This article is an onsite version of our Unhedged newsletter. Sign up here to get the newsletter straight to your inbox every weekday. Good morning Monday’s headlines were dominated by the protests in China. We are unsure of the impact on the market, although the story fits our skepticism about the recent China rally. We are very interested to hear what our readers think: [email protected] and [email protected] Industrials, reduxWe received two interesting – and more or less directly opposing – responses to yesterday’s discussion of the surprise rally in industrials. The point of this article was that it’s odd that industrials outperform radically when everyone is predicting a recession. To date, the sector is up 20 percent since late September, versus 11 percent for the S&P. CrossBorder Capital’s Michael Howell, a regular Unhedged correspondent, wrote to make a classic point: It’s the economy, dumbass. In recent months, he argues, the US and global economies have shown real strength and cyclical stocks, like industrials, are simply reacting. For example, here is the Atlanta Fed’s real-time estimate of inflation-adjusted GDP growth, based on available data for the quarter to date:
That metric will be revised quite a bit over the quarter, but if we’re seeing 4 percent inflation-adjusted GDP growth, perhaps the cyclical rally in equities makes a lot of sense. Similarly, the Citigroup Economic Surprise Index, which tracks the extent to which data is ahead of forecasts, was heavily negative in June and July, moved up in August and September and has been in slightly positive territory since. Howell shared this chart showing the results of his company’s real-time GDP growth model versus an index of cyclical value stocks (the model uses inputs such as commodity prices, trade-sensitive currencies and credit spreads to derive its estimate):
Howell also notes that the industrial-heavy German stock market has rallied right alongside cyclical US stocks, confirming the signal. This still leaves us wondering how to reconcile the US and German market data and real-time economic data with the significantly gloomier news from the deteriorating new orders surveys we looked at yesterday. But it is clear that we must take the possibility of an increase in economic activity seriously. Brandywine Global Investment Management’s Patrick Kaser, a value investor and another regular, says he has “no idea” what to make of the industry rally, but: Here are three things the story suggests: First: The market doesn’t usually bottom out until the Fed actually pauses; Second, inflation typically takes more than three years to normalize; and third, recessions occur after tightening cycles of this magnitude. So I think it’s just complacency and some are desperate to capture a seasonal rally. Number three clearly applied to the recessions of 1981, 1990, 2001, and 2008: they began to come down after the fed funds rate had already fallen (as you can see here). Number two is the longer higher point, which we’ve been talking about for a while. For number one, a chart of the S&P over the last two rate hike cycles makes his point pretty well:
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History is never destiny, but Kaser’s comments paint a plausible picture of a market that has yet to internalize what the Fed needs to do. This is in contrast to Howell’s comments, which pointed to macroeconomic data suggesting the slowdown might not be too bad this time. Which side of the debate does Unhedged fall on? We continue to hold the view that inflation will slowly moderate, suggesting that there will be more economic ups and downs before the market finds a permanent bottom. But the fact that the stock market doesn’t seem to agree with us gives us serious pause. DeFi vs. CeFi Another week, another crypto bust. The latest is BlockFi, a crypto lender with a list of notable PE backers that filed for bankruptcy with a tiny $9 billion hole in its balance sheet. FTX had bailed out BlockFi with a $400 million line of credit in July before also going bankrupt. Now, BlockFi is suing Sam Bankman-Fried for Robinhood stock he allegedly owes. More broadly, this year has wreaked havoc on crypto rental services. The biggest three – BlockFi, Voyager and Celsius – have all collapsed now. The basics of this are simple enough: crypto lenders take customer deposits for an absurd rate of return. In order to make money while paying out that absurd rate of return, lenders need to invest customer funds in something that pays an even more absurd rate of return. These investments involve risk, often at an alarming level. The information varies. For example, Celsius made unsecured loans to crypto traders and invested in dubious yield farming projects. When crypto prices drop, this high-risk, high-reward stuff suffers. Customers panic and demand their money back. But their money is in risky stuff that has lost most of its value or that may be illiquid or both. It has to be said that centralized funding or CeFi fared poorly during this crypto crash. However, decentralized finance, or DeFi, has held up well. DeFi exchanges and lending protocols are (mostly) chugging along, enjoying a spurt of activity as panic elsewhere in crypto drives yields in DeFi higher. That makes sense. Most things in DeFi are just software that matches lenders with borrowers or buyers with sellers; They don’t typically hold client funds like centralized exchanges do. Some see a pattern here, or at least an opportunity to reiterate the virtues of decentralization. Here’s a Wall Street Journal op-ed entitled “Centralization Caused the FTX Fiasco,” co-written by “Anti-Woke” fund manager and DeFi investor Vivek Ramaswamy, urging regulators not to burden DeFi with rules that intended for CeFi: The critical element in [centralised exchanges like FTX] Is that someone – either the operator of the central limit order book or an independent intermediary such as a broker – is doing custody of user funds? of the automated market maker. An exchange attracts liquidity providers who deposit tokenized assets into a smart contract [ie, self-executing code that takes care of clearing and settlement]?.?.?.?Because smart contracts are publicly visible, funds contained within are easy to audit. Since they cannot be changed by any person (provided the underlying code is strong), no person can steal the money. With no actor taking custody, there’s no risk of theft from a rogue manager. This system requires that we trust pieces of public code, not potentially guilty people. The FTX story turns the question on its head: why would people trust a third party with their money if they don’t have to? Ramaswamy’s question has good answers: DeFi comes with heavy tradeoffs. JPMorgan’s Nikolaos Panigirtzoglou laid out some in a recent note reproduced by our own Robin Wigglesworth over in Alphaville on Friday. Decentralized exchanges, says Panigirtzoglou, depend on price discovery on centralized exchanges, are slower for large orders, and are prone to hacking and front-running. A harsher critique, put forward by the Bank for International Settlements last year, argues that DeFi’s purported decentralization is an illusion. The BIS begins by noting that, just like paper contracts in traditional finance, the code underlying DeFi projects cannot possibly cover all eventualities. CeFi’s answer is courts, regulators, and other centralized institutions. DeFi’s answer is governance protocols, usually some sort of voting system based on freely traded cryptocurrencies called governance tokens. But these governance tokens are often issued to and hoarded by insiders, putting decision-making of DeFi protocols in the hands of a few. Choosing between DeFi, with all of the above disadvantages, and CeFi, where your money tends to disappear, is a murky one. The problem is crypto itself. Centralized or decentralized, neither type of exchange merits regulatory legitimacy as both, as we wrote last week, peddle a still poorly understood asset that supports little legitimate economic activity to date. We hope that CeFi vs. DeFi remains a distinction relevant only to punters, criminals and crypto journalists, rather than a serious investor who needs to understand it. (Ethan Wu)Good readingMajor changes could be coming to the global oil market.Recommended newsletters for youCryptofinance – Scott Chipolina filters out the noise of the global cryptocurrency industry. Subscribe hereSwamp Notes – expert insight into the intersection of money and power in US politics. Sign up here
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