Since before the Brexit vote in June last year, politics has become a more important force in the day to day life of financial markets. In theory, the political events that are known offer up significant tail risk for financial markets, and yet this is barely reflected in current market pricing. Despite our bearish long term structural thesis on risk assets, we doubt that the day of reckoning is upon us immediately (famous last words!). There are, however, some interesting little sub-plots to consider.
First, we want to delve into the somewhat murky world of the oil markets. Oil is the most heavily traded commodity and the most politically important and price action has been very interesting in recent weeks/months.
Chart 1 below shows the price action for the current US WTI Oil contract (June 2017). We have highlighted the bullish factors helping price higher late last year and then highlighted a sharp price decline in early March and again in the last few days. What is also interesting (although not highlighted) is that the recent rally from a low near $48 seems to have failed at $54 which is the lower boundary of the range that existed for most of the December to February period. We view the recent failure at $54 as potentially very significant, and ushering in a more bearish phase for the oil price.
Chart 1 – US Oil Price (June 2017 WTI Contract)
Being so important, both politically and for financial markets, there are strong competing interests in the oil market. Expectations are reasonably high that OPEC will soon announce that they intend to extend the production cuts they announced late last year. They basically have no choice and will hope to encourage the large Non OPEC countries join in. Will this be enough to stabilise price and bring about a better balance in supply and demand?
With demand expected to rise longer term, it is really only a matter of time until the market is balanced, however that does not guarantee price stability in the short term. Chart 2 shows the positioning data for speculative traders via the Commitment of Traders report. Looking at recent developments, speculative traders fully embraced the Trump reflation narrative, a position that made perfect sense when combined with the first OPEC production cut in 8 years. By the end of February, net long positions were at a record high by some margin; higher than in mid 2014 when the price of oil was above $100.
Despite the huge conviction bet made by hedge funds post Trump and the OPEC production cut, price was struggling to make headway as US production rose as Shale production came back with a vengeance. The two recent periods if price declines, together with the price failure at $54 (the low end of previous price support), indicates to us that hedge funds are at risk of being caught on the wrong side of the market. With the best will in the World, OPEC and Non OPEC production cuts are barely making a dent in bloated stockpiles and there is a significant risk that price needs to correct further as the market rebalances, and further price declines would surely lead to bullish hedge funds capitulating, forcing price lower quite quickly.
Chart 2 – US Oil Price with Speculative Net Positioning
With OPEC jawboning likely to increase in the weeks ahead, price may not go straight down even if the bearish thesis comes true. But without more hard work on the part of OPEC to balance the market and reduce stockpiles, price remains vulnerable to hedge funds capitulating on their bullish bets.
Now oil is by no means the only important economic and financial market variable, but it can be important in its own right. Chart 3 below shows the price of oil alongside US inflation expectations.
Chart 3 – US Oil and US inflation expectations
Central banks have been working overtime to move markets away from the deflationary mindsight that was at risk of taking hold in Q1 2016 and back towards steady inflation around the 2% mark. There is very little they can do to influence the price of oil, but we are pretty certain that they will not want to see inflation expectations continue the downtrend that seems to be emerging in the wake of the recent oil price declines.
Next week sees the latest meetings for the European Central Bank and Bank of Japan. These guys are providing the vast majority of liquidity that is continuing to flood the system as well as holding interest rates in negative territory. The game is delicately balanced and neither will announce any substantive changes to policy next week. Longer term, both are hoping to tip toe away from the extreme monetary accommodation they are currently providing, and yet both are at risk of missing their 2% inflation targets. If the price of oil does decline in the months ahead, the ECB and BoJ will have a very tricky time maintaining a steady path for all.
Ahead of these important central bank meetings, we will also have the result of the first round of the French Presidential election. Polls indicate a tight four way race, but then again, polling may not mean much in the end. We suspect that the worst case scenario (a second round run-off between Le Pen and Melenchon) will be avoided, but we are not taking any risks with our clients’ money on this. We are firmly on the side lines going into the weekend.
Even if we assume that the French election ends up being a non-event (a win for either Macron or Fillon in the second round), we suspect that Mario Draghi will be loath to take any risks ahead of the German elections in the Autumn. If we are right on the bearish oil thesis, he will delay any further reduction in monthly asset purchases until Q4. On Friday, the following Draghi headlines were carried by Bloomberg;
*EURO AREA GROWTH RISKS REMAIN TO THE DOWNSIDE
*VERY SUBSTANTIAL DEGREE OF ACCOMMODATION STILL NEEDED
*NO CONVINCING UPWARD TREND IN UNDERLYING INFLATION
*NOT ENOUGH CONFIDENCE THAT INFLATION PICK-UP IS DURABLE
The day before, Bank of Japan Governor Kuroda was interviewed on Bloomberg TV, which carried the following headlines;
*CURRENT PACE OF PURCHASES TO CONTINUE FOR SOME TIME
*DON’T SEE ANY CONSTRAINTS TO BOJ POLICY
Reading these headlines, we are reasonably comfortable with our view that we should expect modest changes at best from these guys in the months ahead. And this means that the collective global central bank balance sheet will continue to rise, albeit maybe not quite as quickly. Chart 4 shows the combined balance sheets of the Fed, ECB, BoE, BoJ and SNB (chart courtesy of BoAML). As indicated by BoAML, collectively these central banks have bought US$1 trillion in assets in 2017. Seriously, $1 trillion in three months – this is faster than at any time ever in history; ever, including in 2008 when the financial system was on the verge of collapse. This pace of balance sheet enlargement cannot continue as it has in the first quarter of this year, and is due to slow quite quickly later this year.
Chart 4 – Major developed country central bank balance sheets
It is no surprise that, with this continuing extraordinary market intervention (and let’s not forget that cash holders will be penalised with near zero or even negative rates of interest), equity markets refuse to go down despite continuing disappointment on nearly every front. Chart 5 below is indicative of the continuing levitation in equity markets. The chart compares the performance of US equities with US breakeven inflation rates and the oil price since just before the US election late last year.
What we see here is that, having ignored the oil price decline in early march, US yields (measured in various ways but shown here by the 5 year breakeven inflation rate) woke up and reacted to the decline last week. The forces holding up equity markets are currently powerful enough to overcome nearly every other indicator we are watching.
Chart 5 – US equities alongside 5 year breakeven inflation rate and the oil price
And it’s not just price based indicators (such as the oil price and bond markets) that equities are ignoring. They have ignored the fact that US economic indicators have begun to miss expectations as measured by the Citigroup economic surprise index (Chart 6).
Chart 6 – US equity market and the Citigroup Economic Surprise Index
The confidence displayed by equity investors is quite staggering considering just how expensive US equities are. We came across a little table from Goldman Sachs this week. In simple terms, the aggregate measure for the S&P 500 shows valuation to be in the 89th percentile. For the median stock, we are currently seeing price in the 99th percentile. Just what is that equity investors are seeing that makes them comfortable buying/holding at these valuation levels when so many indicators are flashing warning signals and geopolitical risks are rising?
Chart 7 – US equity market valuation table
So as we sit here surveying the investment, political and economic landscape, we see a relatively calm veneer which belies the underlying vulnerabilities that we believe is evident. We think we know how to explain the staggering complacency shown in market pricing. Simply put, the markets have not been allowed to find their own clearing prices. Central bank QE and ZIRP/NIRP policies have distorted price in recent years. This distortion has been aggravated by two further price insensitive buyers, namely companies buying back their own shares and ETFs buying to match record inflows.
We have to suspect that when the influence of central banks, corporate buy backs and ETFs begins to wane, then markets will be left to find their own clearing price, and that seems to be happening at the outer edge of the global system. For example, the activities of these three groups will have less influence in the commodity markets, where even with the huge political interference in the oil markets, prices appear to be heading lower.
We don’t know when market pricing will normalise, but we strongly suspect that it will happen quite violently and will hurt a huge number of investors. We think the odds of something happening later this year are much higher than many currently suspect. We have the Fed seemingly intent on continuing with rate rises and starting the balance sheet reduction process by year end. We wonder whether Draghi simply wants to get past the German elections in October before removing some more accommodation. We wonder whether the Chinese will allow some volatility after the 19th party congress in October.
So although we can envisage a benign outcome to the French (and British) elections in the weeks ahead, we see huge risks in the latter part of this year. We are managing our portfolios on a tactical basis at the moment which allows us to be flexible in trying to navigate the potential swings and roundabouts that may come with the short term political and economic inputs we see. However, we are keeping an eye on the big picture too that we believe could come to the fore much quicker than many believe possible. We have shown many times in recent months how both bond and equity investors will not be rewarded in the years ahead. We strongly believe that investors should be considering diversifying opportunities into macro/trading strategies where risk can be tightly managed and rewards can come through positioning for an environment where markets are one again allowed to find their own natural clearing prices.
Stewart Richardson
RMG Wealth Management
