LD Capital How to Understand the Current Increase in Geopolitical Risks?

LD Capital Navigating the Rise in Geopolitical Risks - Understanding the Current State

Gold performed strongly throughout the week, but BTC did not demonstrate its safe haven properties this time.

Source: medium

Market Overview

The Middle East conflict exceeded market expectations and escalated, causing the market to exhibit a clear safe haven attitude and reprice. During this period, the auction of US 30-year Treasury bonds was tepid, and yields rose temporarily but were unable to withstand the impact of geopolitical conflicts. As a result, long-term yields fell significantly throughout the week, the stock market declined, and gold, silver, and oil skyrocketed while cryptocurrencies fell.

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Regarding global stock markets, as mentioned in our morning briefing the previous week, the stock market did not give much consideration to the Israeli-Palestinian conflict in the first half, instead, it focused on the positive impact of several Fed officials’ dovish comments, leading to an overall rise. However, during Thursday and Friday, influenced by factors such as the poor auction of US 30-year bonds, consumer price index slightly exceeding expectations, better-than-expected initial jobless claims, an increase in inflation survey expectations, and further escalation of the Israeli-Palestinian conflict, the stock markets in Japan, the United States, and Hong Kong experienced a significant decline, but they still ended the week higher:

Last week, the US earnings season started off well, with JPMorgan Chase, Wells Fargo, and Citigroup all reporting impressive Q3 results, with net interest income and revenue figures exceeding expectations. Previously, there were concerns that deteriorating credit conditions and increased deposit costs could lead to a decline in net interest income for banks, but in reality, neither of these factors has been reflected yet. Currently, only the favorable side of the widening interest rate environment has been evident.

Gold performed strongly throughout the week, but BTC did not demonstrate its safe haven properties this time. On Friday, news that the SEC does not intend to appeal the court ruling on Grayscale’s Bitcoin ETF caused a brief surge, although this event will require the SEC to reconsider Grayscale’s application, it can still reject it for other reasons:

Crude oil prices surged 6%, but an optimistic view suggests that the actual price of oil is already high, making it difficult to imagine a two- or three-fold increase from current levels. The global economy is less dependent on oil than before, so the impact of the Middle East situation on the actual economy and inflation process will be limited. This may be the reason why the market ignored geopolitical risks in the first half of the period.

The US dollar only experienced a slight correction last week after a strong rebound. The DXY returned above 106.6, while USDJPY continued to oscillate near the 150 level:

Long-term interest rates have fallen significantly, while short-term changes have been minor. The market has been concerned about the supply side of the bond market.

All three auctions of new issuances last week saw prices lower than expected, especially the 30-year bond auction. Not only did it reach a new high in terms of yield since 2007, but the overall subscription multiple also noticeably shrank. Prior to the 30-year auction, due to CPI and initial jobless claims data, US bond yields had already risen significantly, in other words, they were discounted in advance. However, terminal demand remains less than ideal.

The US federal budget deficit for the fiscal year 2023 is $1.7 trillion, compared to $1.38 trillion for the fiscal year 2022. The lack of fiscal discipline is the main reason for the market’s pessimistic sentiment. The results of this auction, combined with the Treasury’s announcement of expanded issuance of 4-week, 8-week, and 17-week bills the day before, the largest scale in history, brings to mind the recurrence of the massive financing plan announced by the US Treasury in August (10-year yields spiked from 3.04% to 4.46%). Unlike August, however, the Fed has softened its tone regarding the prospects of tightening monetary policy, but US bond yields remain much higher. Therefore, some opinions now believe that if they want to suppress the upward trend in yields this time, Powell will have to personally make a dovish statement. Thus, now is an asymmetric opportunity to go long on US bonds, including gold, silver, and even cryptocurrencies.

Currently, the volatility in the bond market has surpassed that of the stock market. The three-month implied volatility of the iShares 20+ Year Treasury Bond ETF (TLT), with a market value of $39 billion, is more than 4 percentage points higher than that of the SPDR S&P 500 ETF (SPY). This disrupts their traditional relationship, as the average volatility of bond ETFs is typically more than 3 percentage points lower. Despite TLT’s 37% decline over the past two years, investors continue to pour into the TLT fund, betting on the potential for excess returns once yields begin to fall.

Additionally, it’s worth noting that Italy’s 10-year yield is approaching 5%, the highest level since the end of the 2012 Eurozone debt crisis. This is concerning because Italy is one of the most heavily indebted countries in the Eurozone, and its government’s spending plans are still considered to be unsustainable by many market participants. Italy’s public debt is at 145% of GDP, approximately 15 percentage points higher than during the 2012 crisis. Is the Eurozone heading towards another debt crisis?

Whether the Federal Reserve has completed its rate hiking cycle is an important topic. Currently, the market tends to believe that the labor market has loosened and inflation data has softened, so the FOMC should abandon the last rate hike. Suspending rate hikes at the next meeting can achieve consensus more easily within the FOMC. Additionally, if growth and inflation data in the fourth quarter develop as expected, the justification for a December rate hike is also insufficient.

How to perceive geopolitical risks

Investors naturally dislike uncertainty, and in the short term, the stock market may decline after conflicts arise. However, this impact is usually temporary. Looking back at history, in most cases, even if the stock market performs poorly within a month after a conflict, it will bounce back and rise within 6 months or 1 year. The main driver of stock market value is sustainable profits, and the impact of geopolitical events is often overshadowed by fundamentals.

Regarding the impact on the investment industry: in the context of rising geopolitical risks, the significance of quantitative models used for asset pricing and trend analysis weakens. With the support of global trade growth and minimal political shocks, decades of relative stability have made it easier to predict macroeconomic variables such as growth, interest rates, and inflation. When there are fewer and simpler assumptions about the world, evaluating how these figures will evolve becomes relatively easy.

Today, the economy is increasingly influenced by politics and foreign policy, which go beyond charts, balance sheets, and ratios. Trying to interpret geopolitical events will only bring more human errors to the market. However, research has shown that market volatility expands the return range for active funds, and it is now time to test the skill of fund managers. In a high-volatility environment, portfolio diversification becomes attractive, including alternative assets such as commodities, cryptocurrencies, and art.

Risk points of the current Middle East situation: Will more major countries/energy giants like Iran, the United States, Saudi Arabia, and even Russia get involved? Extreme “tail risks” – for example, will conflict erupt in the Taiwan Strait, or will Russia use nuclear weapons in Ukraine?

The behavioral pattern of the market often tends to either believe that risks are controllable with minimal price disturbances, or that risks are catastrophic to the extent of completely abandoning risk exposure. It jumps between these two extremes, rather than evolving gradually.

Attached are three high-frequency updated risk indices (the principle is to capture the frequency of keywords related to specific risks in analyst reports or traditional and social media, as well as the associated sentiment), and currently the amplitude of increase is not significant:

Dario Caldara and Matteo Iacoviello’s Geopolitical Risk (GPR) Index:

Economic Policy Uncertainty Index for United States:

BlackRock chart on its Geopolitical Risk Indicator:

Market News

Early Friday morning, media reports of Israel demanding the relocation of the entire population of Gaza to the south shocked the world and became the biggest driving factor in the market. Western media, including BBC and CNN, are discussing the phenomenon that half of Gaza’s population consists of children, and public opinion is not as one-sided towards Israel as it was in previous weekends.

Israeli Prime Minister Benjamin Netanyahu vowed on Sunday to “destroy Hamas,” while Hamas told local residents to ignore Israel’s information about moving south. The World Health Organization has called Israel’s order to evacuate 22 hospitals in Gaza a “death sentence” for the wounded.

(Israel has invaded Gaza twice before. The first was the “Operation Cast Lead” in January 2009, which lasted for 15 days. The Israeli Defense Forces occupied territories near the border with the aim of closing tunnels used for smuggling food, fighters, and weapons.

The second was the “Operation Protective Edge” in 2014, during which the Israeli Defense Forces stayed on the ground for 19 days.

Now, a third ground invasion is imminent. It looks like it could be bigger, longer, and more violent than ever. Gaza is a densely populated area with a population of over 2 million, and Israel has a strong retaliatory mindset. Anything could happen under extreme anger. Hamas is deeply rooted in Gaza, with a network of charities, schools, and mosques. It is almost impossible to separate Hamas from Gaza. 14 years ago, Hamas had hundreds of kilometers of tunnels in Gaza. Now, Trump says there are actually two Gazas, one above ground and one underground. One can imagine the scale of the underground Gaza at present. The latest news is that Israel and Hezbollah have already exchanged fire on the Lebanon-Israel border. Hezbollah claimed to have equipped high-precision weapons. Let us pray for world peace this weekend.)

Gaza stated on Sunday that Israel’s retaliatory attacks have killed over 2,450 people so far, of which a quarter are children, and nearly 10,000 people have been injured. Lebanese Hezbollah announced that they have also started mutual attacks with Israel over the weekend, and experts speculate that Israel may launch a ground attack on Gaza as a turning point in the conflict.

Just this morning, Iranian officials stated that they will no longer stand by and watch, saying, “If the crimes in Gaza continue tomorrow, it will be too late.”

The overall CPI in the United States in September rose higher than expected, with the core CPI rising 0.3% month-on-month for the second consecutive month due to difficulties in reducing housing inflation. The “last mile” of the Federal Reserve’s anti-inflation efforts is proving to be quite challenging. Overall, the stickiness of housing projects is the main reason for the unexpected nominal inflation, followed by energy and food, which have always had high volatility. On the other hand, commodity classes, excluding energy and food, have already had negative contributions. Among core service projects, the month-on-month growth rate of the housing index in September accelerated from 0.3% to 0.6%, the rent index rose by 0.5%, and the owner’s equivalent rent index rose by 0.6%.

The US Treasury has expanded the issuance of 4-week, 8-week, and 17-week Treasury notes, with the largest scale in history. US Treasury Secretary Yellen said that the US has not ruled out imposing new sanctions on Iran.

Foreign media reported that China is considering the establishment of a new RMB hundred-billion-scale stock market stabilization fund. This plan may invest in domestic stocks through existing financial institutions and professional management funds. Not only government funds, but also institutions will provide matching funding.

Since October, more and more Federal Reserve officials have emphasized in their speeches that if the recent financial conditions continue to tighten, it may counterbalance the need for further interest rate hikes.

• Logan said that if long-term interest rates remain at a high level due to term premiums, the need for further interest rate hikes may be reduced. However, if strong economic growth is the reason for the rise in long-term interest rates, the FOMC may need to take more action.

• Daly said it is absolutely conceivable for the neutral interest rate to adjust to around 2.5% to 3%, and that tightening financial conditions may be equivalent to a rate hike.

• Bostic said the Fed does not need to raise interest rates again unless inflation falls and stagnates. He does not believe the US will enter a recession.

• Collins said he is optimistic about achieving a soft landing in reality, which may be close to or at peak interest rates.

• Jefferson said he is closely monitoring changes in bond yields and is in a key position to closely assess how tight monetary policy can tighten. He clearly understands that higher bond yields will tighten financial conditions.

The University of Michigan’s consumer sentiment index has declined across the board, while inflation expectations, both short-term and long-term, have increased across the board.

UAW has expanded the strike to a FORD factory in Kentucky. FORD has indicated that it cannot agree to UAW’s demands for more. Kaiser has stated that a preliminary agreement has been reached with the union and that the strike will not expand further, at least not in scale.

On Friday, Scalise announced his withdrawal from the House Speaker race. Jim Jordan, a supporter of Trump who was previously defeated by Scalise, received the GOP’s internal nomination. Kevin McCarthy, who was just dismissed, expressed his support for Jordan to succeed him. There is anger within the Republican Party over McCarthy’s compromise with the Democrats several weeks ago to avoid a partial government shutdown.

The Democratic Party criticized Jordan’s previous remarks as inciting the mob that stormed the Capitol in early 2021. This person’s political leanings are conservative, but apparently not conservative enough for the far-right within the Republican Party, so this faction does not support Jordan’s ascent.

Initial statistics indicate that Jordan still cannot garner enough internal support, which could lead to the continued dysfunction of the Republican Party. If the House of Representatives cannot operate normally, no legislation can be passed in Congress and submitted to the President.

The IRS has issued a notice to Microsoft demanding payment of up to $28.9 billion in taxes. Microsoft plans to file administrative appeals against these notices and is willing to pursue legal proceedings if necessary. There is also good news for Microsoft, as the Competition and Markets Authority (CMA) in the UK has approved Microsoft’s $69 billion acquisition of Activision Blizzard. This record-breaking acquisition, which has taken 20 months, finally got the green light. After the completion of this transaction, Microsoft will become the world’s third-highest-grossing gaming company, second only to Tencent and Sony.

The “miracle weight loss drug” is insanely popular. Nova Nordisk raised its annual revenue growth expectations from 27-33% to 32-38% three times within a year and raised its pre-tax profit (EBIT) growth expectations from 31-37% to 40-46%. Analysts expect a growth rate of 37.5%. As a result, Nova Nordisk’s stock price soared by more than 5% at one point, reaching a new all-time high, and has risen nearly 50% since the beginning of the year. Its market value exceeds that of luxury giant LVMH, making it the most valuable company in Europe.

Positions and fund flows

The subjective investor position has transitioned from moderately short to neutral (46th percentile), while systematic strategy positions have declined to slightly below neutral (37th percentile):

It is noteworthy that CTA funds have turned bearish on the stock market for the first time in nearly a year:

Equity funds saw a net outflow of $8.2 billion this week, ending the consecutive inflows of the past two weeks. Emerging markets (outflow of $4.3 billion) and the United States (outflow of $3 billion) were the driving forces behind the outflows.

Bond funds (inflow of $3.7 billion) have switched to net inflows after two weeks of outflows, mainly driven by a net inflow of $7.2 billion into government bonds, reaching a three-month high:

Money market funds had an inflow of $16.9 billion, but the scale was much smaller than the previous week:

CFTC data, net long positions in US stock index futures dropped for the third week. The decline in net long positions in the S&P 500 dominated this trend, while net long positions in the NASDAQ 100 increased, and net short positions in the Russell 2000 decreased:

In terms of commodities, net long positions in crude oil decreased, while net short positions in gold and silver increased. Net short positions in copper decreased:

Market sentiment

Goldman Sachs’ institutional sentiment index fell to its lowest level since the end of May:

Bank of America’s bull-bear indicator further dropped to 2.2, with below 2.0 being the buying area of excessive pessimism:

AAII survey: Bullish sentiment rose sharply, bearish sentiment decreased, neutral views dropped to the lowest level in a year:

CNN Fear & Greed Index hovered at a low level throughout the week with little change:

Expert opinions

[World War, the most dangerous moment]

Bridgewater Fund’s Ray Dalio published an article on Thursday titled “Taking a Step Forward to World War,” stating that the possibility of the Israeli-Palestinian conflict escalating to a world war has reached 50%. “I believe that this war carries a high risk of sparking several different types of conflicts in many places, and the harmful effects it causes are likely to spread beyond Israel and Gaza… The conflict between Israel and Hamas could ignite other bloody battles, and now the possibility of a world war breaking out is 50-50.” Dalio believes that these two conflicts are part of a larger power struggle that will define a new world order.

As luck would have it, Jimmy Diamond expressed concerns in JPMorgan’s Q3 financial report about the future global situation: conflicts in Russia-Ukraine and the Middle East could have far-reaching effects on energy and food markets, global trade, and geopolitical relationships. This could be the most dangerous moment the world has seen in decades.

[Goldman Sachs: Bond supply not a problem, yields will not significantly rise]

Although increasing fiscal deficits have led to increased government bond issuance, current yield levels are already significantly higher than the potential for economic growth. This makes government bonds attractive to investors, so the increase in supply will not further push up yields. Additionally:

1. Despite the Federal Reserve’s balance sheet reduction, other central banks are still implementing loose policies, putting downward pressure on yields.

2. Economic slowdown and lower inflation also help limit upward movement in yields.

3. The rise in yields itself will drag down economic growth, achieving a self-stabilizing effect.

4. Investor preference for stocks decreasing will lead to increased preference for fixed income, limiting significant upward movement in yields.

[Goldman Sachs: Peaking of the US dollar contributes to foreign funds buying US stocks]

Historical data shows a clear negative correlation between foreign purchases of US stocks and the US dollar index.

GS predicts that the US dollar will gradually weaken before the end of 2024, which means foreign investors’ demand for US stocks will remain positive. GS forecasts that foreign investors will net buy $150 billion in US stocks in 2023 and an additional $100 billion in 2024.

[GS Ryan Hammond: The historical evolution of stock markets during recessions and non-recessions]

History shows that if the economy avoids a recession, US stocks usually rebound after the “hawkish peak” (see chart below). In the 11 tightening cycles since 1965, if there was no recession, the S&P 500 index typically rebounded by 8% within the next 3 months after the peak of the 2-year US government bond yield, and by 23% within the next 12 months. If a recession occurred within the next 12 months, stocks typically declined.

“We assume a soft landing for the US economy, and we predict that the S&P 500 index will rise to 4500 points (+3%) by the end of the year and to 4700 points (+8%) in the first half of 2024. Although we expect stocks to continue to rise from current levels, our predicted gains are lower than during previous ‘hawkish peaks’. Compared to the end of previous Fed interest rate hike cycles, current valuation levels are higher and expected earnings growth is slower. Absolute valuation levels currently rank in the 85th percentile historically, higher than the average level at the end of previous Fed interest rate hike cycles (excluding the tech bubble period). The yield spread between stocks and real returns (as an alternative measure of ERP) has also narrowed to 332 basis points, ranking 88th historically, the lowest since 2002.”

【Morgan Stanley: 80 Targets with the Highest Strategic Security in a Multipolar World】

These include industries such as military, resources, food, aerospace, semiconductors, batteries, and more. They operate in key areas that align with the government’s goal of enhancing strategic autonomy, making them poised for sustained growth in a multipolar world.

The simulated portfolio backtesting results are much better than the overall market:

Valuation and growth expectations for industries and individual stocks, the further to the bottom right, the greater the potential:

This report selects 80 key infrastructure companies, including some Chinese companies, primarily concentrated in the following areas:

• Hikvision in the field of physical security. Hikvision is one of the world’s largest suppliers of video surveillance products and solutions, holding a significant share of the market in China.

• China Nonferrous Metal Mining (CNMC) in the field of natural resource security. CNMC is one of China’s largest producers and processors of nonferrous metals.

• CATL (Contemporary Amperex Technology) in the field of new energy vehicles and battery security. CATL is China’s largest manufacturer of power batteries and is at the forefront of lithium battery technology.

• Baidu in the field of future technology security. Baidu provides internet search, cloud services, and other services for customers in China and around the world, using artificial intelligence technology.

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