Perfect Storm

By?Patrick Donley?and?Shawn O'Malley , edited by?Robert Leonard ?· September 30, 2022

*LinkedIn newsletter is posted at a one-day delay.

Happy Friday and welcome back to?We Study Markets !?

For a fleeting moment of bliss today, it seemed like stocks may close out the week higher, only to reverse their intraday gains and finish sharply lower.?

Shawn: While I wait for the after-effects of the devastating hurricane Ian to rain down on me this weekend, my colleague Patrick is enjoying his honeymoon in Hawaii?

Sounds nice...

Here's the market rundown:

MARKETS

*All prices as of market close at 4pm EST

Today, we'll discuss why macro hedge funds are doing so well this year, how Apple lost $120 billion in market value yesterday, an escalation of the war in Ukraine, and understanding country risks when investing.?

All this, and more, in just?5?minutes to read.

Let's do it!???

IN THE NEWS

???Macro Hedge Funds Are Doing Great This Year (WSJ )?

Explained:?

• Hedge funds betting on macroeconomic movements have raked in their best performances in many years due to sizable moves in interest rates and currency markets.
• While the S&P 500 is down around 23% for the year, funds like Bridgewater Associates and Brevan Howard Asset Management have seen double-digit gains.

What to know:?

• One investor called it "a perfect storm...There's so much going on at the moment, whether it's geopolitical, central-bank-policy divergence, big moves in rates, big moves in FX — I have not seen a more favorable macro backdrop."
• Bets on the U.S. dollar rising and rapid rate hikes from the Fed have underpinned many of these gains for macro funds. Other bets have been related to commodity prices and the belief that inflation wouldn't be "transitory."
• Greg Jensen, co-investment chief at Bridgewater, suggested that despite all of the market turmoil and volatility, we're still only partly through a whipsaw cycle that could unfold over another 24 months.?

???Apple Shares Plummet After Rare Downgrade (Bloomberg )

Explained:?

• If you thought you lost a lot of money in yesterday's big down day in stocks, you've got nothing on Apple (AAPL ). The iPhone maker saw $120 billion of its market cap wiped out after falling nearly 5% following an analyst downgrade. And the stock fell another 3% today.
• Bank of America cut its assessment of the stock to neutral from buy, as it warned of weaker consumer demand for Apple devices.
• The world's most valuable company, with a nearly $2.3 trillion market value, has seen its shares decline 20% this year.

What to know:?

• The analysts said they believe Apple still has strong long-term prospects, though in the short term, earnings estimates are likely to be revised down which poses a risk to its stock price.?
• 2023 earnings growth estimates for large tech companies have already declined by about 6% since the start of this year.?

???Putin Proclaims Annexation Of Ukrainian Territory (Reuters )

Explained:

• Russian President Vladimir Putin announced a large annexation of Ukrainian territory today in a speech at the Kremlin in a major escalation of the war's trajectory
• Russia has claimed it will treat these claimed territories as being part of Russia, which implies that any attacks there and efforts to reclaim the swaths of land would be deemed to be an attack on Russia itself.?
• This could potentially be used as a justification for more extreme tactics from Russia, including the use of nuclear or chemical weapons against Ukraine, as Putin seeks to respond to recent battlefield losses.

What to know:

• Putin said, "People living in Luhansk, Donetsk, Kherson region and Zaporizhzhia region are becoming our compatriots forever" in an address to officials.
• This comes after forced voting referendums in these regions apparently indicated that 99% of voters wished to join Russia, though Western countries are calling these sham and fraudulent elections.?
• Financial markets globally remain on edge as investors pay close attention to how these sorts of escalations reshape the geopolitical landscape.?

WHAT ELSE WE'RE INTO

?? Watch: Ray Dalio's principles of success for life and work, a new video from The Investor's Podcast Network

?? Listen: How to invest — With David Rubenstein, presented by We Study Billionaires

???Read: "Even if things are at their bleakest, it's rational to be an optimist," from the Sirmium Capital newsletter

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DIVE DEEPER: COUNTRY RISKS

Two weeks back, we wrote about?the dangers of investing in certain emerging market countries , and an exchange-traded fund (ETF),?FRDM , that sought to optimize for growth while mitigating political risk.

We've read up more on the topic since, and we wanted to highlight some of esteemed NYU professor Aswath Damodaran's?musings .

What to know

Damodaran is seen as a leading expert on corporate valuation and equity risk premiums, and we've learned a lot from his insights over the years.

In a recent blog post , Damodaran provides a 2022 update to his outlook on how financial risk varies across countries.?

While he does these updates twice a year, he emphasizes that this time around, big changes have been made to his evaluations.?

He explains that this year, as investors have fled to safety, risk assets have seen a major repricing, and countries seen as greater political liabilities have been particularly susceptible to changing capital flows.?

Drivers of country risk

If you had to put your life savings in investments in either Germany and Canada, or in Nigeria and Turkey, which sets of countries would holding your money in help you sleep better at night?

Generally speaking, the answer for most people, is Germany and Canada.

Why??

Well, Damodaran sees four major factors for understanding country risk.

The four factors of country risk

• Political Structure:?While democracies expose businesses to continuous risks, as laws and regulations may frequently change, authoritarian regimes offer, perhaps, more stability on the surface, but at far greater risk of violent and dramatic changes in power.
• Corruption:?This is like a hidden tax that drains business profits. Businesses operating in corrupt areas must choose between accepting that bribes represent an inherent cost of business, otherwise, they risk being disadvantaged against their competition who's willing to pay bribes.?
• War & Violence:?Beyond the obvious costs and risks in places afflicted by these issues, operating in conflict zones is more expensive due to supply chain disruptions and higher insurance premiums.
• Legal & Property Rights:?Without a legal system that respects and enforces property rights, the value of private ownership in businesses is essentially zero. These enforcements must be timely, though. If not, they're pointless. If someone steals your brand, and you cannot stop them for several years, you're in as much pain as you would be in a place with no property rights at all.?

Breaking it down

According to Damodaran's research, the strongest democracies and most politically free countries in the world are in Scandinavia, Canada, Australia, South Korea, and New Zealand, with weaker but still mostly free countries being the U.S., South Africa, and, to a lesser extent, Brazil and several other South American nations.?

A third of the world's population, though, lives under authoritarian regimes, and only 6.4% of the global population lived under strong democracy in 2021.?

For peace scores, that is relative exposure to violence, terrorism, and internal strife, Russia and much of Africa and the Middle East score the worst, with Oceania, most of Europe, and Canada leading the way.?

On this metric, the U.S., Brazil, and China rank quite similarly.

In terms of corruption, the U.S. and its allies rank very well, while much of the rest of the world is plagued by moderate to extreme corruption.?

And on the last metric, regarding legal and property rights, the U.S and its major allies in Europe, Australia, and Japan, lead the way with comparatively excellent legal protections, enforcement of contracts and property rights, patent protections, etc.

Legal protections for businesses are the weakest in Africa and Latin America.?

Default risks

For investors, what matters most typically is the risk of default. At the start of 2022, there were a number of countries either in technical default or at severe risk of defaulting.

Countries like Argentina, Kazakstan, Iran, much of Africa, and Ukraine, stand out as being high default risks. This sort of risk is normally measured by the major ratings agencies (S&P, Moody's, and Fitch).

An alternative way to interpret country risk would be by using sovereign credit default swaps (CDS).?

This represents the costs for those who hold a country's debt to buy insurance against default (being unable to repay their borrowings).?

In other words, this is a market-based, real-time measure of risk.

Lower CDS spreads indicate lower risk, while a higher spread means higher risk, as seen by investors.

Equity risk premiums

In calculating equity risk premiums for countries, and not just sovereign default risk, Damodaran uses the S&P 500 as his baseline, and then adds a risk premium based on default risk for a country (derived either from credit rating agencies or from the CDS market).

In aggregate, country risk premiums have risen significantly this year, led notably by Russia and Ukraine, El Salvador, and Sri Lanka.

At this same time, as interest rates have risen across much of the world, the cost of capital (the cost to raise funds from issuing debt or equity) for businesses has moved in the same direction.?

This reduces corporate valuations, as it becomes more expensive for businesses to fund themselves, which makes their current and future operations less profitable.?

In the U.S., Damodaran estimates that this year alone, the cost of capital for the median firm has risen from 5.77% to 8.97%, and this analysis was conducted several months back. The present increase is likely even greater.?

This, in part, explains why stocks have declined so much this year. As the costs of capital increase due to higher interest rates and greater country risks around the world to investors, business values decline and, therefore, stock prices.?

Takeaway

To invoke Bob Dylan, Damodaran says, "the times, they are a'changin."

In a world with rising risks broadly to investors, he argues that the greatest risk is actually inertia. In this new environment, the most successful investors will prove to be quite flexible.?

We cannot rely on our strategies from the last decade to shape this next one.?

What do you think of Aswath Damodaran's breakdown of country risk — Anything we missed or overlooked?

For his full thoughts, you can read them?here .?

For more from this respected financial academic, you can listen to William Green's?Richer, Wiser, Happier podcast interview with him .

SEE YOU NEXT TIME!

That's it for today on?We Study Markets !?

See you later!

All the best,?

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