Most market commentary tells us what happened. Stocks went up, oil went up, emerging markets rallied, energy stocks jumped, and yields went down. That’s the what. Even the narratives meant to explain why these things happened, are more often just the “what” rearranged. Energy stocks and emerging markets rallied on the back of a rally in oil. Although most analysis ignores the why, it is the why that truly matters. If you don’t understand the why, and instead focus solely on the markers, you won’t recognize when those markers represent something new. I prefer to focus on the why. In this edition, I will focus on why even if higher oil is in the cards (I don’t believe it is), it is not bullish for emerging markets or risk assets in general, BUT that doesn’t necessarily mean the S&P is in danger.
I wrote a Macro Radar piece back in January 2015, where I challenged the perception that markets were behaving irrationally. It’s a discussion that I’ve had with market participants off and on for the last 6 years. When the correlations they believe in hold true, like we’ve been seeing for the last couple of months, then the market is seen as behaving “rationally”. Then when they shift, it creates confusion, losses, and cries of irrational behavior.
The problem isn’t that markets don’t make sense or that they are ignoring macro fundamentals, it is that drivers have changed. The way we define entire asset classes should have been adjusted back in 2010, along with our correlation expectations among them. It is the very definition of terms like “risk on” or the “Dollar trade” that is causing so must pain and consternation. If you are unwilling to accept that, markets will have appeared irrational for much of the last 6 years, with intermittent bouts of sanity. However, those bouts of sanity were merely moments when old correlations, the ones you are holding on to, happened to have held true. Just because a clock is only right twice a day, doesn’t mean every other time piece is wrong the rest of the time.
Let’s go back to the most important factor of all, the historic Chinese urbanization and industrialization that began in 1996. Although, in notional terms it continues on a grand scale today, its impact disappeared in 2009/2010. It affected every market and everyone, both at the onset and again when its impact disappeared. Let’s begin with commodities. I won’t go into the details here, because you can find them in The Real Reason Commodities Collapsed. However, it’s important to note one particular phenomenon that was unique to that period.
Traditionally, demand for commodities is fairly steady. Instead it is the supply side that typically leads to the wild price swings. Think droughts for crops and OPEC manipulation for oil. Here is the significance of that. When supply drives prices, lower volume leads to higher prices, and vice versa. That means there is a negative correlation between price and volume. However, since China began driving year-on-year global demand higher, volume and price have been positively correlated. So, when the price of oil went up, since it was a function of demand going up, volume was going up too. Companies that rely on volume to generate earnings, like Oneok, would rally whenever the price of oil rallied, and it made sense. Oddly, it still happens, but it shouldn’t, and neither should emerging markets.
As I’ve stated numerous times, the impact on commodities from the historic, one-time event of Chinese urbanization is over. It will not return. Ever. Therefore, everything that we’ve come to accept about commodities as a given, based solely on that unique period, must be revised back to historic terms. That period was an outlier, not the norm. If you believe in reversion to the mean, this is important, because the 1996-2010 mean is very different from the true long run mean, and that includes correlations. This is particularly significant at this very moment.
The recent rally in oil is driven not by an increase in demand, but by a potential reduction in supply. This is a radical departure from what had been the case for the entire professional experience of so many investment managers and traders. So they should be forgiven for mistakenly believing that the rally in oil should be seen as a positive for emerging markets and other risk assets. After all, higher oil has long been a signal of stronger demand. It no longer is. Emerging markets don’t need higher oil prices, they need greater demand. Higher oil driven solely by supply side manipulation is a tax on demand. Therefore it is a negative for emerging markets, risk assets and global growth. It breeds greater uncertainty, which encourages even more risk aversion.
Now, let’s return to a point I have been harping on for years. The S&P 500 is not a risk asset like the Bovespa is a risk asset. The US Dollar versus Japanese Yen or Euro is not the same as the US Dollar versus Brazilian Real or Malaysian Ringgit. Yes, during the 1996-2010 period, they were incredibly correlated, because the drivers were directly related. However, that is no longer the case. Just as the price and volume correlation has broken down in commodities, so too has it broken down between the S&P 500 and emerging markets, and US interest rates as a function of the US Dollar versus all currencies. See My View Without Obstruction for a few charts that make the case for treating the S&P 500 differently than emerging markets and other equity indices. The following charts were shared with me by a client after I again made the case that US equities should be seen as an extension of the US Treasury market.
WTI Discount vs Cushing Stocks
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Here is the bottom line. What has been moving markets and economies for the last six years is likely to continue. The only things I see disrupting this trend are war or extreme wealth redistribution through taxation. That means that what has been working for the last six years is likely to continue working. However, if you keep misreading the price action, you will continue to have moments in which you feel like you are finally seeing things clearly again, only to be blindsided by a move that “doesn’t make sense” again. It’s time to recalibrate.
Return of the WTI Discount? In case you haven’t noticed, the ending stocks of crude oil in Cushing, OK have soared. A couple of years ago, I played for the collapse of the WTI discount relative to Brent because the stocks had plummeted. However, given that the stocks are now deep in all-time high territory and the only potential driver for higher oil prices is an OPEC driven supply side shock, it’s worth taking a look at the spread again. Not for a further reduction in the spread, but for it to potentially blow out again. If OPEC does decide to reduce supply, thereby driving prices higher, it’s very likely US producers will attempt to capitalize on it by becoming the world’s marginal producer. If they do so, it should serve to push those stocks even higher. If they have no release valve (they can’t export those stocks), the WTI vs Brent spread could explode once again.
One caveat worth mentioning. I don’t believe an agreement will reduce supply, and I don’t see oil rallying much beyond here even if it does. My view is that oil will remain in the $30-45 range for a long time to come. However, the spread may offer an attractive risk/reward opportunity for those who share my core view on oil.
Global Macroeconomic Cheat Sheet I published the following Global Macro Cheat Sheet back in January of 2015 and am republishing it again here because it remains relevant and potentially helpful...
“There is a coherent, consistent explanation for why markets are moving, policymakers are deciding and fundamentals are playing out as they are. Below is my global macro cheat sheet, which I reference any time I read a CB statement, witness a major move in markets, listen to an analyst speak, take on a position and await the release of new data. The implications of each and every item on the list are far reaching and likely to remain with us for years to come. I have written about these items repeatedly and will continue to do so until they are no longer valid. If you’re not thinking about these things regularly and understanding their direct impact on the ramifications of policy decisions, the economy, feedback loops and market psychology, I would wager you’re either underperforming your views or getting lucky.
The financial crisis did not destroy private wealth.
Wealth disparity is nearing historic highs and economic analysis needs to adjust for the impact of the shift in marginal utility. Government intervention is the only thing that can change its course.
Monetary policy is impotent with regard to the real economy. It merely affects shifts between financial instruments.
The impact of China’s monumental urbanization project, which began in 1996, ended, by pure coincidence, in the midst of the financial crisis.
Technology is moving ever more rapidly up the cognitive value chain.
Fiscal policy is the only thing that can affect the real economy, and the only thing that can drive yields and inflation higher.
Economies and markets are now global.
Policymakers are people.
In this list you will find the answers to all of your questions. Why have commodities collapsed and how long will they stay down here? Why is it that unemployment is likely to continue to fall without triggering wage inflation? How is it that some assets have become hyper sensitive to interest rate adjustments, yet carry isn’t a factor further out on the risk curve? How can prices be so tight, yet untradable? Can the US economy find its legs if the rest of the world is teetering on the brink of failure? Why has the cost of a college education been increasing at several multiples of the overall inflation rate? Why is deflation more likely than inflation, and why doesn’t it matter? What will trigger the US Dollar free-fall? Why is competitive devaluation a fool’s game, and why will protectionism escalate? Why are tech companies sitting on so much cash?”
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.