The year 2021 will likely not deserve a whole chapter in finance history books--as perhaps 1998, 2008, and 2020 did. For bankers, traders, investors, regulators, and corporate financial managers, it was still eventful. An evolving year, some might say, with new fads, trends, and tendencies. A transitioning year, as markets, countries and economies continued to ward off the impact of CoViD 19 and all its variants. In 2021, think pandemic, Zoom, return to work, and recovery. And in 2021, think also SPACS, crypto-everything, market volatility and interest-rate obsessing.
Investors, traders and bankers will spend the new year content about the year behind us because markets progressed upward, deals flowed steadily, and regulators basically watched for now.
As always, the year produced new jargon ("meme stocks" and "DeFi"), new products and flaming fads (SPACS, e.g.). Finance types enjoy crafting new language to spout and new things to sell, although what's new is often a variation of something already old. "SPACS" have been around for years, but the hoopla surrounding them in early 2021 was as if they had been newly discovered New Year's Eve a year ago.
Jargon introduced a few years ago took off in 2021. One example is "ESG," although it is embedded in financial discourse mostly for good reason. A term that was hardly bantered about 15 years ago is spouted everyday and all the time. While it is imperative environmental, social and governance challenges be addressed and corporates and banks be held accountable, the term encompasses hundreds, if not thousands, of topics: investments, capital expenditures, business models, strategy, operations, accounting standards, disclosures, reporting, stakeholder objectives, etc.
By late autumn, 2021, financial markets had become consumed by two variables: (a) another wave (the Omicron variant) of CoVid just as when most thought the pandemic was slowly disappearing and (b) clear signs of inflation. All of a sudden, the economy and markets returned to specific computations of the Consumer Price Index and watched the calculation rise above 2% for the first time in generations.
Inflation Watch
The inflation focus was not only on the metric, but on the strategic steps and timetable of the Federal Reserve Bank. Is the inflation we observe and compute something temporary? Is it for real? Will it rise and continue into 2022? Economics and market strategests opined and debated. What will be its impact? And what will the Federal Reserve do?
As the monthly computations of the CPI index inched higher, we acknowledged the presence of inflation and reviewed the impact on corporate operations, consumer spending, economic recovery, interest rates and the value of bond portfolios. "Fed watch" had become more than an occasional investor activity, but almost an obsession. The Federal Reserve has since announced tentative steps to increase interest rates in 2021. And away we go, assessing the influence of higher rates on economic recovery, GDP output, bond investments, bond positions, corporate borrowing rates, mortgage rates, and banks' bottom lines.
Often markets react negatively not necessarily to higher interest rates, but to greater amounts of uncertainty. The prospect of high interest rates in 2021 hasn't caused equity markets to sink as some would think, because we know what's coming.
SPACs
The hoopla surrounding SPACS ("Special Purpose Acquisition Company") has dimmed since it peaked in early 2021. A year or so ago, just as teens flocked from one phenomenon to another (from Snap to Tic-Toc), older adults swarmed toward what's hip in finance, even if they aren't professionals in business and finance. NBA all-stars, pop musicians and former politicians, all of a sudden, wanted to join what sounded like an extravaganza.
SPACs are rationalized and advertised as a financial maneuver for private companies to go public without the lengthy process of doing an initial public offering, which requires a lengthy process to gain government approval. It also involves significant disclosure of performance and balance sheet and a detailed discussion of operational and legal risks (all those things that could go wrong and upend the value of the solicited investment).
By late 2020 and early 2021, it had seemingly become a legal "get rich" scheme available to those in the right financial, business, social and entertainment circles. Many hurred to join "sponsorships," where the real money could be made with little initial investment and, for some, without much of a time commitment or even intimate knowledge of the structure.
In theory, sponsors are supposed to examine opportunities to acquire the right private business based on the cash already provided by SPAC investors. For their toil (research, analysis, valuation, negotiation, and structuring), they would be rewarded with substantial returns (often shares allocated to them).
Over the past two years, SPAC activity explains a sizeable chunk of the exponential upturn in IPO activity the past two years. (By design, SPACs become public companies upon their birth and can do so without the lengthy, aforementioned SEC approval process. There is not much to analyze in a SPAC at formation, because there is no business operation. Only a pile of cash reserves looking for a target.)
Few, if anybody, are arguing SPACs should be closely, tightly regulated. Many just wonder whether the euphoria around the product could implode like the collapses we saw in junk bonds (the 1990s), dot-com public offerings (the 2000s), and mortgage-backed securities (the 2000s). A worst-case scenario involves the formation of SPACs, the timetable SPACs adhere to while searching for a target, and the plausible scenario where (with time running out) sponsors force the SPAC to acquire an under-performing, under-investigated, or even illegal business operation.
Crypto-Mania
Perhaps the greatest uncertainty is the specific picture of finance in 10 years (or even five!), as cryptocurrencies dominate the landscape. The fuss over cryptocurrencies is not just about the coins themselves, but also the related technology (often referred to as "distributed ledger technology" or the blockchain).
Until the last year or two, cryptocurrency investing, trading, and payments had been a niche segment, mostly spurred by curiosity or participants' being enamored with Bitcoin's creator's mission to establish a currency not controlled by governments. Over the past few years, cryptocurrency mania has exploded because of profit opportunities--multimillionairs and billionaires being minted overnight. There are widely reported disclosures of Bitcoin traders, miners (market-makers), and investors who have accumulated massive amounts of digital wealth.
In finance, when the prospects of immediately attainable wealth increase, the herds flock to the segment and to reap gains before the masses get involved.
The year 2021 was a pivotal point in cryptocurrency finance, perhaps a take-off point. It is no longer a mystical niche. It has stepped into the mainstream and attracted enormous amounts of capital, talent, and offshoot business models. There had been the core cryptocurrencies (Bitcoin, Ethereum, etc.). Nowadays there are opportunities in cryptocurrency exchanges, cryptocurrency futures at the major exchanges, and futures at the less-than-major exchanges (FTX.com, e.g.).
The investor, the trader or even the asset manager (who must now at least contemplate crypto as an asset class on behalf of clients) have multitudes of ways to "get in on the game." Buy the Bitcoin outright. Purchase assets at an exchange. Purchase futures contracts at government-approved exchange. Purchase futures contracts at an unregulated exchange.
There is the offshoot to the offshoot: "DeFi," which stands for "Decentralized finance," but refers to the creation of a financial system based on cryptocurrencies. Within that system, participants not only can make payments in cryptocurrencies, but can borrow and lend to others. A company or institution can borrow in crypto, lend in crypto, or accept payments in crypto.
This world claims any transaction that can be accomplished by the dollar or euro should eventually be accomplished by Bitcoin. The same world envisions corporate borrowers seeking to expand their business financing operations with another, perhaps better, more efficient alternative--borrowing in crypto markets and negotiating, executing and settling the transaction on an efficient blockchain.
The new firm NYDIG is typical of new crypto ventures. It seeks to plug itself into many traditional areas of personal and institutional finance--but with a Bitcoin wrinkle. Insurance, investments, brokerage, and loan products--all involving Bitcoin.
The big banks (JPMorgan Chase and Goldman Sachs, e.g.) that once avoided cryptocurrencies (because they had not figured out how to manage the legal and market risks related to this kind of non-government-sanctioned product) are now cautiously embracing the domain.
Large banks applaud creativity in finance as a way to fend off competition and grow net revenues. In cryptocurrencies, heretofore they have treaded carefully if only because they had not yet addressed the unquantifiable levels of market risk, operational risk, and legal/regulatory risks. They had not yet figured how to sell the activity to shareholders, clients, depositors, and regulators
Just like other business revolutions in the past (most notably, the Internet itself), ideas flourish today. Time will tell how such ideas will come to fruition and work themselves out. Finance history suggests ideas become more defined and concrete after some experimentation fails and results in colossal losses and a short-term threat to the financial system.
Yet still in finance, creativity rules. The intent is that creativity spawns new products, and new products (without the influx of competition) lead to might returns. Over the past year in crypto, creators organized trading in digital images--now better known as "non-fungible tokens," or NFTs. Who knows where this is headed, although many are betting the barn that investments in computer images will be purposeful and fruitful.
Because of the opportunities to make mind-boggling amounts of money, this expanding world of DeFi, crypto and Blockchains has begun to attract talent and expertise. The Stanford or MIT doctorate in computer science might be less interested in working for Google or Intel, less interested in working for Morgan Stanley or Goldman Sachs, more interested in linking up with a crypto operation.
Meme Stocks, Short Sales, and Equity Swaps
From year to year, there always appears to be a trade, transaction or deal that defines the time or period. Often in such transaction, somebody makes huge amounts of money. A counterparty or the other side loses its entire capital base and becomes insolvent overnight. The next day, it liquidates or files for bankruptcy. The financial media scrambles to describe, explain and understand the trade. Critics and pundits point fingers.
In 2021, a pheneomenon, eventually described as trading in "meme" stocks, surged. A few years ago, the phrase "meme stock" would have meant nothing. Today, it describes equity trading where values are driven up artificially based on Internet banter, often uninformed and unexplained. GameStop, the gaming company, was arguably the "meme stock" of the year.
GameStop's business model, on paper at least, appears to be something from the 1990s. Its prospects for revenue growth are suspect and uncertain. Yet random discussions gain momentum on the Internet; home-bound day-traders and basement-room analysts convince themselves the stock has intrinsic value and share their fleeting points of view in social media.
This leads to buying pressures, and the stock price takes off. On the other side exists a hedge fund that has analyzed the prospects for low growth and few profit opportunities. It decides to put on a short-sale trade to profit from the decline in share value. (It must borrow the same stock from a financial institution and then sells it at the unjustiable high price with hopes of repurchasing it later at the rationalized lower price.) The meme brigade, however, has whipped up momentum to push the price to irrational levels. The hedge fund experiences unimaginable losses and eventually has its capital wiped out.
The subplot to the GameStop tale involved the broker/dealer Robinhood, which couldn't handle the flood of volume of requested purchases of GameStop stock and which was required to halt brokering of such trades by its clearing counterparty (DTCC). The hedge-fund losses, the halt in trading in the stock, and the shut down by the broker/dealer provided many lessons to contemplate and learn in the basics of equity trading.
The other notable trade that led to hundreds of millions in trading losses revolved around ViacomCBS stock. The hedge fund Archegos accumulated outsize positions in the stock. Archegos projected an upsurge in growth at the company and decided to bet the ranch. It do so via actual purchases of the stock and via derivatives with participating trading banks ("total-return swaps"). Notwithstanding Archegos' analysis and view, ViacomCBS could be a stock where the company's growth prospects are uncertain. Its business model, for many, like GameStop, appears dated.
In early 2021, after its stock value had peaked, the ensuing plunge caused huge losses and insolvency for the fund. Yet the complexity of the derivatives also led to losses for the banks on the other side of the trades (Credit Suisse, MUFG, et.al.).
The banks' derivatives positions required Archegos to pay them the losses Archegos accrued. As its capital imploded, there were no profits to pay banks for the gains they were entitled to. Archegos owed the banks cash in billions; the banks had to report losses on the receivables due to them. For finance risk managers, this would be another lesson to address: How did the banks have that much confidence that Archegos could make these payments on losses? How could the banks have permitted the fund to accumulate these large positions (the same questions risk managers ask crisis after crisis)? (The lesson learned falls within the banking world's area of "counterparty derivatives credit risk.")
Fin-Techs
For much of the past decade, global finance has embraced financial technology in the same ways technology has wrapped itself around every other industry in the world. But early on, technology experts grasped for a role in finance. Should it be in consumer finance, lending, payments, market analysis, securities trading and settlement, and financial reporting.
The answer is all of the above, although it appears the public generally thinks apps for home lending and consumer payments when it sees references to "fin-tech."
And within fin-tech, traditional players continue to figure out their roles--as partners? As investors? As competition? As researchers and developers? The answer again is all of the above. Large banks hire as many as specialists in technology today as they do for roles in banking, research and analysis. Technology is arguably embedded in every single process, delivery of service, product development, data aggregation, financial disclosure, and financial research and analysis.
For a few years, boutique fin-tech firms believed they could supplant the role of traditional banking. In some ways, they can, but not necessarily because of their technology expertise or advantages. Often their advantages are related to less regulation and fewer capital and leverage requirements. But some fin-tech firms in some areas (including payments and lending) acknowledge they need banks as partners because they need banks' balance sheets and banks' experience in managing market and credit risks.
Fin-tech is here forever. In fact, like the Internet two decades ago, there is no longer a debate over the role and purpose of fin-tech. The latest wrinkle, obviously, involves cryptocurrencies and Blockchains.
Corporate Debt: Bonds, Loans, and Credit Spreads
In 2022, corporate debt markets might take differents turn because of expectations of interest rates will rise. That market includes bank lending, corporate bonds, private placements, mezzanine finance, convertible bonds, and high-yield debt.
Examine this from the office of the CFO, as interest rates creep upward during the year. Corporate CFOs must contemplate whether to pay down some debt or defer some offerings as rates rise. History suggests investment-grade companies tend to ease down debt levels when rates increase incrementally. For all the operating cash they generate, in a low-rate environment, they often consider stock buybacks and increases in dividend payments. With higher interest rates, the amended strategy is to consider de-leveraging the balance sheet. For banks, that could lead to lower levels of debt offerings--something debt markets have already begun to experience in the early days of 2022.
Debt activity, nonetheless, is also influenced by corporate business strategy for expansion and growth. If the company plans an acquisition or major capital expenditure, it may make more sense to finance it with more debt than new equity issuances, since, in theory, the cost of debt is almost always cheaper than the cost of equity. And CFOs, along with CEOs, are always concerned about the equity-value dilution (lower earnings-per-share metrics) when they contemplate issuing new stock.
In higher-yielding debt markets and leveraged finance, activity might be a function of other factor, too: credit spreads (investors' views of the risks of issuers) and deal-making activity. The continuing upturn in deal mergers, acquisitions, takeovers, and buy-outs influences non-investment grade debt markets. M&A transactions must be financed. Low interest rates encourage debt financing. But the possibility of improved credit ratings and credit perceptions do, too.
Deal-making surged in 2021, and signs don't show deal flow declining significantly in the periods to come.
On the investors' side, activity for many years has been spurred by buyers chasing credit spreads. With low U.S. Treasury rates, investors scout out for non-investment-grade issues (those rated BB+ and below) that deliver higher returns and appear not likely to default in the medium term.
Bond theory, for example, might suggest some BB-rated-and-below names should result in bond yields of, say, 5.0-6.00%. But in practice, fixed-income investors who won't settle for 1.5-1.6% yields from Government bonds will tolerate higher risks, assume some well-known names (Tesla, Netflix, e.g.) won't default, and will bid up bond prices or bid down credit spreads.
For much of 2021, credit spreads on non-investment grade portfolios gradually declined because investors "chase spreads" and because the worst days of the pandemic disappeared. Credit spreads for high-yield issues in late autum hovered in the 300-320 basis-points range (based on S&P and ICE BofA portfolios) had been on a steady, downward trends since Mar., 2020.
Stocks: Upward Surge or Downward Correction?
Equity markets are a constant guessing game. Who knew back in Mar., 2020 the S&P indice would rise 27% in 2021? Some even suggested it would take years for stock prices to recover after they plummeted 20%-plus in the first quarter of the pandemic in 2020.
By the end of 2021, the sentiment among many watchers was there is little chance for share values to replicate 2021 and investors should watch for sultry returns in 2022. Many said the same a year ago.
That's not to say 2021 was a smooth ride. Throughout, markets churned and fluctuated. They peaked in late summer, they dove downward in early fall, they rose and fell again in late fall, and they eased to a rising trend by yearend. (And they have choppy in the early days of Jan., 2022.) While projecting where the Dow index (or other major indices around the world) is almost a fruitless exercise, projections of intermittent volatility might be more accurate.
Financial markets, of course, have an index to track expectations of volatility, and the bravest traders try to profit from such an index (the VIX index). That index, keep in mind, is not an index of current or historical volatility, but a gauge that measures how much traders think stocks will fluctuate going forward over the ensuing year.
That index, now at about 17.0, peaked at about 30.0 in early December. Even the index that attempts to project volatility is similarly volatile. At 17.0, the VIX index implies there is 16% chance the portfolio of S&P stocks will fall about 17% in 2021. Yet the same index also implies there is a similar probability the portfolio will rise about 17%, too.
Mergers and Acquisitions
The 2021 numbers are out and tell us bankers had a feast at the deal table last year with $5.63 trillion in consummated M&A deals around the globe ($2.61 trillion in the U.S.). The familiar names led league tables (Goldman Sachs, JPMorgan Chase, et.al.). Private-equity buy-outs account for almost a fifth of global totals.
M&A activity is spurred by many factors. That might even include a company's CEO becoming so uninspired by current business strategy that the CEO initiates an acquisition at least to represent to board members and shareholders that management is doing something as markets evolve.
In the periods as the pandemic spread around the globe, corporate strategies and buy-out companies surveyed the market to see if there were bargain-basement companies up for sale. Stronger companies with predictable cash flow, not impaired too much by the recession and with mounds of cash sitting on balance sheets, explored where they could pick-up discounted companies or companies with market values damaged by pandemic confusion. Private-equity firms combed through the marketplace with similar intent.
Low interest rates also spark M&A activity. In 2020, rates declined to historical lows. Cheap debt financing makes it easy to expedite even some of the most complex takeovers. Occasionally a merger is rationalized by strategy, synergies and effective integration, but financing costs are too high or the increased leverage brings a frown to credit rating agencies.
The M&A momentum should continue in 2022, even as rates creep up as scheduled.
Investment and corporate bankers, corporate CEOs and CFOs, and even investors and traders in certain segments are all not frowing too much.
Tracy Williams
See also:
CFN: Understanding the "Fear Index," the CBOE VIX, 2018
CFN: Market Volatility: Can You Stand It? 2011
CFN: Corporate Debt: Analysis, Topics, 2021
CFN: Corporate Bankruptcy Season, 2020
CFN: Falling in Love With SPACs, 2021
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