Week ended Sept 23rd 2022
Sterling hammered…along with everything else
Would any week be normal these days without markets bouncing around so violently that it is almost impossible to keep track of investor sentiment? We had volatility this week in droves throughout most corners of the global financial markets although the general direction of travel – keeping with recent trends – was down. The shifts were no better illustrated than on Wednesday, when US equities staged a relief rally following the FOMC decision and then proceeded to fall apart in the last hour or so of the session after investors became skittish about the (likely) future path of rate rises. That day alone, the S&P 500’s trading range was 3,789 – 3,907, with the decline peak-to-trough occurring in the last hour and 20 minutes of the session. The VIX briefly touched 30 that day, although generally the volatility index has remained in the mid/high 20s as equities head south in as orderly a fashion as could be hoped. I suppose I could highlight a number of other reasons leading to the poor performance of stocks and bonds, but the main culprit remains the harsh reality of continued central bank tightening and all the misery that entails. I wrote earlier this week about the possibility of the S&P 500 dipping to 3,200 (as one reader had suggested), and it certainly felt after this week that we might be travelling towards that destination with increasing conviction.
If the slide in equities and bonds weren’t enough, Sterling and UK Gilts (government bonds) came under extreme pressure towards the end of the week, with the catalyst being new PM Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng announcing a package of tax cuts that will significantly increase UK debt. I cannot for the life of me figure out why the government would come up with a package of fiscal stimulus measures like this at the same time that the Bank of England is tightening monetary policy in order to rein in inflation. The market showed what it thought of this rather absurd approach by hammering both UK Gilts and Sterling on Thursday and Friday. Sterling fell to its lowest level in over 40 years ($1.086/£1.00 close), whilst the yield on the 2y UK Gilt increased 68bps on the week, with 41bps of that increase coming on Friday alone as market sentiment soured dramatically.
This leads me into the other ongoing story driving markets – the (seemingly) ever-strengthening US Dollar. The USD-USDX index closed Friday at 112.08, its highest in 20 years. Putting aside the divergence in monetary policy by the Bank of Japan (vis-à-vis the Fed, BoE and ECB), the US Dollar is clearly benefiting from a relatively stronger US economic outlook and a flight-to-quality as risk appetite wanes. The US Dollar was up 3.1% this week, with the greenback strengthening even though the Bank of Japan (finally) announced on Thursday that it would intervene in the foreign exchange market by buying Yen/selling USDs to stabilise Yen. This intervention brought some relief to Yen, but it proved to be short-lived, with Yen/Dollar still declining 0.3% on the week. The BoJ refuses so far to back off of its nil (–0.1%) overnight bank rate and yield curve control (10y JGB =< 0.25%) policies, preferring intervention in the FX market rather than tightening monetary policy like most other central banks. The strengthening US Dollar is claiming other victims too, with Sterling slipping to $1.086/£1.00 and the Euro to €0.969/$1.00 to end the week. With the Pound is at its lowest level since 1985, it’s hard to believe that Sterling briefly topped $2.00/£1.00 in 2007. As for the Euro, it has broken parity as resistance has finally crumbled and is at its lowest level in 20 years.
The misery was wide-spread and reached all corners of global financial markets this week, as you can see by the red in the summary table below.
Whatever mix of stocks and bonds you want to suggest, it hasn’t really worked this year with – for example – the returns on the S&P 500 and 20+ year UST total bond indices down 24.0% and 27.7%, respectively, YtD. From a portfolio perspective, these dismal correlated returns in traditional asset classes raise valid questions about the value of cash now that short-term yields have risen, as well as the attractiveness of (low correlation) alternative assets, including private debt and equity, fine art, wine, classic cars, collectible coins and stamps, and so forth. These are areas I will be writing about in the coming weeks since they should are garnering more attention.
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
Central banks tighten everywhere (except Japan)
Although most focus might be on central banks in larger economies, the Riksbank set the stage early in the week for a string of central bank rate decisions by bumping its overnight borrowing rate 100bps (to 1.75%) as the Swedish central bank tries to tame 9% inflation, which remains at a three decade high. The Fed and the Bank of England followed by increasing the Fed Funds and Bank Rate by 75bps and 50bps, respectively, to 3.00%–3.25% (US) and 2.25% (U.K.).
US equities initially rallied on the FOMC decision (here), a sort of relief rally. However, as investors began to digest the rate rise along with the Fed’s revised Summary of Economic Projections (here), they changed their tune. The infamous dot plot (p.4 of Economic Projections, extracted below) suggests a terminal rate of the Fed Funds rate next year in the range of 3.9% to 4.9%, and this spooked markets as US Treasuries tanked along with US stocks.
The BoE rate rise was a non-event to me, largely because expectations for the U.K. economy are so poor anyway. The Monetary Policy Decision released Thursday is here. Somehow, U.K. equities remain less volatile and slightly more resilient than US equities, which is a reflection I suppose of the composition of the FTSE. What I find more interesting in the UK is how investors will ultimately respond to new PM Liz Truss’s aggressive fiscal programmes to “rescue” the slumping economy. As I mentioned earlier, I find it very difficult to reconcile how fiscal policy can push one direction and monetary policy the other. It is worrisome because of the threat of the government messing about with central bank independence. To be fair, perhaps these conflicting measures matter less in the UK at the moment because its seems inflation is coming down, consumers are pulling in their horns, and it feels like we are in a recession already. That’s hollow logic though given the beating that Gilts and Sterling took on Friday.
I mentioned earlier that the Bank of Japan did not change its dovish approach, holding the bank policy rate at –0.1% and engaging in yield curve control to maintain the yield on the 10y JGB at 0.25% or less. You can find the Statement of Monetary Policy released by the BoJ here.
Citrix Systems leveraged buyout financing – FAIL
The failed syndication and take-out bond financing for the Citrix Systems leveraged buyout, well covered by the financial press, has caused ripples throughout the leveraged finance and LBO markets. The Citrix transaction is the largest and most visible sign yet of cracks starting to form in the global credit markets, even though credit spreads remain reasonably resilient so far. In summary, the LBO of Citrix by Vista Equity Partners and Elliott Partners announced in January 2022 included around $15 bln of debt underwritten by three banks: Bank of America, Goldman Sachs and Credit Suisse. The $8.55 billion of senior bank debt ($4.55 bln) and high yield bonds ($4 bln) were sold this week at significant discounts (mid-80s) resulting in large losses for the leads, reported to be around $600 million The banks remain long a large chunk of the remaining debt, too. Matt Levine provided some terrific commentary in Bloomberg Opinion which you can find here. These failed syndications cause severe collateral damage in the acquisition debt financing market and bring down headline acquisition prices, yet another indication of asset prices deflating as the pandemic-stimulus period fades.
Banker bonus cap (UK)
As a former banker, I feel obliged to say something about one specific feature in the proposed mini-budget from PM Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng – removing the bonus cap on bankers compensation. Lifting the bonus cap is an interesting idea but would remove an easy target of politicians and media in the UK that quite enjoy bashing overpaid bankers. What I never understood in the first place is the economic rationale – other than a form of after-the-fact punishment for bankers following the GFC – that the EU (including the UK at the time) had in mind in adopting a cap on bankers’ bonuses (two times salary) in the first place. The bonus cap led to nearly every senior banker worth their salt in Europe getting a significant bump in base salary, such that their total remuneration (including a lower bonus) remained about the same. In other words, banks significantly raised the fixed component of their employee costs making the banks more vulnerable to a market downturn since they would be saddled with higher fixed costs. I never completely understood how this made any sense at all, since most bankers were happy to have their salaries – the non-variable component of their remuneration – double or triple overnight in exchange for a lower bonus, even as total remuneration remained about the same. However, a bonus cap sure made politicians in Brussels happy and provided satisfaction to those that wanted to punish bankers following the GFC. In summary, the bonus cap is stupid and should be lifted.
Below are some of the key data releases and other financial events that matter for the weeks ahead.
There’s not a lot of meaningful economic data as the month draws to a close next week, although eyes will be very much focused on US housing price data (largely Tuesday) and the Fed’s preferred measure of inflation, the PCE on Thursday
S&P 500 earnings – most initial focus to be on banks which begin reporting 3Q22 earnings on Friday, Oct 14th (JPM, MS, WFS, CITI) (BoA on Oct 17th and GS on Oct 18th)
End of quarter rebalancing will like cause heightened volatility towards the end of next week, especially on Friday
Upcoming central bank meetings (and last one of year):
ECB – Oct 27th (next and Dec 15th)
Federal Reserve – Nov 1-2 (next Dec 13-14)
Bank of England – Nov 3rd (next Dec 15th)
Bank of Japan – Oct 27-28 (next Dec 19-20)
Corporate bonds (credit)
Safe haven and other assets
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