Monday digest

Posted 16 May 2022

Overview: bear market fears gnaw at investors
The old investment wisdom of ‘Sell in May and go away’ appears to have once again proven correct, especially after the US S&P500 fell within touching distance of the bear market threshold of -20% last week. For such a long time, the weak economic growth environment meant buying large-cap US tech because their secular growth potential. However, in the current post-COVID period, this dynamic seems to have changed. Several mega-cap tech firms have been telling investors that the change in the economic backdrop means – due to their size and variable revenue base – they are no longer confident of their ability to simply outgrow such headwinds. A couple of weeks ago Netflix was hit as subscribers cancelled subscriptions – presumably to unburden household budgets to pay for more essential goods. Last week, ride-hailing app Uber told investors it too would be cutting costs. We should therefore expect the travails of the US stock market to have quite an impact on consumer confidence and ultimately in their willingness to spend.

At the beginning of April, when markets recovered from the shock of the invasion of Ukraine, we said markets felt priced for perfection. Now they appear priced, and braced, for the onset of a global recession. Those recession fears centre largely on the input price inflation from energy and food supply constraints forcing central banks to increase rates further, thereby choking off the post-pandemic economic recovery. In other words, market sentiment has likely slipped from one extreme to the other.

Yes, inflation readings are high, but they are no longer increasing. High energy prices are also having the effect of bringing idle production capacity of oil exporting countries back online. Last week volume figures from Iraq showed far higher export levels than OPEC’s caps would have us expect. If current market pessimism stems from the cost-of-living crisis caused by the energy price shock, by autumn this concern may well be confined to those parts of Western Europe particularly dependent on Russian gas. Additionally, while uncertainties persist, productive capacity in China appears to be coming back online quicker than anticipated and having been reluctant to offer Western-style economic support during the main pandemic period, China at last appears willing to embrace a much looser and accommodative policy stance.

This leaves the fallout from the bursting of the latest tech (and crypto) bubble to contend with. Those who remember the aftermath of the dot-com bubble in 2000 will know consumer demand dropped enough to cause a recession. There is some risk of this, although history tends to rhyme rather than repeat. Should the setback in the tech and crypto markets subdue consumer demand, and also take the heat out of central bank rhetoric, then we may have reached a notable turning point for a decline in 2022’s bond market headwinds.

All in all, the various economic data points of the week suggest there is some cause for optimism that the ‘bear scare’ may be running out of fuel. Not only have market valuations reached more ‘normal’ levels but company valuations are also returning to more normal metrics based on facts and figures, rather than merely hopes, believes and self-enforcing herd mentalities.

The crypto fever breaks
Cryptocurrency holders suffered a particularly rude awakening last week, after the vicious bear market knocked trillions of dollars from the value of the biggest digital coins. Bitcoin, the flag-bearer for cryptos, tumbled below $30,000 during midweek trading – its lowest value since last July. At the time of writing, its value has fallen more than 50% since the peak last November. Ethereum has had a similar fate, while Elon Musk favourite Dogecoin is teetering closer to total collapse. But as with the dot-com bust 20 years ago, the catalyst was a shift in policy. Central banks have flagged aggressively tighter monetary policy this year – the Fed chief among them. The bond sell-off this provoked led to a market-wide revaluation of risk assets. Although crypto promoters have branded their digital tokens as a hedge against inflation the boom/bust pattern they have followed suggest they currently trade closer to classic risk assets – or at worst as purely speculative ones.

Crypto sell-offs have happened before, and there is certainly no reason to think this is the end for the wider market. Nevertheless, this episode carries the hallmarks of a burst bubble – first in its wider effects on the financial system, and second in its potential to cause a deep rethink in the underlying market. Many investors have already noticed an eerily close correlation between cryptocurrencies and the price of technology stocks, a pattern which has become more apparent this year. The tech-heavy Nasdaq index has sunk nearly 30% in 2022, largely in step with Bitcoin and other popular cryptos. A synchronised dive is perhaps understandable, given that both asset types are popular with retail investors, and are both susceptible to a rising interest rate environment. But it is significant when you consider how different attitudes were just a year ago. Then, cryptos were billed as the future of trade and a protection against inflation, while big tech was seen as a safe haven from faltering growth prospects. When push came to shove and the Fed got serious about fighting inflation, these notions changed rapidly.

There is no doubt that the blockchain technology underlying cryptocurrencies could be genuinely transformative for the world. The problem up to now has been that the space is too crowded with false promises to reliably assess their prospects. There is obviously no guarantee that bitcoin or Ethereum will be the next Amazon, but they have a much better chance of getting there if there is a stable market around them. With any luck, that might be the spring that blooms from crypto’s winter.

Quantitative tightening is here – but draining liquidity is the biggest challenge
Reverse repurchase agreements (repos) held with the Fed – whereby it sells an asset under an agreement to buy it back after a short period of time – reached an all-time high in April. Total reverse repos are now well over $2 trillion, while formal quantitative tightening (QT) at $60 billion/month is only starting later this month. This trend has been building for around a year, but has marked a sudden and significant uptick from historical policy.

Liquidity is a bit like engine fuel in this respect: injecting more will usually make things run quicker, but too much can cause overflow and clog the machine. Reverse repos influence how much money is in free circulation, as money market funds – and not just banks – can make deposits here too. Therefore, reverse repos are a way for the Fed to drain money and prevent such clogs. They involve private institutions temporarily returning cash to the Fed and getting a guaranteed return – the reverse repo rate. Excess liquidity is particularly problematic for short-term money markets, as occurred last year, when a reduction in the TGA created an oversupply of cash elsewhere, pushing down private sector money market rates close to 0%. Since that episode, the Fed has increased its reverse repo rates to 0.8%, well above the return on a one-month Treasury bill (0.5%). This is basically a guaranteed return with zero risk, giving money market funds a huge incentive to park their cash with the Fed, rather than investing it in short-term government debt. It is no surprise then, that reverse repo operations have increased recently. Currently, this amounts to a quarter of the Fed’s outright security holdings, a huge figure which amounts to a significant tightening of financial conditions. The higher return with no risk is hard to ignore, but the fact so much has poured into reverse repo markets could also suggest markets are feeling risk averse.

As the Fed ploughs ahead with its balance sheet reduction, it has two big choices on reverse repos. Keeping rates high will keep liquidity draining out of markets, and could be a very effective way of tightening financial conditions. On the other hand, it also maintains a level of distortion in money markets – and authorities may be more comfortable with a lower balance. Lowering the reverse repo rate would be a way to increase liquidity in the market again even while formal QT is happening in parallel. This could be a valuable option later down the line if stress appears in money markets, and could possibly spill over into other asset classes. It would amount to a loosening of financial conditions, which is not something the Fed will want for as long as inflation has not come down. Ultimately though, the Fed will have to let the build-up from its reverse repo operations drip feed back into the market if it wants to normalise conditions.