Novum Alpha – Daily Analysis 25 September 2020 (8-Minute Read)

Finally it’s Friday and it’s nice to head into the weekend with some good news for a change. 

In brief (TL:DR)

  • U.S. stocks reversed course on Thursday with the S&P 500 (+0.30%), tech-heavy Nasdaq Composite (+0.37%) and blue-chip Dow Jones Industrial Average (+0.20%), all up cautiously as investors weighed the odds of a fresh stimulus package out of Washington. 
  • Asian stocks were mostly up on the final trading day of the week, buoyed by modest gains from Wall Street. 
  • The yield on U.S. 10-year Treasury ticked slightly lower at 0.668% from 0.676% in the previous session, as sentiment was cautiously optimistic that Congress would find a way through the stimulus impasse. 
  • Oil rose slightly as November contracts for WTI Crude Oil (Nymex) (+0.15%) was at US$40.37 from US$40.31, but was mostly flat as traders sat on the sidelines, pending any larger macro factors. 
  • The dollar was flat, in the absence of any clear roads towards stimulus as wells as only modest gains in stocks. 
  • Gold slid further with Gold (Comex) (-0.21%) at US$1,873.00 from US$1,876.90 in the previous session, for December contracts as tech stocks bounced back strongly on Thursday. 
  • Bitcoin (+4.26%) rose alongside tech stocks and was at US$10,723 from US$10,265 (GMT 0130) from 24 hours earlier, with outflows from exchanges ahead of inflows, and on a significant rise in volumes (outflows suggest that traders are holding onto Bitcoin in anticipation of price rises). 

In today’s issue…

  1. Investors Are Junking Junk Bonds – That Says A Lot About the Economy
  2. You Can’t Plan for Retirement the Way You Used To Anymore
  3. Europe Catches Cryptocurrency Wave

Market Overview

Growing up, one of the most unsettling feelings was asking the girl of your dreams to prom and not knowing whether she’d say yes or not. 
 
For now at least, investors are like so many teenage boys waiting for a yes as markets whipsawed on the prospect of an on again, off again, stimulus bill from Congress in the fourth quarter. 
 
While the Democrats are hammering together a US$2.4 trillion stimulus bill to try and break the deadlock with the Republicans, GOP senators are rubbing their hands in glee, as they now have the opportunity to entrench a conservative majority into the U.S. Supreme Court for decades to come. 
 
Across the Pacific in Asia, stocks were up, taking their cue from Wall Street in the pre-lunch trading session, with Tokyo’s Nikkei 225 (+0.69%)Seoul’s KOSPI (+0.38%), Sydney’s ASX 200 (+1.27%) and Hong Kong’s Hang Seng Index (+0.71%) all up.  

1. Investors Are Junking Junk Bonds – That Says A Lot About the Economy

  • U.S. Federal Reserve no longer seen as an assured backstop for corporate debt  
  • Lack of fiscal stimulus from Congress and absence of quantitative easing by the Fed has seen investors leave high-yield bonds in droves, 
When the U.S. Federal Reserve started snapping up corporate bonds alongside U.S. Treasuries, investors took that as a sign that it was open season on corporate debt.

Adding to that belief, the Fed also backstopped dozens of ETFs and funds which invest directly in high-yield or so-called junk bonds.  

As bond yields, especially for the most highly-rated firms plunged, yield-hungry investors poured into junk bonds.

But over the past week, as the Fed declined to commit to quantitative easing or any further substantive stimulus measures before U.S. elections, bond investors have fled bond funds as concern over the economy has grown.

And as Fed officials have urged Congress to issue another round of stimulus measures, warning that the U.S. economy badly needs it, bond finds have suffered the biggest outflows by investors since March.

A total of US$4.86 billion was pulled from high-yield bonds (the most risky type of firms) to the week ended September 23, according to data from EPFR Global, compared with US$5.6 billion that was withdrawn in the middle of March at the height of pandemic fears.

Blackrock’s iShares high-yield bond ETF, saw outflows of close to US$2 billion in the first two days of this week alone.

Fears over a persistent coronavirus, evidence that the economic recovery may be slowing and a contentious U.S. presidential election are weighing on investor appetite for exposure to some of the riskiest companies in debt markets.

Several top Fed officials, including Chairman Jerome Powell, made clear this week that the U.S. economic recovery hinges in large part on more fiscal support, but with only weeks to the election, Congress has been mostly gridlocked in partisan battles.

For the most part, the riskiest companies were able to borrow easily based on an assumption of fiscal stimulus and an implied backstop from the Fed by its purchase of junk bond ETFs and funds – now that that may no longer be the case, investors have been turned off these instruments.

And that may have a knock-on effect in reduced appetite for other risk assets, including stocks, commodities, and cryptocurrencies and could see greater demand for the dollar. 

2. You Can’t Plan for Retirement the Way You Used To Anymore

  • Negative real yields mean that pension funds and retirement investors will have to take on more risk now in order to meet payments down the road
  • Stocks and other risk assets will need to be considered as the specter of inflation looms large for the foreseeable future and against a backdrop of inflationary pressures 
Running a pension fund used to be a relatively staid affair – you weren’t at the tip of the spear when it came to risk nor were you hiding in a basement and cowering in fear. 

As the 400-pound gorilla in the investment universe, hedge fund managers would come to you with their colorful presentation decks and Hugo Boss suits to court your dollars as you doled out employee’s pensions to resemble what would approximate to a 60/40 stock and bond portfolio split. 
And then it was off to the fairways for a three o’clock tee time. 

No longer as topsy-turvy markets have upended long-held assumptions about market behavior and forced pension funds to be far more active in managing their members’ retirement obligations. 

With the coronavirus pandemic sending already declining bond yields off a cliff, pension investors have had to put into more stocks and other risky assets just to breakeven on contingent obligations. 
And pension investors may have little choice in the matter. 

With most institutional pension funds and individuals not saving enough right now to meet future cash flow needs, investors are growing to accept that a certain level of risk is needed in order to grow the inflation-adjusted value of retirement assets. 

Risk is necessary on the assumption that investing in equities will at the very lease preserve the purchasing power of retirement assets. 

With the Fed committing to keep interest rates low at least until 2023, and by the looks of inflation targets, well beyond that as well, the balance of power has shifted from savers to borrowers. 

Because what does it even mean to make long-run saving decisions in a world of negative real yields? 

As the policy response to the coronavirus is likely to be inflationary for a long time – an environment that erodes the value of fixed income – an increasingly larger equity allocation, beyond the typical 60/40 split, will be needed at the heart of a retirement portfolio, but that alone won’t be enough. 

With stock valuations becoming increasingly divorced from their value within a retirement portfolio, investors will need to accept that diversification will no longer be within asset classes or just stocks and bonds and will have to remain open to alternative investments as well. 

And that means that relying on your pension fund manager (who’s no longer able to hit the fairways as regularly) or on conventional wisdom may no longer be sufficient to prepare for retirement needs.
 
Instead, investors may need to become increasingly proactive about their portfolios and to be more active in their management strategies, which requires greater education, research and application, something which few investors are prepared for.  

3. Europe Catches Cryptocurrency Wave

  • European Commission proposes most comprehensive set of cryptocurrency regulations to position itself as a leader in the field 
  • Greater regulatory certainty and legal framework provide the roadmap towards institutional participation in the cryptocurrency sector and should boost adoption and prices long term 
In the early days of cryptocurrency trading, one of the major risks wasn’t the volatility of cryptocurrency prices, but that the exchange which you had been happily trading on for months would up and disappear overnight, along with all of your digital assets. 

But regulation in many jurisdictions has created greater certainty for cryptocurrency traders and it looks like Europe may be enhancing that certainty. 

In a major step for a developed jurisdiction to regulate digital assets, the European Union is attempting to balance the protection of its financial markets, without depriving citizens and companies of access to new technologies. 

Under an initiative unveiled yesterday the E.U.’s executive arm will be looking to establish clear ground rules for cryptocurrencies, which thus far have had to be covered under a patchwork of regulations, often leaving investors without protection or recourse. 

The proposal by the E.U.’s executive branch is considered one of the most comprehensive in any jurisdiction and will include regulation for so-called stablecoins, including Tether and Facebook’s Libra (if it ever gets off the ground). 

A dramatic spike in stablecoin usage this year, which has the potential to threaten financial stability, has provided a wakeup call to regulators to adopt more proactive policies for digital assets. 

In a statement, Valdis Dombrovskis, Executive Vice President of the European Commission, noted, 

“We should embrace the digital transformation proactively, while mitigating any potential risks. An innovative digital single market for finance will benefit Europeans and will be key to Europe’s economic recovery by offering better financial products for consumers and opening up new funding channels for companies.” 

And in what will be viewed by cryptocurrency traders as a welcome move, the proposed cryptocurrency rules will require cryptocurrency trading platforms to have a physical presence in the E.U. and be subject to capital requirements. 

Furthermore, the most significant stablecoins will now come under the scrutiny of the European Banking Authority. 

The proposed new cryptocurrency regulations will now be up for a debate by the European Parliament and national governments before it can become law, with the European Commission stating that it plans to have a framework for cryptocurrency assets in place by 2024. 

And while the regulation is welcome, enforcement will likely be tricky, especially for stablecoins. 
With the vast majority of stablecoins operating off the popular Ethereum blockchain, tracing, tracking and regulating their usage and movements will not be as straightforward as it may appear. 

The addition of “mixers” – software that deliberately obfuscates the source and destination of cryptocurrency, European enforcement agencies will have their hands full trying to police the space. 

Nonetheless, the proposed regulation provides a more clear path for greater institutional participation in cryptocurrencies not just for Europe, but for the rest of the world in general. 

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

Exclusive access to Novum Digital Asset Alpha’s Daily Analysis is made in conjunction with Bitcoin Malaysia.

The information and thoughts laid out in this analysis are strictly for information purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws.

It does not constitute a recommendation or take into account the particular allocation objectives, financial conditions, or needs of specific individuals.

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