September 2021 Update

San Francisco, CA 

The VIX Returns!

September proved to be the volatile month it traditionally advertises itself as.  We saw the VIX (fear index) spike up to a high of 25.60 from a low of 15.61 and finally emerge from its base that has lulled the markets for months now.  Below are some of the reasons for the spike in fear, but we would like to underscore that the overwhelming cause for concern in any asset market going forward is the potential shift in Fed policy and, to a greater extent, global central bank policy.


Will this past month be looked back on as the period when the sea change in Fed policy finally becomes a reality and not just a theoretical “someday” event?  If indeed it is then the rest of 2021 will be highlighted by how and if assets are re-priced.  This situation would likely lead to some frightening sessions, but more importantly, to some amazing trading opportunities, the likes of which we have not seen in years.


There have been rumblings around China’s massive property development company Evergrande for some time now; we even briefly mentioned Evergrande in past missives.  This month, for a few days at least, it caused some trepidation when there were rumored bond payment defaults that sent the markets in a tizzy for a day as the SP-500 fell over 2% and threatened to fall over 5% for the first time in over 200 trading days.


The systemic threat that some thought Evergrande would cause soon turned out to be more bark than bite and the indices, particularly US stocks recovered quickly, then retreated on inflation and rate concerns.  But the Evergrande saga leads us to a deeper discussion regarding the ongoings in China and how the changes there will reflect a new global economy for the years ahead.


President Xi has seemingly had enough of the Chinese wealthy running amok in speculation and wealth.  He has already aggressively attacked the tech sector, even limiting the amount of video games allowed to play and has made it quite clear that China is not going to turn into an open capitalistic society and see the chasm between classes widen any further. 


Evergrande likely won’t cause a “Lehman moment” as some were quick to proclaim, but there will be pain felt by foreign bondholders and local investors.  While the CCP is not expected to bail out Evergrande per se, we have seen the PBOC inject massive amounts of liquidity, to the tune of $100 billion yuan for four straight days, into the system during the week of September 20-24th – which one could argue was a stealth bailout.


All this pales in comparison to the bigger picture in China.  And that is their Five-Year Plan which includes:


  1. Emphasizing quality of growth over quantity
  2. Building China into a technological and manufacturing superpower
  3. Liberalizing the business environment (on their terms)
  4. Attempting to level the class playing field through the urbanization of rural areas


All these objectives along with the Belt and Road initiative that began in 2017, are directed squarely at the United States, the appearance of which also likely coincides with the fact that media reports of communication between the White House and China are at multi-year lows.


So far, the China situation has not negatively affected the US markets, sans the Chinese ADRs such as Alibaba and Netease – which have been obliterated this year.  But let’s make no mistake about what is going on.  China has a plan and the will to implement it.  “Common Prosperity” is a term being used quite often this year by President Xi and the Chinese obviously are taking all measures to execute that theme in order to make it grow into a reality.


To achieve this goal, there will be some corpses sacrificed along the way. Thus far, they include Chinese tech billionaires, local property developers, and certain foreign bondholders.  In China, the government decides who survives and who gets sacrificed for the greater good.  That alone gives them an advantage over the US.  This doesn’t necessarily make them stronger or better at allocating resources.  But given the current political climate here in the US and the absolute refusal by the two parties to agree on anything (one of the latest being raising the debt ceiling to keep the government open), we have to at least concede that China is much more focused and organized than we are.


Which is also quite probably why communication lines are so scarce right now.  China is likely just keeping to themselves and watching as Rome smolders here in the US – all while quietly pushing their narrative.


With supply chain issues at the forefront of inflation woes and profit margins, the China versus US tale becomes even more critical as we peer into 2022.  This is especially poignant in the semiconductor chip sector, on which we heavily rely for foreign production.  Tawain Semi is the world’s biggest chip producer and is headquartered right where China has squarely set its sights for an always rumored invasion – one according to the White House, that would cross the “red line.”


The next few years are going to be a knock-down, drawn-out battle between a totalitarian society and a democracy, with Taiwan the jewel for which battle is waged. We aren’t suggesting that a physical war is imminent by any means, but an economic one is already in the middle rounds with the critical conclusion coming quicker than many anticipate, especially given the lack of togetherness the US currently displays.


Lastly, President Xi next year will seek to usurp the traditional power hierarchy breaking the party’s established system of leadership succession and will be the most powerful leader in decades in China.  He’s not going anywhere soon and knows it.


Aside from the “mini crisis” in China this month, the Fed’s meeting on the 22nd has garnered the most interest – and confusion.  The soon to-be-tapering Fed led by Jerome Powell upped its inflation forecasts slightly and tempered its GDP forecast, also slightly.  For the first time in seemingly a month the word transitory was absent from any verbiage (how many months of stubborn inflation does it take to eliminate the transitory line?)  


The $120 billion in asset purchases will carry on until at least November 3rd when the FOMC meets once again.  Mr. Powell did stress that while inflation levels have met their 2% target (to say the least), the employment situation has not (partly due to the fact that you can make more staying home than working in some sectors these days)


So, apparently the September jobs report, the only jobs report to be released before the meeting on November 3rd, suddenly has taken on a gargantuan meaning.  It’s pretty safe to assume that with current supply chain issues combined with the consistent strong demand that inflation is not diminishing anytime soon (oil is over $75 barrel).  So, if we do get a strong jobs report maybe that will be the final dagger into the heart of the easy money express train.


Overall, the meeting and verbiage out of Mr. Powell was predictably dovish.  The same “Wait and see” rhetoric we have heard for years now was front and center per usual.  And with the Delta Variant acting as an Ace in the hole for the Fed to use to defer any tapering, the Fed still maintains a dovish tone, albeit of a slightly lesser variety.


But one difference that came out of the 22nd was the fact that the Fed now says they would like to complete the tapering by mid-2022, assuming it starts sometime late this fall (which as we have reiterated is a big if)


Also interesting was this: “For me, it wouldn’t take a knockout, super strong employment report for September to think the test is met to begin a taper in November. It would take a reasonably good employment report for me to feel like that test has been met”


Also: “If sustained higher inflation were to become a serious concern, the Fed would respond”


The world would love to know at what rate or sustained elevated levels of higher inflation can be translated into a “serious concern” and what a response entails exactly.


The tapering would begin with a $15 billion a month drawdown ($10 billion in treasuries and $5 billion in mortgage-backed securities


That advanced timetable did spook the rate markets and saw the 10-year yield trade to 1.51% on the following day.  Stocks seemed oblivious in the short term to the news as the SP-500 jumped 1.35% on the 22nd and recaptured all the losses it sustained from the week and the Evergrande “crisis” 

Google searches for the pandemic are nearing lows not seen since March of 2020.  In our opinion, this is a tell-tale sign that we are sick of the pandemic and are learning to live with it.  Yes, the vaccination argument inexplicably rages on in this country, but for the most part things are back to (the new) normal.  Kids are back in school, football stadiums are packed, airports are busy, and the office workers are, albeit slowly, trickling back into downtowns.  Also, Merck just announced positive data for an oral antiviral drug that could reduce hospital visits by 50% for Covid patients.  A real potential game changer.


Maybe this all alters as we enter the colder seasons, and the flu cases pick up.  A doctor we know well has told us he expects this flu season to be one of the worst in years.  Maybe another ugly variant surfaces and starts to wreak more havoc on the ICUs.  No one knows nor is anyone rooting for any of this, but for now at least it’s tough to argue that society is back to normal (with a mask), and we must wonder if the sharp jump in rates this month was helped by this notion?  Because it sure feels like the equity markets have gotten over this pandemic for some time now.


Crypto update

China banned all crypto transactions (again) in the last week in August.  This is the 5th time they have proclaimed this in 2022 and it fits in nicely with the mantra we have been highlighting in this update.  China is trying to control all the flows of capital as they see fit and is using climate concerns (i.e., Bitcoin mining) as their latest reason for this proclamation.  It should be noted that cryptocurrencies have rallied sharply after these China-news-induced selloffs (Bitcoin is up 6446% since China’s first ban attempt in 2013) Let’s see if history continues to repeat itself.


Other than the China news, it has been relatively quiet on the crypto front. Bitcoin, after spiking back to a shade over $50,000, has settled into a range between $40,000 – $50,000 for weeks now. There has been talk out of institutions that a swap-out of Bitcoin and into Ethereum is underway but it’s hard to see it reflected in the prices or charts.


Coinbase came out this month and upped the size of its debt offering from $1.5 billion to $2 billion, citing market interest.  Also, the crypto giant announced they would soon be offering crypto futures and options trading in an attempt to bolster their derivative side of the business and become more of a one-stop shop for all things cryptocurrencies.  The stock however has not reflected any good news lately as it hoovers in the $230 range – mirroring the price action in most of the cryptocurrency world save a few random alt-coins.


Keeping with the funding theme:  This month crypto exchange Gemini announced they soon will close a round that values the firm at $7 billion. Meanwhile Binance is poised to be valued at a current valuation of $3.7 billion and some are saying Binance could raise at a valuation as high as $300 billion soon.


“But this will take years. The next 3 to 5 years in crypto will be about setting the battle lines and then using the courts and lobbyists to reach a grand settlement of what it means to classify something as a security. In the end, that will help the space.”


“My view is that in the end, we will get new securities laws for digit assets and that they will be cheaper, faster, fairer and much less onerous on issuers. Consumer protection will have to come via warnings or some sort of risk metrics.” – Anthony Pompliano, The Pomp Letter


Some in the crypto world see regulation as the antithesis of what cryptocurrency was established for.  We on the other hand agree with the above quote and view regulation as a way to legitimize an asset class that will be at the forefront of change in how we as a world conduct commerce.  So, any short-term price depreciations due to regulation “fears” are simply short-term blips on a much longer upward road to becoming an official asset class for decades.


We now have 3 months left in 2021 and they are sure to be anything but dull.  It’s always good to create some simple lists that clearly showcase the current positives and negatives circulating the globe.  It’s a simplistic exercise for sure, but we find it effective.  Let’s start with the positives:


  1. Increasingly less emphasis on Covid, slowly gaining vaccination rates, and an overall sense that a return to normal is inching closer.
  2. Overall global liquidity remains extremely strong, and the TINA trade is alive and well.
  3. Corporate America is flush and demand for goods and services remains robust
  4. Seasonally, November through January tend to be positive times for equities, highlighted by the always fun “Santa Claus Rally”
  5. The SP-500 houses the best companies in the world, this was echoed recently with the goings-on in China and will continue to attract marginal capital regardless of the negative narratives out there.


And the negatives:


1) The inability of our government to agree on anything including a debt ceiling bump

2) The Fed taper is too aggressive (which could make point #2 above irrelevant)

3) China continues their scorched earth policy on all assets and capitalism

4) Covid resurges as the weather cools or more variants emerge

5) Corporate America begins to report lackluster results starting in mid-October

6) Supply chain problems persist, and inflation remains high, potentially hitting the bond market and causing a spike in rates, which would be particularly bad for tech (and also helps negate point #2 on the positive ledger)


The 10-year bond yield moved from 1.3% to briefly over 1.6% this month.  It was all the rage on financial television for the last week in September. What was the alleged catalyst for this move? 


Some will point to the change in Fed policy as we have detailed above.  Others will insist that it is an improvement in the economy coupled with the lessened effects of Covid (also noted above) and the continued push to return to normalcy.


 Whichever catalyst you choose to embrace the overriding point is that we have likely finally entered an environment where higher rates, at least relatively speaking, will become the new normal.  This new dynamic is going to force a change in psychology for not only the investor class, but society as well.  Credit cards, auto loans, mortgages, refinances, and interest on savings accounts will all start to feel the reset of this “new normal” which will lead to varying levels of sticker shock, something we have been immune to for quite some time – at least in regard to rates.


And maybe Covid, as awful as it has been, could also actually produce some change for the good and a smarter way of life in the future.  Improved supply chain logistics, less reliance on foreign manufacturing, increased emphasis on better health to combat viruses, more efficient ways to work, less reliance on commuting, more attention and a deeper appreciation for family and friends are just some of the “good” items to emerge from this wretched pandemic.


Looking Forward and other Market Commentary: 

As we continue into the “scary” parts of the year for equities, all eyes will turn to corporate earnings. The season will unofficially launch on October 13th when JP Morgan reports their results.  There seem to be high levels of fear that this quarter’s reports will fail to assuage investors.  The three biggest concerns are inflationary pressures due to gummed-up supply chains, lack of consumer faith, and the effects of higher interest rates.  These factors were prevalent in September when we did hear from a few corporate heavyweights:  Fed Ex, Costco, Nike, and Sherwin Williams, all reported their results during the latter part of the month and all cited inflation and supply chain issues as reasons for lackluster guidance, specifically for Fed Ex and Nike.  These reports have not emboldened investors with much confidence as we enter the earnings season.


According to FactSet, consensus for third-quarter earnings for the S&P 500 are for an earnings growth of 27.6% on a revenue growth of1 4.9%.  Also, since the beginning of 2020 analysts on Wall Street have upped their S&P forecasts from $167/share to $201/share.  So, it seems reasonable to expect a pullback from these lofty expectations as we enter the most current reporting season without taking a series of slightly disappointing results as a harbinger for a coming equity meltdown; especially with the excuse of Covid, supply chains, Fed policy, and inflationary pressures out there.  It should also be noted that despite the bouts of volatility in September equity prices, the corporate bond spreads and US investment grade spreads have remained near their lows and in tight ranges (bullish)


As noted above, we will not hear from the Fed until the November 3rd but we will hear from the Bank of Canada on the 27th and both the ECB and BOJ on the 28th of this month.  As we have seen from the Bank of Norway last month, and less so from the Bank of England, we are now required to pay attention to once lesser-followed central banks as the entire globe rethinks rate and debt policies.


Also, we are still stuck keeping our eyes on Washington as they bumble through various infrastructure bill proposals, debt ceiling wrangling, and a general sense of complete cluelessness – whichever side of the aisle you reside on.  We won’t spend much time on this since seeing that trying to predict the goings-on in DC has been a total mugs game for some time now.  No need for us to try and become political experts.  


Lastly on politics (we hope), Senator Warren attacked Chairman Powell during a congressional hearing on the 28th, calling him a “dangerous man” and vowed not to support him for reappointment. This flies in the face of fellow Democrat Secretary Yellen’s support for Powell.  The White House has not yet announced whether they will support Powell for another term starting in February of 2022, but the betting markets have taken him from a shoe-in just months ago to less than a 60% chance for re-nomination.


Also, two FOMC members abruptly resigned this month due to trading controversies and will need to be replaced and there are also rumblings from the progressives that they are pressuring President Biden to replace Powell with a candidate more suitable to their liking.  One of the names mentioned being Lael Brainard.


Are the markets prepared for a totally revamped Fed and permanently higher interest rates as we wrap up 2021 and peer into 2022?  Despite all the other goings on in the world, and there are plenty, this is the overall riding catalyst to focus on now and for 2022 when the tapering (in theory) is set to conclude mid-year followed by a series of rate hikes.  


All this assuming the markets don’t start to hike rates at the long and mid-ends of the curve well before any Fed policy change.  Stay tuned.