Market fault lines exposed by oil shock
Published on: March 10, 2020 • Duration: 16 minutes
This week we look at the incredible moves in global asset prices which suggest that the oil shock has revealed the weaknesses that have been building up across financial markets. Has the double blow of coronavirus and the oil price collapse now worked its way through the system or have they exposed the fault lines that were festering beneath the surface?
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[00:00:04] Events in the oil market have added yet more volatility to assets that were already reeling from the effects of coronavirus. There's gonna be a lot of knock on effects. Some of them are going to be in currencies, some of them are going to be in other commodities. In today's big conversation, we’re going to look at some of these and try and work out where we think markets may be going from here. This is clearly an incredible time in global financial markets. Last week we talked about a lot of key levels that we thought were must hold levels and in one week only we'd blown through most of those and far beyond them. I think what the coronavirus and this this battle within the oil market is really revealed is just how fragile the underlying market has been and continues to be. And last week we talked about how we expect the Fed to cut by 50 basis points. It was priced into the market. But how that would not be enough, what they needed to do was proper QE and potentially fiscal and further fiscal is the thing that we've been really focussing on for quite a while. Well, they did come with that 50 basis points of cuts. It had almost no impact on the market. Markets clearly rolled over from there. They actually did expand their balance sheets. If you look at the Fed's balance sheet, I think middle of last week, there's quite a big uptick. So they were increasing that kind of repo operation. It did have a minor impact. But once again, as we can see today, it needs a lot more than that, not just from the Fed, but from all central banks. And one of the reasons behind this being an issue is that the framework is is currently very, very weak. We've already seen corporate profits stagnating and these robes are being ploughed into things like buybacks or buybacks are going to struggle. Yes, yields are falling to the cost of capital might be falling as well. But in this environment, people are just gonna step away. And when you look at things like smart beta rules based funds, they often use as one of the major inputs, things like volatility realized volatility, which is actual volatility in the market. Often it's a three month number that they use. Well, those levels are probably beyond the trigger point where they are sellers rather than buyers of the market. So many smart beta rules-based funds will be sellers rather than buyers of the market in this juncture. So that's another problem that we've got. And obviously just incredible volatility that we've seen is going to mean that many players who had some very solid, large positions in the market where they're going to be carried out, they're gonna be forced to close positions. In fact, on Friday, when we had that very late surge on the S&P, it looked like it might have been somebody being taken out of the market. We saw a very, very large spike in the VIX and then it suddenly collapsed into the close as markets rallied. Well, today, obviously, volatility is much, much higher. So the overall framework remains very, very fragile. Now we're going to look at two. I'm going to just look at some of the big moves, some of the big asset prices. The big one, obviously, was oil. And we've been highlighting the key support level around 42.50 for the last two or three weeks. It broke through that 30 percent decline has a knock on effect into many other kind of energy commodities as well. But obviously, one of big areas that's a problem is that the highly levered US oil shale patch, which is so dependent on at least a really stable and preferably slightly higher oil price, well, that is now going to come under a lot of pressure. One of the biggest sectors of the high yield market in the US is high yield energy that comes under pressure. It could start to undermine that massive amount of low grade, either junk grade or low end of the investment grade corporate bond market, which is one of those sort of ticking bombs that's never found the detonator. But perhaps this could be it. So the oil price in itself is a negative, but it's what it's going to do to the high yield market, corporate bond market. That's perhaps the knock on effect we have to worry about. I think something else within oil as well as that, often with oil prices falling, people say, well, that's great for discretionary expenditure. It is. But this sort of speed of move that we've seen is such that the impact it will have on things like CapEx. So us CapEx, the whole the sort of CapEx cycle in the biggest areas has been the industrial sector around the oil price, oil price and oil shale. That's going to come under a lot of pressures and CapEx is going to decline. It's going to be the sort of earnings recession that we saw when the oil price fell dramatically in 2014 2015. We also mentioned last week copper. Now copper’s testing but hasn't really broken below its key level of 250, at least not when we filmed this around lunchtime U.K. time on Monday. But if it does and I think it will, it's a very similar chart to oil that's going to put even more pressure on all the global miners. So I think that copper and other commodities are going to fall not as dramatically as oil, but they have a lot of potential downside from here. Maybe the one bright spot is, is gold. Gold did see some liquidation on Friday of last week. Some margin calls are still an issue. Gold should be going up with real yields collapsing like they are. But even though real yields have collapsed, people who've made losses elsewhere across their portfolio will still need to lock in some profits of their winners. Gold has been a winner, therefore, like today, when real yields have fallen dramatically. Gold is sort of struggling. It's slightly up, slightly down its probably a battle between people wanting to lock in profits, but also people wanting to go long given what's going on in the market. So commodities is obviously the epicentre of what's going on. But let's look at the other markets. Let's look at currencies. Let's look at equities. I think when we look at currency markets, firstly, what we talked about last week was this bifurcated world between dollar against emerging market and commodities versus those safe haven plays. And when we say safe haven is often repatriation of capital. Well, who were all markets where money was flowing out from Europe, from Japan, from Switzerland, part of Europe into other markets where they could get a better yield? And then when things start to behave badly, they repatriate the capital. And sure enough, over the last week, we've seen a lot of strength in yen, particularly in yen. We've seen it in euro. We've seen it in the Swiss. The Japanese will be very worried. The Japanese authorities, 105 is a big level that got broken. 100 is the big psychological level. The Bank of Japan doesn't really wanted to go through there, but that's the risk. So yen still showing the safe haven type of performance. And yet on the other side of that, so the DXY is made up of those safe haven currencies? The dollar looks like it's on the backfoot. But this morning we've seen an almost 2 percent gain versus the broad based emerging market FX index, which is dollar versus other currencies. We've obviously seen the oil commodity currencies falling dramatically. So we've seen ruble and Norwegian kroner. We saw an early set of weakness across the other commodity currencies such as Aussie dollar, New Zealand dollar, South African rand. They've regained a little bit of poise, but they still look like they will suffering. If commodities such as copper break, then that's going to happen as well. And one thing we mentioned last week is Aussie dollar yen. On the downside, yen, safe haven, Aussie dollar looks like it's under pressure. So I'd stick with those. We've also had dramatic moves and we should expect volatility in both directions. But if this framework is under pressure, then that should still happen. One dramatic currency today, Mexican peso that moved seven percent down versus the dollar. So it does indicate that if you look at the euro, you think the dollar's weak. But if you look at emerging market currencies, the dollar is strong. And yields? I mean, what can we say about yields that’s not been said already? It's been an incredible move, a most fantastic move where we were targeting 1 percent on the U.S. 10 year. We talked about on one of our program, zero on the U.S. 10 year. We got to 31 basis points on Monday morning. If you look at U.S. yields on a log chart, you can see just how incredibly dramatic this move lower is. And what's more, what we're seeing here is that the yield curve has been flattening as well. And the reason behind that is we expect more rate cuts at the front end. But there's a limit to what they can do, where near the zero bound and rates will be locked probably in the U.S. somewhere 25 basis points. Maybe they'll get to zero at the back end is free to move and it will potentially go into negative territory. So the yield curve, which initially steepened on the rate cut has been flattening. It's a long and has moved the most dramatically in Europe. There is also another dynamic at play, which is this difference between periphery and the core. Bund yields have fallen, Italian yields have been rising. There is obviously a corona virus issue going on in Italy. But what we've seen within Europe and we've been talking about this ad infinitum and you can see it through the banks, the eurozone banks today, they broke through their all time lows. They were down 10 percent at one point. It reflects the fact that structural problems persist in Europe. It's these problems persist. It's not just about coronavirus. The core yields are falling. That's the Bund. But BTP, these are rising and we can see specifically through these banks. But the problems for Europe are there. This needs a fiscal response as well as a monetary response. It needs governments to support their markets and their banks. So the yields have been moving quite dramatically. One thing to also watch for something that's only really happened in the last two days is what's called FRA OIS. The forward rate agreements vs. the overnight index swaps. So FRA OAS has moved dramatically higher. One point on Monday, it was the highest level since 2011. This is effectively the difference between borrowing. It's sort of Fed funds, so from the government versus LIBOR. So banks lending to each other when it widens out as it has been doing, it shows us there is tensions in the system. We are higher than we were during the repo issues at the end of last year. So we can see that in the far away spread that there is more than just a bond market move going on. There's funding move that's going on as well. Hence, the Fed is going to have to keep on with its repo operations. So I think within that bond market, have we reached the bottom in terms of yields? Clearly, we might be getting close in absolute terms, but will we get a massive rebound? Will it rebound to 2 percent in the next year? It's unlikely we'll pretty find ourselves locked towards a sort of zero level on the U.S. 10 year and clearly below there in Europe, even if the ECB does come out and cut 10 basis points this week, it's not really going to have a material impact. So now we go on to equities. Equities have been moving down 10 percent in certain sectors. Some of the bonds that have moved are the ones we thought would have a big downside move last week. So European basic resources have broken their very big support level. They were down over 10 percent at one point this morning. The European banks, they were down over 10 percent as mentioned earlier. That's the bit that really worries me because is that the structural story in Europe that's starting to implode and needs that fiscal support. Oil stocks, as you can imagine, they've moved the most. And in fact, the European oil and services sector, the SXEP, is at the lowest level at one point today since 1996. So these are incredible moves in many senses. Banks and oil stocks much worse than the eurozone crisis, much worse than the crisis of 2008. In terms of where to look? Well, in some ways, the best performing stocks overnight were in Asia. And I guess that's because Asia was the first to experience the big issues coming out of the coronavirus. But also those those markets where they are maybe importers of oil. So importers of oil will seek benefit over the medium to long term if they can lock these prices in. Then they're maybe not seeing the same sort of downside as other markets, which are either leveraged into that industrial complex, a lot of which is playing the oil sector itself, or they are oil and commodity exporters as countries which are therefore under the in the dark firing line. The one sector which I think is is attractive here is the gold miners. Obviously, if you think gold's going up, gold miners should go up as well. Gold miners have a high volatility. They are an equity. So if equities fall, there will be pressure on them. But overall, with lower oil prices, again, if they can lock the oil prices in oil, a big component of what they do and we expect to the gold price to rally from here, then those gold miners, those small cap gold miners look very attractive from these sorts of levels. But overall, the equity market, I think it's still going to find its feet. Something I mentioned last week is we've not seen the Nasdaq, which was the leader of the last 12 months, underperformed the broad markets. The place where everyone is hiding is still outperforming. And we saw people add to their Nasdaq positions, thinking here of the QQQs, the ETF last week, people added to that position. These sorts of positions need to unwind before we see the sort of short to intermediate term bottom that we can trade on a one to two week or maybe one to two day view. There’s lots of volatility. I'm watching for the vol of vol VVIX to see if this is becoming much more of a structural problem. So what are the sort of things that we should be looking for here was maybe the game plan? And where do we think asset prices will go? It's too early to say where oil is going to go. We looked last week potentially hitting $28 on WTI. Well, we've already got there. A lot of analysts are suggesting we'll hit $20 and $20 is the sort of lows we saw in 2008. And I think that's perfectly reasonable as we see this fallout continue. I think the other area that we've got to look at is, is the copper, as mentioned before, copper is one way. I think there's still some value on the short side. If this is becoming the true bust that we might expect focussed on those currency commodities, they're the ones at risk. And I think Aussie dollar, which has bounced on Monday morning, Aussie dollar still looks very, very vulnerable. We may have already had some of the move. That's the best move in the oil commodity currencies. The other commodity currencies still look attractive. So I'd still be playing those from the short side. And I think yen needs to to test that 100 level to force the hand of the Bank of Japan. In terms of equities, defensive equities, well, this is not really about being defensive equities because we're seeing a correlation event going through the market. Yes, the lower beta sectors will perform slightly better. But we saw a couple of times last week where the whole of the market moved 4 to 5 percent and it didn't really matter which sector was which. I'm looking at that vol of vol. I'm hoping it doesn't explode higher, but if it does, then I think we get another leg lower. Bonds probably have some more upside. I think that the yield curve will flatten a little bit more. Yet fiscal, which we hope will come into the market - fiscal takes a long time. This is where governments do the actual expenditures. For fiscal to come through, they need to announce it. They need to do it. It's not like just cutting interest rates or sticking some liquidity in overnight. So the fiscal will eventually allow yields to to rise. But that's not the story for this week or next week, even though there might be a reaction to the announcement. So in terms of game plan, one thing that I'm looking for is whether we get a potential low into the quarterly expiry. These happen in March, June, September and December. When the big options in Europe and the US expire, often you get these periods of volatility into and out of those expiries. I remember Bear Stearns went under in 2008. That was March 2008. Lehman accelerated the market to the downside through the incident in 2008 September, although the market sold off for about a month and a half more after that. And even at the end of 2018, we saw the low the day after the December expiry that was on, I think the 21st. And then the low was on Christmas Eve on the 24th. It's not a hard and fast rule, but if you're trying to plan, work out where this sort of volatile period could end end up or where it could go to, then the next 10 days could be that sort of low that we can effectively trade in a short term basis. But in reality, I think it's pick a couple of hours. Look at that FRA OIS spread, look at vol of vol. And we're gonna be doing lots of updates over the next next couple of weeks. We'll hopefully keep flash updates going like we did on Friday just to see whether any of these are starting to hit our targets, whether things are in fact getting worse, and where the central banks are coming back with the sort of liquidity which added to fiscal can perhaps help markets find a decent low or least a decent base from which certain sectors, the defensive ones curtly start to rise and give an indication that maybe for the market, the worst of it is now behind us.