Paradigm shifts begin to impact financial markets

Everyone hopes that the new vaccines will prove effective. But we doubt there will be a quick return to ‘business as usual’. Instead, we expect important paradigm changes to impact markets in the West, and in China.


Oil

We focus on Brent as the global benchmark.

Brent closed up at 42.63/bbl. Today is Fibonacci Day, named for the famed Italian mathematician. And ‘technically-biased traders’ (the majority in futures markets) are focusing on Brent’s failure to break through the $45/bbl Fibonacci 38.2% resistance level shown in the chart.

Paradigm shifts in supply/demand balances and geopolitics are adding to their concern:

  • OPEC alliance. Tensions are growing between Saudi Arabia and the UAE as the UAE continues to expand its reserves, which are now 107bn barrels, the 6th largest in the world. Yet its OPEC quota is just 2.59mbd.
  • Geopolitics. President Biden is unlikely to maintain Trump’s close links with Crown Prince Mohammed bin Salman (MbS). Like the UAE, he also wants to develop a more positive relationship with Iran.

The usually well-informed Simon Watkins of Oilprice.com suggests that “MbS’s hold on power has never been more tenuous.

WATCH FOR: Frayed tempers within OPEC as 2021 budgets are squeezed, leading to increasingly noisy rumours about the break-up of the group


S&P 500

We focus on the US S&P 500 Index as the world’s major stock market index.

The Index saw some minor profit-taking after the latest rally, ending down 0.8% at 3557, whilst the VIX volatility index rose slightly to 24.

Traditional value-based investors have not done well in recent years. Momentum traders were the winners, as policymakers followed stimulus with $tns of Milton Friedman’s “helicopter money” in the form of zero-rate lending to corporates and cash payments to every household. The FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) have soared as a result, supporting both the NASDAQ and the S&P itself.

All good things come to an end, however, and there seems little sign of new stimulus or furlough payments in the short-term. This raises the question of where FAANGM prices might go, if traditional valuations ever returned:

  • Ben Graham is the ‘father of security analysis’ and was Warren Buffett’s mentor.  His valuation metric accurately predicted the 1987 Crash
  • Its relatively simple but effective formula requires a forecast of annual earnings growth over the next 10 years.
  • A company with zero growth over this period has a Price/Earnings ratio of 8.5, and each 1% of growth above this adds 2 to the P/E ratio

If we take Facebook, for example, it currently has a P/E ratio of 32.61, suggesting annual growth of 12% out to 2030. This seems optimistic, given Facebook’s size, with regulators asking questions about its business model.  A flat growth scenario, with a P/E of 8.5, would give it a Graham Value of $71 versus today’s $270 level.

We will look at the metrics for the other FAANGMs in coming weeks.

WATCH FOR: We continue to expect prudent investors to take some profits ahead of likely higher taxes in 2021 in December, putting pressure on equity values


Interest rates

We focus on the US 10-year rate, as this is the “risk-free” benchmark for global markets.

The rate slipped back to 0.82%, with the MOVE volatility index unchanged at 42.    

The consensus view is that the helicopter money will finally create high levels of inflation – reducing current debt levels in real terms.  Consensus thinking is therefore convinced yields will rise, probably quite sharply.

We continue to believe, however, that a paradigm shift is underway due to today’s ageing populations, as discussed on 2 November. And as we discuss above, energy costs – the single most important economic input – looks set to fall rather than rise. We therefore see negative rates as more likely in 2021 than a major increase.

WATCH FOR: Volatility to continue till the battle between the inflation bulls and deflation bears is resolved


China lending

A major paradigm shift is also underway in China, with the government set on reducing the role of shadow banking in the economy.  This is a major paradigm shift as China’s shadow lending, shown in the chart, provided the rocket-fuel for the global recovery after 2008.

  • But today, the government is focused on financial stability and avoiding a domestic financial crisis, to support the new Dual Circulation and increased self-sufficiency policies discussed on 26 October
  • Official state-owned banking is now seen as core, with shadow banking sector seen as high risk
  • Lending quotas have increased for the state banks, whilst the Supreme Court recently banned minimum interest rates for shadow lenders
  • The abrupt postponement of Ant’s IPO, and Huaxin Trust/Evergrande refinancing problems, confirm the determination to curb shadow banking

WATCH FOR: Investors to slowly realise that China is not repeating its massive 2009 stimulus via shadow banking, and is instead increasing regulation

4 thoughts on “Paradigm shifts begin to impact financial markets”

  1. why should I be worried that shadow financing is drying up, when it is more than offset by social funding? Is there any difference between the two in the context of macro analysis?

  2. Thanks for the question, Paul. Shadow banking was essentially the ‘Wild West’ of Chinese lending, without the normal standards or repayment etc applied. It simply assumed that the government would always bail out an over-indebted borrower – and so the lender could always get their money back if the borrower defaulted. Now the government is seeking to bring lending back under its control – and imposing tighter standards. Corporate defaults are therefore starting to appear, as described in this South China Morning Post piece https://www.scmp.com/economy/china-economy/article/3110903/chinese-authorities-warn-bond-issuers-they-cant-run-away

  3. Good question! To some extent exchange rates reflect interest rate differentials, so if US rates went lower than others, this might weaken the USD. But in reality, US rates have been higher than European rates for most of the year, but the USD has still fallen. So that probably isn’t the rationale today.

    We think the issue is probably more that we have been in a period of cyclical weakening of the USD, which has in turn been pushing liquidity into financial markets. Global tensions have been relatively low, so people haven’t felt the need to go into the USD as a ‘safe haven’. And the US economy has not been very strong, so people have tended to look for investment opportunities outside the US in the EMs and Europe, causing them to sell dollars.

    A typical feature of this process in the past has been that hedge funds will sell the dollar and buy commodities like oil, on the grounds that a lower dollar makes dollar-priced commodities cheaper for EMs. We’ve seen this pattern many times before since the central banks started their stimulus programmes, as there’s nothing like the prospect of free cash to encourage hedge funds to increase their leverage. The key ‘tell’ that this strategy is operating in the market is when futures prices rise sharply without any actual commodity shortages appearing in the market to suggest a supply/demand imbalance. And that is certainly the case today – storage tanks are filled with oil/products all around the world, but the price is still rising.

    Our conclusion is therefore that rates can impacts the USD at times, but that market focus changes from day-to-day and month-to-month, with other factors like the stimulus programmes or growth prospects all having their ‘day in the sun’. We would suspect that we are nearer the end than the beginning of the current cyclical move, so are watching for a change to occur, and for investors to start refocusing on a new trend. We will of course be highlighting this in Insight as/when it occurs.

    Hope this helps.

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