Investors Are Bracing For A Dip

Hello Traders, and happy Monday. Here are some of the biggest stories from last week:

• Spending on interest and gasoline reached its highest percentage of US disposable income in nine years.
• Most Americans have depleted their excess pandemic savings.
• The bond market rout continued last week.
• London is on the verge of overtaking Paris as Europe's largest equity market.
• Trading in options tied to the VIX index is on course to hit record volume this year.
• Lithium prices have collapsed by over 70% from their November record as of last week.

Dig deeper into these stories in this week’s review.

Macro

The US central bank’s most aggressive monetary tightening campaign in decades has sharply pushed up the cost of credit, and Americans are beginning to bear the brunt, with interest payments swallowing up a growing share of their income this year. In fact, according to Bureau of Economic Analysis figures published last week, interest payments now account for 2.5% of Americans’ disposable income (the money left over to spend or save after taxes have been deducted). That’s the highest share since September 2008.

What’s more, with oil prices surging since the summer, Americans are forking out a bigger share of their disposable income on gasoline too. All in all, consumer spending on interest and gas combined accounted for 4.7% of US disposable income in August – the most in nine years. That’s not a good omen considering that increases in the proportion of income going to either interest or gas often precede recessions, and the recent surge in both poses a double challenge for the US economy.

That’s because higher interest and gas costs reduce Americans’ discretionary income (the money left over after paying taxes and essential expenses like housing, food, interest, gas, and so on). That subsequently dents consumer spending, which accounts for around two-thirds of the US economy. And we’re already seeing signs of that, with overall consumer spending rising by just 0.1% in August after adjusting for inflation, marking the weakest reading since March. Don’t expect Americans’ Covid-era savings to come to the rescue either: according to the latest Fed study of household finances, Americans outside the wealthiest 20% of the country have depleted their excess pandemic savings, possessing less cash today than they had at the onset of the pandemic.

Adding further insult to injury is that all of this is happening just as millions of Americans resume student loan payments. See, these repayments were suspended more than three years ago at the height of the Covid crisis, but that relief ended in October, burdening student-debt-laden Americans with $200 to $300 of extra payments a month. It’s crazy to think that student debt in the US has more than doubled over the past two decades and now stands at a massive $1.76 trillion, bigger than auto loans or credit card debt.

Finally, the selloff in government bonds resumed last week, pushing long-term yields in the US and Europe to the highest level in more than a decade. At one point last Wednesday, the yield on 30-year Treasuries touched 5% for the first time since 2007. The equivalent yield on German government bunds crossed above 3% for the first time in 12 years. The selloff comes as the European Central Bank and Fed make it increasingly clear that they are unlikely to cut interest rates any time soon, with the entire situation being made worse by increasing worries about growing government deficits and rising bond supply.

Stocks

Less than a year after relinquishing its title as Europe's largest equity market to Paris, London is on the verge of reclaiming the top spot. As of last week, the combined dollar-based market capitalization of primary British listings sits at $2.90 trillion, closely trailing France's $2.93 trillion, according to data by Bloomberg. The gap between the two has narrowed steadily this year due to two key factors. First, sector composition. Energy has a 14% weighting in the FTSE 100 index, and the sector is benefitting from a 30% surge in oil prices over the past three months. In contrast, LVMH, L’Oreal, Hermes, and Kering collectively make up nearly a fifth of the CAC 40 index. These luxury goods and cosmetics firms are contending with faltering demand at home in Europe as well as in China due to the country’s economic slowdown.

Second, currency tailwinds. See, inflation is finally beginning to stabilize in Britain, which might allow the Bank of England to conclude its 22-month policy-tightening cycle. This could subsequently lead to a weaker pound compared to the dollar – a significant factor for an index filled with exporter stocks (FTSE 100-listed firms generate about 75% of their sales overseas). If the UK does manage to reclaim its position as Europe's biggest equity market, it would go a long way toward reversing years of post-Brexit declines that have led to a steep valuation discount to its global peers. Based on the forward P/E ratio, the FTSE 100 currently trades at a 35% discount to the MSCI World Index.

Elsewhere, trading in options tied to the VIX volatility index is on course to hit record volume this year, according to new data out last week from exchange operator Cboe. The VIX – a volatility index popularly known as Wall Street’s “fear gauge” – measures the expected volatility of the S&P 500 over the next 30 days, and is used to assess the level of anxiety in the market. A low reading indicates tranquil markets, whereas a high one indicates investor panic. So far this year, investors have traded an average of 742,000 options tied to the VIX each day – more than 40% higher than 2022’s levels and above the full-year record of 723,000 set in 2017.

The bulk of the increase in trading this year has come from investors buying call options on the VIX, which pay off if volatility surges. Such spikes often coincide with sharp market selloffs, suggesting that investors are growing increasingly skeptical of this year’s stock market rally and are positioning themselves for a dip. The S&P 500 has risen by around 10% this year, but that rally is starting to fade as investors finally accept the Fed’s message that economy-busting interest rates will remain higher for longer.

Commodities

Supercharged in recent years by strong EV demand and limited supply, the price of lithium carbonate in China, which serves as a global price benchmark for the essential battery metal, soared more than 10x from early 2021 to a record 597,500 yuan last November. But that sharp rally has flipped into reverse, with lithium prices collapsing by over 70% from their November record as of last week. The plunge can be attributed to two key factors: a surge in global lithium supply expected to come online this year, and a slowdown in EV demand in China – the world’s biggest EV market – after the government cut subsidies to the sector. Analysts at Goldman Sachs anticipate lithium carbonate prices to fall further over the next 12 months, suggesting that the lithium market hasn’t bottomed yet.

The slump will be felt across the entire EV value chain. Lithium miners, for example, are price takers who’ll have to swallow lower revenues as the price of the commodity falls. Battery producers and EV firms, meanwhile, are both engaged in their separate price wars, with both most likely taking the opportunity offered by lower lithium costs to slash their prices to protect or expand their market share. All in all, that means EV costs are set to fall, which should accelerate adoption even further, benefiting firms at the very end of the value chain – namely: 1) firms that build and operate EV charging stations; and 2) electric utilities that generate and distribute the necessary power to charge the vehicles.

This week

• Monday: China loan growth (September), eurozone economic sentiment (October).
• Tuesday: Earnings: PepsiCo.
• Wednesday: Minutes of the Fed’s latest meeting.
• Thursday: UK GDP (August), US inflation (September), minutes of the ECB’s latest meeting, China foreign direct investment (September).
• Friday: China inflation (September) and trade balance (September), eurozone industrial production (August). Earnings: BlackRock, Citigroup, JPMorgan Chase, Wells Fargo, UnitedHealth.