Another One Bites The Dust

All eyes were on the US’s October inflation report, which came out on Thursday and offered some much-needed relief to investors. Meanwhile, with the third-quarter earnings season nearing an end in the US, we look at what’s been happening to profit margins (spoiler: they shrunk for the first time since the pandemic). But arguably the biggest story last week was the dramatic and sudden collapse of FTX – one of the largest crypto exchanges in the world that was valued at $32 billion at the start of the year. Find out what happened exactly in this week’s review.

Macro

The latest US inflation report showed consumer prices increased 7.7% last month compared to the same time last year, and that was good news for several reasons. First, it’s the smallest annual advance since the start of the year. Second, it was lower than the 7.9% economists were expecting. And third, it was a marked slowdown from September’s 8.2%. On a month-on-month basis, consumer prices increased by a less-than-expected 0.4%. Meanwhile, core consumer prices (which strip out volatile energy and food components) advanced 0.3% from September and 6.3% from a year ago. Both these figures came in below economists’ forecasts.

The better-than-expected report offered hope that the highest inflation in decades is finally cooling, which would allow the Fed to slow down its aggressive rate-hiking campaign. Case in point: after the news, traders moved to price in a half-point Fed hike in December, rather than 75 basis points. That explains why stocks and bonds both soared after the report, while the US dollar fell against a basket of currencies. In fact, the S&P 500 ended Thursday up 5.5% – its best first-day reaction to a CPI report since at least 2003 when records began.

Stocks

In an inflationary environment, businesses can pass on some of the higher costs to their customers. But companies typically have to swallow some of the elevated costs themselves, leading to lower profit margins. This year’s third-quarter earnings season has been a prime example of this. As of the previous Friday (the 4th of November), 85% of the S&P 500 firms have reported their results, with the average profit margin for the third quarter coming to 11.9%. That’s a full percentage point lower than what it was during the third quarter of last year. Put differently, profit margins have shrunk by 8% year-on-year – the first contraction since the pandemic.

Falling profit margins are never a good thing, and they ultimately lead to lower earnings. In fact, Goldman Sachs just cut its earnings estimates for the S&P 500 for every year till 2024, saying that last quarter’s shrinking margins mean there’s even more pain ahead. The investment bank is now forecasting earnings-per-share to remain flat in 2023 – down from an earlier prediction of 3% growth. What’s more, it said that earnings could slump 11% next year if the US enters a recession. And it’s not the only one taking a dim view of things: many other banks are cutting their 2023 earnings forecasts for the S&P 500 firms.

The takeaway here is that the current macroeconomic environment is a challenging one for stocks. Higher interest rates are pushing valuations lower, while slowing economic growth and higher costs that can’t be fully passed onto customers are hitting corporate earnings. All in all, that means stocks might not look up until the broader economic environment takes a real turn for the better – till interest rates peak, for example, or the US economy avoids a recession.

Crypto

Oh my, where do we start? Last week saw some of the most dramatic events the crypto industry has experienced in its roughly 14-year history. Before we recap what happened, we need to get some quick definitions (and lots of acronyms) out of the way:

• FTX: one of the biggest crypto exchanges in the world that was valued at $32 billion at the start of the year.
• Sam Bankman-Fried (SBF, as he’s known) is the founder and CEO of FTX.
• FTT is FTX’s exchange token. Owners of FTT earn rewards and get discounts on FTX trading fees and increased commissions on referrals.
• Alameda Research: a crypto trading firm founded and owned by SBF.
• Binance: the world’s biggest crypto exchange by daily volume.‍
• Changpeng Zhao (CZ, as he’s known) is the founder and CEO of Binance.

With that out of the way, let’s begin. FTX faced a near collapse at the start of the week after a surge in customer withdrawals sparked a liquidity crisis. According to Reuters, FTX was hit with about $6 billion in withdrawals in the 72 hours before Tuesday morning. What sparked the exodus? Two things.

First, CoinDesk put out an article on 2-Nov saying there’s something fishy going on with Alameda. The trading firm and FTX were meant to be two completely separate companies, but it turns out they were a lot closer than SBF led on. In summary: Alameda’s balance sheet was loaded with FTT, and it was using that huge stash as collateral to borrow from FTX to speculate on markets. Here’s another way to put it: accepting FTT as collateral, FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda. That means that if Alameda's investments go south or if the FTT collateral slumps in value, then Alameda goes under and pulls FTX down with it.

Second, after the CoinDesk revelation, CZ announced on Twitter that Binance is selling all of its FTT holdings (worth over $500 million at the time). Binance had received these tokens as part of an earlier investment in FTX. While CZ cited concerns over the exchange’s financial stability and “recent revelations that have come to light” (i.e. the CoinDesk article), it didn’t help that CZ and SBF’s relationship has been souring, with CZ accusing SBF of talking crap about Binance to regulators behind closed doors. Just check out the Tweet below.

As you can imagine, CZ’s tweet caused FTT’s price to plunge. Recall that if Alameda's FTT collateral slumps in value, then the firm goes under and pulls FTX down with it. So with fresh memories of Celsius’s collapse in June, investors decided to pull their funds out of FTX in a hurry. SBF responded on Monday, saying a “competitor is trying to go after us with false rumors”. But by Tuesday, the damage was already done and FTX needed a bailout, which it received (or thought it received) by none other than – and no, we’re not joking here – Binance. Yup, CZ’s firm signed a letter of intent on Tuesday to fully acquire FTX The plot twist? Binance backed out just a day later on the back of concerns about FTX’s business practices, investigations by regulators into the mishandling of customer funds, and an $8 billion shortfall on its balance sheet.

After Binance pulled out, SBF told FTX investors on Wednesday that the company would need to file for bankruptcy if it can’t get a cash injection. Meanwhile, all the drama reverberated across the entire crypto market, with bitcoin and many other coins plunging last week. So did US-listed crypto exchange Coinbase, whose stock dropped by 19% over Tuesday and Wednesday.

This week

The third-quarter earnings season continues this week. Some big names reporting include retail giants Walmart and Home Depot, Chinese ecommerce behemoths JD.com and Alibaba, and tech firms Cisco Systems, NVIDIA, and Palo Alto Networks. On the economic front, we have eurozone industrial production on Monday, Chinese retail sales on Tuesday, UK inflation and US retail sales on Wednesday, and Japanese inflation and UK retail sales on Friday.

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