Thursday, June 30, 2022

5 things to start your day

Good morning. Putin swoops on key gas plant, travel chaos widens, a milestone in crypto rules and a royal subsidy. Here's what people are ta

Good morning. Putin swoops on key gas plant, travel chaos widens, a milestone in crypto rules and a royal subsidy. Here's what people are talking about. 

Putin Swoops

President Vladimir Putin signed a decree to transfer rights to the Sakhalin-2 natural gas project to a new Russian company, a move that could force foreign owners including Shell to abandon their investment in the facility. The decree cites threats to Russia's national interests and economic security. The move could prove complicated for Shell, which holds a 27.5% stake in the liquefied natural gas facility in Russia's far east. The energy giant announced it would exit the project after Russia invaded Ukraine and that it wouldn't commit to any new investments in the country. In other war-related developments, Ukrainian President Volodymyr Zelenskiy praised the departure of Russian forces from Snake Island in the Black Sea. Ukraine, meanwhile, is exploring the possibility of debt restructuring with funding options at risk of running out.

Can't Fly

The chaos that has plagued the European travel industry for weeks is coalescing in France as staff at Paris-Charles de Gaulle airport plan to strike for the second day in a row Friday and a country-wide rail walkout looms next week. France's civil aviation authority ordered the scrapping of 17% of flights through the hub between 7 a.m. and 2 p.m. Friday after talks between unions and management at airport operator Aeroports de Paris failed to reach a wage deal. As demand surges, airports and carriers in Europe have been forced to reduce flight schedules due to staffing shortfalls. Just a day before, London Heathrow asked airlines to cut 30 services, citing concern that peak passenger numbers would exceed levels it could safely handle. 

Landmark Crypto Rules

The European Union late Thursday reached a provisional agreement on its landmark Markets in Cryptoassets directive, bringing years of debate on how to regulate the digital-asset industry to an informal close. The key legislation will regulate the crypto sector with common rules across all 27 member states, marking the first time globally that lawmakers have attempted to supervise the sector on such a scale. The European Parliament, Council and Commission approved new provisions on the supervision of cryptoasset service providers, consumer protection and environmental safeguards for cryptoassets, including cryptocurrencies like Bitcoin and Ether. 

Royal Subsidy

UK taxpayers will pay an additional £27.3 million ($33 million) over the next two years to plug a funding gap at the royal family and cover a drop in profit at the Crown Estate, which helps pay their expenses. Demands for more government cash follow a 17% increase in spending by the royals last year and comes at a time when the average UK household income fell for the longest period since records began in 1955. Family incomes are 1.3% lower than the year before, and public-sector workers have walked off the job in protest against pay offers below the current rate of inflation.

Coming Up…

European stocks may face a gloomy day after Asian stocks and US equity futures fell Friday while bonds extended a rally amid a looming economic slowdown that drove another bout of risk aversion. Treasuries added to gains -- leaving the 10-year yield below 3% -- in the wake of softer than expected US consumer spending and inflation. The stand out data release is for euro-area inflation, which could reach a new record above 8%.

What We've Been Reading

This is what's caught our eye over the past 24 hours. 

And finally, here's what Cormac is interested in this morning

Global stock investors are over the first half hump and enthusiasm is scarce on the ground, with one glaring exception -- China. An MSCI gauge of the country's stocks finished the half on the front foot, climbing almost 6% in June despite the near 9% slump in the equivalent AC World Index. Easing Covid restrictions have boosted sentiment and a Bloomberg survey of 19 fund managers and analysts predicts that benchmark stock indexes in China and Hong Kong will post gains of at least 4% by year-end to outperform their global peers. The iShares MSCI China ETF lured $333 million on Wednesday, its largest single-day inflow since the fund's inception in 2011. Valuations still look relatively attractive versus global peers with Chinese stocks trading at a more than 2 point price-earnings discount although the gap was over 8 points in March. Still, the upbeat forecast for Chinese equities stands in stark contrast with the more negative outlook for US stocks, with Morgan Stanley and Goldman Sachs among those predicting that Wall Street will see further declines.

Cormac Mullen is a Deputy Managing Editor in the Markets team for Bloomberg News in Tokyo.

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Brussels Edition: Record inflation

Welcome to the Brussels Edition, Bloomberg's daily briefing on what matters most in the heart of the European Union.Euro-area inflation is p

Welcome to the Brussels Edition, Bloomberg's daily briefing on what matters most in the heart of the European Union.

Euro-area inflation is poised to set another record when details are published this morning, with economists predicting an 8.5% annual rate for June that will prime the European Central Bank for its first interest-rate increase in more than a decade. The lofty number will follow a series of mixed national figures from around the region. Spain reported an eye-watering 10% — the first double-digit reading in a major euro economy. By contrast, Germany's 8.2% rate and 6.5% in France were in line with or below what economists expected. ECB officials will crunch the data as they debate whether their July 21 decision will be for a quarter-point hike or something even bigger.

Craig Stirling and Katharina Rosskopf

What's Happening

Gas Worries | Securing Germany's gas supply for the winter will be a "tight calculation," Economy Minister Robert Habeck warned, adding that gas is still flowing into storage sites because the government is willing to pay high prices. Storage facilities are about 60% full, and need to reach above 90% for the winter heating season, said Habeck.

Gas Threat | The ECB plans to ask the region's lenders to factor in the economic hit of a potential end to Russian gas supplies when considering payouts to shareholders. "We will propose to ask banks to recalculate their capital trajectories under a more adverse scenario including also potentially a gas embargo or a recession," said Andrea Enria, who heads the central bank's supervisory board.

Joint Debt | The EU should seek more resources to face the fallout from Russia's invasion of Ukraine and a host of growing domestic emergencies and global crises, according to Janez Lenarcic, commissioner for crisis management. Options include a new joint borrowing scheme, similar to the bloc's response to the Covid-19 pandemic, or setting up a trust fund.

Lower Burden | The EU should also urgently cut fuel taxes, taking its cue from a US plan unveiled by President Joe Biden last week, according to the European People's Party. The bloc should provide some direct relief to citizens through a similar "holiday on fuel taxes" within the existing EU taxation framework, EPP Chairman Manfred Weber wrote to Economy Commissioner Paolo Gentiloni.

Parliament Power | The leftist alliance opposed to President Emmanuel Macron's economic agenda will chair the influential finance committee in the French parliament after Eric Coquerel was chosen to head the panel yesterday. The committee can request access to documents that are normally off limits, and hamstring the legislature with inquiries.

In Case You Missed It

Gas Setback | As host of the G-7 this week, German Chancellor Olaf Scholz pushed his counterparts to agree on a deal that opens the door for new gas investments, disappointing his own climate envoy, Jennifer Morgan. "It's not what I would have hoped to have seen the G-7 do," Morgan told us after leaders effectively weakened a commitment just last month to end such financing by the end of this year.

Carbon Fix | The EU suggested changes to its 20 billion-euro plan to finance a shift away from Russian fossil fuels, seeking to alleviate member states' concerns over the way funds from a carbon market-based tool will be distributed. France yesterday proposed a new method of assigning to countries revenues from extra sales of emissions permits, after a group of governments strongly opposed the original allocation key used in a post-pandemic recovery fund.

Crypto Rules | The EU reached a provisional agreement late yesterday on its landmark Markets in Cryptoassets (MiCA) directive, bringing years of debate on how to regulate the digital-asset industry to an informal close. The key legislation will regulate the crypto sector with common rules across all 27 member states, marking the first time globally that lawmakers have attempted to supervise the sector on such a scale.

Tax Hopes | French Finance Minister Bruno Le Maire said the EU can deliver the global minimum corporate tax with or without the support of Hungary, circumventing Budapest's veto earlier this month just as the bloc was on the brink of a agreement. "Europe can no longer be held hostage by the ill will of some of its members," Le Maire said.

New Zealand Deal | The EU and New Zealand yesterday sealed a trade deal that was four years in the making, eliminating tariffs for a wide range of products including wine and chocolate. Bilateral trade may increase by 30%, or 4.5 billion euros, per year, Commission Vice President Valdis Dombrovskis said.

Chart of the Day

German unemployment unexpectedly rose in June, snapping 15 straight months of declines. The number of people out of work jumped by 133,000, lifting the jobless rate to 5.3% — the highest since November. Economists had estimated a drop of 5,000. "These increases are due to the fact that Ukrainian refugees are now being recorded in the job centers and are therefore visible in the labor-market statistics," Federal Labor Agency chief Detlef Scheele said.

Today's Agenda

All times CET.

  • 8.30 a.m. Commission President Ursula von der Leyen to address Ukrainian parliament
  • Von der Leyen and Council President Charles Michel join EU commissioners in visit to Prague to celebrate the beginning of the Czech presidency

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Cuban Crisis Parallels Give Stocks a 1962 Look

The Fluctuation of 2022The stock market — the daytime adventure serial of the well-to-do — wouldn't be the stock market if it didn't have it

The Fluctuation of 2022

The stock market — the daytime adventure serial of the well-to-do — wouldn't be the stock market if it didn't have its ups and downs. Anyone knows that the elder J.P. Morgan, when asked to predict the market, said: "It will fluctuate."

That is how John Brooks chose to start his book Business Adventures. Now something of a classic, Warren Buffett is on record as saying it is his favorite book about finance. It starts by telling the story of 1962, when the US stock market suffered its worst selloff since the Great Crash of 1929. Little remembered, the crash of 1962 now has a fresh distinction. This year's first half, thankfully over, has been the worst start for stocks since the war — except for 1962. This is how the two years compare: 

Can history be any guide? In 1962, the bottom was hit in late June, and anyone buying then would have made 15% by the end of the year. However, they would have had to wait for the peaceful resolution of the Cuban missile crisis before the market made a convincing recovery. Overall, it was still a bad year, with the S&P shedding 11%.

Worries about nuclear conflict have probably been canvassed more in 2022 than in any of the 60 years since, which helps explain the backdrop of low confidence. There's much appeal in the suggestion by my colleague Kriti Gupta that we might have to wait for some clear settlement to the Ukraine conflict before there is any durable recovery — just as markets needed to know that Kennedy and Khrushchev had stepped back from the brink before stocks rallied 60 years ago. 

Then as now, price declines were led by falling multiples, which had started at an over-expensive level. As the chart shows, the two years look startlingly similar in this respect. Encouragingly, the S&P 500's price-earnings ratio hit a low on June 29 in 1962. Less encouragingly, the tumble 60 years ago looked much more like a cathartic end to speculative excess, thanks in large part to a true crash in late May. Despite everything, there's no such clear catharsis this time. Indeed, the exercise if anything suggests that the definitive decline still lies ahead — markets tend not to crash from a high, but when they have already clearly started to head down. Valuation isn't as excessive as it was, for sure; but it's hard to argue that it's now at a robust sustainable level:

If multiple compression still has a way to go, the question of earnings is more insistent. P/Es are backward-looking, while prospective P/Es tell much the same story and are based on forecasts that currently look rosy. In 1962, profits proved robust; that might happen again, but it's probably the most important question hanging over stock markets. 

Broader historical parallels are intriguing. Brooks, writing half a century ago, went out of his way to explain just how technologically advanced and vast the US stock market had become:

By a heaven-sent stroke of prescience, Merrill Lynch, which handled over thirteen per cent of all public trading on the Exchange, had just installed a new 7074 computer — the device that can copy the telephone directory in three minutes — and, with its help, managed to keeps accounts fairly straight. Another new Merrill Lynch installation — an automatic teletype switching system that occupied almost half a city block and was intended to expedite communication between the firm's various offices — also rose to the occasion, though it got so hot that it could not be touched. 

Along with panic came near chaos. Whatever else may be said about Tuesday, May 29th, it will be long remembered as the day when there was something very close to a complete breakdown of the reticulated, automated, mind-boggling complex of technical facilities that made nationwide stock-trading possible in a huge country where nearly one of out of six adults was a stockholder. Many orders were executed at prices far different from the ones agreed to by the customers placing the orders; many others were lost in transmission, or in the snow of scrap paper covered the exchange floor, and were never executed at all. Sometimes brokerage firms were prevented from executing orders by simple inability to get in touch with their floor men. 

This was how trading was done then. The critical problem was with the tape — as in the physical paper tape that recorded all stock trades — which was already 56 minutes late by 12:45 p.m. on that fateful day, when the market hit bottom and turned. Therefore, "the ticker was engaged in informing the stock market community of a selling panic at a moment when what was actually in progress was a buying panic." 

Fast forward, however, and the concerns are similar. In 1962, there was concern over margin calls, and over the risks that holders of mutual funds, a new-fangled instrument gaining in popularity, might all sell and create a downward spiral. This seems very similar to worries about ETFs now. Then, the greatest concerns were whether the technological infrastructure and innovative financial instruments would work when put under pressure. They came through the test 60 years ago. Today's technology is far more advanced, but so are the demands. The question remains the same: Will the market infrastructure be able to deal with what lies ahead, or will it buckle and create a far worse crisis? 

The Madness of 2008

Meanwhile, there's another historical echo that I find disquieting. One of the best trades this year has been to bet against banks while pouring money into oil. This is pursuing the narrative that inflation and higher rates will pummel banks and the rest of the financial system, while there is money to be made from sticking with the boom in commodities. A trade of going long WTI oil futures while shorting the KBW index of big US banks would have almost exactly doubled your money.

What worries me is that this is an almost perfect repeat of 2008, the year of the Lehman Brothers bankruptcy. At this point then, the long oil/short banks trade had done even better (although 2022 did outpace it for five months). The top lasted another two weeks as oil hit a record that still stands. Then, as the chart shows, the trade collapsed spectacularly. Oil fell so far that by the end of the year it had underperformed bank shares:

No particular news sparked the end. The trade just collapsed under the weight of its own contradictions. If financial conditions were bad enough to push banks into crisis, there couldn't possibly be enough demand to sustain a record oil price. This time around, the Russian invasion of Ukraine provided a clearer justification for rising oil prices. But the same arguments hold. Higher oil prices can be expected to attract more supply, and to choke off demand. 

A resolution in Ukraine could well create relief along the lines of the 1962 missile crisis. But it would be really bad for those who've been surviving 2022 by betting on oil and against banks.

A Buying Opportunity?

Should we buy? A range of equity strategists say yes. At the outset, with the S&P 500 close to 4,800, a number were calling for a down year, with Morgan Stanley and Bank of America Corp. the most conspicuously bearish of the big houses. Since then, virtually all have cut forecasts for the year-end (with the exception of UBS Group AG, whose 4,850 prediction remains unchanged). I'm grateful as ever to Aneet Chachra of Janus Henderson Group Plc for putting together the following chart. Estimates are not only reducing, but have also become more dispersed:  

However, all the strategists Chachra looked at implicitly believe the selloff has now gone far enough. From Thursday's close, all have predictions that involve a gain by the end of the year. Some see profits of almost 30% in six months:

Earnings estimates produced by the strategists' colleagues have been widely criticized as unduly optimistic. Overall, profit forecasts for the whole of 2022 remain slightly higher than at the beginning of the year, despite factors such as sharply higher rates and a much less favorable dollar exchange rate. While the tone is negative, top-down strategists are also more optimistic than they seem.

Either both top-down and bottom-up Wall Street analysts have slipped behind and will grow more pessimistic as they publish revisions, or there's more reason for confidence than at first appears. It's hard to see this as a major low for sentiment among professional investors.

Peak Inflation?

The half ended with an exciting shift in the bond market. Bets are now moving heftily to discount a Fed hiking program that is completed by early next year, followed by a series of cuts that will be well underway by the end of 2023. As a result, bonds rose sharply as stocks sold off. The effect had dissipated by the end of the day. Long bonds, as represented by the TLT exchange-traded fund, had still underperformed stocks (proxied by the SPY ETF) for the year so far. But it was close at the end:

If the emerging new consensus is proved right, then this should be a very good time to buy bonds, while stocks should be avoided. Is it right?

The latest data do offer some support. US personal spending rose only 0.2% last month, much below expectations. Even though consumers are flush with cash and the economy is reopening, they're still not spending much.

Meanwhile, jobless claims continue to rise. Based on the four-week moving average, the second quarter saw greater percentage growth than any since 1974 (with the significant exception of the first quarter of 2020, when Covid drove an increase in claims of more than 800% —  I excluded that quarter from the chart below because it would have rendered the whole thing illegible):

There are still plenty of stories of labor shortages, and claims are increasing from a low base. But it's what happens at the margin that matters most in economics, and new claims have plainly started to rise again. If this continues, then predictions that the Fed is forced into a U-turn on rates within 12 months could easily be fulfilled.

Another data point to cause excitement was the May personal consumption expenditure deflator. On both a monthly and year-on-year basis, PCE avoided increases and came in lower than expected. That also offers support to the notion that the peak for inflation is in at last. Even if inflation remains high, on this argument, the change in direction is the crucial point.

I fear this reading may be too optimistic. The Fed sets great store by "trimmed mean" estimates, in which the greatest outliers in either direction are excluded, and an average is taken of the components that remain. For statisticians, there's a good argument that the trimmed mean PCE is the best pure measure of underlying inflationary pressure. 

The Dallas Fed calculates trimmed mean PCEs over 12 and six months, and one month. The results aren't great:

On a year-on-year basis, inflation is its highest since 1990. Month-on-month, it dropped in April, but bounced straight back in May, at a rate equivalent to 5% per year. The measure is below its peak earlier this year, but higher than any other reading since 1990. 

A year ago, the Dallas Fed measures were popular with what was then known as "Team Transitory"; they showed core inflation staying under control below 2% well into 2021. Now, this measure tells an uglier story. 

A year ago, the narrative of "Team Non-Transitory" was that extreme price moves would steadily dislodge inflation expectations, and lead to a steady broadening of price pressures. The Dallas Fed numbers, unfortunately, are telling exactly that story. 

Inflation and the jobs market may be gently pivoting in different directions. But neither is certain yet. The decline in bond yields looks premature.

And Finally: Factoid of the Year (So Far)

I try to make this newsletter about actionable and sensible ideas. But it's always fun to see what totally absurd and "out there" ideas might have worked. And one of the best trades of the last six months is simply astonishing. Here goes.

Contrarian trade of the year so far has to be buying the Russian ruble. Its recovery from the brief disaster caused by the invasion of Ukraine has been phenomenal. This is the number of US dollars needed to buy a ruble over the last five years:

If you saw that coming, well done. I certainly didn't. Now let's look at the other eye-catching currency of the last six months: bitcoin. It's less surprising that the leading cryptocurrency has taken losses this year, as it has always been intensely volatile. But the scale of the downturn, just as the crypto complex appeared to be coming of age, has taken many by surprise. Here is bitcoin over the last five years:

To make yourself very rich over these difficult last six months, all you needed to do was put these trades together. A short bitcoin/long ruble trade would have moved into orbit since Jan. 1:

So if you used bitcoin to buy rubles at the beginning (a profit of almost 250%), or especially if you did so at the ruble's nadir in March (460%), then hats off. Although perhaps I shouldn't be too effusive. Bitcoin and rubles made for a great investment this year, but a sizeable chunk of demand for both is for not totally above-board purposes.

That aside, if anyone out there saw the ruble as the big gaining currency of the first half, and also foresaw the crypto meltdown, well done. I'm guessing that this trade won't do quite as well over the next six months, though.

Survival Tips

America is about to take a break for July 4. It's a great festival. For a range of songs about the great country that gave the rest of the world jazz, the blues, rock 'n' roll and hip-hop, try this fascinating collection for a "more pensive" Independence Day. Or you can enjoy the most glorious piece of music yet to celebrate how America became independent and then built a new country; Lin Manuel Miranda's Hamilton. Have a good weekend everyone, even if you're not one of the ones who celebrate an independent America. 

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