Edition #97
Evergrande Clarity + FOMC Policy Decision = Less Uncertainty = Bullish
This newsletter will be slightly unique, as there are two primary topics that I want to focus on & analyze. Both topics are predominantly related to the broader economy, both globally and domestic, but also have direct impacts on financial markets, risk sentiment, and investor psychology. So while these are largely economic issues, they are also tied to the other sections I cover on this newsletter, being the stock market and cryptocurrencies. With that said, let’s dive right in.
Evergrande:
Each of these issues will flow perfectly into the other, but I want to start with the Evergrande situation. I have zero value to add in terms of the details or the actual story of Evergrande, so I highly recommend that you watch the following video by Patrick Boyle who summarized it very succinctly:
Patrick has been providing multiple updates as new developments have unfolded, but this should give everyone an ample baseline of knowledge if they were previously unfamiliar with the issue.
On September 20, I posted the following on Twitter where I decided to focus on Evergrande’s impact on investor psychology, as I felt this was an area I could actually add value and unique perspectives. Here is that post, with the entire thread in one single chain:
“Investors are highly sensitive. A potential default/bailout from a $310Bn foreign developer would put more pressure on a market that investors are already fearing is becoming weaker. Most people were freaking out last week when the S&P 500 was -2.5% from the ATH’s. In my opinion, today’s -1.7% decline in the S&P 500 is reflective of a simple theme: Sell now, ask questions later. This is a common reaction when the market suddenly gets introduced to a new risk event with a high degree of uncertainty. To add to this point, I don’t think most investors in the U.S. were even aware of Evergrande. I like to think I have a strong pulse on market dynamics, but even I hadn’t heard of Evergrande until earlier this year. Still, I didn’t know what they do until last week. Essentially, everyone is trying to get their bearings. It’s likely not just retail either. Institutions are probably mystified also. Everyone is searching for answers & clarity on this situation. Almost no one has it. It seems there’s no consensus conclusion or path forward.
As such, increased uncertainty causes an increase in volatility. Risk-on assets are exchanged for safe-haven assets. The increased demand for assets with less risk, such as fixed income securities, pushes yields lower. The result:
Bonds ↑
Stocks ↓
In today’s market, that’s exactly what happened. Additionally, securities that are further out on the risk curve get punished the most. This explains why Bitcoin is down more than -9% over the past 24 hours & why tech stocks were amongst the most damaged industries today. The key is: elevated uncertainty caused the response in today’s equity markets. At this point, any news is good news, even if it’s bad news. It will allow investors to make more informed decisions & increase clarity about the future.
Even after today’s decline, the S&P 500 is only -4.2% below the ATH’s. I think the short-term action is bearish, but limited. At the present moment, I don’t know enough about Evergrande to assess the economic implications, but I do know enough about investor psychology. I expect that volatility will keep rising in the short-run, likely until we get a formal announcement about default and/or bailout. This will keep pressure on stocks (notably tech/growth) & risk-on assets, including cryptocurrencies…
In my opinion, the market fundamentals that have reaffirmed my bullish stance remain intact. The monetary policy environment is also an important topic this week, with elevated uncertainty from the FOMC policy decision & statement. The focus will be the tapering timeline. The press release is practically insignificant (we already know that the target rate will remain at 0-0.25%. I’ll be most keen to watch the press conference & speech by Chairman Powell. I think that he’ll get asked about Evergrande, but his response will likely be brief & vague.
The final point that I want to touch on is one of my favorite themes in finance/investing: bull markets climb a wall of worry. This uncertainty is causing discomfort & panic. Selling stocks is equivalent to frenzied consumers hoarding water & toilet paper at the start of COVID. The resolution of this event could act as a launch pad for the next move higher in U.S. equities. It likely yields poor results for Chinese equities & ADR’s, but the U.S. stock market has been able to grind higher all year despite a massive slide in Chinese stocks.
Just 38 hours after posting this to Twitter, a report came out on Wednesday morning that the Chinese government is making moves in regards to Evergrande:
More specifically, an article from Asia Markets specified that the CCP is planning to take control of the firm, making it a state-owned “enterprise”.
Regardless of whether or not this is good or bad, the market rejoiced. We finally got some additional clarity regarding a resolution to this matter. The S&P 500 had already gapped up +0.3% to start the trading session, but immediately got a boost after these reports were published. The decrease in uncertainty prompted an increase in demand for risk assets, not just for U.S. stocks. At the time of writing, the price of Bitcoin is +6.4% over the past 24 hours.
This is exactly what I meant when I outlined the impact of Evergrande on market psychology: any news was good news, even if it was bad news. In this case, I can’t discern whether or not a takeover by the CCP & a restructure of the debt is good or bad, but I actually couldn’t care less as a trader. As an economist, it’s an interesting problem to tackle, but it has nearly no impact on my trading unless the situation materially deteriorates or the reports are discovered to be found false and we’re right back to square #1. I said that market pressure & increased volatility would be present until an announcement was made. Now that we’ve gotten some semblance of an announcement regarding CCP takeover, default, restructuring, bailout, etc, the market is interpreting that as a green light. In closing, I said that a “resolution of this event could act as a launch pad for the next move higher in U.S. equities”. I reiterate that stance.
FOMC Policy Decision & Jerome Powell Press Conference:
Highlights:
“We’re seeing an upward pressure on prices, particularly becuase supply bottlenecks in some sectors has limited how quickly production can respond in the near term. These bottleneck effects have been larger and longer lasting than anticipated, leading to upward revisions in participants’ inflation projections for this year. While these supply effects are prominent for now, they will abate, and as they do, inflation is expected to drop back toward our longer-run goal.”
“Our asset purchases have been a critical tool. They helped preserve market stability and market functioning early in the pandemic, and since then have helped foster accommodative financial conditions to support the economy… The Committee continued to discuss the progress toward our goals since the Committee adopted its asset purchase guidance last December. Since then, the economy has made progress toward these goals. If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.
“We also discussed the appropriate pace of asset purchases once economic conditions satisfy the criterion laid out in the Committee’s guidance. While no decisions were made, participants generally viewed that so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.”
Powell hinted that the announcement to begin the taper will be data dependent, as always, but could come as soon as the next FOMC meeting. Much of this decision will be focused on further improvements in the labor market, as well as the broader market at that time.
I think the Federal Reserve is planning the upcoming taper process perfectly. Both in regards to the tempering of market expectations & timelines, and the general process of carrying it out. The only pushback I’d have at this time is that the completion of the tapering process seems rather fast. Powell hinted that the tapering process could be announced in the upcoming meeting, which will be in early November; however, the process will likely conclude in mid-2022 assuming that the economy develops in-line with the Fed’s current assumptions and expectations. Let’s assume that gives a window of 6-9 months for tapering the rate of asset purchases. One question that I don’t have clarity on at this time is: what is the level of asset purchases that we are aiming to achieve once the taper process is complete? Is the Fed planning to bring asset purchases completely towards zero, or will they simply try to reduce the current rate of at least $120Bn/month to $40Bn/month.
The Fed has made it clear that they will continue to roll interest payments from their current assets into new holdings of additional assets, so it’s evident that they’ll continue to have net purchases of assets. If the Fed completes the tapering process in mid-2022, what will they do until the moment when they decide to actually raise the target federal funds rate above 0.25%? If the options are between sitting on their hands vs. slowing the rate of the tapering process & stretching it out further over time, I’d prefer the latter. I understand & support the need to taper, but I don’t think the window of completion should be sped up.
If this is indeed the plan that plays out over the course of the next 9 months or less, that means that the taper process will both start and end sooner than I had initially forecasted. I’ve been repeatedly saying that I expect for tapering to begin no sooner than Q1 2021, and I had believed that it would be a 12-18 month undertaking. Assuming that the 9 month timeline is accurate, I feel obliged to slightly reduce my bullish outlook for U.S. stocks. In reality, this is a reduction from overwhelmingly optimistic to very optimistic, so this shouldn’t be interpreted as a 180° turn. I still want to be overweight U.S. stocks, particularly in the technology, healthcare, and consumer discretionary sectors. I also reiterate my emphasis on the six investment themes that I outlined in my paper at the start of the year:
Mobile Payments & E-Commerce
Data Analytics & Cloud SaaS
Internet Transfer & Innovation
Semiconductors
Clean Energy & Renewables
Consumer Technology & Discretionary Spending
Conclusion:
The thread that I published on Monday provided an extremely accurate foreshadowing of this week’s events thus far. In either case, the government takeover of a $310Bn indebted real estate developer and a faster-than-expected tapering timeline wouldn’t normally be positive news for stocks & risk assets. Nonetheless, the S&P 500 rose +0.95% in yesterday’s session. This is simply because investors and market participants had a reduction in their uncertainty about the future. That doesn’t mean that there can’t be more short-term downside if there are new developments about either of these topics, but the momentum thrust to the upside today definitely made me feel encouraged about investor psychology. As I said in my original tweet, bull markets climb a wall of worry. Time to buckle up for the ascent?
Talk soon,
Caleb Franzen