Education Series: Single-Stock ETPs

US Loan Defaults Spike, England Warns of Recession

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Regardless of the outcome of the ongoing debate as to whether the US is in recession or not (as outlined in last week’s article), credit rating firms and government agencies now indicate that loan defaults have been increasing in recent times.

The least affected area codes in automobile and credit card defaults have been the “4th quartile” areas, i.e. the areas with the highest quartile in average income. All other quartiles have seen a surge in defaults, with the highest recorded in the “1st quartile”, i.e. the areas with the lowest average income ranges. As per the New York Federal Reserve’s Center for Microeconomic Data last Tuesday, Americans opened 233 million new credit card accounts in the April-June period, the most since 2008. In that same period, credit card balances increased 13% in the year-over-year, which is the highest in 20 years.

Further igniting the recession debate was a comment by San Francisco Federal Reserve President Mary Daly in the course of a podcast on the 3rd of August:

“I don’t feel the pain of inflation anymore. I see prices rising but I have enough… I don’t find myself in a space where I have to make tradeoffs because I have enough, and many Americans have enough.”

Many critics were quick to cite from public records that President Daly draws a salary of $422,900 – easily making her a denizen of the “4th quartile” and a typical elite who’s out of touch with the hardships faced by the ordinary citizenry of the country.

Now, as discussed in the article written two weeks ago that was centered around the Bank of America’s Fund Manager Survey for July, fewer panelists consider US treasuries to be unattractive relative to US equities, despite lower yields expected. A rising yield indicates falling demand for US Treasury bonds, thus signalling to the issuer that higher coupon rates are needed to attract investor interest. On the other hand, falling yields indicate that demand is rising.

A far-leading indicator of a recession has been the the 10-2 Treasury Yield Spread, which is the difference between the 10 year US Treasury rate and the 2 year Treasury Rate. A 10-2 Treasury Spread that approaches 0 signifies a “flattening” yield curve while a negative 10-2 yield spread has historically been a precursor to a recessionary period. A negative 10-2 spread has predicted every recession from 1955 to 2018, occurring anywhere between 6 and 24 months before a period is officially deemed a recession.

The 10-2 Treasury Yield Spread has been negative since the first week of July:

The 10 Year Treasury has been trending downwards since mid-June while the 2-Year Treasury Yield has doing the opposite in the same period.

On Sunday, President Daly said that interest rates will “absolutely” be raised by half a percent in September to try to bring down red-hot inflation. When a “Fed rate hike” happens, the cost of capital faced by companies go up, thus bringing down stock valuations.

Meanwhile, over in Europe, the Bank of England (BoE) estimates that the UK economy would shrink in Q4 of this year and steadily through 2023, the longest downturn since the 2008 financial crisis. It further highlighted its belief that a recession would last at least five quarters. Despite the grim economic outlook, the BoE’s Bank Rate was hiked for the sixth consecutive time in the biggest upward move since 1995 by 50 basis points, as the Bank tries to avoid inflation becoming embedded. Typically, the BoE tends to be far more proactive than the US Federal Reserve System which tends to be more “dovish” towards the stock markets.

In Germany, fears of Russian company Gazprom cutting off gas supplies entirely after a shutdown for maintenance purposes proved unfounded. However, while natural gas continues to flow in via the Nordstream 1 pipeline, volumes flowing through are only a fifth of what it was before the shutdown. A slight recovery seen in the forward prices for German price after the resumption of flow has now been lost altogether with prices climbing even higher.

In this scenario, Germany’s Commerzbank warns that an economic crisis similar “to the one that occurred after the financial crisis in 2009” is inclement and that gas rationing is inevitable. It further estimates that German economic activity would shrink by 2.7% this year and 1.1% in 2023. The International Monetary Fund, in a reflection of the views being espoused by US officialdom, still continues to predict an 1.2% increase in GDP for 2022 and a 0.8% increase next year.

The loan default scenario is also making an impact on the bank’s balance sheets: the level of loans in default in the quarter rose 8.9% to €1.53 billion and the bank expects to take a €700 million hit from loan loss provisions in the full year. Should gas supplies stop completely, this would almost double to up to €1.3 billion.

Last week’s article also showed that energy stocks were the leading contributors to week-on-week rises seen in both the S&P 500 and the Nasdaq-100. In the past week, this rally has been corrected as predicted.

This was particularly felt in the S&P 500:

and to a somewhat slighter extent in the Nasdaq-100:

Another phenomenon that has witnessed a steady build-up over the past several months have been high volumes of Exchange-Traded Funds (ETFs) traded. As opposed to a “conviction-driven” investment in select stocks, attaining diversified exposure is now generally being considered a safer choice. Last week also saw strong volumes in certain ETFs centered on healthcare stocks.

As of the end of 2017, there were 70 times more stock market indices than listed stocks in the world. Indices form the core of almost every major ETF; this gives fund managers enormous flexibility in designing new products. Studies have indicated that more and more ETFs across a variety of investing styles have been outpacing the S&P 500. Leading the charge in the YTD are “Smart Beta/Factor” ETFs – wherein the rebalancing rules are based on market factors – and “active” ETFs – wherein the fund manager is empowered to react swiftly and reconstitute their products.

The flow into healthcare stocks is likely a “defensive” manoeuvre by fund managers, as seen in energy stocks over the weeks prior to the past week. This could face correction over the course of this week and the next: in the face of a recessionary outlook, overvaluation tends to get shut down rather swiftly.

The overall bearish outlook on equities also show an interesting possibility: as shown above, there is currently very low confidence that the Federal Reserve’s proposed measures will contain inflation in the short run. A similar sentiment is likely prevalent to some measure in Western European countries, where the Debt to GDP Ratios tend to be higher than in Central and Eastern European countries. However, its likely that flows towards bonds will increase over the course of the quarter. While the rate of return isn’t historically as high as in equities, earning low returns is preferable to earning none (or, for that matter, losing value). This is, of course, dependent on whether fund managers can sway their clients into gaining increased exposure to government bonds and other fixed-income securities.

For investors, the current scenario also lends weight to the proposition of utilizing pragmatic momentum-driven tactical investments to build portfolio returns as opposed to conviction-driven investing.

Exchange-Traded Products (ETPs) offer substantial potential to gain magnified exposure with potential losses limited to only the invested amount and no further. Learn more about Exchange Traded Products providing exposure on either the upside or the downside to US Oil, the upside or the downside to the S&P 500, the upside or the downside to the Nasdaq-100, and the upside or the downside to the German DAX.

Your capital is at risk if you invest. You could lose all your investment. Please see the full risk warning here.

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Sandeep joined Leverage Shares in September 2020. He leads research on existing and new product lines, asset classes, and strategies, with special emphasis on analysis of recent events and developments.

Sandeep has longstanding experience with financial markets. Starting with a Chicago-based hedge fund as a financial engineer, his career has spanned a variety of domains and organizations over a course of 8 years – from Barclays Capital’s Prime Services Division to (most recently) Nasdaq’s Index Research Team.

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Violeta joined Leverage Shares in September 2022. She is responsible for conducting technical analysis, macro and equity research, providing valuable insights to help shape investment strategies for clients.

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He joined LS from UniCredit, where he was a corporate relationship manager for multinationals. His previous experience is in corporate finance and fund administration at firms like IBM Bulgaria and DeGiro / FundShare.

Oktay holds a BA in Finance & Accounting and a post-graduate certificate in Entrepreneurship from Babson College. He is also a CFA charterholder.

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