One trading day after epic carnage shook global markets, US index futures staged a modest recovery on Monday after Wall Street’s worst selloff in almost two years. S&P 500 Index contracts rose 0.1% from an 11-month low, while Nasdaq 100 futures gained 0.4% with volumes thinned by holidays in several markets including the UK, China and Hong Kong. European and Asian stocks fell as disappointing corporate earnings, expectations of global monetary tightening, poor data from China and the prospect of sanctions on Russian oil weighed heavily on risk appetite. The VIX remained elevated, trading above 33, as investors braced for a week that’s likely to see a global round of monetary-policy tightening that will add to concerns about global growth. 10Y Treasury yields pushed higher again, rising to 2.94% before easing ahead of this week's key event, the Fed's upcoming 50bps rate hike. The dollar gained as worries over high inflation and China’s Covid lockdowns contributed to investor caution, and sent the offshore yuan sliding to just shy of 6.69m the lowest since November 2020. Gold extended its slump and Brent oil dropped about $2 to trade around $104.50.
Focus has shifted back to the Fed’s policy outlook after last Friday's pledge by China to boost economic stimulus damped demand for havens on Friday. The week's main event will take place on May the 4th (be with you), when the Fed is expected to lift rates by 50bps, the first "double-hike" since May 2000, and will announce it will let its balance sheet start to shrink at a pace that will quickly step up to $95 billion a month. Odds of 75bps rate hike in June remain at 50%. Bond yields may stay “elevated for the foreseeable future” due to inflation and the Fed’s sharp rate hikes allied with balance-sheet reduction, Seema Shah, chief global strategist at Principal Global Investors, wrote in a note. Japanese institutional managers - known for their legendary U.S. debt buying sprees in recent decades - are now fueling the great bond selloff just as the Federal Reserve pares its $9 trillion balance sheet.
In premarket trading, Activision Blizzard gained 2% after Warren Buffett snapped up more of the stock in a merger arbitrage bet (yes, Berkshire is a merger-arb powerhouse now, how long until Berkshire does Twitter). Here are some other notable movers:
- Comerica (CMA) upgraded to overweight and KeyCorp (KEY) cut to underweight at Piper Sandler as the broker shuffled ratings to reflect its post-earnings preferences
- Piper Sandler analyst Alexander Twerdahl cut the recommendation on Community Bank System (CBU) to underweight, becoming the first broker to downgrade the company with a sell-equivalent rating since July 2020
- Piper Sandler analyst Arvind Ramnani raised the recommendation on Epam Systems (EPAM) to overweight, citing healthy demand for digital IT services
In Europe, the automotive and tech sectors led the Stoxx Europe 600 Index down 1%, extending its losses this year to 8.6% with focus on the potential for the European Union to propose a ban on Russian oil by year-end as well as concerns over China’s economy. Vestas fell 5.9% in Copenhagen after the Danish maker of wind turbines cut its revenue outlook for the full year and forecast its first loss in a decade. Confidence in the euro-area economy fell to the lowest in a year as the impact of the war in Ukraine drained overall sentiment from industry to consumers.
Among individuals moves in Europe, Adler Group SA shares plunged more than 40% after KPMG said it was unable to give an audit opinion and Vestas Wind Systems A/S slumped after forecasting its first loss in a decade.
Earlier in the session, Asian stocks slid on delayed reaction to the Friday carnage after underwhelming earnings guidance from U.S. tech giants fueled worries about a further slowdown in a global economy already smarting from the Federal Reserve’s policy tightening and China’s lockdowns to curb the coronavirus. The MSCI Asia Pacific Index dropped as much as 0.8%, weighed down by losses in financials and technology. The key gauge in Australia fell the most ahead of Tuesday’s local central bank policy meeting that is expected to raise rates for the first time since 2010.
Markets in China, Hong Kong, Taiwan and Singapore were closed for holidays. Chinese economic activity contracted sharply in April, data released Saturday showed, weighing on regional investor sentiment even after the Politburo pledged to meet economic targets. Fed Chair Jerome Powell has as good as promised that U.S. officials will deliver a 50 basis-point interest-rate increase this week.
“The U.S. economy appears to be peaking while markets expect almost four 50-basis-points rate hikes by the Federal Reserve in upcoming policy meetings,” said Norihiro Fujito, chief investment strategist at Mitsubishi UFJ Morgan Stanley Securities. “China’s PMI announced over the weekend was terrible. When you have the world’s two largest economies in conditions like this, there will be pressure on corporate earnings.”
Asian tech stocks were weak after Amazon.com Inc. plunged on Friday by the most since 2006 on a sales forecast that fell short of analyst estimates. IPhone maker Apple Inc. warned last week of a hit of up to $8 billion in its second-quarter revenue as China’s Covid-19 lockdowns undermine the world’s supply lines
Japanese equities fell slightly ahead the Federal Reserve’s planned interest-rate hike this week and amid continued concern over the impact of China’s lockdowns to curb the coronavirus. Japanese markets will be closed Tuesday through Thursday for Golden Week holidays. The Topix fell 0.1% to close at 1,898.35 Monday, while the Nikkei declined 0.1% to 26,818.53. Nintendo Co. contributed the most to the Topix decline, decreasing 2.4%. Out of 2,172 shares in the index, 1,110 rose and 973 fell, while 89 were unchanged.
India’s key equity gauges fell on Monday, dragged by information technology stocks and index heavyweight Reliance Industries while corporate earnings performance for March quarter remains mixed. The S&P BSE Sensex fell 0.2% to 56,975.99 in Mumbai, while the NSE Nifty 50 Index also retreated by an equal measure. The key gauges fell 2.6% and 2.1% in April, respectively and have retreated in three of four months this year. Indian markets will be shut on Tuesday due to a local holiday. Ten of the 19 sector sub-indexes compiled by BSE Ltd. declined, led by consumer durables. Metal and basic material companies were the best performers.
Foreign investors, who have been net sellers of Indian stocks since end of September, dumped about $3.4 billion in month through April 28. The global funds have sold a total of $21.7 in the preceding 7 months as surging inflation and a war in Ukraine dented global risk-appetite for equities. Infosys contributed the most to the index decline, decreasing 1.7%. Out of 30 shares in the Sensex index, 11 rose and 19 felf.
In rates, Treasuries reopened slightly richer across the curve when trading resumed following holiday closures across Europe. 10-year TSY yields were around 2.915% is richer by ~2bp vs Friday’s close, vs 2.5bp for German 10-year. U.S. 10-year sector slightly outperforms front-end where 2-year yields are lower by 1bp on the day; curve spreads remain within ~1bp of last week’s close. Bunds outperform with gilts closed for U.K. bank holiday. Dollar issuance slate empty so far; estimates for the week are around $25b, and some expect a historically busy month with $125b-$150b of IG credit supply.
In FX, a gauge of the dollar’s strength advanced, outperforming most other Group-of-10 currencies. Trading volumes thinned with holidays in countries including the U.K. China’s manufacturing and services activity plunged to their worst levels since February 2020, according to purchasing managers surveys. The Bloomberg Dollar Spot Index gains 0.1%; cash Treasuries are closed until U.S. hours. “There’s a good chance that we would go towards parity in euro-dollar,” Union Investment’s Christian Kopf said in an interview with Bloomberg Television on Monday. Elsewhere, the yen underperformed all its G-10 peers/ The Australian and New Zealand dollars dropped amid momentum selling and liquidation of longs by leveraged funds, traders said. “As long as the Fed doesn’t blink, the dollar stays bid,” ING Groep NV analysts including Chris Turner wrote in a note. The offshore yuan weakened in the wake of data signaling a sharp contraction in Chinese economic activity amid idled factories and snarled supply chains.
In commodities, WTI and Brent fell with downside occurring alongside the pressure in equities; downside was exacerbated by the loss of multiple psychological support levels. Newsflow has been heavily focused on a potential Russian oil/gas embargo, with Hungary remaining heavily opposed; however, Politico reports of a potential compromise for such member nations.
A missile attack on an oil refinery in Iraq's Erbil hit an oil tank and caused a fire although the fire was put under control, according to Reuters citing security forces. Iraq’s oil exports reached a total of 101mln bbls in April which raised USD 10.55bln in revenues, while exports averaged 3.4mln bpd.
Bitcoin prices are marginally higher and rebounded from beneath the 38,500 level.
Looking at today's calendar, we get the April manufacturing PMI and US ISM Manufacturing data, new car registrations, US March construction spending. We also get earnings from NXP Semiconductors, Devon Energy, Expedia, MGM resorts, SolarEdge.
- S&P 500 futures down 0.1% to 4,125.75
- STOXX Europe 600 down 1.4% to 444.02
- MXAP down 0.6% to 167.87
- MXAPJ down 0.6% to 556.31
- Nikkei down 0.1% to 26,818.53
- Topix little changed at 1,898.35
- Hang Seng Index up 4.0% to 21,089.39
- Shanghai Composite up 2.4% to 3,047.06
- Sensex down 0.5% to 56,783.95
- Australia S&P/ASX 200 down 1.2% to 7,346.99
- Kospi down 0.3% to 2,687.45
- German 10Y yield down 3bps to 0.91%
- Euro down 0.2% to $1.0526
- Brent futures down 2.6% to $104.32/bbl
- Gold spot down 0.8% to $1,881.25
- U.S. Dollar Index up 0.41% to 103.38
Top Overnight News from Bloomberg
- A gauge of the dollar advanced as traders positioned for the Federal Reserve to deliver its biggest rate hike since 2000 this week.
- Australian bonds sold off as investors anticipate the nation’s central bank will raise interest rates on Tuesday for the first time since 2010.
- In times of Treasury turmoil, the biggest investor outside American soil has historically lent a helping hand. Not this time round.
- Oil slipped at the start of the month as investors weighed the impacts of China’s measures to contain the coronavirus and moves by Europe to cut its reliance on fuel from Russia
- In times of Treasury turmoil, the biggest investor outside American soil has historically lent a helping hand. Not this time round
- China’s factory activity fell to the lowest level in more than two years in April, underscoring the economic damage caused by Covid outbreaks and lockdowns and escalating concerns about further disruption to global supply chains
- A widespread sell-off in China is rippling through emerging markets, threatening to snuff out growth and drag down everything from stocks to currencies and bonds
A more detailed look at global markets courtesy of Newsquawk
Asia-Pac stocks declined amid mass holiday closures, weak Chinese PMIs and upcoming key risk events including central bank meetings. ASX 200 underperformed with all sectors pressured as yields edged higher ahead of an expected rate lift-off by the RBA tomorrow. Nikkei 225 was subdued after stalling on approach to the 27,000 level and with participants tentative ahead of a three-day closure. Hang Seng and Shanghai Comp remained shut due to Labour Day holidays but will reopen on Tuesday and Thursday, respectively.
Top Asian News
- Billionaire Cannon-Brookes to Seek Stake in Australia’s AGL
- Asian Factories Defy China Slowdown as Euro Area Loses Momentum
- Marcos Jr. Keeps Lead Ahead of Philippine Presidential Poll
- Australia Yields Hit Highest Since 2014 With RBA, Fed Hikes Seen
European bourses are lower across the board, Euro Stoxx 50 -1.60%, following a subdued APAC handover amid holiday thinned conditions, soft data and COVID concerns. US futures are firmer across the board, ES +0.3%, but relatively contained ahead of the FOMC and an expected 50bp hike. US and Japan are to increase cooperation in constructing supply chains for cutting-edge semiconductors, via Nikkei. Nasdaq has decided to call for stressed market conditions on all Swedish equity and index derivatives until further notice or at the longest until close of business as of May 2, 2022.
Top European News
- Deutsche Bank AGM Shouldn’t Absolve Leaders, Advisor Says
- Spanish Prime Minister’s Phone Hacked With Spy Software in 2021
- Credit Suisse Falls Most in 2 Months; Outpaces Drop in Swiss SMI
- Partners Group Declines 9.3%, Most in Two Years
- Specs add to Buck longs before FOMC and NFP, but DXY slips a tad further from 103.930 peak into range above the round number - index meandering from 103.530-100.
- Euro hampered by mixed Eurozone manufacturing PMIs and weaker than forecast sentiment indices as it retreats from 1.0550+ and 0.8400+ vs Dollar and Sterling respectively.
- Recoil in oil undermines Loonie and Norwegian Crown, USD/CAD elevated mostly above 1.2850 and EUR/NOK 9.9000+.
- Aussie underpinned ahead of anticipated RBA hike, AUD/USD straddling 0.7050 and AUD/NZD cross pivoting 1.0950.
- Offshore Yuan weak amidst clean sweep of contractionary Chinese PMIs, USD/CNH not far from retest of 6.7000.
- Holiday-thinned trading volumes compound choppy price action as bonds brace for big week to begin May.
- Bunds whipsaw within 154.12-153.25 range, BTPs and Bonos undermined by sub-forecast Italian and Spanish PMIs with 10 year debt futures flattish between 130.71-129.71 and 143.05-140.50 parameters.
- USTs mostly softer and curve steeper awaiting Fed and NFP following the final manufacturing PMI, ISM and construction spending; T-note just under 119-00 vs 119-01 high and 118-22+ low.
- WTI and Brent are pressured with downside occurring alongside the pressure in equities; downside was exacerbated by the loss of multiple psychological support levels.
- Newsflow has been heavily focused on a potential Russian oil/gas embargo, with Hungary remaining heavily opposed; however, Politico reports of a potential compromise for such member nations.
- A missile attack on an oil refinery in Iraq's Erbil hit an oil tank and caused a fire although the fire was put under control, according to Reuters citing security forces.
- Iraq’s oil exports reached a total of 101mln bbls in April which raised USD 10.55bln in revenues, while exports averaged 3.4mln bpd. It was also reported that Iraq’s Basra Oil Company said a third oil pipeline at the Khor Al-Amaya oil terminal in southern Iraq will be operational by end-2023 with a capacity of 600k bpd, according to Reuters.
- Libya’s NOC announced a temporary resumption of work and lifting of the force majeure at the Zueitina oil terminal to reduce stock and free up storage capacity, according to Reuters.
- Spot gold has lost the USD 1900/oz mark, as yields continue to climb ahead of the FOMC.
US Event Calendar
- 09:45: April S&P Global US Manufacturing PMI, est. 59.7, prior 59.7
- 10:00: March Construction Spending MoM, est. 0.8%, prior 0.5%
- 10:00: April ISM Manufacturing, est. 57.6, prior 57.1
- April ISM Employment, est. 55.0, prior 56.3
- April ISM Prices Paid, est. 87.4, prior 87.1
- April ISM New Orders, est. 54.1, prior 53.8
DB's Jim Reid concludes the overnight wrap
Filling in on the May Day bank holiday as we enter a new month. Despite the holiday, the industrious Henry Allen on our team has put out the April month asset performance review, link available here. The US dollar was among the best performing assets on the month, following the Fed’s anticipated supercharged tightening combined with fluttering risk sentiment, making it the top performing G10 currency YTD. Elsewhere, brent and WTI crude gained for the fifth month in a row, the latest run aided by growing speculation that Europe is prepared to countenance Russian energy embargos. Agricultural goods rounded out the top performers. On the downside, equities and sovereign bonds both lost ground over the month, with the S&P 500 posting its worst monthly return since covid seized markets in March 2020. Credit and EM assets were also down over the volatile month.
From the month gone to the packed week ahead. The highlight is Wednesday’s FOMC meeting, which our US economics team has previewed in full, here. They believe the Fed will kick tightening up a notch, lifting the fed funds target range by +50bps. The market agrees, and then some, with +51.8bps of tightening priced for the meeting, suggesting some market participants believe there’s still some risk of an even larger hike. Our US econ team believes the Chair will signal this is but the first of a series of potential +50bp hikes, as the Fed tries to get policy to neutral as quickly as possible in light of historic inflation. With the question of how fast the Fed needs to raise rates generally understood (answer: very), focus will shift to how far they need to hike rates to tighten financial conditions adequately.
That task will be augmented by balance sheet rundown, as the Fed has also signaled they will announce the beginning of QT, with the first assets likely rolling off the Fed’s portfolio in June. Our estimates are that QT will proceed through next year, adding around three additional +25bp hikes of tightening, only to stop once the economy careens into recession at the end of 2023.
The BoE is similarly expected to raise rates and signal tighter balance sheet policy on Thursday. Our UK economist full preview can be found here. The team expects the MPC to continue wrestling with the trade-off between slowing growth and intensifying inflation, with the latter winning out and bringing a +25bp Bank Rate hike, along with two more hikes coming this year. On the balance sheet, our team thinks the MPC will confirm its intention to sell gilts later this year, with more guidance coming over the next few meetings and sales beginning in September.
There’s no rest for the weary, as the week ends with the US employment situation report, where our US economists expect nonfarm payrolls to gain +465k, the unemployment rate to tick down to +3.5%, and average hourly earnings to gain +0.2%. Unemployment figures from Europe are also due this week. Production data, starting with ISM manufacturing out later today, also feature this week.
After last week’s mega-cap deluge, this week’s earnings are a sample platter drawing from travel, hospitality, and energy firms.
Available Asian stock markets are trading lower after China’s downbeat PMI data released over the weekend is weighing on the regional investor sentiment. The Nikkei (-0.53%), Kospi (-0.60%) are both trading in negative territory.
The Chinese official manufacturing PMI for April worsened to a level of 47.4 (v/s 49.5 in March), a second straight month of contraction and notching its lowest level since February 2020 as the nation has been severely challenged by the resurgence of Covid-19, leading some firms to reduce or halt production. Additionally, the official non-manufacturing segment slumped by 6.5 percentage points to a level of 41.9 in April, with 19 of the 21 sectors surveyed in the contraction range. Also, a private survey also showed further deterioration in Chinese factory activity with the Caixin manufacturing PMI for April coming in at 46.0, declining from 48.1 in March. This follows last week’s reports that President Xi vows to step up government support in response to the slowdown.
Wrapping up last week’s action. The intensification of China’s lockdowns to stanch the most recent covid outbreak pushed the offshore renminbi -1.72% lower (+0.27% Friday) against the US dollar. The anticipated slowdown in Chinese activity drove global growth fears, prompting cross-asset volatility as investors layer in slower growth into the anticipated central bank reaction function.
US equity volatility reached levels not seen since Russia’s initial invasion of Ukraine, with the Vix picking up +5.18pts to 33.39 (+3.41pts Friday). The macro backdrop interacted with mega-cap tech earnings which painted a mixed outlook, that saw the S&P 500 down -3.27%, a full-3.63% lower on Friday’s month end trading. The STOXX 600 proved more resilient, retreating just -0.64% (+0.74% Friday).
Crude oil prices started the week lower on global demand fears, but eventually recovered following tensions around Russian energy exports to Europe ratcheting higher. Brent crude finished the week +6.92% higher (+1.63% Friday) at $109.34/bbl.
In data, the US employment cost index increased +1.4% versus +1.1% expectations, while core PCE gained +0.3% month-over-month, in line with expectations. Nominal 10yr Treasury yields were up a relatively tame +3.5bps over the week, but the on net figure masks intraweek volatility. 10yr yields were -18.8bps lower intraweek on the growth fears, before selling off more than +11bps on both Wednesday and Friday to finish the week. 10yr bunds were -3.4bps lower over the week (+3.8bps Friday), after hitting much lower troughs as well. Italian spreads widened +14bps to +184bps over 10yr bunds.
Off Campus Texas A&M Housing With “Resort Style” Rooftop Pool Defaults On Debt Payment
Off Campus Texas A&M Housing With "Resort Style" Rooftop Pool Defaults On Debt Payment
Who could have possibly thought, amidst all this…
Who could have possibly thought, amidst all this euphoria, that luxury college housing complexes for students might not be the best idea in the world?
It's looking like for one complex - with, of course, a "resort style" rooftop pool (which everybody knows is integral to ones studies) - near the Texas A&M University campus is starting to find out this harsh reality.
The 3,400-bed student housing complex, called Park West, is going to default on its July debt payment according to Moody’s Investors Service, who downgraded the company's bonds deeper into junk territory this week.
The property, which provides off-campus housing for students, is located in College Station, Texas, Bloomberg reported in a mid-week wrap up. It has reportedly been struggling since even before the pandemic, thanks to the building's higher rents.
Moody's commented: “The project’s financial distress is directly linked to prolonged weakness within its College Station, Texas student housing submarket which has been an ongoing problem since Park West opened for fall 2017.”
$15.3 million is due in principal and interest, but the complex will only pay $8.5 million. The company that sold the bonds, NCCD-College Station Properties LLC, still has about $342 million in bonds outstanding, Bloomberg reported.
The vice president and director of operations for the company confirmed that the company would default but offered up no other color.
For a look at the complex's posh amenities, you can review its website here.
“Worst Start Since 1788”: A Closer Look At The Catastrophic First Half Performance
"Worst Start Since 1788": A Closer Look At The Catastrophic First Half Performance
As discussed yesterday…
Worst first half for stocks…
As discussed yesterday...
Worst first half for stocks in 52 years. pic.twitter.com/mOYvbJ6pvo— zerohedge (@zerohedge) June 30, 2022
... and again this morning, when Rabobank's Michael Every said that "if you bought stocks in H1, you lost; if bonds, you lost; if commodities, you were doing great until recently; if crypto you lost; if the US dollar, you were fine" but lost purchasing power to inflation, the first six months of the year were terrible.
Just how terrible? To quantify the destruction, we go to the latest chart of the day from DB's Jim Reid who writes that "the good news is that H1 is now over. The bad news is that the outlook for H2 is not looking good."
To demonstrate just how bad H1 was, Reid shares three charts. They show that:
1) Deutsche Bank's US 10yr Treasury proxy index did indeed see the worst H1 since 1788 in spite of a sizeable late June rally, and...
2) the S&P 500 saw the worst H1 total return since 1962 after a rally last week just pulled it back from being the worst since 1932.
Here, BofA has outdone DB, and notes that in real timers, the S&P500's performance was the worst since 1872!
As Reid further notes, "I’ve found through my career that these type of charts are always the most demanded as investors want to put their performance in context." Which is why he also added a the third chart which is an abridged version of one published by DB's Henry Allen in a report fully reviewing H1, June and Q2 (more below, and also available to professional subs in the usual place).
As Reid concludes, "if you like horror stories its an alternative to Stranger Things which returns to our global screens today. Obviously if you run a commodity fund you may think differently!"
Stepping back from this narrow take, we look at the full performance review for June and Q2 conducted by Reid's colleague, Henry Allen, which finds that "it's hard to overstate just how bad markets have performed over recent months, with the returns in Q2 very much following in Q1’s footsteps... a range of asset classes saw significant losses, including equities, credit and sovereign bonds, whilst the US dollar and some commodities like oil were among the few exceptions. In fact, in total return terms we’ve just seen the biggest H1 decline for the S&P 500 in 60 years, and in June alone just 2 of the 38 non-currency assets in our sample were in positive territory, which is the same as what we saw during the initial market chaos from the pandemic in March 2020."
On a YTD basis as well, just 4 of 38 tracked assets are in positive territory, which as it stands is even lower than the 7 assets that managed to score a positive return in 2008.
The main reason for these broad-based declines is the fact that recession and stagflation risks have ramped up significantly over Q2. This has been for several reasons, but first among them is the fact that inflation has proven far more persistent than the consensus expected once again, requiring a more aggressive pace of rate hikes from central banks than investors were expecting at the start of the quarter. For instance, the rate priced in by Fed funds futures for the December 2022 meeting has risen from 2.40% at the end of Q1 to 3.38% at the end of Q2. A similar pattern has been seen from other central banks, and the effects are beginning to show up in the real economy too, with US mortgage rates reaching a post-2008 high. The good news is that as of today, the market is now pricing in not just rate hikes to peak in Q4, but about 14bps of rate cuts in Q1.
in any case, the big worry from investors’ point of view is that the cumulative effect of these rate hikes will be enough to knock the economy into recession, and on that front we’ve seen multiple signs pointing to slower growth recently in both the US and Europe. For instance, the flash Euro Area composite PMI for June came in at a 16-month low of 51.9, whilst its US counterpart fell to a 5-month low of 51.2. Other recessionary indicators like the yield curve are also showing concerning signs, with the 2s10s Treasury curve still hovering just outside inversion territory at the end of the quarter, at just +5.1bps. The energy shock is adding to these growth concerns, and that’s persisted over Q2 as the war in Ukraine has continued. Brent crude oil prices built on their sizeable gains from Q1, with a further +6.4% rise in Q2 that left them at $115/bbl. Meanwhile, European natural gas is up by +14.8% to €145 per megawatt-hour. However, fears of a global recession have knocked industrial metals prices significantly, and the London Metal Exchange Index has just seen its first quarterly fall since the initial wave of the pandemic in Q1 2020, and its -25.0% decline is the largest since the turmoil of the GFC in Q4 2008.
That decline in risk appetite has knocked a range of other assets too:
- The S&P 500 slumped -16.1% over Q2, meaning its quarterly performance was the second worst since the GFC turmoil of Q4 2008.
- Sovereign bonds built on their losses from Q1,
- Euro sovereigns (-7.4%) saw their worst quarterly performance of the 21st century so far as the ECB announced their plan to start hiking rates from July to deal with high inflation.
- Cryptocurrencies shared in the losses too, with Bitcoin’s (59.0%) decline over Q2 marking its worst quarterly performance in over a decade
Which assets saw the biggest gains in Q2?
- Energy Commodities: The continued war in Ukraine put further upward pressure on energy prices, with Brent crude (+6.4%) and WTI (+5.5%) oil both advancing over the quarter. The rise was particularly noticeable for European natural gas, with futures up by +14.8% as the continent faces up to the risk of a potential gas cut-off from Russia.
- US Dollar: The dollar was the best-performing of the G10 currencies in Q2 as it dawned on investors that the Fed would hike more aggressively than they expected, and the YTD gains for the dollar index now stand at +9.4%.
Which assets saw the biggest losses in Q2?
- Equities: Growing fears about a recession led to significant equity losses in Q2, with the S&P 500 (-16.1%) seeing its second-worst quarterly performance since the GFC turmoil of Q4 2008. That pattern was seen across the world, with Europe’s STOXX 600 down -9.1%, Japan’s Nikkei down -5.0%, and the MSCI EM index down -11.4%.
- Credit: For a second consecutive quarter, every credit index we follow across USD, EUR and GBP moved lower. EUR and USD HY saw some of the worst losses, with declines of -10.7% and -9.9% respectively.
- Sovereign Bonds: As with credit, sovereign bonds lost ground on both sides of the Atlantic, and the decline in European sovereigns (-7.4%) was the worst so far in the 21st century. Treasuries also lost further ground, and their -4.1% decline over Q2 brings their YTD losses to -9.4%.
- Non-energy commodities: Whilst energy saw further gains over Q2, other commodities saw some major declines. Industrial metals were a significant underperformer, with the London Metal Exchange Index (-25.0%) seeing its largest quarterly decline since the GFC turmoil of 2008. Precious metals lost ground too, with declines for both gold (-6.7%) and silver (-18.2%). And a number of agricultural commodities also fell back, including wheat (-13.6%).
- Japanese Yen: The Japanese Yen weakened against the US Dollar by -10.3% over Q2, which also marked its 6th consecutive quarterly decline against the dollar. By the close at the end of the quarter, that left the Yen trading at 136 per dollar, which is around its weakest level since 1998. That came as the Bank of Japan has become the outlier among the major advanced economy central banks in not hiking rates with even the Swiss National Bank hiking in June for the first time in 15 years.
- Cryptocurrencies: The broader risk-off tone has been bad news for cryptocurrencies, and Bitcoin’s -59.0% decline over Q2 is its worst quarterly performance in over a decade. Other cryptocurrencies have lost significant ground as well, including Litecoin (-59.2%) and XRP (-61.2%).
Looking specifically at June rather than Q2 as a whole, the picture looks even worse in some ways since just 2 of the 38 non-currency assets are in positive territory for the month, which is the same number as in March 2020 when global markets reacted to the initial wave of the pandemic. The two positive assets are the Shanghai Comp (+7.5%) and the Hang Seng (+3.0%), which have been supported by improving economic data as Covid restrictions have been eased. Otherwise however, it’s been negative across the board, and even commodities have struggled after their strong start to the year, with Brent crude (-6.5%) and WTI (7.8%) posting their first monthly declines so far this year as concerns about a recession have mounted. The main catalyst for this was the much stronger-than-expected US CPI print for June, which triggered another selloff as it dawned on investors that the Fed would be forced to hike rates even more aggressively to rein in inflation, which they followed through on at their meeting when they hiked by 75bps for the first time since 1994.
Finally, without further ado, here are the charts showing total returns for the month of June...
... for Q2...
... and for YTD.
Risk Capital and Markets: A Temporary Retreat or Long Term Pull Back?
As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices…
As inflation has taken center stage, markets have gone into retreat globally, and across asset classes. In 2022, as bond rates have risen, stock prices have fallen, and crypto has imploded, even true believers are questioning what the bottom for markets might be, and when we will get there. While it is easy to call the market movement in 2022 a correction and to argue that it is overdue, it is facile, and it fails to address the question of why it is happening now, and whether the correction is overdone or has more to go. In this post, I will argue that almost everything that we are observing in markets, across asset classes, can be explained by a pull back on risk capital, and that understanding the magnitude of the pull back, and putting in historical perspective, is key to gauging what is coming next.
Risk Capital: What is it?
To put risk capital in perspective, it is best to start with a definition of risk that is comprehensive and all-inclusive, and that is to think of risk as a combination of danger (downside) and opportunity (upside) and to consider how investments vary in terms of exposure to both. In every asset class, there is a range of investment choices, with some being safer (or even guaranteed) and others being riskier.
Risk capital is the portion of capital that is invested in the riskiest segments of each market and safety capital is that portion that finds its way to the safest segments in each market.
While risk and safety capital approach the market from opposite ends in the risk spectrum, one (safety capital) being driven by fear and the other (risk capital), by greed, they need to not only co-exist, but be in balance, for the market to be healthy. When to two are not in balance, these imbalances can have profound and often unhealthy effects not just of markets, but also on the overall economy. At the extremes, when risk capital is absent and everyone seeks safety, the economy and markets will atrophy, as businesses and investors will stay away from risky ventures, and when risk capital is too easy and accessible, risky asset prices will soar, and the economy will see too much growth in its riskiest segments, often at the expense of more stable (and still necessary) businesses.
Risk Capital's Ebbs and Flows
It is a common misconception that the risk-takers supply risk capital (risk takers) and that the investors who invest for safety draw from different investor pools, and that these pools remain unchanged over time. While investor risk aversion clearly does play a role in whether investors are drawn to invest in risk or safety capital, it obscures two realities:
- Variation within an investor's portfolio: Many investors, including even the most risk averse, may and often do set aside a portion of their portfolios for riskier investments, drawn by the higher expected returns on those investments. For some investors, this set aside will be the portion that they can afford to lose, without affecting their life styles in any material way. For others, it can be the portion of their capital with the longest time horizon (pension fund savings or 401Ks, if you are a young investor, for example), where they believe that any losses on risk capital can be made up over time. For still others, it is that segment of their portfolios that they treat las long shot gambles, hoping for a disproportionately large payoff, if they are lucky. The amount that is put into the risk capital portion will vary with investor risk aversion, with more risk averse investors putting less or even nothing into the riskiest assets, and less risk averse investors putting in more.
- Variation across time: The amount that investors are willing to put into risk capital, or conversely redirect to safety capital, will change over time, with several factors playing a role in determining whether risk capital will be plentiful or scarce. The first is market momentum, since more money will be put into the riskiest asset classes, when markets are rising, because investors who benefit from these rising markets will have more capital that they are willing to risk. The second is the the health and stability of the economy, since investors with secure jobs and rising paychecks are more willing to take risks.
There are two macro factors that will come into play, and both are in play in markets today. The first is the return that can be earned on guaranteed investments, i.e., US treasury bills and bonds, for instance, if you are a investor in US dollar, since it is a measure of what someone who takes no or very low risk can expect to earn. When treasury rates are low or close to zero, refusing to take risk will result in returns that are very low or close to zero as well, thus inducing investors to expose themselves to more risk than they would have taken in higher interest rate regimes. The second is inflation, which reduces the nominal return you make on all your investments, and the effects of rising inflation on risk capital are complex. As expected inflation rises, you are likely to see higher interest rates, and as we noted above, that may induce investors to cut back on risk taking and focus on earning enough to cover the ravages of inflation. As uncertainty about inflation rises, you will see reallocation of investment across asset classes, with real assets gaining when unexpected inflation is positive (actual inflation is higher than expected), and financial assets benefiting when unexpected inflation is negative (actual inflation is less than expected).
If you are wondering why you should care about risk capital's ebbs and flows, it is because you will feel its effects in almost everything you do in investing and business.
- Risk Premiums: The risk premiums that you observe in every risky asset market are a function of how much risk capital there is in play, with risk premiums going up when risk capital becomes scarcer and down, when risk capital is more plentiful. In the bond and loan market, access to risk capital will determine default spreads on bonds, with lower rated bonds feeling the pain more intensely when risk capital is withdrawn or moves to the side lines. Not only will default spreads widen more for lower-rated bonds, but there will be less bond issuances by riskier companies. In the equity market, the equity risk premium is the price of risk, and its movements will track shifts in risk capital, increasing as risk capital becomes scarcer.
- Price and Value Gaps: As those of you who read this blog know well, I draw a contrast between value and price, with the former driven by fundamentals (cash flows, growth and risk) and the latter by mood, momentum and liquidity. The value and price processes can yield different numbers for the same company, and the two numbers can diverge for long periods, with convergence not guaranteed but likely over long periods.I argue that investors play the value game, buying investments when the price is less than the value and hoping for convergence, and that traders play the pricing game, buying and selling on market momentum, rather than fundamentals. At the risk of generalizing, safety capital, with its focus on earnings and cash flows now, is more likely to focus on fundamentals, and play the investor game, whereas risk capital, drawn by the need to make high returns quickly, is more likely to play the trading game. Thus, when risk capital is plentiful, you are more likely to see the pricing game overwhelm the value game, with prices often rising well above value, and more so for the riskiest segments of every asset class. A pull back in risk capital is often the catalyst for corrections, where price not only converges back on value, but often overshoots in the other direction (creating under valuations). It behooves both investors and traders to therefore track movements in risk capital, since it is will determine when long term bets on value will pay off for the former, and the timing of entry into and exit from markets for the latter.
- Corporate Life Cycle: The ebbs and flows of risk capital have consequences for all businesses, but the effects will vary widely across companies, depending on where they are in the life cycle. Using another one of my favorite structures, the corporate life cycle, you can see the consequences of expanding and shrinking risk capital, through the lens of free cash flows (and how they vary across the life cycle).Early in the corporate life cycle, young companies have negative free cash flows, driven by losses on operations and investments for future growth, making them dependent on risk capital for survival and growth. As companies mature, their cash flows first become self sustaining first, as operating cash flows cover investments, and then turn large and positive, making them not only less dependent on risk capital for survival but also more valued in an environment where safety capital is dominant. Put simply, as risk capital becomes scarcer, young companies, especially those that are money-losing and with negative cash flows, will see bigger pricing markdowns and more failures than more mature companies.
Risk Capital: Historical Perspective
How do you track the availability and access to risk capital over time? There are three proxies that I will use, and while each has its limitations, read together, they can provide a fuller measure of the ebbs and flows of risk capital. The first is funds invested by venture capitalists, with a breakdown further into types, from pre-seed and seed financing to very young companies to capital provided to more young companies with more established business models, as a prelude to exit (acquisition or IPO). The second is the trend line in initial public offerings (number and value raised), since companies are more likely to go public and be able to raise more capital in issue proceeds, when risk capital is plentiful. The third is original bond issuances by the riskiest companies (below investment grade and high yield), since these issuances are more likely to have a friendly reception when risk capital is easily available than when it is not.
Let’s start with venture capital, the typical source of capital for start ups and young companies for decades in the United States, and more recently, in the rest of the world. In the graph below, I trace out total venture capital raised, by year, between 1995 and 2021, in the US:
|Source: NVCA Yearbooks|
|Source: Jay Ritter|
In the final graph, I look at corporate bond offerings, broken down into investment grade and high yield, by year, from 1996 to 2021:
Here again, you see a familiar pattern, with the percentage of high-yield bond issuances tracking the availability of risk capital. As with IPOs, you see big dips in 2000-01and 2008-09, reflecting market corrections and crises, and a period of easy access to risk capital in the last decade. Again, the percentage of corporate bond issuances hit an all-time high in 2021, representing more than a quarter of all bond issuances. In sum, all three proxies for risk capital show the same patterns over time, pulling back and surging during the same time periods, and with all three proxies, it is clear that 2021 was a boom year.
The last two and a half years may not represent much time on a historical scale, but the period has packed in enough surprises to make it feel like we have aged a decade. We started 2020 with a pandemic that altered our personal, work and financial lives, and in 2022, at least in North America and Europe, we have seen inflation reach levels that we have not seen for decades. Looking at the 30 months through the lens of risk capital can help us understand not only the journey that markets have gone through to get where they are today, but also perhaps decipher where they may go next. In the graph below, I look at venture capital, IPOs and high yield bond issuances over the last two and a half years:
|Spreadsheet for implied ERP|
|Source for raw data: S&P Cap IQ|
The big question that we all face, as we look towards the second half of the year, is whether the pullback in risk capital is temporary, as it was in 2020, or whether it is more long term, as it was after the dot-com bust in 2000 and the market crisis in 2008. If it is the former, there is hope of not just a recovery, but a strong rebound in risky asset prices, and if it is the latter, stocks may stabilize, but the riskiest assets will see depressed prices for much longer. I don't have a crystal ball or any special macro forecasting abilities, but if I had to guess, it would be that it is the latter. Unlike a virus, where a vaccine may provide at least the semblance of a quick cure (real or imagined), inflation, once unleashed, has no quick fix. Moreover, now that inflation has reared its head, neither central banks nor governments can provide the boosts that they were able to in 2020 and may even have to take actions that make things worse, rather than better, for risk capital. Finally, at the risk of sounding callous, I do think that a return of fear and a longer term pullback in risk capital is healthy for markets and the economy, since risk capital providers, spoiled by a decade or more of easy returns, have become lazy and sloppy in their pricing and trading decisions, and have, in the process, skewed capital allocation in the economy. If a long-term slowdown is in the cards, it is almost certain that the investment strategies that delivered high returns in the last decade will no longer work in this new environment, and that old lessons, dismissed as outdated just a few years go, may need to be relearned.
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