Today, the Federal Reserve announced that it sent $107.4 billion of income earned from its QE-bloated portfolio to Uncle Sam last year, up from $86.9 billion in 2020. 

Also, today, The Wall Street Journal reported on a lawsuit led by Texas Attorney General Ken Paxton and joined by over a dozen other states against Google. The search giant, plaintiffs allege, rigged online ad markets to enrich itself at the expense of customers: “under Google’s Bernanke program, AdX would at times knock out the second-highest bid, allowing the third-highest bid to win, thus depriving the publisher of revenue, according to the complaint. At the same time, Google would charge advertisers the price of the second-highest bid and pocket the difference,” the complaint said.

Why the Google coders would deem the initiative “Bernanke” remains a mystery. 

Overseas has been the place to be so far in 2022, as the MSCI World ex-USA Index has enjoyed 380 basis points of outperformance compared to the MSCI USA Index in the month-to-date through yesterday.  That’s on track for the best relative monthly performance for non U.S. equities since November 2020.  The recent trend is broad-based, as 90% of foreign markets have outperformed the S&P 500 over the last 21 trading days, data from Sentimentrader show. 

Might the foreigners’ fast start represent a blip on the radar, or perhaps augur the reversal of a long-term bias towards buying American? The MSCI USA Index sports a $41.9 trillion market cap, compared to $19.7 trillion for the MSCI World ex-USA Index, which tracks other developed markets across the globe. That 68% market share for United States stocks compares to less than 50% in 2010 and 37% in 1995.  

Talk about a New Year’s resolution. “The year 2022 will be one of turnaround, stability and one where things get back on track,” Turkish Treasury and Finance Minister Nureddin Nebati told Bloomberg today.  “We resolved the exchange rate issue,” the freshly-installed cabinet member declared, referring to President Recep Tayyip Erdogan’s announcement last month that the government would compensate citizens for FX-related losses on deposits of at least three months. Since that decree, the Turkish lira now trades at 13.55 per dollar, compared to the 16.41 nadir logged in mid-December but well off the sub 9:1 exchange rate from early October.   

With the currency problem ostensibly solved, the emboldened Nebati went on to predict that “we’ll enter the general elections in June 2023 with single digit inflation.” Official CPI logged a 36% annual advance in December, following a counterintuitive easing cycle from the Central Bank of the Republic of Turkey on the orders of easy money aficionado Erdogan, pushing the benchmark one-week repo rate to 14% from 19% in August. 

As the political class patiently waits for the tide to reverse, citizens deal with the fallout of Erdogan’s inflation-stoking policies.  Today, a dozen members of the BBC’s Istanbul bureau commenced a strike after rejecting their employer’s proposed 20% raise for calendar 2022.  The Journalists Union of Turkey (TGS), which represents the disgruntled employees, added in a statement that “the currency’s collapse has reduced the cost to the BBC of the Istanbul’s staff wages. . . by nearly half.” 

The lira’s precipitous price action could pose still larger problems for the government.  The CBRT disclosed a week ago that it burned through $7.3 billion in foreign reserves last month in open market operations designed to prop up the value of the lira. That leaves net reserves at just $7.9 billion, while analysts at Goldman Sachs peg net reserves at negative $66 billion after accounting for funds borrowed from domestic lenders and foreign central banks.  

Indeed, any further round of protracted lira weakness could spell trouble for the local financial system, as some 30% of Turkish bank loans were denominated in foreign currency as of the end of 2020, analysts at S&P Global observed in December. “Balance of payment and related financial stability risks are rising,” the rating agency warned.  

An increasingly volatile political environment further muddies the waters for the second-largest component of the $20 billion iShares J.P. Morgan USD Emerging Markets Bond ETF. Erdogan’s approval rating slid to 38.6% last month according to a Metropoll survey, down from 55.5% in early 2020, while 57.2% disapprove of the President, compared to 36.6% at the onset of the pandemic.  

Acute pain in the Treasury complex highlighted today’s proceedings, as the two-year yield jumped to 0.97% to mark a fresh Covid-era high while the long bond ascended to a near three-month peak at 2.13%.  Stocks managed a modest bounce off yesterday’s sharp selloff with the Nasdaq 100 gaining 75 basis points.  WTI crude ripped past $84 a barrel to test the multi-year highs logged in October, gold ticked lower to $1,816 an ounce and the VIX pulled back to near 19, giving up about half of yesterday’s gains. 

- Philip Grant

Fourth quarter earnings season is set to get rolling, with S&P 500 components projected to generate a 21.7% year-over-year uptick in earnings per share, estimates compiled by FactSet show. That sits slightly higher than the 20.9% estimate logged in September and would mark the fourth straight quarter featuring bottom line expansion of more than 20%. 

But as the pandemic slowly fades into the rear-view, those explosive figures look set to settle into more banal territory.  Annual earnings growth will foot to 45% across 2021 if analyst expectations for the final quarter prove accurate, figures which are projected to contract to 6.3% for the now-underway first quarter, then 4.2% for the three months ended June 30. 

Then, too, 61 S&P 500 companies issued negative earnings guidance ahead of their imminent fourth quarter results, the most since the second quarter of 2020, while 25 constituents provided a positive earnings preannouncement, also marking the fewest since the depths of the pandemic. 

Today’s splashy December CPI report, which featured a headline 7% year-over-year advance to mark a second straight 39-year high in the data series, established another unwelcome milestone for the U.S. worker.   Real average hourly earnings fell by 2.4% from a year ago, marking the ninth straight month of negative inflation-adjusted wage growth.  That represents a sea change from the pre-virus norm, as real wage growth remained in positive territory in nearly every month from 2013 to 2019. 

Indeed, workers at a wide variety of household names find themselves behind the eight ball.  A Brookings Institution study of hourly workers at 13 of the largest U.S. employers including McDonalds, Target and CVS published last month found that only one (Amazon) paid workers a living wage of $17.70 an hour as of October, meaning a level sufficient to afford basic necessities in a household with two full-time working adults and two children. 

Might a raft of wage increases enacted to counter current price pressures help entrench the increasingly “untransitory” inflation regime?  U.S. businesses are budgeting a 3.9% increase in average pay in 2022, the Conference Board found last month. That’s the highest reading since 2008 and compares to a planned 3.0% wage hike for this year as of April 2021.   

Perhaps most tellingly: the return of cost of living adjustments (COLA), or automatic pay increases designed to help workers keep pace with inflation. On Dec. 21, striking Kellogg Co. employees ratified a labor pact including a new COLA clause, following a November agreement between Deere & Co. and the United Auto Workers featuring automatic quarterly wage adjustments.    

Inflation-burnished transfer payments have been codified at the federal level, as well. Social security recipients will receive a 5.9% COLA increase this year, the largest raise since 1983 and nearly quadruple the 1.65% average annual hike seen over the past 10 years.  

Public servants duly read the tea leaves. Bloomberg reported yesterday that Securities and Exchange Commission employees have accused chairman Gary Gensler of conducting “an aggressive, anti-employee agenda” in contentious negotiations over pay and benefits.  The attorney-heavy staff, who earn an average annual salary of more than $200,000, demanded that federal mediators intervene after talks produced little beyond ill will. “He’s kind of a ‘my way or the highway’ kind of guy, and that’s how he’s dealing with the union,” Greg Gilman, president of the Chapter 293 union representing the SEC employees, told Bloomberg. Labor strife seems to follow the SEC chair, as staff at the Commodity Futures Trading Commission voted to unionize after Gensler departed as CFTC head during the Obama administration. 

That phenomenon isn’t confined to the 50 states, as the inflationary mindset takes hold far and wide.  Politico reported on Nov. 23 that the trade union representing staff at the European Central Bank demanded higher wages this year, as the central bank’s proposed 1.3% raise “no longer protects our salaries against inflation.” With similarly acute price pressures plaguing the Old Continent, including a 5% year-over-year rise in Euro Area CPI (triple the post-1997 average)  “the gap between these two figures means that each of us will suffer a permanent loss in purchasing power,” the International and European Public Services Organization (EPSO) lamented in an email. “The ECB is not able (or willing?) to protect its own staff against the impact of inflation!”

Public facing communications evince slightly less concern over the subject. On Nov. 17, the same day that the EPSO launched that email broadside, ECB vice president Luis de Guindos declared in a television interview that: “The reality check is going to be the evolution of inflation next year. . . if you look at the drivers, the transitory nature of these drivers of inflation are quite clear and are going to become tangible and evident next year.”

Someone tell the rank and file. 

Stocks managed to build on their recent strength with modest gains across the S&P 500 and Nasdaq, though the indices finished well off their early-session highs, while Treasurys traded weaker across the board following today’s CPI data, with the two- and 30-year yields each rising three basis points to 0.91% and 2.09%, respectively.  WTI crude jumped to near $82 a barrel for its best finish in two months, gold edged higher to $1,826 an ounce for its fourth straight green finish, and the VIX fell another 4% to slip below 18.  

- Philip Grant

Last week’s 1.9% decline in the S&P 500 augurs poorly for 2022, if history is any guide.  According to data from CFRA Research, stocks have averaged an 11.5% annual return over the past 92 years when logging gains over the first five sessions of the year.  When equities are underwater after that initial five-day trading stretch, the average annual return is minus 0.9%. 

The bearish start to the year is hardly confined to the stock market.  This morning, the price of bitcoin sliced below $40,000, extending its decline to as much as 14% in this young 2022. That marks the digital ducat’s worst start to the year since at least 2012, when the benchmark cryptocurrency was still in short pants.  With the liquidity tide ebbing ahead of the Federal Reserve’s anticipated policy tightening, sentiment has turned in kind. Jay Hatfield, CEO of Infrastructure Capital Advisors, told Bloomberg today that “bitcoin could end 2022 below $20,000.”

Similarly, Bianco Research president and eponym Jim Bianco relays that the 30-year Treasury absorbed a hefty 9.35% loss last week on a total return basis. That not only marks the worst single weekly performance on record going back to 1973 but would also represent the fifth worst annual showing over that period. As for the drivers of that historically poor performance, Bianco offered the following postmortem:

Simply put, the bond market saw one of its worst weeks in history because bond market players finally "got it" that the Fed is going to end liquidity. This kicked off a big scramble to get out and not be the "bond bag holder" when the Fed printer is turned off.

Indeed, as the Fed continues its pivot from full-speed monetary accommodation (see last Friday’s ADG for a review of Federal Reserve Bank of San Francisco president Mary Daly’s policy 180 over the past eight months), persistently escalating price pressures add urgency to the situation.  Wednesday’s reading of the December CPI will feature a 7.1% year-over-year headline increase, if economist guesstimates are on target. That would mark the hottest print since 1982 and compares to measured annual price increases of 6.2% in October, 5.4% in June and “just” 2.6% in March 2021. 

That unwelcome trend has not escaped Washington’s attention. During this past weekend’s meeting of the American Economic Association, establishment financial thinkers including former Treasury Secretary Lawrence Summers, ex-White House chief economist Jason Furman and Council of Economic Advisers chairman Glenn Hubbard each contended that the Fed is behind the eight ball in dealing with the situation.  Stanford economist John Taylor, architect of the eponymous rule guiding monetary policy, argued that the Fed funds rate should now be somewhere between 3% and 6% based on current economic conditions, instead of the current 0% to 0.25% range. 

Some Eccles Building alumni share that view.  Former Federal Reserve Bank of New York President Bill Dudley put it this way in a Bloomberg Opinion column today: “I have news for those who think the U.S. Federal Reserve has turned more hawkish on inflation: It has only just begun.” Noting that the median Fed staff forecast calls for inflation (as measured by the Core Personal Consumption Expenditures Price Index) to fall to 2.1% by 2024 – with a stop at 2.6% this year – from 5.3% in 2021, despite a projected funds rate of 2.1% by the end of 2024 (well below the 2.5% “longer run” projected funds rate), Dudley concludes: “This is a remarkable, even surreal forecast. Inflation won’t be a problem, even if the Fed does little to rein it in.”  

Instead, persistent PCE readings of 2.5% to 3% would call for a funds rate of potentially as high as 3% to 4%, Dudley believes.  As that suggested range is far higher than market expectations, as measured by Eurodollar futures, “the ‘taper tantrum’ may have been merely delayed, not avoided,” the former Fed governor warned. 

On the bright side, investors won’t have to wait long for clues on the monetary mandarins’ next move. Fed chairman Jerome Powell is set to face the Senate Banking Committee tomorrow morning for his renomination hearing, with pointed questions from the political class surely in store. 

The bulls scored a sorely-needed win today, as the S&P 500 and Nasdaq 100 indices erased early losses of 2% and 2.7%, respectively, to finish little changed. The back end of the Treasury curve also caught an intraday bid with the long bond yield finishing at 2.08% compared to 2.15% this morning, while the two-year finished at 0.9%, compared to just 0.2% six months ago.  WTI crude slumped to near $78 a barrel, gold eked back above $1,800 an ounce and the VIX rose 3% to 19.5. 

- Philip Grant

It’s raining money on Wall Street. The passive investment machine kicked into full gear in 2021, as worldwide inflows into exchange traded funds blew past $1 trillion over the eleven months through November, easily topping the full-year record haul of $735 billion established in 2020.  The venture capital industry similarly reached new heights in 2021:  Investors allocated $93 billion towards seed- and early-stage startups last year through December 15 per PitchBook, lapping the $52 billion sum seen in 2020 and triple that of 2016. 

Some investment categories, however, had to settle for relative scraps. Global hedge funds gathered a net $24 billion in assets over the first nine months of 2021, data from HFR show, yet on pace for the first annual inflow since 2017.  The three years through 2020 delivered a net $110 billion in withdrawals. 

Lackluster performance informs that cold shoulder: the HFR Global Hedge Fund Index rose a modest 3.65% last year, a fraction of the 28.5% total return for the S&P 500.  “Alpha [was] terrible,” Salvatore Cordano, co-CEO at Investcorp-Tages, told the Financial Times yesterday, referring to investment returns independent of market gyrations.  

Hedge funds’ waning popularity is reflected in dwindling compensation for the general partners, as the once customary 2% management fee and 20% performance fee schedule fall by the wayside. Management fees registered at 1.36% on average in the third quarter per HFR, while the average incentive fees came in at 16.17%. Each marked the lowest reading on record (HFR was founded in 1992).   

That compression hasn’t been enough to coax major investors back into the asset class:  Marcie Frost, chief executive of the $500 billion California Public Employees Retirement System (Calpers), described industry fees as “problematic” to the FT on Dec. 22, adding that the country’s largest pension fund has no plans to invest in hedge funds after completely exiting the category in 2014.  Calpers, whose board voted in November to upsize its private equity and private credit allocations to 13% and 5%, respectively, from 8% and less than 1%, while adding $25 billion of embedded leverage to help reach its 6.2% annual return target, believes that the public markets are “a little overheated,” Frost added. 

Might the solution to asset-price sticker shock be found within the industry structure pioneered by Alfred Winslow Jones? The traditional “hedged” fund, which first rose to prominence in the post-World War II era, represented a true market neutral strategy. Designed to produce satisfactory absolute returns across bull and bear markets alike, a successful hedged fund produced outperformance over the course of full investment cycles despite typically lagging during good times. Of course, with only a pair of nasty multi-month downdrafts (in late 2018 and early 2020) since the post-financial crisis bull market got underway and near-zero rates helping confer ever-richer valuations on favored industries, the recent environment has been particularly ill-suited for that old school, agnostic strategy.  The Nov. 26 edition of Grant’s Interest Rate Observer put it this way:  

At certain speculative junctures, prudence itself becomes unprofitable, and this juncture – say, the five or six years starting in approximately 2015 – has been the showcase of that paradox. Reaching for yield and chasing after performance were once what a conscientious fiduciary would never stoop to do. In the age of ZIRP (and the full heat of indexation), those offenses against good practice became almost compulsory. 

Of course, the past 21 months have proven particularly painful for the conservatively positioned. Last year’s meme-stonk frenzy, in which sometimes fundamentally-shaky companies enjoyed parabolic share price rallies after capturing mainstream attention, further complicates life for the prudent manager who uses short selling to maintain a balanced book, Grant’s noted:

In a sense, hedged investors, dodging the meme stock enthusiasts, are in the same unenviable position as professional poker players when pitted against overconfident amateurs. In both cases, the professional, knowing the odds, should beat the unseasoned, all-in novice, but it takes money to call the tyro’s bluff – and sometimes the tyro wins. 

For now, at least, evidence suggests the tide may be turning. Following yesterday’s 3.3% wipeout in the Nasdaq Composite Index, a whopping 40% of the components of that tech-heavy gauge now sit 50% or more below their respective 52-week high, Sundial Capital Research’s Jason Goepfert reports. 

See the analysis “Hedged for the long run” in the Nov. 26 edition of Grant’s for a speculation on the revival of the largely dormant hedged fund, featuring an enlightening profile of a longstanding industry mainstay.  

Stocks consolidated yesterday’s acute selloff, with the S&P 500 and Nasdaq 100 each finishing unchanged to remain weaker by 1.5% and 3.4%, respectively, so far in this young 2022, while the VIX remained just below 20. The Treasury curve flattened a bit after some aggressive weakness to start the year, with the two-year yield settling at 0.87% and the long bond at 2.08%, while gold was clubbed by 2% to $1,789 an ounce and WTI crude advanced to the cusp of $80 a barrel.  

- Philip Grant

Easy does it:  The People’s Bank of China sliced the benchmark one-year loan prime rate to 3.8% from 3.85% this morning, its first such rate cut since the unpleasant days of April 2020.  That follows a 50 basis point decrease to the reserve requirement ratio for local banks, a measure which came into effect last Wednesday and infused some $200 billion into the financial system. “Each step so far seems marginal and constrained, which only means that more will be needed,” commented analysts at Société Générale.  

While relatively modest in scope, those efforts to ease financial conditions stand as a marked contrast to the authorities’ prior stance, as Beijing struggles to get a debt-soaked property bubble under control without unleashing financial mayhem. Most notably, the three red lines policies, which were introduced this year to constrain developer balance sheets, perhaps helped to catalyze a rash of distress across the industry.  With the long-awaited default of behemoth China Evergrande Group, Asia’s largest issuer of high-yield bonds, a reality, trouble spreads far and wide:  

Today, shares in Evergrande-affiliated investment firm China Estate Holdings suffered a 35% plunge following a failed go-private attempt, while shares in Kaisa Group Holdings (the industry’s third-largest issuer of dollar-denominated debt but only 27th largest by property sales) tumbled 14% in its first trading day since the company fell into default earlier this month.  

That follows last week’s swooning share and bond prices in formally-investment-grade-rated China Shimao Group, China’s 13th-largest developer by sales, after revelations that buyers of apartments in Shanghai were unable to secure ownership transfer, as Shimao has already pledged those units as collateral to secure loans.  Days later, Shimao announced the sale of a 22.5% stake in its Grand Victoria Hong Kong project for HKD $2.1 billion ($270 million), realizing an HKD $770 million loss in a transaction which “could signal an urgent need to boost liquidity,” analysts at Bloomberg wrote. 

A fast-cooling real estate market further complicates life for the now-stricken industry. Home prices, as measured by the Chinese apparatchiks, logged a 30 basis point decline from a year ago, the weakest reading in the officially-sanctioned data series since early 2015 and marking the third straight monthly downdraft.  Only nine of the 70 cities tracked by the National Bureau of Statistics reported annual price gains, also the weakest reading since early 2015.  

By way of response, regulators have “urged” banks (politely, no doubt) to extend financing to support “high-quality” real estate investments and foment industry merger and acquisition activity, state media reports today.  Analysts at S&P Global estimated last week that the ratio of nonperforming real estate loans will reach 5.5% by year-end, up from 2.5% as of June 30 and 2% at the end of 2020. A little pain could go a long way for China’s distended banking system, which featured $53 trillion in assets as of Sept. 30, nearly 60% higher than that of the U.S. despite an economy that remained some 30% smaller in terms of nominal output last year.

Indeed, China’s suddenly frosty real estate market could augur a wider slowdown for the world’s largest consumer of iron ore, copper and aluminum. Third quarter GDP grew by a measly 4.9% from the pandemic-addled year-ago period, roughly half the average growth rate over the three decades through 2019.  Last week’s reading of November retail sales showed a 3.9% year-over-year advance, well shy of the 4.7% consensus and a fraction of the average 12.5% gain seen over the past 20 years, while M2 money supply growth remained at just 8.5% year-over-year, roughly half its 30-year average of 15.4%.  

With China’s growth engine on the fritz and the lynchpin real estate market sputtering, today’s easing move from the PBOC is something of a no-brainer.  However, Beijing has futilely tried to curtail its burgeoning property bubble for years, as President-for-life Xi Jinping has repeated the mantra that houses “are for living in, not for speculation” since 2016.  Will the powers-that-be have any more success at reviving financial glory days past?  

The last full week of the year got off on a bearish note, with stocks losing more than 1% to leave the S&P 500 3% off its Dec. 10 highs and the Nasdaq 100 at a near-two-month low, though the averages did finish well off their intraday nadirs and the VIX gave back most of its early 26% surge to finish higher by just 6% at 23.  Weakness in the long-dated Treasurys left the curve a bit steeper as the 30-year yield rose to 1.85%, gold retreated to $1,790 an ounce and WTI crude fell to $69 a barrel. 

- Philip Grant