More on the cyclicals rally

Good morning. The headlines on Monday were dominated by the protests in China. We are not sure about the market implications, though the story does fit with our scepticism about the recent China rally. We’re very keen to hear readers’ views: and

Industrial stocks, redux

We received two interesting — and more or less directly opposed — responses to yesterday’s discussion of the surprising rally in industrial stocks. The point of that piece was that it is weird that industrials should outperform radically when everyone expects a recession. As of today, the sector is up 20 per cent since the end of September, versus 11 per cent for the S&P.

Michael Howell of CrossBorder Capital, a regular Unhedged correspondent, wrote in to make a classic point: it’s the economy, stupid. In the past several months, he argues, the US and world economies have shown a real burst of strength, and cyclical stocks such as industrials are simply responding. Here, for example, is the Atlanta Fed’s real-time estimate of inflation-adjusted gross domestic product growth, based on the available data for the quarter to date:

This measure gets revised quite a bit as the quarter goes on, but if we are experiencing inflation-adjusted GDP growth of 4 per cent, maybe the cyclical stock rally makes a lot of sense. Similarly, the Citigroup Economic Surprise index, which tracks the degree to which data is coming in ahead of forecasts, was deeply negative in June and July, ripped upwards in August and September and has remained in modestly positive territory since.

Howell sent along this chart, which shows the output of his firm’s real-time GDP growth model against 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 US cyclical stocks, confirming the signal.

This still leaves us the question of how to match the US and German market data and the real-time economic data to the notably gloomier message from the deteriorating new orders surveys we looked at yesterday. But it is clear that we need to take the possibility of a surge in economic activity seriously.

Patrick Kaser of Brandywine Global Investment Management, a value investor and another regular interlocutor, says he has “no idea” what to make of the industrials rally, but:

Here’s three things history suggests:

One: the market does not normally bottom before the Fed actually pauses;

Two: inflation usually takes more than three years to normalise; and

Three: recessions happen after tightening cycles of this magnitude

So I think it’s just complacency and some desperately trying to capture a seasonal rally.

Number three was clearly true of the 1981, 1990, 2001 and 2008 recessions: they began after the fed funds rate had already come down (as you can see here). Number two is the “higher for longer” point we have been harping on about for a while. On number one, a chart of the S&P during the past two rate rising cycles makes his point pretty well:

History is never destiny, but Kaser’s comments paint a plausible picture of a market that has not yet internalised what the Fed has to do. This is in opposition to Howell’s comments, which point to macroeconomic data suggesting that this time round the slowdown might not be too bad.

Which side of the debate does Unhedged come down on? We remain committed to the slow grind down view of inflation, which suggests there will be more economic ups and downs before the market finds a durable low point. But the fact that the stock market seems to disagree with us gives us serious pause.

DeFi vs CeFi

Another week, another crypto bust. The latest is BlockFi, a crypto lender with a roster of big-name PE backers, which filed for bankruptcy with a wee little $9bn hole in its balance sheet. FTX, before it too went bankrupt, had bailed out BlockFi with a $400mn credit line in July. Now, BlockFi is suing Sam Bankman-Fried for Robinhood shares he allegedly owes it.

More broadly, this year has laid waste to crypto lending services. The biggest three — BlockFi, Voyager and Celsius — have all now collapsed. The basics of how this happened are easy enough:

  • Crypto lenders take customer deposits in return for some preposterous yield.

  • To make money while paying out that preposterous yield, lenders need to invest customer funds in something that pays an even more preposterous yield.

  • Those investments will involve risk, often a frightening amount of it. The details vary. For example, Celsius was making undercollateralised loans to crypto traders and investing in dubious yield farming projects.

  • If there is a downturn in crypto prices, that high-risk, high-yield stuff suffers. Customers panic and demand their money back. But their money is in risky stuff that has lost most of its value, or which might be illiquid, or both.

  • At that point, the choice is bailout or bankruptcy.

With the three big crypto lending platforms plus FTX all in bankruptcy, it barely needs saying that centralised finance, or CeFi, has fared poorly during this crypto crash.

Yet decentralised finance, or DeFi, has held up fine. DeFi exchanges and lending protocols are (mostly) chugging along, enjoying a bump in activity as panic elsewhere in crypto pushes up yields in DeFi. This makes sense. Most things in DeFi are just pieces of software that match lenders with borrowers or buyers with sellers; they usually don’t hold customer funds, as centralised exchanges do.

Some spot a pattern here, or at least an opportunity to rehash the merits of decentralisation. Here’s a Wall Street Journal op-ed called “Centralisation caused the FTX fiasco” co-written by “anti-woke” fund manager and DeFi investor Vivek Ramaswamy, calling for regulators not to burden DeFi with rules meant for CeFi:

The critical element in [centralised exchanges like FTX] is that somebody — either the operator of the central limit-order book or an independent intermediary like a brokerage — takes custody of user funds . . . 

Decentralised exchanges, by contrast, require no custody thanks to the blockchain-based innovation of the automated market maker. An exchange attracts liquidity providers, which deposit tokenised assets into a smart contract [ie, self-executing code that takes care of clearing and settlement] . . . 

Because smart contracts are publicly visible, the funds within them are easy to audit. Because they can’t be altered by any one person (assuming the underlying code is strong), the money is impossible for any one person to steal. Because no actor assumes custody, there’s no risk of theft by a rogue manager. This system requires us to trust bits of public code rather than potentially culpable humans . . . 

For years, observers have questioned why people would use DeFi when centralised exchanges are often faster and cheaper. The FTX story flips the question: Why should people trust their money to a third party if they don’t have to?

Ramaswamy’s question has good answers: DeFi comes with heavy trade-offs. JPMorgan’s Nikolaos Panigirtzoglou spelt out a few in a recent note, which our own Robin Wigglesworth reproduced on Friday over at Alphaville. Decentralised exchanges, says Panigirtzoglou, depend on price discovery happening on centralised ones, are slower for large orders, and are vulnerable to hacking and front-running.

A harder-hitting critique, offered last year by the Bank for International Settlements, argues that DeFi’s purported decentralisation is an illusion. The BIS starts by noting that the code underlying DeFi projects, just like paper contracts in traditional finance, can’t possibly cover all contingencies. CeFi’s answer is courts, regulators and other centralised 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 DeFi protocols’ decision-making in the hands of a few.

The choice between DeFi, with all the downsides mentioned above, and CeFi, where your money is prone to vanishing, is a grim one. The problem is crypto itself. Centralised or decentralised, neither type of exchange deserves regulatory legitimacy because, as we wrote last week, both peddle a still poorly understood asset that, as of yet, supports little legitimate economic activity. We hope CeFi vs DeFi remains a distinction relevant only to punters, criminals and crypto journalists, and not one a serious investor has to understand. (Ethan Wu)

One good read

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