LME week is upon us and
with our first year of trading drawing to a close, we at Arion take time to
reflect on markets and draw some conclusions about our expectations
for the year ahead.
1. The withdrawal of QE and the tightening rate cycle in the US
After a decade of monetary stimulus, western central bankers are removing themselves from the centre of discussion and nudging markets back towards what some of us would consider a normal state of the world. This has a number of spillover effects:
a. Return of Volatility - QE was a major downward force on volatility. That effect is now gone – Viva la Vol!
b. Emerging Markets - EM looks vulnerable in as capital outflows chase increasingly attractive yields in the US, and EM economies start to look shaky.
c. Risk Premia - QE pushed risk premia everywhere lower. There is now danger of a rebound across all markets - EM/Vol/Credit - Corporates look vulnerable
d. Stocks at all-time highs - With discount rates rising, the necessary growth in earnings for valuations to be sustained starts to look improbable. Fiscal stimulus to avoid this has potential inflationary impact. Either point to increased systemic volatility ahead.
2. Politics is front and centre
The world is an increasingly polarised place. After decades of increasingly centrist policy, the backlash in politics leads to a world riven by division. The current US administration, the rise of populist parties in Europe and the ‘benign’ oligarchies of the EM world create a world of highly antagonistic actors given to radical economic policy and unorthodox communication and policy making. (e.g. Twitter based Trade announcements!!). Current hot topics include:
a. Tariffs - The simmering tensions emanating from the US threaten to create great problems in world trade. The onward effects from there remain unforeseen
b. Brexit - We recently hosted a lunch with Nigel Farage as a guest. Our increasing sense of disaster was not assuaged, and we start to feel that the threat of ramifications in 2019 is high.
c. Fiscal Stimulus - Governments seem more inclined to fiscal stimulus (US tax cuts, Chinese infrastructure spending etc.). We see risks from these policies on a number of angles, not least of all as a contributing factor to inflation risk.
3. .Market Structure is untested for crisis
In the aftermath of 2008 commodity markets underwent a period of contraction as Banks closed or reduced their businesses. The withdrawal and/or reduction of activity from those institutions in the light of Basel III and Dodd-Frank has changed the market on a seemingly permanent basis.
a. Juniorisation - Traders now in charge of most bank trading books were not in the market in 2008. That means we have a generation of risk runners and market makers who are inexperienced in truly high volatility markets. This is dangerous unknown ground.
b. Risk Warehousing - Risk warehousing capacity in markets has diminished; leading to jumpy stochastic pricing. This increased stochasticity adds an exponential factor to volatility events that was not present previously. (this is not a solely commodity market phenomenon but one we see as being common to all markets e.g. VIX in Feb, EM in summer)
c. Flows - Flows are at elevated levels as risk parity/CTAs and other products become forced into ever larger size to maintain returns profiles. We are in a period of unwind for this, but it exacerbates the problems found around risk warehousing.
We don’t see an immediate catalyst to change market trajectory, but risk factors point towards a rising probability of a significant risk-off event. Whilst we do not anticipate a 2008 scale meltdown, market structure seems fragile and unable to cope with significant risk events, as the number of violent (mostly technically driven) market moves has increased.
Be it an emerging market default or full-blown trade war, depth of book liquidity is simply not there, and the risk of a rapid spiraling market move has increased.
In commodities the era of buy and hold is seemingly at an end and so we look for opportunities and risk structures that give us longevity in holding period and are broadly market neutral whilst we wait for more opportunity rich markets. Markets that are now beginning to unfold.
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About Arion: Arion is a commodity focused investment adviser and manager with offices in London. Arion is authorised and regulated by the FCA (registered no. 742037), is registered with the U.S. Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator and Commodity Trading Adviser and is a member of the National Futures Association (NFA).