by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EDT] | PDF
Good morning! Today’s Comment begins with a quick observation on the market action following the CPI data. Next is our take on the midterm election results. Then, we point out the recent slowdown in the movement toward deglobalization. Lastly, we give an update on the downfall of FTX.
What the CPI Data Tells Us: CPI data for October came in less than expected (see the data section in the pdf) triggering some sharp moves in the financial and commodity markets. The most violent moves occurred in equities, with S&P futures jumping 3.5%. Treasuries also rallied strongly, with the 2-year yield dropping over 20 bps. But perhaps the key market indicator is the dollar as the DXY plunged nearly 200 pips after the release. Gold, often thought to be an inflation hedge, revealed its true nature as prices popped nearly $30 per ounce on weaker than expected inflation. Gold, like bitcoin (which also rallied) is a debasement, not an inflation hedge.
As we note below, yearly CPI is still 7.7% higher than last year. The fact that we can see such violent moves in markets on a rather modest improvement in inflation suggests that (a) there is still ample liquidity available to move markets on “good” news and (b) the data is raising hopes that the FOMC will be done soon, as shown by the rally in the 2-year T-notes.
We have doubts about this market move because we are less optimistic this data will change the Fed’s policy trajectory all that much. Today, as we note in the data section, we have a full slate of Fed speakers so we should have some insight soon on how at least some of the members of the FOMC view the report. We would look for some “fade” after this early move, but today does suggest there is a lot of liquidity and more investors seem worried about missing out on the rally rather than protecting themselves from further weakness.
The Red Ripple: Congress will likely narrowly split between the Democrats and Republicans, which should be favorable for equities.
- More results came in from Tuesday’s election. Currently, only three senate races have yet to be called. Georgia will head to a run-off; meanwhile, results for Arizona and Nevada are expected to be released later this week. In the House of Representatives, there are 33 races that have not been called, including 21 of the 53 most competitive races. Betting odds on Predictit.org show that the Democrats, as of the time of this writing, have an over 90% chance of winning the Senate, while Republicans are eight seats away from taking back the House. A split Congress came as a surprise to investors who were expecting a “red wave,” but in time this change should be viewed favorably by the market.
- Off the heels of the Democrats’ better-than-expected performance, President Biden announced that he wants to run for a second term.
- The market reaction was slightly lower as investors awaited more results to be announced. The S&P 500 stocks closed down 2.1% on Wednesday. Meanwhile, the election uncertainty contributed to the choppy trading of U.S. bonds. The yield of the 10-year Treasury, which moves inversely to its price, rose 2.5 bps to 4.151% the day after polls closed. However, Wednesday’s trading showed investors are still a bit wary about the outcome, but we do not expect that feeling to last long.
- A divided legislative branch is a net positive for equities as it reduces the likelihood of policy changes. It will be more difficult for the Democrats to push through another round of fiscal stimulus as the Republicans will look to block it. It will also strengthen the hand of Democrats that favor Ukraine-Russia peace talks. Last month, House Minority Whip Kevin McCarthy warned that Ukraine would not be given a blank check to fight its war. The lack of stimulus and a possible end to the war in Ukraine should remove some inflationary pressure and make it easier for the Fed to ease up on policy tightening.
- However, there is some downside risk. The lack of a solid Republican majority will allow fringe groups to potentially play party spoiler. As a result, the likelihood of a debt ceiling showdown is now elevated.
On Second Thought: There are signs that major countries are looking to slow the trend toward deglobalization.
- Moscow ordered its forces to leave the city of Kherson, an embarrassing setback for Vladimir Putin. Meanwhile, the U.S. is working behind the scenes to secure peace talks with Russia. The developments suggest that there is wavering support for the war in Ukraine; thus, there may be room for negotiations. Although we may point to Russian losses as the reason for the Kremlin wanting to start talks, Western support for restrictions, particularly on Russian energy, is far from solid. As a result, both groups have room to make concessions.
- A possible solution to the war in Ukraine would be favorable for equities as it should lead to fewer supply chain disruptions and stable pricing for commodities.
- In the United Kingdom, Brexiteers are starting to loosen their opposition to immigration. On Thursday, Next plc (NXT.L, £5,528) boss Simon Wolfson urged the government to allow more foreign workers to enter the country. As a backer of the leave camp during the Brexit vote, Wolfson’s comments are noticeable given the group’s strong anti-immigration stance. Therefore, his reversal may reflect a growing sense of regret that the U.K. left the European Union. Although it is unlikely that the U.K. will apply to rejoin the EU within the next decade, it does suggest that populist policies are starting to lose some appeal as the country struggles to find labor and cope with higher levels of inflation.
- The shift toward deglobalization is going to take a lot of work. In a free trade world, countries had access to cheap labor and relatively stable commodity prices. That said, the cost of maintaining these benefits came at the expense of higher inequalities within countries. Although it would be foolhardy to believe that the latest developments could lead to a reversal in the trend toward deglobalization, the recent push by governments to prevent further decline of international ties suggests that the world is still a long time away from a complete fracture. Assuming we are correct, it would indicate that a more regionalized world is still far away.
A Crypto Moment: FTX may be the digital currency version of Lehman Brothers.
- Major trading platform FTX is going bust. On Wednesday, Binance announced that it was pulling out of its deal to buy FTX. The breakdown in talks was related to the discovery of a big hole it found in FTX’s financial data. The platform has an $8 billion shortfall and needs $4 billion to remain solvent. The problem began when Coindesk reported that Almada Research, a trading desk for FTX, had more liabilities than assets and escalated when traders began offloading FTTs, the platform’s signature crypto tokens. The sell-off threatens to hurt other platforms that hold FTTs in their portfolio of crypto currencies.
- In another twist, U.S. regulators are investigating FTX over how it has handled customer funds.
- The rapid decline in FTX has spilled over into other digital currencies and crypto institutions. For example, Bitcoin has fallen below $17,000, and shares in Silvergate Capital (SI, $34.69), a financial bank for digital currencies, declined more than 7% on Wednesday. Meanwhile, investors pulled $700 million out of Tether after the stablecoin fell below parity with the dollar for the first time since July. The fragility of crypto markets is related to the lack of users for digital assets. As a result, the market is susceptible to runs as investors look to liquidate at the first sign of trouble.
- The biggest unknown from this development is how the regulators will interpret the turmoil. Unlike money market funds, crypto is not deeply integrated into the financial system. That said, the recent market crash could lead policymakers to pass legislation restricting these assets’ use as leverage in financial transactions. At this time, the likelihood of a possible financial crisis related to the downturn is minimal. However, the shift away from digital assets reflects investor preference for shorter-duration assets since they can provide quick returns.
- The crypto crisis is another example of how tightening financial conditions have negatively impacted risk assets. We expect these episodes to persist as long as the Federal Reserve continues to raise interest rates.