Market Mayhem (19/03/22)
Rate Hikes, the Oil Dilemma, and Chinese Stocks
Dear Readers,
I hope you are all well and wish you a nice weekend.
Blitz Finance just hit 500 subscribers, for which I am deeply grateful. It is rewarding to know that you value the content I put out each week.
I recently finished reading Michael Lewis’s ‘Liar’s Poker'. I found it both absurdly funny and surprisingly informative, and I wholeheartedly recommend it to you. It definitely changed my expectations of a career in finance.
Now, I’m immersing myself in ‘The Big Short: Inside the Doomsday Machine’, which is certainly more pessimistic - although brilliant - and written by the same author. IN my experience, the book is almost always better than the film, and I’ll update you when I finish it.
As mentioned last week, I am approaching a busy time. For now, you can continue to expect the Market Mayhem posts, and I will try to surprise you with a value pick as soon as possible.
Kind regards,
JL
Central Bank Rate Hikes
This week, the Fed raised its target federal funds rate (FFR) by 25 basis points to a range of 0.25% to 0.5% in order to combat record inflation of 6.4% YoY (the core CPI, which excludes volatile food and energy prices) and spiralling wages (5.8% YoY).
Another key measure - the unemployment rate - is at pre-pandemic levels of 4.2%. 8 members of the FOMC voted in favour of the rate increase, with 1 dissenter having demanded a larger hike.
The FFR describes the interest rate at which banks lend money to each other overnight. To give context, banks are required to hold a certain percentage of their deposits in interest-free accounts with the Fed. This reserve requirement ensures that they can fulfil deposit withdrawals and credit obligations. But any cash that exceeds the required reserve is available for lending to peers, who may, for example, need this to make up their own reserve shortfalls. Importantly, the target FFR set by the Fed - which cannot directly manipulate supply-demand in the overnight lending market - tracks the effective FFR quite closely.
In addition, after putting a stop to its pandemic-relief bond purchase program, the Fed announced that it would finalise plans to shrink its $9 trillion-dollar asset portfolio at its next meeting around the 3rd-4th of May. Implementation of the plans would follow shortly afterwards.
To cover some economic basics (watch this excellent video), raising rates would make debt - which is absolutely crucial to the economy - more expensive for corporations and individuals, and thus less attractive. In contrast, saving becomes more attractive.
The overall effect is that spending is reduced which, in turn, reduces inflation. But remember that one person’s spending is another person’s income, so the possibility of a recession is real. This is the fine balance that the Fed needs to maintain here.
Below we can see the Federal Open Market Committee’s (FOMC) most recent expectations of how the FFR will change going forward (green line). Rate expectations have increased as compared to those originally outlined at the FOMC’s December meeting in 2021 (grey line).
Across the pond, the Bank of England has already bumped rates by 25 basis points three times since December, putting the central bank at the forefront of hawkish monetary policy. The UK imports most of its energy and is thus more exposed to energy prices spiralling due to the Ukraine-Russia crisis than the U.S. The latest CPI for the UK (January) came in at 5.5% YoY, but further rate hikes are unlikely for now as their impacts already appear stronger than expected.
Renewed lockdowns in China are sure to be another concern for monetary policy makers around the globe.
The Oil Dilemma
At the end of World War II, the U.S. agreed to protect Saudia Arabia and export arms to the nation in exchange for privileged access to its oil. That oil was provided primarily by Saudi Aramco. The state-owned firm still holds the record for the largest IPO haul ever, with $26 billion having been raised in its 2019 debut. It also raked in $89 billion in net income in the past twelve months on $310 billion of revenues.
But this important relationship has recently soured, with areas of contention including:
U.S. accusations that the Saudi crown prince ordered the murder of Jamal Khashoggi.
The spontaneous withdrawal of U.S. troops from Afghanistan.
The lack of U.S. support for Saudi intervention on behalf of Yemen’s government in the nation’s civil war.
Now, the Saudis are considering pricing some oil sales to China in Yuan, and creating Yuan-denominated futures contracts known as ‘petroyuan’. This would undermine the dominance of the Dollar not only in international oil markets (where it currently accounts for about 80% of transactions), but also in the wider financial system. Naturally, it would also strengthen China’s Yuan.
“The oil market, and by extension the entire global commodities market, is the insurance policy of the status of the dollar as reserve currency.”
“If that block is taken out of the wall, the wall will begin to collapse.”
- Gal Luft, Co-Director of the Institute for the Analysis of Global Security
But these talks have been ongoing for years, and the Saudi Arabian economy would be vulnerable to the move. Its currency, the Riyal, is pegged to the U.S. Dollar, ensuring that it rises and declines in tandem with the latter. Furthermore, in 2020, 70% of Saudi Arabia’s export value was oil-related, and oil comprised 53% of the government’s income (Energy Information Administration). Any screw ups in this business could wreak serious havoc.
So, these very public talks appear to be a political tool to force the U.S. to reconsider its stance towards the nation and remember both its unquenchable thirst for oil and rivalry with China. Frankly, as the world’s largest exporter of oil, the Saudi Arabian government would be foolish not to use its leverage.
As to the wider context, oil prices remain extremely volatile. People will instantly point to the Russia-Ukraine crisis as the cause, but everything is more complicated than it seems. Indeed, other influences include the aforementioned cozying up of Saudi Arabia to China, hawkish central banks, China’s renewed lockdowns, the Iranian nuclear deal (if completed, this could bump Iranian oil sales), etc.
It does seem that there will be a supply deficit in the near future, leading several nations to urge OPEC to boost output.
Chinese Stocks Remain Volatile
Public companies headquartered in China have faced negative sentiment for several months, with possible factors including:
Chinese regulators eviscerating the for-profit education sector and cracking down on near-monopolies like Alibaba and Tencent.
U.S. regulators threatening to delist Chinese firms unwilling to comply with financial inspections from U.S. supervisory institutions.
Geopolitical risks, especially in view of Western sanctions triggered by the Ukraine-Russia crisis. This has some investors worried that China could be disconnected from the global financial system also, especially if it aligns itself with Russia.
Naturally, this has resulted in negative returns. But this week, Chinese authorities including Xi Jinping’s top economic adviser announced market friendly policies and general intent to keep capital markets functioning smoothly.
The recovery was rapid, with the NASDAQ Golden Dragon index - which represents U.S.-listed Chinese firms that do most of their business in their home country - gaining about 43%. The more diversified mainland CSI 300 gained circa 7%.
Now, I admit that I would be on the side of those who stray from investing in China; the extra risk is simply unnecessary from my view. But I can still acknowledge that these movements appear to be a perfect example of short-term investor ‘voting’. In fact, the CSI 300 currently trades at a seemingly undemanding P/E and EV/EBIT ratio of 15x.