Financial Market Musings
Week 33 : August 2020
With a continuation and acceleration of COVID-19 in the US and many other countries, alongside the escalation of US-China tension, I thought I would use this as an opportunity to note down my thoughts of some interesting (at least what I think are interesting) developments and potential risks in certain asset classes.
Fixed Income: The unconventional monetary policy is understandable and appropriate since no one wants to see an economic or social crisis on top of the COVID-19 crisis, however the almost unlimited money-printing action also sets policy on the edge of a liquidity trap - under the current environment, there is not much room for an interest-rate cut, particularly with corporates and households still seeming to favor saving instead of spending. It seems as if it’ll take time to see inflation coming back, notwithstanding the large fiscal stimulus put in place by many governments. If another crisis occurs due to a source other than coronavirus, a negative interest rate policy is also possible, though from historical experience, negative interest rate policy tends to be ineffective and damages commercial banks more as people tend to keep “cash under the mattress” to avoid the negative interest rates.
This will certainly accelerate the push by central banks and governments to promote digital currencies for which there is no avoidance of negative interest rates, except via the still minor (in terms of capitalization) so-called crypto-currencies. Besides, some industries’ corporate bonds (particular services and traveling) will remain under strong pressure for a long time due to the restrictions imposed to attempt to control the epidemic.
US Equity Market: We have the phenomenon of retail investors becoming much more active in the equity markets, aggressively buying large market capitalization stocks, highly leveraged stocks and stocks exhibiting large price declines caused by the COVID-19 crisis. In contrast, institutional investors in some countries have been net sellers of the very same stocks.
Some researchers claim that the “striking and pervasive” divergence of amateurs and professionals is due to those who have been furloughed, seeking additional income via capital gain as alternative income sources during the downturn. Other researchers indicate that this abnormal activity is due to “the absence of leisure activities” and thus retail investors are betting and playing the stock market, which is referred to by Bloomberg as the “boredom markets hypothesis”.
The technology sector, which is the current market darling and which has seen its prices soaring for years, has benefitted from the COVID-19 crisis: their marketing dream has come true - a large proportion of people from all ages have been forced to learn how to use modern products/apps to buy daily necessities (Amazon, etc.), greeting friends (Facebook, etc.), seeking entertainment (Apple, Google, Netflix, etc.), doing businesses (Microsoft, etc.) or meeting online (ZOOM, etc.). The digital lifestyle has been promoted as a technological response to the social distancing recommendations and those enforced to contain the epidemic.
Potentially, it will endanger some traditional business models. Take Amazon as an example, versus traditional small stores that people visit in person. When people get used to the e-commerce lifestyle, it will have a big impact on small stores as Amazon has more products (SKUs (stock keeping unit) on its webpage for selection) and lower cost (do not need to pay high rents for the locations), higher efficiency (no meaningless advertisement expenses due to advanced online recommendation algorithms). Institutional investors will need to review their portfolio to see whether some of the stocks will be riskier in the future, not just because of the COVID-19 crisis but as a result of the life-style deriving from the responses to the COVID-19 crisis.
Emerging Market: Last month our model indicated an unnatural Intrinsic Energy build on the Chinese stock market, an alarm signal indicating an increase in underlying volatility with a likely change of state (new price equilibrium). The Chinese financial market has gradually become more open, more mature, and more functional. Due to the strict control of COVID-19, the Chinese financial market has been more stable than those in many countries and has thus attracted global capital as a new asset allocation target. This attraction also stems from the potential for growth of the Chinese economy as well as more conservative fiscal policies. I think that the Chinese stock market, as it is less correlated than many other classes to the western markets indexes, will attract more global institutions for diversification purposes.
Currency and Commodity markets: It may seem odd that I believe the Australian dollar appreciated to a 20 month high mainly because of Brazil. The rationale being COVID-19 has strongly impacted the production activities of Brazil - second largest iron ore exporter globally. Iron ore price soared to 12 month highs, directly favouring Australia’s mining industry.
Gold price has recently surged to historical highs, catalyzed by the strong weakening of the US dollar resulting in part from the aggressive monetary policies in the US to support the economy as well as the monthly payment to hundreds of millions of US citizens, arguably promoted by Trump to help his re-election. The escalation of the US-China tension is also a contributing factor. When J.P. Morgan stated in his testimony before Congress in 1912, “Gold is money, Everything else is Credit”, he was referring to the fact that the central bank cannot print gold. Once again our model shows an unnatural build and level of Intrinsic Energy in gold price, indicating the possibility for a short-term correction. However, with the attraction to gold from both institutional and retail investors, I won't be surprised if gold goes beyond $2200 per ounce before the end of this year, particularly if the numerous different sources of uncertainty are not significantly eliminated.
Geo-Political Musings
The Thucydides Trap, according to Graham Allison, refers to the theory that “When one great power threatens to displace another, war is almost always the result”, with numerous historical examples: from the Athens and Sparta war to the past 500 years witnessing 16 cases in which a rising power threatened a ruling one, twelve cases ended in war, including WW1 and WW2.
The resurgence of China, of course, ignites the fear of the US, and the US will continue to try to curb the economic development of China as much as it can.
The South China Sea has become the focal point and seen as the primary strategic goal in an attempt to curb the Chinese state & economy. According to a United Nations Conference on Trade and Development, the South China Sea accounts for one-third of global shipping. China, Japan, South Korea, all rely on the Strait of Malacca, which connects the South China Sea and, by extension, the Pacific Ocean with the Indian Ocean. For China, around 40% of total trade and the majority of the oil import transit through the South China Sea. China’s exponential industry and economic development are heavily reliant on energy, particularly oil. This makes Chinese interest in the South China Sea critical, almost of existential importance.
Since the start, in 2018, of the US-China trade war, the US has increased its pressure on China over technology, international trade, finance, and currency. It is understandable for a Continental country to protect itself and ensure its supply routes. However, from the logic of a Maritime country (the US via an extension of its Navy), any threat to the Strait of Malacca and to the South China Sea amounts to challenging its power. Not to mention the US really wants to curb China’s growth and influence. No matter who will win the next US presidential election, the US-China relationship changed in 2018 and the pre-2018 understanding and cooperation is unlikely to be returned too.