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Pondering Pandemia, Politics, & Policy Mistakes In 2022 (But The Credit Market Is The Biggest Risk)

Pondering Pandemia, Politics, & Policy Mistakes In 2022 (But The Credit Market Is The Biggest Risk)

Authored by Bill Blain via MorningPorridge.com,

“Reader, suppose you were an idiot. And suppose you were a member of Congress. But…

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Pondering Pandemia, Politics, & Policy Mistakes In 2022 (But The Credit Market Is The Biggest Risk)

Authored by Bill Blain via MorningPorridge.com,

“Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

Let me present a list of things to worry about next year. Inflation, US and China growth, Stagflation, Central Banks, Stocks, Climate and Equality, etc, etc.. But the big risks will be the consequences of US Politics and a Liquidity Meltdown in the Credit Markets.

As promised yesterday, ahem, my outlook for 2022: I can state with some certainty that 2022 will begin very early in January and go right through to the end of December…..  Otherwise, take your pick from the following:

I’ve got a number of main themes..

  • Inflation will not be transitory – it will grind away at savings as wage demands, labour shortages, supply chain instability, and energy costs undermine the global economy.

  • Two economies matter – the US will do relatively well. China is going to suffer from major energy dislocation, deepening the global supply chain crisis. Europe – really? UK – please…

  • There is a moderate probability of stagflation – recession plus inflation.

  • Central Banks have limited choices: destroy the global economy long-term by doing nothing to unwind monetary distortion, or destroy the global economy now by normalising interest rates. (Basically..)

  • Stock markets are not at record levels because of productivity gains or soaring earnings, but because money has been overly cheap and central banks accommodative – fuelling the rally. Mean reversion is not a risk – it’s a rule.

  • Credit spreads don’t reflect current real risks, which will magnify as rates rise – Credit Markets are my number one pick for a chronic liquidity crisis.

  • Too much easy money and minimal returns have fuelled massive speculation, financial asset inflation, crushed returns and is generating a pensions crisis.

  • FOMO and social media pressure reached a crescendo with retail desperately gambling on meme stocks and praying that crypto will make them rich. Hope is never an investment strategy.

  • Politics – especially in the US – will have major consequences for markets.

  • Regulatory risk in terms of tech and finance are substantial.

  • Climate change is now recognised as a major risk – policy makers will act.

  • Inequality is an even larger risk – policy makers are unlikely to act.

Let’s start with the big known unknown: Dysfunctional US Politics.

Back in January 2021 we started the year wondering if Donald Trump would actually exit the White House. He did, but left the US bitterly divided and fractional with 70% of his party convinced the election was “stolen”. The Biden administration has singularly failed to pass any meaningful legislation – and the Republicans haven’t had to do much, letting the Democrats beat themselves. There is no Democratic party as such, just different interest groups sailing in different directions.

The Republicans (at this stage) look certain to win both houses in the Nov mid-terms. That’s going to be the big political theme of the year on markets: just how badly Biden will fail and the Republicans are set to benefit.

If a united purposeful Republican party wins, then that’s a good thing? Well… it would be if it wasn’t likely to confirm a succession of voter-registration “laws”, consolidation of electoral power, and gerrymandering of seats designed to ensure the minority US party retains a majority of power. The party remains in thrall of a vengeful Trump setting its agenda, with moderates being forced out. There will be rising fears the failure of the left in the US is pushing the world’s most important economy towards long-term right-wing protectionism and global disengagement.

If we see the US morphing towards a one-party “democratic-state”, or even a Trump dynasty,  markets will probably embrace it, looking forward to tax breaks, subsidies and protections, and a push-back on anti-oil and climate change programmes. Long-term the consequences of a shift to an isolationist right-wing US on geopolitics will be immense. It’s not a pretty vision. All China and Russia have to do is…. wait.

Meanwhile..

Last year I correctly predicted the global economy would stage a swift recovery from the Pandemic lockdowns, but that supply chains were troubled (brought into focus when a container ship blocked the Suez cannal), and inflation would be a rising risk factor through the year. I pointed out Billionaires got $1.9 trillion richer in 2020 on the back of recovering markets. They did it again the year just past. No political party is yet serious about addressing income inequality.

Outlook

We’re heading into a very uncertain year for the global economy and markets in 2022. The fiscal consequences of the pandemic spending bailouts are mixed; on one hand government largesse avoid collapse and actually strengthened fundamentals, but the consequences include soaring wage demands, while rising debt levels terrify many investors. Inflation/Stagflation and renewed Covid recession are also known unknowns.

One immediate issue to deal with will be a winter energy crisis. Markets are vastly underestimating just what higher power prices are going to do to corporate earnings and growth across the globe. Europe is particularly vulnerable, the numbers coming out of China may be even more scary – power outages and serious industrial dislocation (caused by rising prices and their unwise attempts to bully Oz), could rapidly send renewed rounds of supply chain chaos around the globe, triggering a host of consequences.

The dearth of financial asset returns has focused investors on now ways to generate alpha on the investment spectrum. That’s always a risk – new risks require new skills and experience to manage. Some of the return strategies are founded in common sense; generating high returns from negotiated private and structured assets, (equity, debt and hybrid). However, although hopes and dreams seldom pay out, inflated hopes and expectations from “disruptive” technologies, right across to wildly speculative conflabulations like cryptocurrencies and NFTs which few folk understand, but which everyone expects to get rich from – will likely still droive markets in 2022.

Never forget – it’s not what you know about markets and expect that matters, but what the market believes that matters. The market is just a voting machine – and if the voters are daft, then prices might be daft, but the price is the price is the price. As the well known saying goes; the market can remain irrational longer than you can remain solvent. But even daft markets revert to mean stupidity over time. You can speculate and win in the short-term. In the long run, returns are mean reverting and smart long money generally wins.

So… some quick thots on two dominant other trends likely to set the story of 2022:

The risk of Policy Mistakes

There is a significant risk parts of the global economy could tip into Stagflation triggered by further Covid induced slowdowns and/or policy errors by central banks and governments raising taxes, austerity spending and overly aggressive tightening too early. Policy mistakes will remain a major fear through the new year.

The big risk for the year? Credit

At its core the credit market is broken. Credit Spreads no longer reflect real risks – they gave up doing so sometime after Central banks took over being the market. Now they simply reflect misperceived relative interest rates vs other financial assets. Ultra-low rates have distorted the business cycle – allowing failing firms to survive longer. The market sees lower default rates as positive signal of corporate resilience rather than a signal of something fundamentally wrong. (There you are, my Big Short trade: sell mispriced credit…)

When the whole market is missing debt fundamentals like the capacity to repay debt, the strength of future earnings, and resilience (ie, all the old-fashioned stuff about lending to firms with effective management with a high propensity to repay lenders), then it’s time to be betting against them.

Default risks look to be relatively low, but Zombie overleveraged firms that have beggared themselves via stock buybacks and are now clinging on due to absurdly low rates will clearly suffer as rates rise, and face financing risks in a diminished liquidity environment.. (Which will occur as rates rise.)

But if you want to sell credit… who will buy? Regulation means there is no market making, and if central banks stop buying, the smart money will already be out. The market will go offered only. Anyone left in will find liquidity as rare as an ice-cube in hell.

And on that happy note…. There are a host of other topics I need to cover like energy transition, climate threats and change, growth, the taming of ESG, and many more. I will write about them all in the porridge through the coming year…

Tyler Durden Wed, 12/15/2021 - 06:30

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Spread & Containment

Japanese yen remains directionless

The Japanese yen has posted slight gains on Tuesday. In the North American session, USD/JPY is trading at 129.32, up 0.17% on the day. The US dollar pummelled…

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The Japanese yen has posted slight gains on Tuesday. In the North American session, USD/JPY is trading at 129.32, up 0.17% on the day.

The US dollar pummelled the yen in the months of March and April, but the yen has held its own in May. Still, USD/JPY remains at high levels and the 130 line, which has psychological significance, remains vulnerable. If there is a line in the sand for the Japanese government or the BoJ to intervene and prop up the yen, it certainly is not the 130 level, as the dollar broke through this line without a response. The yen is extremely sensitive to the US/Japan rate differential, and with the BoJ demonstrating that it will tenaciously defend its yield curve, the yen is at the mercy of Powell & Co.

Japan releases GDP for Q1 on Thursday. The markets are braced for a decline of 0.4%, after a respectable gain of 1.1% in Q4 of 2020. Investors never like to see negative growth, and a lower-than-expected GDP report will put downward pressure on the yen.

 

US retail sales within expectations

Over in the US, retail sales for April came in at 0.9%, just shy of the consensus estimate of 1.0%. Core retail sales rose 1.0%, above the forecast of 0.7% and close to the 1.1% gain in March. The numbers were not spectacular by any stretch, but were respectable, given that consumer confidence has weakened – the UoM Consumer Sentiment index fell to 59.42 in May, its lowest level since October 2011. US households continue to spend, despite a deterioration in consumer confidence. Wages are not keeping up with the cost of living, but consumers appear to be using savings which accumulated during the Covid pandemic.

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USD/JPY Technical

  • USD/JPY is testing resistance at 1.2938, followed by resistance at 1.3123
  • There is support at 1.3000 and 1.2918

 

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Bonds

Best Stocks to Buy in a Bear Market: Your Complete Guide

To protect your portfolio this year, keep reading to find the best stocks to buy in a bear market and how they can still earn you a profit.
The post Best…

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Stocks fell again last week, making it six straight weeks of fallout. Everything is slipping from its highs between stocks, bonds and the latest victim, crypto. With this in mind, if you wish to find the best stocks to buy in a bear market, there are several factors to consider first.

For one thing, the Federal Reserve is committing to using all the tools necessary to bring down the price of goods. Although the pace of inflation is slowing, prices are still on the rise.

The latest Consumer Price Index (CPI) reading shows prices rose another 0.3% in April. Furthermore, as the fed works to get inflation under control, Chairman Jerome Powell is warning there could be more pain ahead.

Several analysts are cutting their economic predictions as a result. For example, Former Goldman Sachs CEO Lloyd Blankfein suggests a recession may be in the works. On CBS’s “Face the Nation,” he mentions “there’s a path” to a recession, and taming inflation will be tricky. If you wish to protect your portfolio this year, keep reading to find the best stocks to buy in a bear market and how they can still earn you a profit.

What Are the Best Stocks to Buy in a Bear Market?

The first thing to consider is not all bear markets are the same. They can appear out of nowhere, often caused by a black swan event such as the pandemic.

At the same time, bear markets are a natural part of investing. In a way, they can help correct valuations, allowing investors to build long-term wealth. For example, the S&P 500 (SPX) P/E ratio is around 20, down from 38 in December. Yet the value is still higher compared to its historical average of 15.

However, they can also be detrimental if you are not prepared. There are a few things to look for to find good stocks to invest in during a recession, such as…

  • Dividends
  • Sales Growth
  • Free Cash Flow

On top of this, how the stock performs relative to its peer can help you identify leaders. If a stock is trading above its 200D SMA while its peers are slipping, it’s generally a sign of strength and momentum. To get your portfolio ready for what’s next, check out the best stocks to buy in a bear market.

No. 4 Consumer Defensive

When inflation is high, it makes goods more expensive, reducing consumers’ purchasing power. Although this is true, people still need their essentials. With this in mind, the consumer defensive sector consists of companies that make essential goods such as household essentials, tobacco and food.

Kroger (NYSE: KR)

Kroger is one of the largest food retailers in the U.S., with close to $138 billion in sales in 2021. Despite growing inflation and wage pressure, the grocer continues growing at an impressive rate. Lastly, with many locations having pharmacies and fuel centers, Kroger’s margins shouldn’t see too much pressure as food and wage prices continue climbing.

Boston Beer Co. (NYSE: SAM)

Sticking with the theme of industry leaders, Boston Beer is a top brewing company in the U.S. with brands such as Sam Adams, Twisted Tea and Truly. Although the brewer saw sales decline in the first quarter, its positioning itself for future growth with younger-generation favorites such as Truly hard Selzer.

Companies in the consumer defensive sector are some of the best stocks to buy in a bear market. However, as employees seek higher wages to offset inflation, we could see some short-term pressure. With this in mind, both companies are fundamentally solid while positioned for future growth.

No. 3 Healthcare Stocks

Healthcare is an investor’s favorite industry when the economy is slowing. For one thing, healthcare is an industry with stable demand. To explain, consumers have healthcare plans, and people will still get sick. Not to mention patients still need to take their medication.

One of the last things people will cut out of their budget is healthcare. As a result, the industry sees relatively stable earnings. That said, the Health Care Select Sector SPDR Fund (NYSE: XLV) is down 6% YTD compared to the SPDR S&P 500 ETF (NYSE: SPY), down 15%.

CVS Health (NYSE: CVS)

During the pandemic, CVS transformed its business to meet the changing industry needs. By providing affordable, convenient, and personal care, CVS is seeing the results pay off. In Q1, health care benefits, pharmacy sales, retail, and store visits rose significantly as a result. Even more, the company is raising guidance for 2022.

Mckesson (NYSE: MCK)

As the largest pharmaceutical distributor in the U.S., Mckesson plays a critical role in healthcare. Although exiting international markets may slow growth in the short term, an aging U.S. population and more access to healthcare should promote higher sales.

Both CVS and Mckesson have strong free cash flow, pay dividends, and are trading above their 200D SMA.

No. 2 Materials and Miners

Materials and mining companies are some of the best stocks to buy in a bear market with tangible value. Mining companies extract resources such as metals, selling them to be made into goods. Other materials firms can include chemicals, packaging and agricultural goods.

Mosaic (NYSE: MOS)

One of the largest fertilizer nutrient producers looking to fill the supply gap left by the war in Ukraine. Furthermore, a tight agriculture market is driving prices higher, resulting in over 300% operating earnings growth. Lastly, crop prices are likely to remain elevated this year with growing sanctions and lack of supply.

Alcoa Corp. (NYSE: AA)

The world’s largest bauxite miner plays a vital role in the aluminum market. Bauxite is used to produce alumina, then used to make aluminum. With demand for aluminum expected to remain elevated (especially as automakers pick up again), Alcoa rewards shareholders with a new dividend and increased buyback program.

Another key thing to consider is the Infrastructure Investment and Jobs Act intended to rebuild and replace America’s roads, bridges, etc. Many of these projects will require significant resources such as steel, iron, and other construction materials. With this in mind, the bill states these materials must be domestic.

No. 1 Best Stock to Buy in a Bear Market: Energy Stocks

This year, energy stocks are outperforming the market, and it’s not even close. The Select SPDR Trust Energy ETF (NYSE: XLE) is up 48% so far in 2022. Yet the sector doesn’t look to be slowing anytime soon.

Devon Energy (NYSE: DVN)

The number one performing stock in the S&P 500 last year looks to continue its reign. With oil prices over $114 a barrel, Devon Energy is seeing profits soar as operating cash flow rose another 14% in Q1 to $1.8 billion. With this in mind, the company is returning profits to investors through a record $1.27 dividend (nearly 8% yield) and a massive $2 billion share buyback.

Chevron (NYSE: CVX)

The second-largest oil company in the U.S. (behind Exxon) is ramping spending to boost production. After several smart partnerships and acquisitions, Chevron is investing in growth. So far, the strategy is paying off as the company becomes more efficient and profitable. Lastly, Chevron’s focus on a lower carbon future with renewable energy investments will likely prove to be a smart bet in the long run.

As many nations look to phase out Russian oil, other companies are stepping up to increase production and fill the supply gap. The economy is largely dependent on oil and gas to continue running smoothly. People will still need gas and oil to power their homes, get to and from work, etc.

Given these points, energy stocks are on the top of my list of best stocks to buy in a bear market. Even though energy is outperforming this year, they have more room to run. To explain, energy makes up only about 4.5% of the S&P 500, even after running up this year. However, it’s still relatively low compared to its historical average of around 10%.

The post Best Stocks to Buy in a Bear Market: Your Complete Guide appeared first on Investment U.

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Bonds

A central bank digital euro could save the eurozone – here’s how

By changing the rules around bank lending, you can make a huge cut to national debt.

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Blockchain bailout? 4K_Heaven

The European Central Bank and its counterparts in the UK, US, China and India are exploring a new form of state-backed money built on similar online ledger technology to cryptocurrencies such as bitcoin and ethereum. So-called central bank digital currencies (CBDCs) envision a future where we’ll all have our own digital wallets and transfer money between them at the touch of a button, with no need for high-street banks to be involved because it all happens on a blockchain.

But CBDCs also present an opportunity that has gone unnoticed – to vastly reduce the exorbitant levels of public debt weighing down many countries. Let us explain.

The idea behind CBDCs is that individuals and firms would be issued with digital wallets by their central bank with which to make payments, pay taxes and buy shares or other securities. Whereas with today’s bank accounts, there is always the outside possibility that customers are unable to withdraw money because of a bank run, that can’t happen with CBDCs because all deposits would be 100% backed by reserves.

Today’s retail banks are required to keep little or no deposits in reserve, though they do have to hold a proportion of their capital (meaning easily sold assets) as protection in case their lending books run into trouble. For example, eurozone banks’ minimum requirement is 15.1%, meaning if they have capital of €1 billion (£852 million), their lending book cannot exceed €6.6 billion (that’s 6.6 times deposits).

In an era of CBDCs, we assume that people will still have bank accounts – to have their money invested by a fund manager, for instance, or to make a return by having it loaned out to someone else on the first person’s behalf. Our idea is that the 100% reserve protection in central bank wallets should extend to these retail bank accounts.

That would mean that if a person put 1,000 digital euros into a retail bank account, the bank could not multiply that deposit by opening more accounts than they could pay upon request. The bank would have to make money from its other services instead.

At present, the ECB holds about 25% of EU members’ government debt. Imagine that after transitioning to a digital euro, it decided to increase this holding to 30% by buying new sovereign bonds issued by member states.

To pay for this, it would create new digital euros – just like what happens today when quantitative easing (QE) is used to prop up the economy. Crucially, for each unit of central bank money created in this way, the money circulating in the wider economy increases by a lot more: in the eurozone, it roughly triples. This is essentially because QE drives up the value of bonds and other assets, and as a result, retail banks are more willing to lend to people and firms. This increase in the money supply is why QE can cause inflation.

If there was a 100% reserve requirement on retail banks, however, you wouldn’t get this multiplication effect. The money created by the ECB would be that amount and nothing more. Consequently, QE would be much less inflationary than today.

The debt benefit

So where does national debt fit in? The high national debt levels in many countries are predominantly the result of the global financial crisis of 2007-09, the eurozone crisis of the 2010s and the COVID pandemic. In the eurozone, countries with very high debt as a proportion of GDP include Belgium (100%), France (99%), Spain (96%), Portugal (119%), Italy (133%) and Greece (174%).

One way to deal with high debt is to create a lot of inflation to make the value of the debt smaller, but that also makes citizens poorer and is liable to eventually cause unrest. But by taking advantage of the shift to CBDCs to change the rules around retail bank reserves, governments can go a different route.

The opportunity is during the transition phase, by reversing the process in which creating money to buy bonds adds three times as much money to the real economy. By selling bonds in exchange for today’s euros, every one euro removed by the central bank leads to three disappearing from the economy.

Indeed, this is how digital euros would be introduced into the economy. The ECB would gradually sell sovereign bonds to take the old euros out of circulation, while creating new digital euros to buy bonds back again. Because the 100% reserve requirement only applies to the new euros, selling bonds worth €5 million euros takes €15 million out of the economy but buying bonds for the same amount only adds €5 million to the economy.

However, you wouldn’t just buy the same amount of bonds as you sold. Because the multiplier doesn’t apply to the bonds being bought, you can triple the amount of purchases and the total amount of money in the economy stays the same – in other words, there’s no extra inflation.

For example, the ECB could increase its holdings of sovereign debt of EU member states from 25% to 75%. Unlike the sovereign bonds in private hands, member states don’t have to pay interest to the ECB on such bonds. So EU taxpayers would now only need to pay interest on 25% of their bonds rather than the 75% on which they are paying interest now.

Interest rates and other questions

An added reason for doing this is interest rates. While interest rates payable on bonds have been meagre for years, they could hugely increase on future issuances due to inflationary pressures and central banks beginning to raise short-term interest rates in response. The chart below shows how the yields (meaning rates of interest) on the closely watched 10-year sovereign bonds for Spain, Greece, Italy and Portugal have already increased between three and fivefold in the past few months.

Mediterranean 10-year bond yields

Following several years of immense shocks from the pandemic, the energy crisis and war emergency, there’s a risk that the markets start to think that Europe’s most indebted countries can’t cover their debts. This could lead to widespread bond selling and push interest rates up to unmanageable levels. In other words, our approach might even save the eurozone.

The ECB could indeed achieve all this without introducing a digital euro, simply by imposing a tougher reserve requirement within the current system. But by moving to a CBDC, there is a strong argument that because it’s safer than bank deposits, retail banks should have to guarantee that safety by following a 100% reserve rule.

Note that we can only take this medicine once, however. As a result, EU states will still have to be disciplined about their budgets.

Instead of completely ending fractional reserve banking in this way, there’s also a halfway house where you make reserve requirements more stringent (say a 50% rule) and enjoy a reduced version of the benefits from our proposed system. Alternatively, after the CBDC transition ends, the reserve requirement could be progressively relaxed to stimulate the economy, subject to GDP growth, inflation and so on.

What if other central banks do not take the same approach? Certainly, some coordination would help to minimise disruption, but reserve requirements do differ between countries today without significant problems. Also, many countries would probably be tempted to take the same approach. For example, the Bank of England holds over one-third of British government debt, and UK public debt as a proportion of GDP currently stands at 95%.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.

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