Three's A Crowd

This week saw another inflation report, this time in the UK, and – surprise surprise – another four-decade high. Fed chair Jerome Powell, meanwhile, gave his most explicit admission to date that steep rate hikes could tip the US economy into recession. Should that happen, expect investors to flock to Treasury bonds. What’s more, the recent fall in the copper-to-gold ratio suggests the 10-year Treasury yield could fall too. Elsewhere, quant hedge funds are piling into crypto. Last but not least, Kellogg is joining the corporate vogue of splitting itself into three.

Macro

Data out on Wednesday showed UK inflation accelerated to 9.1% in May – its highest level since 1982 – with prices sharply increasing across a broad range of categories. In fact, the prices of a quarter of all the individual items the Office for National Statistics measures were 10% higher than the year before. And for half of the items, they rose by 7% or more. The biggest contributors to May’s inflation were energy, food, motor fuel, and clothing, which collectively accounted for half of the jump in prices.

Accelerating inflation will only add to the cost-of-living crisis facing British households. But the worst is yet to come: the Bank of England (BoE) expects the inflation rate to exceed 11% in the coming months, reflecting the planned increase in the energy price cap in October. That’s set to intensify demands for wage rises. On Tuesday, Britain’s rail network was brought to a near standstill thanks to the industry’s biggest strike in 30 years, with unions demanding higher pay. UK teachers and postal workers also warned this week of potential industrial action if their pay doesn’t track spiraling inflation.

That all raises the prospect of spiraling inflation in the UK. That’s when rising prices of goods and services push employees to demand higher wages, which leads to increased spending and higher inflation. The situation is made worse as companies raise the prices of their goods and services to offset higher wage costs. This loop leads to higher and higher (i.e. spiraling) inflation. That could push the BoE to join the growing global trend of bigger interest rate hikes of 50 basis points or more.

Do you know who else isn’t particularly optimistic about the inflation situation? US Treasury Secretary Janet Yellen, who said over the weekend that “unacceptably high” inflation is likely to stick with consumers throughout all of 2022. She also said that she expects the US economy to slow down but that a recession is not inevitable.

Not everyone is convinced: soaring prices are hurting Americans and an economic downturn by the start of 2024, barely on anyone’s radar just a few months ago, is now close to a three-in-four probability, according to the latest estimates by Bloomberg Economics. And in a testimony to the Senate banking committee on Wednesday, the Fed chair Jerome Powell gave his most explicit admission to date that steep rate hikes could tip the US economy into recession, saying one is possible and calling a soft landing “very challenging”.

Stocks

On Tuesday, food giant Kellogg announced that it’s planning to split into three separately listed firms, joining others recently announcing splits like GE, Johnson & Johnson, and GlaxoSmithKline. Kellogg will keep the fast-growing and highly profitable global snacking business, which represents 80% of the company’s total sales, while spinning off its plant-based food unit and its North American cereals arm, where the Corn Flakes maker’s origins lie. The move should allow each company to innovate more and grow faster, since they won’t have to compete with one another for internal resources.

What’s more, the split will create separate units that appeal to different investors, potentially boosting their valuations. For example, the international snacking business is growing revenue at a faster pace than the North American cereals arm. Becoming a standalone firm could generate significant shareholder value if it can continue this growth trajectory and achieve a valuation multiple closer to that of rival Mondelez International, which trades on an EV/EBITDA ratio of 16.1x compared with Kellogg’s 13.6x.

The North American cereals business is more mature, with slower growth but steady cash flow generation. If it can boost its profitability, as Kellogg hopes, and pay an attractive dividend, it could appeal to shareholders seeking income. It could also make it an attractive target for a leveraged buyout by a private equity firm. Finally, the split will create a new plant-based stock play for investors, and one that’s already profitable – a nice change from Oatly and Beyond Meat, both of which have yet to turn a profit. It can also become an acquisition target by other food companies like Nestle, which has been building its vegan portfolio.

Commodities

Here’s an interesting observation: the copper-gold index, which is the ratio of copper’s price to gold’s, fell to its lowest level since February 2021 this week. This matters because the index is a good gauge of global economic sentiment. See, the distinct roles of copper versus gold – the red metal’s industrial necessity, the yellow metal’s safe-haven status – can embed useful information in their market prices, especially in relation to each other. Broadly speaking, the copper-gold index can serve as an indicator of the market’s appetite for risk assets (like industrial metals or stocks) versus safe-haven assets (like gold or Treasuries). 

In fact, the index also serves as a leading indicator of the 10-year Treasury yield. The index’s absolute level is irrelevant. What matters is its direction – and whether the 10-year Treasury yield has moved in the same direction or diverged. In past episodes of divergence, the 10-year yield has eventually tended to follow the copper-gold index. So the index’s recent drop could suggest that yields may soon fall too – a potentially positive sign for Treasury investors.

Crypto

According to the Financial Times, a small group of hedge funds is profiting from all the volatility in the crypto market that has already wiped trillions of dollars off the total value of cryptocurrencies. Some quantitative funds, which use algorithms to try to predict and trade price moves in crypto without taking directional views on the overall market, have made big profits from rapid falls in coins like BTC and LUNA. These quant funds employ market-neutral strategies that have grown into one of the most popular trading methods among crypto funds – especially in the current bear market, which is when market-neutral strategies really shine.

In fact, hedge funds are increasingly becoming more and more involved in crypto markets. And here we’re not just talking about dedicated crypto ones: many old-school quant hedge funds have been diversifying into more niche markets like crypto in recent years, as they try to avoid crowded positioning in traditional markets and improve their returns. The drawback of hedge funds' increasing involvement in crypto is that retail investors, who tend to be on the opposite side of quant funds’ trades, may find it more difficult to generate good returns in a market that’s increasingly dominated by sophisticated players with fast-moving trading algorithms.

Next week

Next week is a relatively quiet one in terms of major, market-moving economic releases. On Monday we have US durable goods orders, which serves as a leading indicator of industrial production and capital spending. The following day we have US consumer confidence. It’ll be interesting to see if that follows the UK, where consumer confidence hit a record 48-year low this week. On Wednesday we get June’s preliminary inflation data for Germany – Europe’s biggest economy. It’s followed by the same report for France on Thursday.