(Claire Willemse – Vice President of UCLIF)
Welcome to the UCLIF Analysts’ Insights, a weekly newsletter that brings you some interesting feature reads and unique perspectives from the Analysts at UCLIF!
Irrational Exuberance: A brief look into history
The dramatic rise and fall of GameStop Corp (NYSE: GME) seemed like an out-of-the-norm occurrence driven by a new era of retail trading. However, such a frenzy is all-too-familiar to the stock market, whose history is littered with examples from the Asian Financial Crisis to the Dot Com Bubble (Figure 1). Coined by former Fed Chairman Alan Greenspan, “irrational exuberance” describes a speculative chase for growth with no regard for fundamentals, leading to excessive rallies that eventually collapse.
Perhaps a pertinent case to look into is the 2007-2008 Subprime Mortgage Crisis. Mortgage lenders face default and prepayment risks – when interest rates fall, borrowers have incentives to pay them off early and refinance at lower interest rates, denying lenders of future interest payments. As such, investment banks created mortgage-backed securities by packaging hundreds of mortgage loans together and selling them to investors. These were regarded as attractive investments as they supposedly had high return and low risks. Shortly after, banks started issuing subprime mortgages to those with low credit scores. To make matters worse, banks borrowed to buy more loans, heavily increasing their leverage (Figure 2).
US house prices skyrocketed, subprime borrowers started defaulting on their mortgages and this spilled over to the mortgage-backed securities market. Housing supply exceeded demand and prices plunged (Figure 3). Since then, governments rushed to bail out banks and the Dodd-Frank Act was enacted to crack down on predatory lending. Quantitative easing became more prevalent to increase liquidity in the banking system.
Today’s (12/2/21) S&P 500 Shiller CAPE Ratio stands at 35, the highest in 2 decades, albeit still shy of the dot-com bubble’s 44. The question remains if we are once again caught in irrational exuberance – a 12-year bull run, retail investors’ optimism, SPAC mania and sky-high IPOs seem like the perfect concoction to cook up the next storm.
Why the price of equivalence will be too high?
Boris Johnson in the weeks leading up to his Christmas Eve trade agreement with the European Union has called for an “Australian-style” trade relationship. After the agreement was sealed, for the financial services – the UK’s core competence and dominant industry making up 7% of its GDP – the outcome was sub-Australian.
The EU recognises Australian rules as broadly equivalent to the EU’s in 17 different areas compared with only two for Britain. It is now easier to sell many financial products to clients in the EU from 10,000 miles away in Sydney then 215 miles away in London.
The causes of the government’s neglect of the financial-services sector are obscure, but the consequences are clear. Between the Brexit referendum in June 2016 and the end of the transition period at the end of 2020, around 7,500 jobs and over £1.2trn of assets moved from Britain to European financial centres according to EY. That may be an underestimate, as EY tracked only larger firms; and many more may go. According to Morgan McKinley, recruitment data also suggests that Brexit may not just be sending work abroad but also discouraging growth in Britain.
The main question now is whether the EU will grant Britain further “equivalences”. Compared to “passporting” rights Britain used to have, equivalence covers fewer market functions and can be withdrawn with 30 days’ notice. Therefore, equivalence can be used for political leverage as was demonstrated in 2014 when the right for Swiss-listed shares to be traded on European exchanges was suddenly withdrawn.
A crucial question is what the EU would require of Britain in exchange for equivalence?
Being around a third of its exports, the EU is a valuable market for Britain’s financial services industry. Being bound by the EU’s existing rules wouldn’t be a great burden to Britain since it had a big role in designing them. However, due to the EU’s tendency to be more interventionist and protectionist than Britain, the rules are most likely to be tightened. The EU could also write rules designed to boost their own financial centres by undermining London.
If the price is that the EU writes the rules, Britain should walk away. The EU’s share of the global markets is shrinking and equivalence can be withdrawn at 30 days’ notice. The EU has little hesitation in using rules as political weapons, as its threat last month to stop vaccine trade between Ireland and Northern Ireland has demonstrated.
Britain would have done better to stay in Europe’s financial services market, retaining its clout over the rules being written. That’s no longer an option. Being kicked out of trading European products will hurt. But rather than accept rules set by other governments, Britain should cut its losses and diverge.
Tesla investing $1.5 Billion in Bitcoin: What does it mean?
On Monday 8th of February, Tesla announced in a SEC filing that the company has invested $1.5 billion in Bitcoin and will look to accept Bitcoin as a form of payment in exchange for its products in the future. The news caused Bitcoin’s price to surge by 16% to an all time high of $44,795.20 on the same day and over $48,000 in the next 24 hours. This began to spark a huge discourse over the future of cryptocurrency, the influence over large corporates to be part of it and the potential risk towards Tesla’s balance sheet over the decision.
The rationale behind this decision was said to provide the company with more flexibility to further diversify and maximize returns on their cash and cash-equivalent holdings. Many corporate finance experts were sceptical on this decision because of the inherent risk and volatility brought by Bitcoin, evident in its 30% fall in price at the start of 2021. Companies traditionally hold excess cash/cash-equivalents, such as treasury bills or commercial paper on their books to provide liquidity and raise capital when financing projects, hence investing in Bitcoin might be detrimental to the company’s financial health if the value of it decreases significantly. However, with Bitcoin’s bullish momentum on the rise and more investors resonating with the value of decentralised finance, Elon Musk might be a visionary. A few additional benefits would also be the ability to hedge against inflation risks caused by the global economic recovery and revaluation of Tesla’s share price factoring in its crypto exposure.
What does this mean to the general market and to other blue-chip companies? Well, furthering Tesla’s announcement of its investment in Bitcoin, there has been rumours of Google, Apple and Twitter wanting to get involved. If all the big tech companies decide to make similar investments and/or integrate cryptocurrencies/Bitcoin into their payrolls, there is no doubt that it would trigger a “bull run”, potentially raising Bitcoin’s value to between $100,000 ~ $200,000.
For example, a Royal Bank of Canada Capital Markets analyst made an equity research report positing that Apple would generate more than $40 billion from the cryptocurrency business should a small fraction of its users make transactions using Apple pay. These are all positive signs of making the crypto market mainstream.
For now, regulators are still concerned with issues of security breaches, cyberattacks, destruction of private keys to access digital assets, lack of infrastructure and volatility spillover of crypto prices into traditional capital markets hampering the growth of “decentralised finance”. By the looks of it, cryptocurrencies are still very young as an asset class and would need time to be integrated in daily transactions and be on the same calibre as traditional asset classes. Although at this point, Bitcoin seems to be a “buy” asset, looking at its growth trajectory, but it would be interesting to observe its long term effects on the market next.