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What Is Diversification? Definition, Strategies & Examples

What Is Diversification in Investing? In finance and investing, diversification is a popular term for mitigating risk by dividing one’s investments between a variety of asset classes and investment vehicles. Diversification also refers to dividing one’s..

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A diverse portfolio can help minimize losses during times of volatility and financial uncertainty. 

Simone Hutsch via Unsplash; Canva

What Is Diversification in Investing?

In finance and investing, diversification is a popular term for mitigating risk by dividing one’s investments between a variety of asset classes and investment vehicles. Diversification also refers to dividing one’s investments within each asset class.

For instance, In addition to diversifying their portfolio by investing in stocks, bonds, real estate, certificates of deposit, and collectible baseball cards, an investor could further diversify their portfolio within the stock asset class specifically by investing in small, mid, and large-cap companies; buying stock in both domestic and foreign companies; and choosing a variety of stocks that span many different industries (e.g., banking, technology, automotive, food production, and energy).

How Does Diversification Mitigate Risk?

No investment is perfectly safe, but some carry far less risk of loss than others. For instance, government bonds are considered extremely safe, as they carry very little default risk. That being said, government bonds usually only yield a 3–6% return each year. The S&P 500, which is composed of 500 large-cap stocks, on the other hand, returned 31.5% in 2019 and 18.4% in 2020. Back in 2008, however, the same stock index lost 48% of its value due to the financial crisis and subsequent recession.

If an investor put 100% of their savings in the stock market in early 2007, they may have reduced their wealth by almost half by the end of 2008. If they had invested half of their savings in government bonds, however, they would likely have lost closer to a quarter. This is a perfect illustration of the benefits of diversification. While diversification by no means provides the largest gains, it certainly helps minimize the losses that can occur when a single asset or single asset class loses value quickly for some reason or another.

The 2008 financial crisis crashed the entire stock market, but more minor events often have more subtle consequences. For instance, people travel far less frequently during pandemics. The onsets of SARS, swine flu, and COVID-19 all led to notable drops in airline stock prices. If at any of these moments in time, an investor was holding only airline stocks, their portfolio would have lost significant value quickly. An investor with a diversified portfolio, however (let’s say one composed of only 5% airline stocks with the rest divided across many industries), would have sustained a far less noticeable loss.

Diversification can perhaps be best explained with the classic adage, “don’t put all your eggs in one basket.” If the bottom falls out of your basket, and your basket contains all 10 of your eggs, you end up with a yolky mess and nothing to eat. If, on the other hand, you divide your 10 eggs between five baskets and the bottom falls out of one, you’ve lost 20% of what you had, but you still have enough leftover to make four two-egg omelets, so you won’t go hungry.

What Is an Asset Class?

An asset class is a type of investment defined by certain characteristics. Each asset class is a little different, and some are riskier than others. Generally, the safer an asset class is, the lower its potential returns are. The riskier an asset class is, the higher its potential returns (and losses) are. Each asset class is subject to its own unique set of features and regulations, and some assets are more liquid (easier to convert to cash) than others.

Common Asset Classes

  • Fixed-Income Investments: This asset class includes treasury, corporate, and municipal bonds as well as certificates of deposit.
  • Equities: This asset class includes stocks, which represent partial ownership of an entity. Historically, equities produce higher returns than other asset classes, but they also carry more risk.
  • Derivatives: This asset class includes options, swaps, futures, forwards, and other tradable securities whose values are derived from other underlying assets.
  • Commodities: This asset class includes physical materials like gold, crude oil, and corn.
  • Cryptocurrencies: This asset class includes digital, decentralized currencies like Bitcoin, Ethereum, Litecoin, and Dogecoin.
  • Cash and Cash Equivalents: This asset class includes currencies, money market instruments, and highly liquid short-term securities that could be converted to cash very quickly.
  • Alternative Investments: This asset class includes real estate and collectibles such as trading cards, stamps, mineral specimens, and art.
There are many ways a diverse portfolio can look—the above is just one possible example. 

Armando Arauz via Unsplash; Canva

How to Diversify a Portfolio

Diversification looks different for every investor, and some take diversification a lot more seriously than others. How (and how much) an investor should diversify their portfolio should depend on how much money they have to invest, how long they want to be invested for, what their investment goals are (retirement, growth, fixed income payments, etc.), and their individual risk tolerance.

That being said, there are a number of things any risk-conscious investor can do to diversify their portfolio. Keep in mind, however, that while diversification definitely reduces risk, it can also reduce potential returns.

Inter-Class Diversification

The best way to safeguard savings from serious loss without leaving them to languish in a low-interest savings account is to divide them among different asset classes. The equity (stock) market may be the best asset class for growth, but as evidenced by the 2007–2008 financial crisis, stocks can be subject to rapid, unexpected, market-wide devaluation.

For this reason, investing in treasury bonds, certificates of deposit, real estate, and even commodities like gold can be a good way to safeguard some of one’s wealth from unexpected volatility. Just how much of someone’s wealth should be kept in these safer, more stable asset classes depends—as always—on goals, timeline, and risk tolerance.

A young, risk-tolerant investor who wants to see their portfolio grow significantly in value and plans to stay invested for 20+ years might want to keep 80 percent of their wealth in equities, while an older, soon-to-be-retired investor whose priorities are stability and fixed income payments might want to keep 50 percent of their wealth in dividend-paying equities, 35 percent in bonds of various terms, and 15 percent in commodities.

Diversification Methods Within the Stock Market

In addition to diversifying by spreading wealth between asset classes, investors can (and usually should) diversity within the equity market by owning different stocks with different characteristics. There are a number of ways to do this:

  • By Industry/Sector: As mentioned above, investing in only one industry can expose an investor to unnecessary risk, as entire industries can experience volatility. For instance, when the “dot com” bubble burst in the early 2000s, internet-related technology companies lost almost 80 percent of their value. By holding stocks across a variety of industries and sectors, investors can protect some of their wealth from these sorts of industry-wide crashes.
  • By Company Size: Another way to diversify within the equity market is by investing in companies of different sizes. Companies with larger market caps tend to be more stable, but companies with smaller market caps may have more room for growth. Spreading investments across small, mid, and large-cap stocks is a good way to balance growth potential with stable returns.
  • By Company Location: Investing in companies from a number of different countries allows for exposure to multiple markets, which can help mitigate risk. If one market experiences volatility, owning businesses that operate in other, more currently stable markets can help offset any short-term losses.

How to Diversify With Mutual Funds and ETFs

For more passive investors who want to diversify but don’t have the time to pick individual stocks, buying ETF shares and investing in mutual funds can be a great way to gain exposure to companies of various sizes from a variety of industries located in different markets. ETFs and mutual funds exist for almost every characteristic imaginable. One ETF might focus on small-cap U.S. growth stocks, while another might be designed to capture the Indian energy market.

An investor might first decide what markets, company sizes, and industries they are interested in, then identify a range of ETFs and mutual funds to match. Next, they could decide on a reasonable amount to invest each month and use dollar-cost averaging to add to their portfolio on a regular basis without watching the market particularly closely.

Do Diverse Portfolios Perform Better During Recessions?

During a recession, money tends to move out of the equity market and into safer asset classes like bonds and commodities. For this reason, portfolios with a higher proportion of these more stable assets are likely to sustain smaller losses than portfolios consisting primarily of stocks. That being said, it is impossible to time a recession, and keeping all of one’s money out of the equity market in case a recession is around the corner isn’t a very good investment strategy for anyone seeking to grow their wealth efficiently.

What Are the Limitations of Diversification?

What makes diversification effective as a risk-management strategy can also make it somewhat limiting in terms of growth potential. With greater risk come greater potential returns. The more of an investor’s money is in one asset, the more they stand to gain if that asset skyrockets in value (and, on the other hand, the more they stand to lose if it tanks). Diversification limits both gains and losses. 

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Economics

Where Are Interest Rates Headed? Is The Fed Correct Or The Eurodollar Curve?

Where Are Interest Rates Headed? Is The Fed Correct Or The Eurodollar Curve?

Authored by Mike Shedlock via MishTalk.com,

The Eurodollar curve…

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Where Are Interest Rates Headed? Is The Fed Correct Or The Eurodollar Curve?

Authored by Mike Shedlock via MishTalk.com,

The Eurodollar curve implies four quarter-point cuts are on the way starting in 2023. The Fed believes otherwise. Let's discuss stock market implications.

Data from CME and Fed via Wall Street Journal.

Eurodollar Curve

The eurodollar curve has nothing to do with euros or dollars. Rather it is an interest rate curve and one of the world's most widely traded futures.

After peaking at about 3.9% this year, eurodollar betters believe the Fed will then cut rates all the way down to 2.8%. 

Five Not-Quite-Impossible Things the Market Believes

Wall Street Journal Contributor James Macintosh discussed the above chart in Five Not-Quite-Impossible Things the Market Believes

  1. Inflation is transitory. 

  2. The Fed realizes this in time.

  3. The jobs market cools enough to slow wage rises. 

  4. But not so much it means falling household spending.

  5. So consumer spending rises in real terms. 

In reference to the led chart, Macintosh says "The first assumption is the hardest to believe."

I disagree. The hardest thing to believe is the overall goldilocks scenario and that the current rally makes any sense at all. 

Inflation may easily come down if the Fed tightens too much too fast causing a severe recession. What would that do to corporate profits? 

But assume otherwise, that inflation does not come down more. What would that do to corporate profits? 

While any of the first three points may easily be correct, the combination of all five being correct and that stocks will rise in a goldilocks scenario is what I find hard to believe.

Is the Market Forward Looking?

Goldilocks proponents will tell you that the market is forward looking. 

The market isn't forward looking and never was. It is a coincident indicator of current sentiment, wildly wrong at major turns.

If the market was forward looking, what precisely was it looking forward to at the November 2007 peak with recession starting the next month? 

What was it looking forward to at the 1929 peak, the 1933 bottom, the 2009 bottom or any other top or bottom?

The Fed Will Hike Until It Breaks Something

I believe the eurodollar curve is more likely to be correct than the Fed. When has the Fed gotten much of anything correct?

The eurodollar view has two ways to win. The first is the Fed actually does tame inflation to the degree that it wants.

That's possible in a severe enough recession. And the global picture is easily weak enough for that to happen.

The second way the eurodollar curve might be correct is if the Fed breaks the credit market. 

The Fed would immediately reverse course, regardless of inflation, should that happen. 

Neither a credit event nor strong recession would be good for the stock market.

The least likely thing is that the Fed achieves a goldilocks soft landing. Yet, assume that happens. 

Macintosh says, and I agree, "The bull case that stocks and corporate bonds are pricing requires the combination of low joblessness and wage rises to allow spending to rise faster than inflation even after pandemic savings run out. But not so much faster that it hits capacity constraints and accelerates inflation."

The problem with goldilocks is stocks are priced so much beyond perfection that they may decline anyway. 

Globally Speaking 

  1. China Does Surprise Rate Cut to Help Its Economy, But It Won't Work

  2. German Costs to Ship by Barge are up Twenty Times and May Soon Be Impossible

  3. UK Average Electricity Cost Will Soar to $5,370 Per Year By 2023

  4. US Industries Are Buckling Under Pressure of Surging Electricity Costs

Good luck with goldilocks, especially with the Fed still hiking. 

*  *  *

Please Subscribe to MishTalk Email Alerts.

Tyler Durden Wed, 08/17/2022 - 09:45

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Bonds

Futures Tumble After UK Double-Digit Inflation Shock Sparks Surge In Yields

Futures Tumble After UK Double-Digit Inflation Shock Sparks Surge In Yields

Futures were grinding gingerly higher, perhaps celebrating the…

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Futures Tumble After UK Double-Digit Inflation Shock Sparks Surge In Yields

Futures were grinding gingerly higher, perhaps celebrating the end of the Cheney family's presence in Congress, and looked set to re-test Michael Hartnett bearish target of 4,328 on the S&P (which marked the peak of yesterday's meltup before a waterfall slide lower when spoos got to within half a point of the bogey), when algos and the few remaining carbon-based traders got a stark reminder that central banks will keep hammering risk assets after the UK reported a blistering CPI print, which at a double digit 10.1% was not only higher than the highest forecast, but was the highest in 40 years.

The print appeared to shock markets out of their month-long levitating complacency, and yields - both in the UK and the US - spiked...

... and with yields surging, futures had no choice but to notice and after trading at session highs just before the UK CPI print, they have since tumbled more than 40 points and were last down 0.85% or 37 points to 4,271.

Nasdaq 100 futures retreated 0.9% signaling a selloff in technology names will continue. The dollar rose as investors awaited the minutes of the Fed’s last policy meeting for clues on policy makers’ sensitivity to weaker economic data.

In US premarket trading, retail giant Target slumped 4% after reporting earnings that missed expectations despite still predicting a rebound. Applied Materials and PayPal dropped at least 1.3%. Tech stocks are the forefront of the growing pessimism over equity valuations on the back of Fed rate increases. The S&P 500 had posted a small gain on Tuesday, aided by earnings reports from retailers Walmart Inc. and Home Depot. Here are some of the other biggest U.S. movers today:

  • Manchester United (MANU US) rises as much as 17% in US premarket trading before trimming most of the gains, after Tesla CEO Elon Musk said he was buying the English football club but later added that he was joking.
  • Hill International (HIL US) shares rise 61% in premarket trading hours after it announced Global Infrastructure Solutions will commence an all-cash tender offer for $2.85/share in cash, representing a premium of 63% to the last closing price.
  • BioNTech (BNTX US) was initiated with a market perform recommendation at Cowen, which expects demand for Covid-19 vaccines to mirror annual flu trends as the pandemic enters its endemic phase.
  • Bed Bath & Beyond (BBBY US) shares surge 20% in premarket trading, putting the stock on track for its sixth day of gains. The home-goods company has helped reinvigorate a wave of meme stock buying
  • Agilent (A US) saw its price target boosted at brokers as analysts say the scientific testing equipment maker’s results were strong thanks to growth in biopharma and a recovery in China, while the company’s guidance was on the conservative side. Shares rose .
  • Jefferies initiated coverage of Waldencast Plc (WALD US) class A with a buy recommendation as analyst Stephanie Wissink sees 29% upside potential.
  • Sea Ltd. (SE US) ADRs slipped as much as 2.1% in US premarket trading, extending Tuesday’s declines, as Morgan Stanley cut its PT on expectations of slowing growth at the Shopee owner’s e-commerce business in the third quarter.
  • Weber (WEBR US) downgraded to sell from neutral at Citi, which says there are too many concerns to remain on the sidelines, including a decline in point-of-sale traffic and macro factors like inflation weighing on consumer demand

In the past two months, US stocks rallied on signs of peaking inflation and an earnings-reporting season that saw four out of five companies meeting or beating estimates. Boosted by relentless systematic (CTA) buying and retail-driven short squeezes, as well as a surge in buybacks, stocks recovered more than 50% of the bear market retracement. Yet, continuing rate hikes and the likelihood of a recession in the world’s largest economy are weighing on sentiment. Meanwhile, concern is growing that Fed rate setters will remain focused on the fight against inflation rather than supporting growth.

“We expect the FOMC minutes to have a hawkish tilt,” Carol Kong, strategist at Commonwealth Bank of Australia Ltd., wrote in a note. “We would not be surprised if the minutes show the FOMC considered a 100 basis-point increase in July.”

In Europe, the Stoxx 600 fell after a strong start amid signs the continent’s energy crisis is worsening. Benchmark natural-gas futures jumped as much as 5.1% on expectations the hot weather will boost demand for cooling. In the UK, consumer-price growth jumped to 10.1%, sending gilts tumbling. Real estate, retailers and miners are the worst performing sectors. The Stoxx 600 Real Estate Index declined 2%, making it the worst-performing sector in the wider European market, as focus turned to UK inflation that soared to double digits for the first time in four decades and also to today's FOMC minutes. German and Swedish names almost exclusively account for the 10 biggest decliners. TAG Immobilien drops 5.4%, Wallenstam is down 4.7%, Castellum falls 4% and LEG Immobilien declines 3.3%. The sector tumbles on rising bond yields, with 10y Bund yield up 11bps, and dwindling demand for Swedish real estate amid rising rates.

Earlier on Wednesday, stocks rose in Asia amid speculation that China may deploy more stimulus to shore up its ailing economy while Japanese exporters were boosted by a weaker yen. After a string of weak data driven by a property-sector slump and Covid curbs, China’s Premier Li Keqiang asked local officials from six key provinces that account for 40% of the economy to bolster pro-growth measures. The MSCI Asia Pacific Index advanced as much as 0.8%, with consumer-discretionary and industrial stocks such as Japanese automakers Toyota and Honda among the leaders on Wednesday. The benchmark Topix erased its year-to-date loss. Chinese food-delivery platform Meituan also rebounded after dropping more than 9% in the previous session on a Reuters report that Tencent may divest its stake in the firm. Chinese stocks erased declines early in the day, as investors hoped for more economic stimulus after a surprise rate cut on Monday failed to excite the market. Premier Li Keqiang has asked local officials from six key provinces that account for about 40% of the country’s economy to bolster pro-growth measures.

“I believe policymakers have the tools to prevent a hard landing if needed,” Kristina Hooper, chief global market strategist at Invesco, said in a note. “I find investors are overly pessimistic about Chinese stocks -- which means there is the potential for positive surprise.” Asia’s stock benchmark is trading at mid-June levels as traders attempt to determine the trajectory of interest-rate hikes and economic growth globally -- as well as the impact of China’s property crisis and Covid policies. Meanwhile, minutes of the US Federal Reserve’s July policy meeting, out later Wednesday, will be carefully parsed. New Zealand stocks closed little changed as the country’s central bank raised interest rates by a half percentage point for a fourth-straight meeting. Australia's S&P/ASX 200 index rose 0.3% to close at 7,127.70, supported by materials and consumer discretionary stocks. South Korea’s benchmark missed out on the rally across Asian equities, as losses by large-cap exporters weighed on the measure

In FX, the Bloomberg Dollar Spot Index rose as the dollar gained versus most of its Group-of-10 peers. The pound was the best G-10 performer while gilts slumped, led by the short end and sending 2-year yields to their highest level since 2008, after UK inflation accelerated more than expected in July. The yield curve inverted the most since the financial crisis as traders ratcheted up bets on BOE rate hikes in money markets, wagering on 200 more basis points of hikes by May. The euro traded in a narrow range against the dollar while the region’s bonds slumped, led by the front end. Scandinavian currencies recovered some early European session losses while the aussie, kiwi and yen extended their slide in thin trading. EUR/NOK one-day volatility touched a 15.12% high before paring ahead of Norges Bank’s meeting Thursday where it may have to raise rates by a bigger margin than indicated in June given Norway’s inflation exceeded forecasts for a fourth straight month, hitting a new 34-year high. Consumer sentiment in Norway fell to the lowest level since data began in 1992, according to Finance Norway. New Zealand’s dollar and bond yields both rose in response to the Reserve Bank hiking rates by 50bps, while flagging concern about labor market pressures and consequent wage inflation; the currency subsequently gave up gains in early European trading. The Aussie slumped after data showing the nation’s wages advanced at less than half the pace of inflation in the three months through June, backing the Reserve Bank’s move to give itself more flexibility on interest rates.

In rates, treasuries held losses incurred during European morning as gilt yields climbed after UK inflation rose more than forecast. US 10-year around 2.87% is 6.5bp cheaper on the day vs ~13bp for UK 10-year; UK curve aggressively bear-flattened following inflation data, with long-end yields rising about 10bp. Front-end UK yields remain cheaper by ~20bp, off session highs, leading a global government bond selloff. US yields are higher on the day by by 4bp-7bp; focal points of US session are 20-year bond auction and FOMC minutes release an hour later. Treasury auctions resume with $15b 20-year bond sale at 1pm ET; WI 20-year yield at around 3.35% is ~7bp richer than July’s sale, which stopped 2.7bp through the WI level.

In commodities, oil fluctuated between gains and losses, and was in sight of a more than six-month low -- reflecting lingering worries about a tough economic outlook amid high inflation and tightening monetary policy.  Spot gold is little changed at $1,774/oz

Looking at the day ahead, the FOMC minutes from July will be the main highlight, and the other central bank speaker will be Fed Governor Bowman. Otherwise, earnings releases include Target, Lowe’s and Cisco Systems, and data releases include US retail sales and UK CPI for July.

Market Snapshot

  • S&P 500 futures down 0.3% to 4,293.00
  • STOXX Europe 600 little changed at 443.30
  • MXAP up 0.5% to 163.48
  • MXAPJ up 0.2% to 530.38
  • Nikkei up 1.2% to 29,222.77
  • Topix up 1.3% to 2,006.99
  • Hang Seng Index up 0.5% to 19,922.45
  • Shanghai Composite up 0.4% to 3,292.53
  • Sensex up 0.5% to 60,168.83
  • Australia S&P/ASX 200 up 0.3% to 7,127.68
  • Kospi down 0.7% to 2,516.47
  • German 10Y yield little changed at 1.06%
  • Euro little changed at $1.0178
  • Gold spot down 0.0% to $1,775.21
  • U.S. Dollar Index little changed at 106.50

Top Overnight News from Bloomberg

  • More market prognosticators are alighting on the idea of benchmark Treasury yields sliding to 2% if the US succumbs to a recession. That’s an out-of-consensus call, compared with Bloomberg estimates of about a 3% level by the end of this year and similar levels through 2023. But it’s a sign of how growth worries are forcing a rethink in some quarters
  • The euro-area economy grew slightly less than initially estimated in the second quarter as signs continue to emerge that momentum is unraveling. Output rose 0.6% from the previous three months between April and June, compared with a preliminary reading of 0.7%, Eurostat said Wednesday
  • Egypt became a prime destination for hot money by tethering its currency and boasting the world’s highest interest rates when adjusted for inflation
  • Norway’s $1.3 trillion sovereign wealth fund, the world’s largest, posted its biggest loss since the pandemic as rate hikes, surging inflation and Russia’s invasion of Ukraine spurred volatility. It lost an equivalent of $174 billion in the six months through June, or 14.4%

A more detailed look at global markets courtesy of Newsquawk

Asia-Pac stocks just about shrugged off the choppy lead from the US where markets were tentative amid mixed data signals and strong retailer earnings, but with gains capped overnight ahead of the FOMC Minutes and as participants digested another 50bps rate hike by the RBNZ. ASX 200 swung between gains and losses with the index indecisive amid a slew of earnings and with strength in the consumer sectors offset by underperformance in tech, energy and healthcare. Nikkei 225 climbed above the 29,000 level with the index unfazed by mixed data releases in which Machinery Orders disappointed although both Exports and Imports topped forecasts. Hang Seng and Shanghai Comp were somewhat varied with Hong Kong led higher by tech amid plenty of attention on Meituan after reports its largest shareholder Tencent could reduce all or the bulk of its shares in the Co. which a Tencent executive later refuted, while the mainland was less decisive amid headwinds from the ongoing COVID situation and with power restrictions disrupting activity in Sichuan, although reports also noted that Chinese Premier Li told top provincial officials that they must have a sense of urgency to consolidate the economic recovery and reiterated to step up macro policies.

Top Asian News

  • RBNZ hiked the OCR by 50bps to 3.00%, as expected, while it stated that conditions need to continue to tighten and they agreed that maintaining the current pace of tightening remains the best means. RBNZ also agreed that further increases in the OCR were required to meet the remit objective and that domestic inflationary pressures had increased since May. Furthermore, the RBNZ raised its projections for the OCR and inflation with the OCR seen at 3.69% in Dec. 2022 (prev. 3.41%) and at 4.1% for both Sept. 2023 and Dec. 2023 (prev. 3.95%), while it sees annual CPI at 4.1% by Sept. 2023 (prev. 3.0%).
  • RBNZ Governor Orr stated at the press conference that they are not forecasting a recession but expected below-potential growth amid subdued consumer spending. Governor Orr also stated that they did not discuss a 75bps rate hike today and that 50bps moves have been orderly and sufficient, while he added that getting rates to 4% would buy comfort for the policy committee and that a Cash Rate of around 4% is unambiguously above neutral and sufficient to meet the inflation mandate.
  • Chongqing, China is to curb power use for eight days for industry.
  • China’s Infrastructure Boom Gets Swamped by Property Woes
  • Tencent 2Q Revenue Misses Estimates
  • Hong Kong Denies Democracy Advocates Security Law Jury Trial
  • UN Expert Says Xinjiang Forced Labor Claims ‘Reasonable’
  • Singapore’s COE Category B Bidding Hits New Record
  • Delayed Deals Add to Floundering Singapore IPO Market: ECM Watch

European bourses have dipped from initial mixed/flat performance and are modestly into negative territory, Euro Stoxx 50 -0.5%. Stateside, futures are under similar pressure awaiting fresh corporate updates and the July FOMC Minutes, ES -0.6%. Fresh drivers relatively limited throughout the session with known themes in play and focus on upcoming risk events; stocks also suffering on further hawkish yield action. Lowe's Companies Inc (LOW) Q1 2023 (USD): EPS 4.68 (exp. 4.58), Revenue 27.47 (exp. 28.12bln); expect FY22 total & comp. sales at bottom-end of outlook range, Operating Income and Diluted EPS at top-end. Target Corp (TGT) Q1 2023 (USD): EPS 0.39 (exp. 0.72), Revenue 26.0bln (exp. 26.04bln); current trends support prior guidance.

Top European News

  • German Gas to Last Less Than 3 Months if Russia Cuts Supply
  • European Gas Surges Again as Higher Demand Compounds Supply Pain
  • Entain Falls; Citi Views Fine Negatively but Notes Steps by Firm
  • UK Inflation Hits Double Digits for the First Time in 40 Years
  • Crypto.com Receives Registration as UK Cryptoasset Provider

FX

  • Greenback underpinned ahead of US retail sales data and FOMC minutes, DXY holds tight around 106.500.
  • Pound pegged back after spike in wake of stronger than expected UK inflation metrics, Cable hovers circa 1.2100 after fade into 1.2150.
  • Kiwi retreats following knee jerk rise on the back of hawkish RBNZ hike, NZD/USD near 0.6300 from 0.6380+ overnight peak.
  • Aussie undermined by marginally softer than anticipated wage prices and lower RBA tightening bets in response, AUD/USD well under 0.7000 vs 0.7026 at one stage.
  • Yen weaker as yield differentials widen again, but Euro cushioned by more pronounced EGB reversal vs USTs, USD/JPY probes 21 DMA just below 135.00, EUR/USD bounces from around 1.0150 towards 1.0200.
  • Loonie and Nokkie soft amidst latest slippage in oil, USD/CAD closer to 1.2900 than 1.2800, EUR/NOK nudging 9.8600 within 9.8215-9.8740 range.

Fixed Income

  • Debt retracement ongoing and gathering pace ahead of Wednesday's key risk events.
  • Bunds now closer to 154.00 than 156.00 and 157.00 only yesterday, Gilts not far from 114.50 vs almost 116.00 and 117.00+ earlier this week and T-note sub-119-00 vs 119-31 at best on Monday.
  • Sonia strip hit hardest as markets price in aggressive BoE hikes in response to UK inflation data toppy already elevated expectations.

Commodities

  • Crude benchmarks are currently little changed overall, having recovered from a bout of initial pressure; newsflow thin awaiting fresh JCPOA developments
  • Spot gold is little changed overall but with a slight negative bias as the USD remains resilient and outpaces the yellow metal as the haven of choice.
  • Aluminium is the clear outperformer amid updates from Norsk Hydro that they are shutting production at their Slovalco site (175k/T year) by end-September, due to elevated energy prices.
  • OPEC Sec Gen says he sees a likelihood of an oil-supply squeeze this year, open for dialogue with the US. Still bullish on oil demand for 2022. Too soon to call the outcome of the September 5th gathering. Spare capacity at around the 2-3mln BPD mark, "running on thin ice".
  • US Private Inventory Data (bbls): Crude -0.4mln (exp. -0.3mln), Cushing +0.3mln, Gasoline -4.5mln (exp. -1.1mln), Distillates -0.8mln (exp. +0.4mln).
  • Shell (SHEL LN) announced it is to shut its Gulf of Mexico Odyssey and Delta crude pipelines for two weeks in September for maintenance, according to Reuters.
  • Uniper (UN01 GY) says the energy supply situation in Europe is far from easing and gas supply in winter remains "extremely challenging".
  • China sets the second batch of the 2022 rare earth mining output quota at 109.2k/T, via Industry Ministry; smelting/separation quota 104.8k/T.

Geopolitics

  • China's military is to partake in a military exercise in Russia, their participation has nothing to do with the international situation.
  • Taiwan's Defence Ministry says they have detected 21 Chinese aircraft and five ships around Taiwan on Wednesday, via Reuters.
  • Iran is calling on the US to free jailed Iranian's, says they are prepared for prisoner swaps, via Fars.

US Event Calendar

  • 07:00: Aug. MBA Mortgage Applications, prior 0.2%
  • 08:30: July Retail Sales Advance MoM, est. 0.1%, prior 1.0%
  • 08:30: July Retail Sales Ex Auto MoM, est. -0.1%, prior 1.0%
  • 08:30: July Retail Sales Control Group, est. 0.6%, prior 0.8%
  • 10:00: June Business Inventories, est. 1.4%, prior 1.4%
  • 14:00: July FOMC Meeting Minutes

DB's Tim Wessel concludes the overnight wrap

Starting in Europe, where the looming energy crisis remains at the forefront. An update from our team, who just published the fourth edition of their indispensable gas monitor (link here), where they note the surprisingly fast rebuild of German gas storage, driven by reductions in industrial activity, reduces the risk that rationing may become reality this winter. Many more insights within, so do read the full piece for analysis spanning scenarios. Keep in mind, that while gas may be available, it is set to come at a higher clearing price, which manifest itself in markets yesterday where European natural gas futures rose a further +2.64% to €226 per megawatt-hour, just shy of their closing record at €227 in March. But, that’s still well beneath their intraday high from March, where at one point they traded at €345. Further, one-year German power futures increased +6.30%, breaching €500 for the first time, closing at €507. Germany is weighing consumer relief measures in light of climbing consumer prices and also announced that planned nuclear facility closures would be “temporarily” postponed.

The upward energy price pressure and attenuated (albeit, not eliminated) risk of rationing pushed European sovereign yields higher. 10yr German bunds climbed +7.1bps to 0.97%, while 10yr OATs kept the pace, increasing +7.4bps. 10yr BTPs increased +15.9bps, widening sovereign spreads, while high yield crossover spreads widened +10.2bps in the credit space.

Equities were resilient, however, with the STOXX 600 posting a +0.16% gain after flitting around a narrow range all day. Regional indices were also robust to climbing energy prices, with the DAX up +0.68% and the CAC +0.34% higher. In the States the S&P 500 registered a modest +0.19% gain, with the NASDAQ mirroring the index, falling -0.19%. Retail shares drove the S&P on the day, with the two consumer sectors both gaining more than +1%, following strong earnings reports from Wal Mart and Home Depot.

Treasury yields also climbed, but the story was the further flattening in the curve. 2yr yields were +7.5bps higher while 10yr yields managed to increase just +1.6bps, leaving 2s10s at its second most negative close of the cycle at -46bps. 10yr yields are another basis point higher this morning. A hodgepodge of data painted a mixed picture. Housing permits beat expectations (+1674k vs. +1640k) while starts (+1446k vs. +1527k) fell to their slowest pace since February 2021. However, under the hood, even permits weren’t necessarily as strong as first glance, as single family permits fell -4.3% with gains in multifamily pushing the aggregate higher. Indeed, year-over-year, single family permits have now fallen -11.7% while multifamily permits are +23.5% higher. So the single family housing market continues to feel the impact of Fed tightening. Meanwhile, industrial production climbed +0.6% month-over-month (vs. +0.3%), with capacity utilization hitting its highest level since 2008 at 80.3%.

Drifting north of the border, Canadian inflation slowed to 7.6% YoY in July in line with estimates, while the average of core measures climbed to a record 5.3%. Bank of Canada Governor Macklem penned an opinion piece saying that while it looks like inflation may have peaked, “the bad news is that inflation will likely remain too high for some time.” In turn, Canadian OIS rates by December climbed +16.2bps.

In other data, the expectations component of the German ZEW survey fell to -55.3, its lowest level since October 2008 at the depths of the GFC. In the UK, regular pay (excluding bonuses) fell by -3.0% in real terms over the year to April-June 2022, its fastest decline on record.

On the Iranian nuclear deal, EU negotiators reportedly found Iran’s response constructive, though Iran still had some concerns. Notably, Iran is looking for guarantees that if a future US administration withdraws from the JCPOA the US will "have to pay a price”, seeking insulation from the vagaries of representative democracy.

Asian equity markets are trading higher after Wall Street’s solid performance overnight. The Nikkei (+0.76%) is leading gains across the region with the Hang Seng (+0.57%), the Shanghai Composite (+0.23%) and the CSI (+0.51%) all rebounding from its opening losses this morning. US futures are struggling to gain traction this morning with the S&P 500 (-0.02%) and NASDAQ 100 (-0.09%) trading just below flat.

The Reserve Bank of New Zealand lifted its official cash rate (OCR) for the fourth consecutive time by an expected +50bps to 3%, a seven-year high, while bringing forward the estimate of future rate increases. The central bank expects the OCR will reach 3.69% at the end of this year and expects it to peak at 4.1% in March 2023, higher and sooner than previously forecast.

Early morning data coming out from Japan showed that exports rose +19.0% y/y in July (v/s +17.6% expected) posting 17 straight months of gains while imports advanced +47.2% (v/s +45.5% expected) driven by global fuel inflation and a weakening yen. With the imports outweighing exports, the nation reported trade deficit for the 14th consecutive month, swelling to -2.13 trillion yen in July (v/s -1.91 trillion yen expected) compared to a revised deficit of -1.95 trillion yen in June.

In terms of the day ahead, the FOMC minutes from July will be the main highlight, and the other central bank speaker will be Fed Governor Bowman. Otherwise, earnings releases include Target, Lowe’s and Cisco Systems, and data releases include US retail sales and UK CPI for July.

Tyler Durden Wed, 08/17/2022 - 07:55

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Economics

S&P 3500 By Year End If QT Continues

"Don’t Fight the Fed" echoes through the financial media, Wall Street, and in the minds of retail and institutional investors. The phrasing pertaining…

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“Don’t Fight the Fed” echoes through the financial media, Wall Street, and in the minds of retail and institutional investors. The phrasing pertaining to Fed-generated liquidity is often the sole basis for investors to chase bull markets when the Fed employs easy monetary policy. Unfortunately, some investors forget the phrase is equally meaningful when the Fed is not friendly to markets. As we share in this article, we have developed a model to track Fed liquidity, allowing us to quantify the Fed’s influence on the S&P 500.

Before unveiling our liquidity formula and its forecast for the S&P 500, it’s essential to discuss the three primary drivers by which the Fed is influencing liquidity: Reverse Repurchase (RRP), Treasury General Account (TGA), and the Fed’s balance sheet.

Reverse Repurchase Agreements (RRP)

The New York Fed uses numerous repo programs to manage the supply of cash in the banking system, thereby maintaining the Fed Funds rates within the FOMC’s target range. Currently, they are employing its RRP program to accomplish this task. In an RRP transaction, the Fed sells securities to a counterparty and simultaneously agrees to repurchase them at a future date. The duration is often overnight. The transaction temporarily reduces the supply of money from the banking system. Increasing daily RRP balances results in less system liquidity, and a declining balance reduces liquidity.

As shown below, RRP has been around for 20 years but was scarcely used until early 2021. The various pandemic-related rounds of fiscal stimulus and massive Fed liquidity efforts left banks and money market funds with excessive levels of cash. The excess liquidity would have pushed the Fed Funds rate lower than the target rate without the RRP program. As such, RRP sucks up liquidity, making Fed Funds easier for the Fed to manage.

The Fed has other repo tools, such as repurchase agreements and the standing repo facility, which can dampen money market rates by providing the banking system with liquidity.

The RRP facility has been increasing rapidly and now sits at over $2 trillion daily. Rising RRP balances are a drain on liquidity.

As money market yields rise with Fed Funds and asset markets perform poorly, investors tend to prefer higher cash balances. Such should keep RRP levels elevated for the time being.

Treasury General Account (TGA)

The Treasury General Account is the U.S. Treasury Department’s checking account. The account is held at the Federal Reserve Bank of New York. Like your checking account, the TGA receives deposits (tax receipts and proceeds from debt issuance) and makes payments.

The Fed doesn’t manage the TGA balances, but the surplus cash balance held at the Fed affects banking system liquidity. Fed liabilities (bank reserves) must equal its assets. Bank reserves are fodder allowing banks to make loans and, by default, print money. When the TGA account increases, bank reserves must fall, reducing banking system liquidity. Conversely, a shrinking TGA account adds reserves and liquidity to the banking system.

The graph below shows that TGA balances are elevated versus the pre-pandemic years but have fallen as the banking system normalizes from the massive fiscal cash injections. It will likely drop a bit more, but the TGA will not significantly impact liquidity, barring unusual circumstances.

tga account

Fed Balance Sheet

The Fed’s assets, mainly Treasury bonds and Mortgage-Backed Securities (MBS), are the liquidity elephant in the room. Its assets currently account for 75% of total Fed-sponsored liquidity and historically average over 90%.

When the Fed does Quantitative Easing (QE), they remove securities from the bond markets and, in their place, leaves reserves with the banks. Again, bank reserves can lead to loan creation which is the creation of new money. Ergo, QE adds to the system’s liquidity. Conversely, Quantitative Tightening (QT) removes liquidity and reserves from the system and increases the amount of securities in the market.

For this reason, QE tends to be bullish for stocks, and QT is bearish. 

Liquidity and Stock Prices

With an understanding of the three key factors driving banking system liquidity, we can create a Fed liquidity model. The size of the Fed’s assets less the sum of the TGA and RRP equals the amount of Fed-generated liquidity in the system. Recent changes in net liquidity shed light on how the S&P 500 trends.

The two graphs below compare the liquidity measure and the S&P 500. The first graph shows how the S&P 500 rose in line with liquidity through 2021, and both reversed simultaneously to start 2022. The dotted lines are quarterly moving averages to help smooth out the data. The moving averages track each other almost perfectly this year. The green dashed line forecasts liquidity based solely on the Fed’s plan to reduce its balance sheet by $95 billion a month. The S&P 500 could be close to 3500 by year-end if they follow through with their QT plans and the correlation holds up.

The second graph shares the same data but in scatter plot form. The correlation between liquidity and the S&P 500 is statistically significant, with an R-squared of 0.57. The orange dot shows the S&P 500 is about 3% overpriced based on liquidity.

liquidity Fed
liquidity S&P 500

The model does have an important caveat. Other factors become the predominant driver of market returns when the Fed is inactive and liquidity is relatively stable.  

Summary

The Fed is not the only game in town, but they are the biggest game in town. While many other factors account for stock price performance, liquidity may be the most important to grasp.

To drive home this point, recall March 2020, when covid struck the economy. Global economies were shutting down worldwide. Unemployment was soaring, and the economy was careening toward a depression. Despite zero clarity on the economic future, stocks began to rally strongly in late March. Why? Liquidity via fiscal stimulus and a surge in Fed QE purchases drove markets higher. The economic situation was awful, and earnings outlooks were crumbling, but liquidity trumped fundamentals. 

By accepting what the Fed does, right or wrong, and closely following its actions, we can quantify how liquidity will steer markets. On top of fundamental and technical analysis, this additional layer of research helps us better navigate the market’s twists, turns, and trends when the Fed is active.

The post S&P 3500 By Year End If QT Continues appeared first on RIA.

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