Have We Bottomed?

Leaked financials over the weekend showed popular crypto exchange FTX grew its revenue 10x in 2021. Then China kicked off the week with new economic support measures on Monday. Meanwhile, new data showed business activity in the eurozone dropped to an 18-month low in August, sending the euro to a new 20-year low relative to the dollar. To top things off, Saudi Arabia warned that OPEC+ may cut oil production if prices keep falling and Citi warned that UK inflation is on course to hit 18.6% in January. Finally, the market selloff isn’t over yet according to an indicator created by analysts at Bank of America that has a perfect track record in predicting stock market bottoms. Find out how it works in this week’s review.

Macro

Just a week after data showed China’s recovery unexpectedly weakened in July (prompting the central bank to cut two lending rates), the country announced new economic support measures on Monday. This time, the efforts were directed at the country’s property sector, which accounts for around 20-30% of its annual economic output. China lowered the five-year loan prime rate, a reference for mortgages, by 15 basis points to 4.30%, equaling a rate cut in May that was the largest on record. But while lower borrowing costs could help spur demand for mortgages, it’s unlikely to reverse the sharp slump in confidence faced by Chinese developers, many of which are struggling to finish incomplete homes that they’ve already pre-sold to homebuyers.

Moving on to the FX world: after hitting parity with the US dollar last month, the euro fell to a new two-decade low relative to the greenback this week. The euro dropped to as low as $0.9930 – a level last seen in 2002, just a few years after the currency came into existence.

There are a couple of reasons why this has happened. First, a stronger dollar: it’s appreciated against virtually all major currencies this year on the back of the Fed’s most aggressive rate-hiking campaign in decades. Higher interest rates, after all, make the dollar more appealing to international savers and investors.

Second, a weak euro: it’s fallen in value as the European economy suffers from multiple issues, with the war in Ukraine driving up energy and food costs and a severe drought adding to problems. In fact, new data out on Tuesday showed eurozone business activity declined for a second straight month in August to hit an 18-month low. Germany was a particularly weak spot, posting the sharpest decline in activity since June 2020 as manufacturing production continued to fall markedly on the back of the energy crisis. Activity in France, meanwhile, decreased for the first time in a year and a half.

Tuesday’s eurozone business activity data suggests that the region’s economy is sliding toward recession, according to economists (you can see from the graph above that PMI numbers tend to move in tandem with GDP). And if a recession does break out in the bloc, the euro could be headed even lower relative to the dollar.

Relative to the British pound, however, the euro is virtually flat this year. That’s because the British economy is struggling with the same issues that the eurozone economy is contending with. Soaring energy and food prices, for example, pushed up the UK’s inflation rate to 10.1% in July – its highest level in more than four decades. But according to new research out by Citi this week, the worst is yet to come: the investment bank warned that UK inflation is on course to hit 18.6% in January – the highest peak in almost half a century – because of soaring wholesale gas prices. That would be higher than the 17.8% peak inflation rate the UK witnessed after the second OPEC oil shock of 1979.

Stocks

Here’s a fun one for this week. The graph below plots a simple indicator created by analysts at Bank of America that has a perfect track record in predicting stock market bottoms. The “Rule of 20” takes the S&P 500’s trailing price-to-earnings (P/E) ratio and adds it to the annual inflation rate as measured by the year-on-year change in the US consumer price index (CPI). If the sum (black line) falls below 20 (red line), the market bottom is in, the indicator says. And this has held true for every market trough since the 1950s (blue dots).

But the measure only dipped as low as 27 this year, despite the sharp market selloff. In other words, this indicator is saying the market hasn’t bottomed yet, and the recent bounce is likely just a bear-market rally.

What would it take to push the gauge low enough to signal a market bottom? With the S&P 500’s P/E at around 20 and the most recent US inflation reading at 8.5, the measure currently sits at around 28.5. So to dip to 20, either the annual inflation rate would have to go to zero (very unlikely) or the S&P 500’s P/E ratio would have to dip by 8.5 points. The latter can happen if corporate earnings announcements deliver massively better-than-expected surprises over the rest of the year (also very unlikely), or if the S&P 500’s price drops by 40% (the most realistic possibility out of the three).

Of course, this assumes that the indicator still works at predicting market bottoms. However, just because something’s always worked in the past doesn’t necessarily mean it always will in the future. But if you trust the Rule of 20, then you know we haven’t seen the market bottom yet and it’s not worth chasing the current rally.

Commodities

Saudi Arabia warned this week that OPEC+may cut oil production if prices keep falling, arguing that futures prices have become disconnected from market fundamentals due to extreme volatility and a lack of liquidity. Prince Abdulaziz bin Salman, the Saudi energy minister, told Bloomberg during an interview that OPEC+ had “the capability to reduce output at any time and in different ways”. His comments suggest that Saudi Arabia is unhappy with the latest drop in oil prices, with crude prices having fallen from more than $120 a barrel in June to about $90 a barrel before his comments were made. If the Saudi energy minister isn’t bluffing and indeed does push OPEC+ to cut oil production, it could reverse some of crude’s recent price slide.

Crypto

Leaked financials over the weekend showed FTX grew its revenue 10x in 2021. The popular crypto exchange, which is run by 30-year-old billionaire Sam Bankman-Fried, saw explosive growth last year driven by its global trading business, and generated more than $1 billion in revenue in 2021. That compares to less than $100 million the year before. Operating income, meanwhile, was $272 million, up from $14 million a year earlier and implying a 27% profit margin in 2021. The company ended the year with $2.5 billion of cash on its balance sheet despite a flurry of acquisitions that saw it snap up roughly15 firms from all over the world.

Next week

The second-quarter earnings season comes to an end next week, with Chinese internet giant Baidu the only major company reporting. On the economic front, we have German unemployment figures on Wednesday as well as the first estimate of eurozone inflation for August. A day later we have US PMIs for August, giving us clues on how business activity is faring in the world’s biggest economy. That’ll be followed on Friday by the all-important US jobs report, which the Fed (and investors) use to assess the health of the labor market. Note that UK markets are shut on Monday for a bank holiday.