ICrypto

Hotest Blockchain News in First Media Index

Risky Assets are Thriving Again, and That’s Trouble for Investors

The risk-on rally at the start of 2023 has been so strong, it seems more like an echo bubble than a sustainable move higher despite the upturn in economic fortunes. Commercial property troubles may be a harbinger of what’s to come elsewhere.

Equities were the last in on the Everything Rally. They are now the last out too.

Can we talk about crypto again? Don’t worry — this edition won’t be solely about cryptocurrencies. It’s just that Bitcoin’s surge above $25,000 last week is emblematic of a slew of risky assets that have vaulted higher as 2023 began — and a lot of it has been driven by the recent “no landing” narrative.

This smells like trouble. While I certainly hope the economy isn’t sliding into recession, a whole host of other assets — most notably government bonds and mortgages — have sold off. That likely means risky assets, the last to participate in the Everything Rally, are also likely to be the last to sell off. With punters now also increasing bets via high-volatility zero expiry options, the stakes couldn’t be higher.

This week’s newsletter will set the scene for what to expect going forward, with a special mention on property markets, the subject two weeks ago. Enough has changed in real estate since then to signal pitfalls that lie ahead for all bubble-icious assets.

How did we get here? 

Think back to the summer, when the real angst was around a recession that was expected as soon as the last quarter of year. The US economy had already contracted for two consecutive quarters — for many the technical definition of a recession — and jobless claims were rising on a trajectory that looked recessionary. To top it off, the Federal Reserve was talking tough against inflation, with Chair Jay Powell delivering a terse and hawkish message at the annual central bank gathering in Jackson Hole in August.

But that was also the peak of Fed hawkishness. Since then, financial conditions have eased and the US dollar has declined. 

Yes, the Fed has continued to talk a good game. But the markets had priced in a lot of it. Ironically, that’s also when the employment data started to turn more robust (as I pointed out at the time) and now the labor market is going from strength to strength. So we ended up avoiding a recession in 2022.

The dollar (see above chart) and corporate bond spreads were first to price in a Fed pause toward the end of the summer, followed by Treasury yields peaking in November.

Though equities surged with other assets in October and November, December was a real setback for that rally.

Only this year did equities (and crypto) finally join the Everything Rally party.

From new year cheer to inflation worry

January was the month of easy gains. Yields were coming down, equities were rising and the economic outlook was improving. But February hit,  and not only has the Fed been telling markets they’re getting it wrong; the data have become too good — if that’s even possible.

Starting in February, everyone in the bond market started to worry that resilient growth and persistent inflation meant more pain. A robust jobs report and unexpectedly high inflation numbers pushed up rates abruptly, with two-year yields rising some six-tenths of a percentage point in just two weeks. As I looked at my screen this morning before the equity open, the benchmark 10-year Treasury yield was up yet again to its highest level since November.

This is a sign from bond investors that the short-lived party is now over. Mortgage markets have taken that cue and sold off, while the dollar is back on the rise. However, equities appear to be overstaying their welcome. My fear is that the longer they overstay, the more violent the correction will be when it comes to that.

By the numbers

  • The appreciation needed for Ark Invest's Innovation ETF to reach previous highs two Februaries ago

Long way up 

Let’s turn back back to crypto. We’ve seen a raft of crackdowns in the space recently, including the SEC’s fraud charges against Terraform Labs founder . The US Department of Justice looks like it wants to drive the entire crypto ecosystem offshore, which is probably bad for the industry’s acceptance.

Yet we’re more than 50% above the November lows on Bitcoin and  50% above levels at the start of the year. That’s quite a rally in the face of a tightening regulatory environment.

It’s emblematic of a larger risk-on play that has been at work. Bonds and mortgages were the first to sell off since the new year rally, but gains in equities have also been harder to come by too, with declines in the past two weeks. The easy work appears to be done here. The only thing that could support even higher valuations is the so-called immaculate disinflation narrative. That would see a rapid decline in inflation, coupled with a dovish Fed that kept the economy and asset prices rising. But recent data prints show those tailwinds aren’t apparent, not inflation nor a dovish Fed.

Moreover, these assets are largely dead money. That means for Bitcoin to rescale to previous highs, we’d have to see it nearly triple in price from levels just under $25,000. Tesla, an equity high-flyer, would have to double from prevailing levels. And the Ark Invest Innovation ETF, which contains many speculative but potentially high-growth new economy stocks, would have to nearly quadruple from current levels to return to highs. 

None of that is impossible. But after huge gains, these assets still have a mountain to climb and they’re unlikely to scale these heights. Just look at stocks like Amazon, Microsoft, Cisco or Intel — they were profitable long after the tech bubble burst, but it took them years, if not decades, to beat their tech bubble highs. And many bear-market rallies materialized as the tech bust developed.

Cisco went up about 70% from April to May 2001. At that point, it would have had to more than triple to regain its highs. Instead it sank, with investors finally capitulating more than 60% below that May 2001 bear-market rally top.

It’s all very similar to what’s going on today. We’re seeing a whole new generation of punters used to zero rates who got jazzed up about day trading risky stocks and cryptocurrencies during the pandemic, and refuse to recognize a changed macro environment. They risk getting beaten down by the grind, with many flash-in-the pan bear market rallies along the way. They’re better off concentrating on shares with dividends and proven track records than chasing past winners.

Handing back the keys

Since we’re talking about froth, let’s take a look at commercial real estate. That’s a market facing all sorts of problems due to how many fewer people go into offices these days.

There was a headline last week associated with Brookfield Corporation, the parent company of the largest office landlord in downtown Los Angeles. Apparently there are two properties now in default that are part of a portfolio called Brookfield DTLA Fund Office Trust Investor. Bloomberg reported that the Gas Company Tower ($465 million in loans) and the 777 Tower ($290 million in debt) are now in default “rather than refinancing the debt as demand for space weakens in the center of the second-largest US city”.

Think of this as the commercial real estate equivalent of people handing the keys of their house to the lender back during the housing bust. States like California that had no-recourse loans saw a spate of owners doing the numbers after the bust and simply walking away from their loans, oftentimes because they had also lost their jobs and couldn’t pay. In this case, filings showed that Brookfield pay but it has opted not to. This is a very bad sign of what’s coming to this market.

I asked my London-based colleague Jack Sidders whether it’s a similar story in Europe and the UK, and here’s what he had to say: 

Commercial real estate was one of the big beneficiaries of the free-money era, but thanks to inflation the music has now stopped. Borrowing and hedging costs have shot up and landlords holding assets they paid record prices for suddenly find themselves in situations where they are breaching loan terms around interest cover or relative indebtedness.

Some will inject new capital, others will bring in alternative (and expensive) debt, a few will have no choice but to hand back the keys. As rates began rising last year, transaction volumes slowed, with would-be buyers adjusting their bids to the new rate environment while sellers hung on for yesterday's valuation. By the autumn, the market had all but frozen — London witnessed the lowest volume of office sales in the final quarter for at least 20 years.

There are signs this correction could be shorter and sharper than in previous years. Deals are already ticking up in January, suggesting investors are content that the hiking cycle is nearing a peak and are therefore more confident about where to underwrite their bids. That’s partly driven by a range of motivated sellers like real estate funds that have seen a slew of redemptions pension funds in need of liquidity thanks to the UK's liability-driven investment crisis. That means deals are still happening and valuers have evidence to justify marking down valuations. It is also helped by the fact that operationally — for now at least — the market is still holding up well, with vacancy rates low and rents rising, at least for warehouses the best offices

So investors have persuaded themselves that unlike previous crashes, when banks were massively overextended or the market was suffering from excess building, this time it is purely a monetary policy issue. Now that more certainty is coming on the path of rates, they're likely to be content to buy once prices have re-rated.

Pockets of goodness 

All that said, there are bright spots in this market. I am not that pessimistic on US residential property simply because a very large cohort of millennials is ready to own and start families. And there’s a dearth of inventory, especially with many people locked into low-interest fixed rate mortgages reluctant to move. That should put a floor on any price declines.

Back in May, I wrote that I liked Marriott and the whole hotel industry because the desire to travel after Covid looks to be a long-lasting trend — even if it’s just for staycations. That space could be a market leader in the next bull market. There’s also life sciences commercial property, a booming sector because of the stable spend associated with healthcare.

Finally there’s logistics and infrastructure, both real and virtual. Increasingly, people are shopping online and working from home — even before the pandemic that put property in malls in trouble. But it also means a continued need for venues to house all that data needed for the cloud. And with shopping moving to the equivalent of internet service providers’ fiber-to-the-home “last mile” build-out, we are now in a situation where online retailers want to have inventory as close as physically possible to consumers. That way, they can mimic the in-person purchasing experience with two-hour delivery, but with the ease of shopping online instead of in-person. That increases the need for urban warehouses, especially close to wealthy enclaves.

So the coming bust in commercial property is mostly about existing generic work environments. Several savvy property investors have made similar points to me, and they’re putting their money into spaces with positive fundamentals like the ones I mentioned.

One last thought

I don’t know how long this rally will last. But the fact that bond yields are mostly higher will eventually catch up to equities, regardless of how the economy fares. What concerns me is the large increase in things like zero day options (aka zero days to expiry or 0DTE) that retail investors are using to goose returns (see here). It’s basically gambling.

The problem is that 0DTE increases intra-day swings wildly. And so, add in some momentum-focused algorithmic computer trading and you have the recipe for a very large and very sharp downward move. Think of a catalyst event causing selling that is joined by the algos and then amplified by margin calls cascading us down. That’s the kind of risk the increased use of these short-term options creates. Let’s hope it doesn’t come to that. But it’s clear that speculative investing has come back with a vengeance. As our parents once told us, you play with fire long enough and eventually you’ll get burned.

--------------

By the way, this week, the MLIV Pulse survey attempts to define what a soft landing is and asks whether a different metaphor would be more appropriate for the situation the US is currently in. Click to share your views.

Quote of the week

“It reminds me a lot of what we were seeing about a year and a half, two years ago where you had those gamma squeezes
Peter Tchir
Academy Securities
On the proliferation of short-dated options trading

Things on my radar

  • The big real estate short is spreading to offices from shopping malls.
  • Home Depot is slumping on lower profit as DIY fades.
  • Even Walmart is telling you earnings will be down for a second year.
  • This is just downright depressing: Morgan Stanley says the S&P 500 could drop by over a quarter within months.
  • Credit Suisse has hit a record low. But I look at this as an idiosyncratic problem, not necessarily an indictment of banks writ large.
Subscribe to Bloomberg.com for unlimited access to trusted, data-driven journalism and gain expert analysis from exclusive subscriber-only newsletters.

— With assistance by Jack Sidders

Subscriber Benefit

Bloomberg subscribers can gift up to articles a month for anyone to read, even non-subscribers! Learn more

Subscribe

Share
 21.02.2023

Hotest Cryptocurrency News

End of content

No more pages to load

Next page