnificent Monday to you as markets are mired in a sea of worries from policy tightening to the continuing war in Ukraine.

In brief (TL:DR)

• U.S. stocks sank on Friday with the Dow Jones Industrial Average (-0.53%), S&P 500 (-0.79%) and the Nasdaq Composite (-1.66%) all down as fear continued to grip investors with conditions in Ukraine worsening.

• Asian stocks slid Monday amid fears of an inflation shock in the world economy as oil soared on the prospect of a U.S. and E.U. ban on Russian crude supplies.

• Benchmark U.S. 10-year Treasury yields continued to slide on demand for safe haven assets in increasingly uncertain circumstances with yields tumbling to 1.68% (yields fall when bond prices rise).

• The dollar held gains.

• Oil continued its ascent with April 2022 contracts for WTI Crude Oil (Nymex) (+6.96%) at US$123.73 as Europe and the U.S. demonstrating strengthening resolve to cut Russian oil from global markets.

• Gold continued to gain with April 2022 contracts for Gold (Comex) (+1.59%) at US$1,997.80 on demand for haven assets.

• Bitcoin (-2.71%) fell to US$38,400 as sinking risk appetite continued to put downwards pressure on the benchmark cryptocurrency.

In today's issue...

1. The Global Financial System Has Proved Its First Battle Test

2. China Downside Risks are Mounting

3. Bitcoin Faces Headwinds to its Hedge Status

Market Overview

High energy prices threaten to stall global growth, a risk that is sending tremors across markets.

Grains, metals and energy have surged on concerns of supply disruptions due to the invasion and sanctions on Russia that are turning the commodity powerhouse into a global pariah.

Palladium and copper hit all-time highs.

The global economy was already struggling with high inflation due to pandemic-era supply chain snarls which look set to worsen because of the conflict in Ukraine.

The U.S. Federal Reserve and other key central banks now face the tricky task of tightening monetary policy to contain the cost of living without upending economic expansion or roiling risky assets.

Asian markets were lower Monday with Tokyo's Nikkei 225 (-3.64%), Hong Kong's Hang Seng Index (-3.71%), Seoul's Kospi Index (-2.38%) and Sydney’s ASX 200 (-1.32%) all down in the morning trading session.

1. The Global Financial System Has Proved Its First Battle Test

• Given the amount of trade between Russia and Europe, there was always the risk that Western sanctions would be a double-edged sword, but so far, it appears that market participants are doing their best to maintain stability.

• Even if the conflict should ratchet up in Ukraine (likely) and even if the war should spillover into neighboring countries (also likely), so long as the Fed’s backstop remains available, markets will be unlikely to go into panic mode as in 2008.

While rockets and shells rain down on Ukrainian cities, the global financial system faced its first real test since the 2008 Financial Crisis when the sub-prime mortgage debacle gummed up liquidity and led to steep market corrections, as Russia was essentially “cancelled.”

Given the amount of trade between Russia and Europe, there was always the risk that Western sanctions would be a double-edged sword, but so far, it appears that market participants are doing their best to maintain stability.

A calculated risk, the U.S., European Union and other governments moved to sanction Russia for its invasion of Ukraine, even as pundits warned that their actions could foul up the short-term lending markets that underpin global finance.

While the U.S. Federal Reserve remained at the ready with dollar facilities set up during the pandemic should foreign central banks need to access dollars, there are few signs of any stress currently.

Short-term borrowing stress has risen, but remain well below the levels of previous crises.

Equities are sliding, but to be fair, they were already richly valued as a result of the pandemic.

Sovereign yields are falling (yields fall as bond prices rise) and predictably, the price of key commodities like energy and food are soaring.

But the upshot is that as commodity prices rise, producers have an incentive to make more.

Suddenly, extraction locations that would not otherwise have been economically viable, are and extraction companies whose balance sheets have benefited from years of restructuring, now flush with cash, may want to take advantage of low borrowing costs (for now) to strike.

Because commodity prices are very strongly driven by demand and supply, as prices go up, they tend to correct themselves – as recently as 2007, peak oil was declared and that prices would continue to move upwards, which turned out to be untrue.

It may still be too early to give the “all clear” but it appears that the global financial markets appear to be functioning.

Investors are understandably nervous and some businesses will expectedly be sourcing funding while it’s still available, but there are no signs of panic yet.

Rates on 3-month commercial paper, which enables companies and banks to borrow from investors over a short period of time, rose to about 0.6%, but still well below the levels hit when the pandemic reached the U.S. in early 2020.

Markets were put to the test when Moscow was denied access to its roughly US$630 billion in foreign reserves, which would include dollars normally available for lending in funding markets.

But the Fed’s implied backstop, to provide those dollars should they be needed, has helped to shore up markets and prevent opportunistic price-gouging by lenders.

Even if the conflict should ratchet up in Ukraine (likely) and even if the war should spillover into neighboring countries (also likely), so long as the Fed’s backstop remains available, markets will be unlikely to go into panic mode as in 2008.

2. China Downside Risks are Mounting

• Repeated regulatory crackdowns by Beijing have continued to act as a drag on Chinese tech shares, once a favorite for investors.

• Whereas sealing off Russia from the rest of the world is one thing, a bigger shock in China, especially for emerging market gauges could be pronounced.

While the world remains understandably fixated on the Russian invasion of Ukraine, on the other side of the planet, risks are emerging from the world’s second largest economy, China.

Repeated regulatory crackdowns by Beijing have continued to act as a drag on Chinese tech shares, once a favorite for investors, as U.S.-listed Chinese firms delist from American exchanges and head home and fresh regulations crimp profit margins at some of China’s biggest tech companies.

Investors are now growing increasingly concerned that this week’s meeting of the National People’s Congress, an opportunity to pave the way for Chinese President Xi Jinping to lead China for an unprecedented third term and potentially for life, could presage fresh crackdowns on various sectors of China’s economy.

Whereas sealing off Russia from the rest of the world is one thing, a bigger shock in China, especially for emerging market gauges could be pronounced.

Take for instance the MSCI Emerging Markets Index – Russia makes up just 1.5%, but China makes up a whopping 30% of the benchmark.

Over the past fortnight, Beijing has instructed its state-owned banks to report financial exposure to Ant Group, a major fintech company, which suggests that fresh crackdowns could be expected, while also demanding ride-hailing and food-delivery platforms to cap fees.

But where China could face the strongest headwinds is in a return to normalcy.

Beijing’s zero-tolerance Covid-19 strategy and reliance on its own indigenous vaccination solution has meant that Chinese in general have not had an opportunity to develop the “herd immunity” needed to return the Chinese economy to a pre-pandemic state.

Coronavirus case numbers have been soaring in China, even as they appear to be falling in pretty much everywhere else in the world.

Most of the United States and Europe have already rolled back pandemic restrictions and appear to be entering an endemic state, which will assist in their economic recoveries, while China appears to be taking one step forward, two steps back in its zero-tolerance approach.

And that means investors into China who wanted to pick up cheap Chinese equities may in fact be catching falling daggers as there is room for further correction.

Ill-advised regulatory crackdowns at a time when the economy is already slowing is starting to wear on China’s resilience to market shocks and the People’s Bank of China (PBoC) is loosening, with potentially more support measures, even as the rest of the world’s major central banks look to tighten to combat inflation.

China could be setting itself up for a perfect storm of its own creation – stagflation – where the central bank can’t afford to tighten because of a slowing economy, while inflation rises because of factors beyond its control, like the Russian invasion of Ukraine driving up China’s key commodity imports.

So far, the PBoC’s easy money policies have failed to deliver the revival in Chinese equities that investors may have hoped for, but some point to the longer-term growth potential of the Chinese economy.

Those who do may miss the point when it comes to China – there’s an assumption that Chinese leaders understand how the global economy works, there’s more than enough to suggest that they do not.

China’s history can be summed up in these terms – centralization leading to decline, forcing decentralization, leading to ascent and overconfidence, leading to centralization, leading to decline, rinse and repeat ad infinitum.

China’s leaders today appear to have misjudged how much the reforms of the past several decades since Chinese leader Deng Xiaoping opened up the country have been responsible for its economic progress.

Beijing’s ham-fisted attempts to engineer its economy have so far been ruinous – the real estate sector, which are estimated to be responsible for as much as 70% of the economy and 29% of GDP continues to stutter.

For Chinese investors who have only ever known their property prices to rise, asking them to put down their hard-earned yuan to invest in real estate could be tricky given the crisis of confidence.

And that has also proved a drag on appetite for Chinese equities as well.

Unlike the U.S., retail investors continue to command an outsized role for flows in Chinese equity markets and it would be a plucky trader to call a bottom at this stage.

3. Bitcoin Faces Headwinds to its Hedge Status

• After surging as much as 20%, to close in on US$45,000, Bitcoin has since retraced to US$38,400 at the time of writing, close to its lowest level since the end of February.

• Cryptocurrencies aren’t particularly liquid markets when compared against other traditional assets, and it’s not uncommon for small (by typical standards) purchases or sales to result in outsized swings in price.

Last week, as Russia was ejected from the global financial system, with Russian banks denied access to the SWIFT messaging system integral for cross-border banking transfers, ordinary Russians and Ukrainians poured into cryptocurrencies like Bitcoin and Ether, sending their prices soaring even as other risk asset plummeted.

But after surging as much as 20%, to close in on US$45,000, Bitcoin has since retraced to US$38,400 at the time of writing, close to its lowest level since the end of February.

Born in the wake of the 2008 Financial Crisis, Bitcoin was envisioned as an alternative to the traditional monetary system, immune to the debasement of fiat currencies and censor-proof.

Since that time though, Bitcoin has faced competing narratives, with some declaring that it is a highly speculative risk asset, whereas others believe that it has the potential to unseat gold as a haven and store of value, free from governmental control.

Those conflicting narratives have played out over the past week as Bitcoin’s rally in opposition to stocks which it has had a high correlation with, suggested to many investors that the cryptocurrency’s time to prove itself has come.

Yet by the end of the week, Bitcoin had settled more or less how it started the week, as shells rained down on a Ukrainian nuclear power plant (the biggest in Europe) saw a retreat from risk-taking that didn’t spare Bitcoin and the rest of the cryptocurrency market.

To be fair, most of the large price swings that the cryptocurrency markets are witnessing at the moment are on the back of far lower volumes – the majority of Bitcoin is seldom (if ever) traded, with many investors holding for the very long term.

Cryptocurrencies aren’t particularly liquid markets when compared against other traditional assets, and it’s not uncommon for small (by typical standards) purchases or sales to result in outsized swings in price.

It’s also important to note that cryptocurrency markets are plied by bots, automated trading programs that respond to the 24/7 markets and may be pre-programed to sell and buy based on momentum and price action.

What longer-term investors will need to pay more attention to is that the past week demonstrated that there remains a significant portion of the global population (not just Russian) that may see the value in holding an alternative currency that they can just take with them if they need to.

Even Ukrainians fleeing the conflict in their home country will want to have cryptocurrency because there’s no guarantee that their local banking system will remain intact to remit their money to offshore banks after suffering from Russian bombardment.

And that recognition played out as the Ukrainian hryvnia was one of the top few trading pairs with Bitcoin, second only to the Russian ruble, over the past week.